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Source link: http://archive.mises.org/8194/taking-money-back/

Taking Money Back

June 13, 2008 by

To save our economy from destruction, wrote Murray Rothbard, and from the eventual holocaust of runaway inflation, we the people must take the money-supply function back from the government. Money is far too important to be left in the hands of bankers and of Establishment economists and financiers. To accomplish this goal, money must be returned to the market economy, with all monetary functions performed within the structure of the rights of private property and of the free-market economy.

FULL ARTICLE

{ 128 comments }

Person June 17, 2008 at 2:19 pm

Mike_Sproul: If GM kept issuing new shares, and used the proceeds to buy frivolities, like gold statues of the executives, I would say, “Hey, GM is devaluing its shares.” And I’d be right (though the effect could be blurred if somehow other forces propped up GM’s profitability).

Similarly, if the Fed kept issuing new dollars, and blowing the proceeds on giveaways (like it does), I would say, “Hey, the Fed is devaluing the US Dollar.” And I’d be right (though the effect would get blurred).

And the Austrians here would say the same thing. And they would be right. So again, why keep arguing about all the conditions under which the Fed “could” print money while not devaluing the dollar, conditions which don’t actually apply today?

Joe Stoutenburg June 17, 2008 at 2:54 pm

Mike, you either ignored or missed my post dated June 17, 2008 8:42 AM (understandable while you’re engaging at least half a dozen people at once). I’m still interested in a return comment if you’re willing – especially regarding my questions at its end.

Joe Stoutenburg June 17, 2008 at 3:20 pm

Mike, I have to challenge your first statement:

When the christmas season hits, people need more cash to conduct the extra business.

I can conceive of situations when notes would become so scarce as to hinder transactions from a practical standpoint. To illustrate, suppose for example that we have an economy with a minimum denomination of one dollar. Suppose further that the economy has grown to the point at which the typical household only has a handful of dollars but makes scores of transactions a month. Clearly, there are not enough dollars in circulation.

Fortunately, suitable candidates for money are divisible (even the farm IOU is divisible to a point though the division would be messy and highly subjective). You could break the dollars down to pennies or even smaller units. There would be practical limits to which the division could occur, and an adjustment to the monetary system would be required (such as changing the commodity backing, introducing another one or some other innovation). However, these limits would be entirely independent of any boom/bust seasonal factors.

Even though your first statement kind of loses me on the rest, I will further challenge your closing statement:

(Quantity theorists) did not see that if the money supply were doubled, and the assets backing it were also doubled, there would be no change in the value of the dollar, but the extra cash would make it easier to do business.

I went along with you fine when you put a farm up as backing for money. It’s a real, tangible asset. I can go along with financial assets as long as they are eventually backed by real assets. But you’ve lost me again there. How exactly do you double assets without making money appear out of thin air? And if money is a claim to real assets but is not backed by real assets, then won’t the first receivers of this new money have just received a windfall at the expense of later receivers?

fundamentalist June 17, 2008 at 4:17 pm

Mike: “Think of a hot dog vendor.”

Ah, but the hot dog vendor must supply his customers out of his savings or borrow the savings of others. In order to have the hot dogs that customers will want when they want them, the vendor must save some of his sales revenue, or borrow the savings of someone else, and purchase the hot dogs to sell. If hot dog vendors could create weiners and bread out of thin air, I’m sure they would love it.

If banks were limited to lending only the savings of depositors, that is, required to keep 100% reserves, then they would be like the hot dog vendor. Banks could make available for loan only the money that others had deposited, but could not create money out of thin air. In that case they would be free to make loans available when customers want them, but no more than what other customers had deposited from real savings.

Banks differ from other types of businesses only in the fact that banks can create their product, money, ex nihilo. Everyone else on the planet has to save, or borrow other people’s savings, and buy the needed inputs. Banks don’t under RBD, which is a fancy name for fractional reserve banking.

Mike: “Or should he follow the Austrian ‘countercyclical’ policy of cooking hot dogs when nobody wants them, and then refusing to cook enough to accommodate the lunchtime rush?”

So you acknowledge that the money supply under RBD/mainstream econ makes booms and busts worse by being pro-cyclical, that is, giving a loan to everyone who wants one during the boom while making sure that no one who wants a loan during the bust can get one.

Mike: “That’s what a bank would be doing if it tightened its issue of money during booms, and eased during busts.”

That’s not what Austrians advocate. They advocate letting the market determine interest rates. In the ABCT, a boom (as opposed to steady growth) would happen only if savings increased rapidly. If some event caused an increase in demand for loans, the interest rate would rise naturally. If savings increased relative to demand for loans, interest rates would naturally fall; banks wouldn’t manipulate the interest rate.

The whole point of the ABCT is that capital goods are scarce and take time to make. If banks finance growth through loans from savings, then no mismatch between demand for and supply of capital goods will take place. But if you try to boost growth artificially by creating money out of thin air, as under the RBD, you destroy the balance between supply/demand of capital goods by creating excessive demand and the short-lived booms busts.

fundamentalist June 17, 2008 at 4:21 pm

Joe: “I can conceive of situations when notes would become so scarce as to hinder transactions from a practical standpoint.”

Actually, that’s not very likely. If money becomes scarce, prices don’t stay the same. Scarce money means money is more valuable. More valuable money becomes evident through falling prices. Within a short time prices would fall to a level that matches the new, higher value of money so that the money available will be totally sufficient to allow all of the transactions that people want.

Alex June 17, 2008 at 5:46 pm

Mike Sproul:

Mike, you say: “Alex: When money is issued for assets of inadequate value (like Mugabe’s IOU) then the money will lose value. It might help to ask yourself what would happen if the fed issued money passively, rather than on its own initiative. Some citizen wants cash, and has a $100,000 T-bill. He takes the T-bill to the fed, which pays him $100,000 cash for it. (If the economy were already flush with cash, he would have gotten the cash on the open market, rather than going to the fed.) That way, money is only issued when the economy has a need for it. Since the fed does, in fact, try to issue the ‘right’ amount of money, this voluntary issue is a better way to understand money than those ‘forced’ scenarios you describe.”

Mike, in the “passive” case that you mention. If the public’s demand for money increases by $100 and the Fed increases the money supply by $100, there would be no spending increase resulting from the Fed’s actions, nor would the Fed’s actions cause an observed increase in the price level for goods and services. (Though spending and the price level will still be higher than they would have been had the Fed not increased the money supply to meet the $100 in increased money demand.)

My “forced” examples simply make it easier to see that when the Fed causes the supply of money to increase faster than the demand for money, there will be increased spending on assets and goods and services, and a general increase in goods and services’ prices.

Again I ask you to explain what you think happens to prevent spending and price level increases when a central bank increases the supply of money at a faster rate than the demand for money is increasing. Surely you believe this happens all the time, in other words, that over and over again central banks expand the money supply in a (to use your terminology) non-passive manner.

Mike Sproul June 17, 2008 at 8:08 pm

Person:
“if the Fed kept issuing new dollars, and blowing the proceeds on giveaways (like it does), I would say, “Hey, the Fed is devaluing the US Dollar.” And I’d be right (though the effect would get blurred).

And the Austrians here would say the same thing. ”

Austrians are very explicit in denying the relevance of backing to physically inconvertible currencies like the dollar. Mises and Rothbard specifically say that the value of the dollar is determined by supply and demand, not by backing.

Joe S.:
Inflation happens when the fed’s ratio of assets to money falls, as happens when the fed lends at below-market rates, overpays for bonds, (or if the bonds lose value), hands its interest earnings over to the treasury, wastes money on staff and buildings, etc. Certainly, borrowers gain from unexpected inflation and lenders lose, but if the inflation is anticipated there doesn’t have to be a wealth trasfer.
Yes; Austrians are gold bugs, especially mises and rothbard. It’s not consistent with libertarianism, since they advocate some very unlibertarian restrictions on banking when they denounce fractional reserve banking.
The RBD says you can back money with anything of value–from gold to wheat to land to bonds to lottery tickets. It’s value that matters–and bonds can certainly have value just like precious metals can. Bonds might be less stable, but it should be up to the bank and its customers to decide how stable they want the backing to be.

“How exactly do you double assets without making money appear out of thin air? And if money is a claim to real assets but is not backed by real assets, then won’t the first receivers of this new money have just received a windfall at the expense of later receivers?”
In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn’t say those dollars were created out of thin air. The next 300 paper dollars were issued for the farmer’s IOU, which was worth 300 oz. That is not a case of money coming out of thin air. That IOU has value, just like the 300 oz of silver. Further, the IOU is backed by a lien on the farm, and once that 300 oz. lien is placed on the farm, the farmer is unable to borrow any more money against that farm, unless the farm is worth more than 300 oz. That is not ‘thin air’. Counterfeiters create money out of thin air. Banks only issue money to people who allow that bank to place liens on their assets.
Since the new money is matched by new assets, there is no inflation, and no windfall to the first receivers.

Fundamentalist:
“If banks were limited to lending only the savings of depositors, that is, required to keep 100% reserves, then they would be like the hot dog vendor. Banks could make available for loan only the money that others had deposited, but could not create money out of thin air.”

See my ‘thin air’ comments above. The people with silver got their $300 because they deposited silver. The farmer got his $300 because he ‘deposited’ his farm. You say that deposits must be in the form of gold, silver, etc. I say they can be in any form that the banker and the customers agree to.

“If money becomes scarce, prices don’t stay the same. Scarce money means money is more valuable. More valuable money becomes evident through falling prices. Within a short time prices would fall to a level that matches the new, higher value of money so that the money available will be totally sufficient to allow all of the transactions that people want.”
Exactly the argument that quantity theorists made in the 1800′s, while real bills’ers would have said that issuing new money for assets of adequate value would not cause inflation.

Alex:
“Again I ask you to explain what you think happens to prevent spending and price level increases when a central bank increases the supply of money at a faster rate than the demand for money is increasing. Surely you believe this happens all the time, in other words, that over and over again central banks expand the money supply in a (to use your terminology) non-passive manner.”

If the fed wants to force another $100 into circulation, and if the public is already well-stocked with cash, then the fed will start by bidding $100 for a bond worth $100. But by assumption, the public has no particular desire to trade the $100 bond for the $100 cash, so the fed has to offer $101 in paper for the $100 bond in order for the cash to be accepted by the public. Now the fed’s assets have risen by $1 less than its liabilities, so there will be inflation. I say the inflation was caused by a loss of backing, while you say it was because there is now another $101 chasing the same amount of goods. If I added something about how the $101 of paper simply displaced $101 of checking account dollars (which would reflux to their issuers) then under reasonable conditions, your model would say there would be no inflation. Mine would say there is still inflation, because of the $1 loss of backing.

I haven’t really explained my more-or less complete dismissal of the concepts of supply and demand as regards money. For now I’ll say that supply and demand works fine for commodities, but not for financial securities. Financial securities can be nothing but computer blips, which can be created and destroyed in an instant. Ordinary ideas of supply and demand simply don’t apply.

newson June 17, 2008 at 9:26 pm

fusgerm says:
“I find the RBD helpful in explaining how money maintains its value. I don’t think that the QT adequately explains why money supply growth is often associated with a RISING currency value – e.g. the Yuan or Aus Dollar in recent years.”

isn’t it that the chinese currency is buoyed by tightening monetary conditions (raised banking reserves etc.), trade surplus vis-a-vis rest of world, and rising domestic interest rates? and that the aussie dollar is really only strong against the usd, and that the high interest rates and commodity story is the ostensible short-term reason?

paper currencies can fail to reflect country fundamentals short/medium term, but not long term. i cannot see why this should negate the quantity theory. this seems to me to be the very beauty of the austrian approach – that increasing the amount of money will impact prices, but way various prices are impacted and time-frame are unknowable.

the argentine peso remained overvalued for an incredibly long period before the peso/usd link was broken. money had flowed into the country for years, in spite of vast growth in money supply. why can’t bubbles (mispricing) also affect currencies?

fundamentalist June 17, 2008 at 10:28 pm

Mike: “In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn’t say those dollars were created out of thin air.”

I can’t see how you can describe it as anything else. Say the reserve requirement is 10% undeer the RBD. That means that a bank can loan out about 9 times its cash reserves. How does it create those loans? It simply writes the numbers in the accounting system under the account of the borrowers. The bank doesn’t even have to print paper money, a simple accounting entry does the trick. If that’s not creating money out of thin air, I don’t know what you call it. In exchange for a simple accounting entry, the bank takes as collateral real wealth, such as a farm, so that if the borrower fails, the bank gets real wealth in exchange for its accounting entry.

fundamentalist June 17, 2008 at 10:32 pm

PS: The bank uses the money it created out of thin air to pay workers, dividends, and buy the land it sits on and its building. In that way, the bank exchanges money from thin air for real wealth.

fundamentalist June 17, 2008 at 10:35 pm

fusgerm: “I don’t think that the QT adequately explains why money supply growth is often associated with a RISING currency value…”

In addition to what newson wrote, keep in mind that money supply growth is relative. China may be inflating its money supply, but if the US inflates at a faster rate, Chinese currency will increase in value relative to the dollar, even though both are losing value against commodities such as gold.

fusgerm June 18, 2008 at 8:10 am

Newson says:
the aussie dollar is really only strong against the usd, and the high interest rates and commodity story is the ostensible short-term reason? …i cannot see why this should negate the quantity theory. this seems to me to be the very beauty of the austrian approach

I was referring to the classic statement of the QT, e.g. by Fisher, which asserts an almost linear inverse relationship between the quantity of money and its value. That is certainly false, and Mises was one of its staunchest critics.

The Austrian version of the QT indeed fits the facts of the recent boom very well. Looking at Australia, for example, the monetary base doubled in three years from $AU 52 B from Y/E Jun 30 2004 to $ 106 B in Y/E Jun 30 2007, yet no one claims that retail prices doubled in that time.

In the same period, AUD rose by approx 10% against EUR, GBP and USD, by 20% against JPY, by 15% against CHF, remained stable against NZD, and fell against only one major currency – 10% against CAD. (visual estimates.) AUD has in fact risen against most currencies (except EUR, which also started from a low point in 2002), not just against USD.

Clearly, the results are not what the classic QT would predict.

Where has all the new AUD money gone? Into the local stock market, into the mining sector, and into the property prices of states most affected by the mining boom. This contradicts the RBD, which holds that the new money should be neutral in its effect on prices, so far as it is adequately backed.

Why, then, do I say that the RBD is helpful in understanding AUD? Because the intrinsic value of the Australian dollar, as determined by the backing theory, holds AUD on a leash. When the commodity cycle turns, the bubble sectors will deflate to restore money closer to its intrinsic value. In Austrian terms, the boom can only end in a bust. Or else, of course, in the apocalyptic alternative of the crack-up boom and hyperinflation.

fusgerm June 18, 2008 at 8:16 am

Fundamentalist says:
keep in mind that money supply growth is relative. China may be inflating its money supply, but if the US inflates at a faster rate, Chinese currency will increase in value relative to the dollar, even though both are losing value against commodities such as gold.

I do not have the figures to hand for CNY, but this is contradicted by AUD, at least over the past 5 years. See my reply to Newson above.

Moreover, it is impossible to define precisely the “purchasing power” of a currency, still less to predict it. And the reason is that monetary inflation never makes its presence felt in a uniform fashion. If by “purchasing power” you mean retail prices, then this is a lagging indicator and generally the last to be affected by money which is loaned into existence.

Mises commented in TMC:
we make use in our discussion of only one fundamental idea contained in the Quantity Theory, the idea that a connexion exists between variations in the value of money on the one hand and variations in the relations between the demand for money and the supply of it on the other hand…
Beyond this proposition, the Quantity Theory can provide us with nothing.

Joe Stoutenburg June 18, 2008 at 8:25 am

Mike, you need to clarify something. In your examples to me, you’ve made it seem like you claim that RBD is backed by 100% reserves. What is different is that you say that assets other than precious metals can enter into the financial system as backing to the currency.

This is at odds with what I understand to be the case for our fractual reserve system. To return to your farm-as-collateral example, it seems that posting the farm as collateral worth $300 would allow the bank to lend $3000. Do you claim that somehow the Fed holds assets of real value to back the extra lending?

I see glaring contradictions between how you’ve characterized RBD and the fractional reserve system. The contradictions exist whether I rely upon my recent Austrian studies or if I rely upon my college macro-econ classes.

Mike Sproul June 18, 2008 at 9:22 am

Fundamentalist:
” “In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn’t say those dollars were created out of thin air.”

I can’t see how you can describe it as anything else.”

A bank can issue a checking account dollar because someone (1) deposited one ounce of silver or (2) deposited a $1 IOU backed by a $1 lien on a farm. I’ve never heard anyone but you claim that case (1) creates money out of thin air. Austrians generally claim (wrongly) that case (2) creates money out of thin air, but the only case that I’d say qualifies for ‘thin air’ status is a counterfeiter who doesn’t put his name on the dollar, and won’t buy it back. I’m actually wondering if I heard you right. Did you really mean to apply the ‘thin air’ designation to case (1)?

Joe S.:
“This is at odds with what I understand to be the case for our fractual reserve system. To return to your farm-as-collateral example, it seems that posting the farm as collateral worth $300 would allow the bank to lend $3000.”

That’s a plain old textbook error in your understanding of fractional reserves. If the bank has issued $300 to people who deposited 300 oz of silver, and another $300 to a farmer who ‘deposited’ a $300 lien on his farm, then the only way for the banker to issue another $2400 is for a borrower to ‘deposit’ something worth $2400–like an IOU backed by a lien on his house. Your concept of fractional reserves violates the first rule of banking: Never lend $1 to someone unless they give you collateral worth at least $1.

ASSETS………………………..LIABILITIES
300 oz of silver deposited…..300 chk acct dollars
IOU worth $300………………..300 more chk acct $
another IOU worth $2400……2400 more chk acct $

If you can suffer through a T-account, you’ll see that the left side of the balance sheet must equal the right side. The $3000 in checking account dollars are backed by $3000 worth of assets. Mind you, there is only 300 oz of RESERVES, and the bank has ‘multiplied’ that out to $3000, but only by getting an additional $2400 worth of assets.

Person June 18, 2008 at 9:47 am

Mike_Sproul — college edition!

“Mike, you can’t just run up credit card and student loan debt to fund parties, pizza, and beer!!! Think about what this is going to do to your future!”
“Whoa whoa whoa, timeout, Dad. Under the Human Capital Theory, going into debt *cannot* hurt your net wage, so long as you spend the funds on human capital enchancements that grow faster than the interest rate.”
“But you’re … NOT … spending your money on that stuff, you’re spending it on worthless frivolities, devaluing your own human capital.”
“Yeah, but some of you guys are all acting like going into debt MUST hurt your net wage, when that needn’t be true.”

fundamentalist June 18, 2008 at 10:51 am

Mike: “A bank can issue a checking account dollar because someone (1) deposited one ounce of silver or (2) deposited a $1 IOU backed by a $1 lien on a farm.”

In case (1) the customer either sells the silver to the bank, and receives dollars, or the customer used the silver as collateral for a loan. Either way, where does the bank get the checking account dollars to issue? In RBD it creates them ex nihilo because the bank keeps its cash as reserves and creates 9 more dollars for every dollar in reserve by making new bookkeeping entries. If the customer places the silver in a safe deposit box, he gets no dollars, just receipt. Case (2) is no different. The collateral doesn’t matter. What matters is where the bank gets the dollars to give to the customer.

If you haven’t heard anyone call fractional reserve banking the act of “creating money out of thin air” you should read de Soto’s book. Opponents of RBD/fractional banking have been calling it that for at least four centuries.

Michael A. Clem June 18, 2008 at 11:02 am

You seem pretty well aware of the circularity and general absurdity of this view of money. I think you’d also agree that if money were backed by gold, then there would be nothing ‘complicated’ that required explanation.
Here’s the point you keep missing. Even a gold-backed dollar can have monetary inflation–the bank(s) simply issue more money by buying more gold–but the fact that it is gold, and that they have to buy gold, is the limiting factor on how much they can inflate. Commodity backing doesn’t make inflation impossible, just harder. Currently, there’s no firm limit on how much debt the Fed can buy in issuing currency.

Alex June 18, 2008 at 11:42 am

Mike Sproul:

“If the fed wants to force another $100 into circulation, and if the public is already well-stocked with cash, then the fed will start by bidding $100 for a bond worth $100. But by assumption, the public has no particular desire to trade the $100 bond for the $100 cash, so the fed has to offer $101 in paper for the $100 bond in order for the cash to be accepted by the public. Now the fed’s assets have risen by $1 less than its liabilities, so there will be inflation. I say the inflation was caused by a loss of backing, while you say it was because there is now another $101 chasing the same amount of goods. If I added something about how the $101 of paper simply displaced $101 of checking account dollars (which would reflux to their issuers) then under reasonable conditions, your model would say there would be no inflation. Mine would say there is still inflation, because of the $1 loss of backing.

I haven’t really explained my more-or less complete dismissal of the concepts of supply and demand as regards money. For now I’ll say that supply and demand works fine for commodities, but not for financial securities. Financial securities can be nothing but computer blips, which can be created and destroyed in an instant. Ordinary ideas of supply and demand simply don’t apply.”

Okay, so you do agree that when the supply of money is increased relative to its demand, that causes increases in spending and the relative price level. I thought you disputed that point. Semantics appear to be different, however. When the Fed buys a bond for $101, it has acquired an asset not worth $100, but $101, so in your terminology the “backing” for the $101 of new money is $101. In my terms when the Fed issues $101 of new money, there is never any “backing.” The big pieces of meaningless paper (government bonds held on the Fed’s balance sheet that don’t pay the Fed any interest and will never be paid back) is no backing in my books. If the Fed simply burned those pieces of paper, what difference would it make, apart from the fact that it would hinder the occasional open market bond sale the Fed might want to make? (So, let’s say the Fed burns almost all of their government bonds that they hold. Big meaningless deal!)

I would love an example of how the laws of supply and demand are violated when credit transactions are carried out via securities created by computers.

PR June 18, 2008 at 11:56 am

IOU worth $300

An asset is only worth what someone is willing and able to pay for it. If the farmer’s IOU is truly worth $300, then he could exchange it for 300 of the existing paper dollars belonging to a real saver. If he can’t do this, then his IOU isn’t worth that much. Of course, the IOU might come to be worth $300 to someone after the RBD bank has printed up 300 more paper dollars and injected them into the economy, but doesn’t that prove that the injection was inflationary?

Joe Stoutenburg June 18, 2008 at 12:08 pm

So we should be able to look at the entire money supply and identify the reserves and collateral that backs it. I’m skeptical that you can do it, but I’d like to see actual data reconciling the Fed’s balance sheet with the total money supply (realizing that much of it is now unpublished). I welcome anyone other than Mike as well who might have a handy data source.

Supposing for the moment that there are assets backing every dollar in circulation, the backing must consist primarily of government bonds – IOUs by the federal government to pay in the future. Whatever your economic views, you must admit that an IOU by a government to pay out of future tax receipts differs markedly from an IOU voluntarily contracted on personal property.

The federal government can issue bonds and sell them to the Federal Reserve in exchange for newly created cash. (Alternatively, it sells to the public or banks – ultimately some of them end up as reserves at the Fed.) By RBD, you may claim that the bonds have real value because they are claims on future tax receipts. (Am I right?) The government then spends the newly created money (enriching the connected contractors in the process). The new money enters the economy and begins circulating. Taxes are levied against this rising monetary base thus providing the income necessary to pay interest on the bonds.

Have I followed the process through correctly? [Comments from others than Mike are welcome] Wouldn’t this monetizing of government debt (really a promise to steal in the future) cause inflation? Is this really a system that you defend?

fundamentalist June 18, 2008 at 12:26 pm

Mike or Alex (I’m not sure who wrote it): “I haven’t really explained my more-or less complete dismissal of the concepts of supply and demand as regards money. For now I’ll say that supply and demand works fine for commodities, but not for financial securities. Financial securities can be nothing but computer blips, which can be created and destroyed in an instant.”

So it wouldn’t bother you at all if someone hacked into your bank’s computer and deleted the “computer blips” stored in your account?

Alex June 18, 2008 at 2:52 pm

Joe:

You said:

“Supposing for the moment that there are assets backing every dollar in circulation, the backing must consist primarily of government bonds – IOUs by the federal government to pay in the future. Whatever your economic views, you must admit that an IOU by a government to pay out of future tax receipts differs markedly from an IOU voluntarily contracted on personal property.

The federal government can issue bonds and sell them to the Federal Reserve in exchange for newly created cash. (Alternatively, it sells to the public or banks – ultimately some of them end up as reserves at the Fed.) By RBD, you may claim that the bonds have real value because they are claims on future tax receipts. (Am I right?) The government then spends the newly created money (enriching the connected contractors in the process). The new money enters the economy and begins circulating. Taxes are levied against this rising monetary base thus providing the income necessary to pay interest on the bonds.”

You are exactly right, except for the last sentence. No taxes are levied against the rising monetary base. No taxes are needed to pay interest on Federal Reserve held government bonds, since almost all the interest on these bonds is remitted back to the government. And since the government bonds on the asset side of the Fed grow with the monetary base over time, effectively there are no taxes needed to pay off any of these bonds.

Taxation occurs at the moment a government spends a given $1. The only question is the manner of the taxation. The government may decide to raise explicit taxes by $1 to finance the spending. The government may decide to borrow $1 to finance the spending, in which case the present value of the future taxes needed to repay the debt is exactly $1. When a central bank purchases government debt for $1, $1 of taxes are effected at that time through the monetary system.

Mike Sproul June 18, 2008 at 7:21 pm

Fundamentalist:

“In case (1) the customer either sells the silver to the bank, and receives dollars, or the customer used the silver as collateral for a loan. Either way, where does the bank get the checking account dollars to issue? In RBD it creates them ex nihilo because the bank keeps its cash as reserves and creates 9 more dollars for every dollar in reserve by making new bookkeeping entries. If the customer places the silver in a safe deposit box, he gets no dollars, just receipt. Case (2) is no different. The collateral doesn’t matter. What matters is where the bank gets the dollars to give to the customer.”

Case 1 is 100% reserve banking, not fractional reserve banking, and nobody but you puts the ‘thin air’ label on 100% reserve banking.
The 9 more dollars are only issued if a customer gives the bank collateral worth at least nine dollars. No bank would issue the $9 otherwise. No thin air here either. That’s why I want to hold on to my computer blips.

Michael Clem:
“Even a gold-backed dollar can have monetary inflation–the bank(s) simply issue more money by buying more gold–but the fact that it is gold, and that they have to buy gold, is the limiting factor on how much they can inflate. Commodity backing doesn’t make inflation impossible, just harder. Currently, there’s no firm limit on how much debt the Fed can buy in issuing currency.”

I suppose by ‘monetary inflation’ you mean an increase in the money supply, as opposed to price inflation. And of course the only limit on how much money can be created is how many goods the borrowers are able to present to the bank as collateral. But what we care about is PRICE inflation, and as long as every new dollar is adequately backed by the bank’s assets, price inflation won’t happen.

Alex:
“Okay, so you do agree that when the supply of money is increased relative to its demand, that causes increases in spending and the relative price level. I thought you disputed that point. Semantics appear to be different, however. When the Fed buys a bond for $101, it has acquired an asset not worth $100, but $101,”

No; my assertion is that when money increases relative to the assets of the bank that issued it, there will be inflation. Supply and demand is not an appropriate model for financial securities–just for commodities. And when I said the fed paid $101 for a bond worth $100, I really meant the bond was worth $100–not $101.

Joe S.
“So we should be able to look at the entire money supply and identify the reserves and collateral that backs it. ”
You have to remember that paper dollars are issued only by the fed, so they are backed by the fed’s assets, which are published every month. The fed’s assets do not back wells fargo’s checking account dollars. Those are backed by wells fargo’s assets.

” Wouldn’t this monetizing of government debt (really a promise to steal in the future) cause inflation?”

If the government loses the ability to steal, then the dollars have less backing and there will be inflation. If the government keeps the ability to steal, then the dollars are backed by that ability, and will hold their value..

Person June 18, 2008 at 9:24 pm

Mike_Sproul: Didn’t you think my post was kinda clever?

Mike Sproul June 18, 2008 at 11:27 pm

Person:

So clever that I didn’t even understand it.

newson June 19, 2008 at 1:03 am

to mike sproul:
leaving aside fiduciary media, would you acknowledge that if gold were used exclusively as money, and that its quantity were to increase markedly, then it’s likely gold’s purchasing power would be eroded to some extent?

fundamentalist June 19, 2008 at 6:40 am

Mike: “Case 1 is 100% reserve banking, not fractional reserve banking, and nobody but you puts the ‘thin air’ label on 100% reserve banking.
The 9 more dollars are only issued if a customer gives the bank collateral worth at least nine dollars. No bank would issue the $9 otherwise. No thin air here either. That’s why I want to hold on to my computer blips.”

Case 1 may or may not be 100% reserve banking. It all depends on where the bank gets the money to loan on the collateral, whether silver or land. If the money comes from reserves or from the savings of another customer, then it is 100% reserve banking. On the other hand, if the bank just enters the value in the borrower’s account, it is fractional banking.

No, everyone may not use the exact words “thin air” but every Austrian and most economists since John Law have used similar terminology for the same process of credit expansion.

You’re using “backing” for a loan as a red herring, attempting to distract the reader from the main event, the creation of money ex nihilo by the bank.

Person June 19, 2008 at 8:26 am

Mike_Sproul: What’s not to understand? :-(

-You claim that printing money won’t cause inflation as long as certain standards are met, even though the Fed doesn’t meet those standards.

-I made fun of this by comparing it to your college-years rationalizations that going deep into debt wouldn’t hurt your income as long as certain standards were met, even though you weren’t meeting those standards.

Joe Stoutenburg June 19, 2008 at 9:30 am

Mike, I wrote:

Wouldn’t this monetizing of government debt (really a promise to steal in the future) cause inflation?

Your response (paraphrased) was that the government’s ability to steal ensures an absence of inflation. I disagree, though our disagreement may well be semantic and be due partially to the difficulty of defining inflation. So let’s clarify what we mean when we say inflation. Let’s consider an economy at an instant in time with a given amount of consumer goods, capital goods and money. A moment later, the money supply is doubled by entering some of the capital goods as collateral. The prices of the goods purchased by the new money will tend to rise to reflect the increased amount of money chasing the same amount of goods. This is inflation.

So I’m left wondering what you mean when you claim that entering assets to back new money will not cause inflation. Even most gold-bugs admit that inflation would occur under a gold standard due to the on-going (and more predictable) discovery of gold that finds it way into coinage. The thing is, I could see inflation being benign that caused by an RBD banking system (one which is backed not only by assets held by the banks but also by assets pledged as collateral). If people voluntarily mortgage their assets in their desire for current consumption, it is right for them to bid up prices.

Now here’s an epiphany that I find very interesting. This price bidding (inflation) could be an alternative to rising interest rates that might be present with a gold standard. I’ll explain. Suppose that in a gold standard economy that the demand for current consumption increased. In order to induce current money (gold) holders to increase loans, borrowers would need to offer higher rates of interest. On the other hand, if borrowers offered instead their property as collateral for newly issued credit, then the increased demand for current consumption would be felt in rising prices while interest rates remained steady.

These are trade-offs that I think that we could all accept as long as they are made voluntarily. What is insidious about our current monetary system is that the government forces us to place collateral into the system through its issuance of bonds (promises to tax). The new money does cause prices of some goods to rise, and it does not get spread uniformly among the economy. In essence, the collateral represented by my future tax dollars gets distributed to someone else, and I have to pay higher prices to boot! This is theft just as the Austrians have been claiming. But it’s not theft by virtue of the fact that we are not on the gold standard. It is theft by virtue that the government can create an asset out of my property and create money with its backing without my consent.

So Mike, your claim that RBD does not cause inflation falls flat on its face as far as I’m concerned. This doesn’t mean that RBD is without value. I have expanded my acceptance of money to include the possibility of a banking system with a variable amount of money whereby demand for current consumption is felt not by the interest rate but by inflation. The thing is though, inflation in this manner wouldn’t need to be managed. And deflation might be just as likely (just as rising and falling interest rates would be normal with a gold standard) though general inflation trends would be expected as the economy grew and added new assets as backing to the currency.

fundamentalist June 19, 2008 at 9:39 am

Mike: “Supply and demand is not an appropriate model for financial securities–just for commodities.”

This is a key point of RDB. Money lives in an alternative universe not subject to the laws that every other commodity/service must respect. Austrian econ relies upon money acting like any other commodity with respect to supply and demand. RBD doesn’t give a reason for money not being subject to the law of supply and demand; it assumes it. Austrian econ not only has the theory and logic to support its position, but history as well.

Joe Stoutenburg June 19, 2008 at 9:58 am

I agree with fundamentalist.

Supply and demand for money in a banking system backed real assets would be driven by people’s willingness to exchange unencumbered ownership of their property for new credit. The demand for money in this system would be manifest in inflation.

In a more banking system with a more stable money supply (based upon gold or some other relatively rare asset), people would not write IOUs on their current assets. Rather, they would simply write IOUs on future earnings. Such a system would manifest demand in interest rates.

Either way, there is demand for money. When its supply is fixed (commodity money), its price (interest rates) will fluctuate. When its supply may vary (real asset backed money), its price will remain relatively steady. The demand for goods would be seen directly in their prices.

Alex June 19, 2008 at 10:29 am

Mike Sproul:

You said: “my assertion is that when money increases relative to the assets of the bank that issued it, there will be inflation. Supply and demand is not an appropriate model for financial securities–just for commodities. And when I said the fed paid $101 for a bond worth $100, I really meant the bond was worth $100–not $101.”

I’m not going to argue whether the bond is “worth” $100 or $101 when it finds its way onto the balance sheet of a central bank, though that distinction seems to be a central point for you. Instead, consider the following brief example.

A central government prints up a $100 bond, carts it to the central bank and receives $100 deposit, which the government then spends on goods and services. How has this not created additional net purchasing power that will drive up prices?

[Note: In your terms, note, there is 100% "backing" for the new money that the government created and spent. In fact, to the extent that some of this new money received by sellers of goods and services finds its way into the bond market, bond prices will rise and, again in your terms, there will be more than 100% backing for the newly created money, since the government bond held by the central bank will have a market value in excess of $100.]

Mike sproul June 19, 2008 at 1:31 pm

Newson:
“would you acknowledge that if gold were used exclusively as money, and that its quantity were to increase markedly, then it’s likely gold’s purchasing power would be eroded to some extent?”

Yes. Gold is a commodity. Supply slopes up and demand slopes down, so there’s a meaningful equilibrium of supply and demand. Paper or electronic dollars that are claims to something worth 1 oz of silver are not commodities. Both supply and demand would be horizontal lines with a height of 1 oz/$, with no meaningful equilibrium of supply and demand.

Fundamentalist:

“Case 1 may or may not be 100% reserve banking. It all depends on where the bank gets the money to loan on the collateral, whether silver or land. If the money comes from reserves or from the savings of another customer, then it is 100% reserve banking. On the other hand, if the bank just enters the value in the borrower’s account, it is fractional banking.”

Case 1 was clearly 100% reserve banking. A customer deposits 1 oz of silver and gets a warehouse receipt for it. If the bank keeps the ounce on hand, that’s 100% reserves. If the bank lends part of it out, that’s fractional reserves.

Person:
“You claim that printing money won’t cause inflation as long as certain standards are met, even though the Fed doesn’t meet those standards.”

All I’ve ever claimed is that IF the fed adequately backs its dollars, those dollars will hold value, and IF the amount of backing per dollar falls, the dollars will lose value.

Joe S.:
“the money supply is doubled by entering some of the capital goods as collateral. The prices of the goods purchased by the new money will tend to rise to reflect the increased amount of money chasing the same amount of goods. This is inflation.”

One minute, a bank holds 100 oz of silver as backing for 100 paper receipts (dollars), each of which is redeemable at the bank for 1 oz. The next minute, customers deposit miscellaneous goods (gold, wheat, land, even bonds) that are worth 200 oz. of silver. The bank issues 200 more paper dollars to these customers.

Before the issue of $200, one loaf of bread sold for 1 oz or $1. After the issue of $200, the real bills view is that 1 loaf will still sell for $1 or 1 oz. If you want to assert that the price of bread will rise because of this, either in terms of silver or paper or both, you’ll have some pretty thorny arbitrage issues to work out. Think about them long enough and you’ll see that the rbd is correct, and the quantity theory is wrong.

Alex:
“A central government prints up a $100 bond, carts it to the central bank and receives $100 deposit, which the government then spends on goods and services. How has this not created additional net purchasing power that will drive up prices?”

One way to answer that is with the answer I just gave to Joe S. in the previous paragraph. Another is to note that the $100 bond has to be paid back, so every extra $100 the government spends is matched by a $100 fall in future government spending, or a $100 fall in private spending. Austrians should know all about the crowding out effect.

Joe Stoutenburg June 19, 2008 at 3:32 pm

Mike, you said:

Before the issue of $200, one loaf of bread sold for 1 oz or $1. After the issue of $200, the real bills view is that 1 loaf will still sell for $1 or 1 oz. If you want to assert that the price of bread will rise because of this, either in terms of silver or paper or both, you’ll have some pretty thorny arbitrage issues to work out. Think about them long enough and you’ll see that the rbd is correct, and the quantity theory is wrong.

Let me summarize what you just wrote in my own words:

My view is correct. There are mysterious problems with your view that I won’t explain. If you think about them long enough, you’ll see that I’m right and that you’re wrong.

Do you realize how poor of a job you’re doing advocating your position? I can only guess at what you mean. Arbitrage pricing is squarely within my professional field, so I can think of plenty of ways to approach the matter. For all I know, you may have a point that I do not immediately see. But it is also possible that you’re employing arbitrage principles incorrectly. So I don’t know whether we need to discuss your valid points or your incorrect understanding of arbitrage.

I’m not going to guess at what you mean. Please make an argument supporting your view, and we’ll discuss.

Mike Sproul June 19, 2008 at 4:00 pm

Joe S.

Click on my name above and read about the real bills doctrine, and you won’t have to guess at what I mean.

Some arbitrage scenarios:

1) A loaf of bread, which used to cost $1 or 1 oz., now costs $3 or 1 oz. because of the issue of 200 new dollars.

Arbitrage problem: Each dollar is redeemable at the bank for 1 oz, so everyone runs on the bank. The bank pays 1 oz per dollar, as contracted. Customers sell the ounce for 1 loaf, which they sell for $3, which they return to the bank for 3 oz.

2. A loaf of bread, which used to cost $1 or 1 oz., now costs $3 or 3 oz., because of the issue of 200 new dollars.

Arbitrage problem: Bread from around the world floods in to this town to get 3 oz./loaf. Price of bread must fall to 1 oz, but if it still costs $3, same arbitrage probel as above.

3. Bread stays at $1 or 1 oz.: No arbitrage problem.

Mike Sproul June 19, 2008 at 4:27 pm

Fundamentalist:

“RBD doesn’t give a reason for money not being subject to the law of supply and demand; it assumes it. Austrian econ not only has the theory and logic to support its position, but history as well.”

On the first page of my paper “There’s No Such Thing as Fiat Money”, I referenced studies by Sargent, Wallace, Smith, Siklos, Bomberger and Makinen, and Cunningham. Each paper studied different historical episodes of inflation, and each found that the backing version of the real bills doctrine explained the episode better that the quantity theory. You haven’t cited any historical episodes where the rbd did worse than the qt, and I don’t expect you to, because there are no such episodes.

fundamentalist June 19, 2008 at 5:05 pm

Mike: “Case 1 was clearly 100% reserve banking. A customer deposits 1 oz of silver and gets a warehouse receipt for it. If the bank keeps the ounce on hand, that’s 100% reserves. If the bank lends part of it out, that’s fractional reserves.”

You may have forgotten your example. You wrote the following:

“In my earlier example, the bank issued 300 paper dollars in exchange for 300 oz. deposited. You wouldn’t say those dollars were created out of thin air…The people with silver got their $300 because they deposited silver.”

You’re right that if the customer deposits silver and the bank gives him a receipt for it, then that is not fractional banking. But that wasn’t you’re example. You said that the person depositing the silver got paper dollars in exchange for the deposit. If the dollars the customer received from the bank did not come from the bank’s reserves, then that is the very definition of fractional reserve banking. Again, the backing of the loan has nothing to do with the definition of fractional reserve banking. The loan can be backed by gold, or just a promise. It doesn’t matter. What defines fractional reserve banking is where the money comes from that the bank loans the customer. Is it from reserves or did the bank just make an entry into the customer’s account? If the money comes from reserves, then the bank practices honest 100% reserve banking; if not, it practices fractional reserve banking.

Mike: “You haven’t cited any historical episodes where the rbd did worse than the qt, and I don’t expect you to, because there are no such episodes.”

I didn’t write that RBD doesn’t have any historical episodes to cite. I wrote “RBD doesn’t give a reason for money not being subject to the law of supply and demand; it assumes it.”

Every theory, no matter how utterly stupid, can cite historical examples that appear to support it. That is why Austrians insist that you must approach history with sound theory. Otherwise, history doesn’t make sense and it can support any idea.

Alex June 19, 2008 at 7:14 pm

Mike Sproul: “One way to answer that is with the answer I just gave to Joe S. in the previous paragraph. Another is to note that the $100 bond has to be paid back, so every extra $100 the government spends is matched by a $100 fall in future government spending, or a $100 fall in private spending. Austrians should know all about the crowding out effect.”

Mike, I have explained at least twice before that the bonds on the balance sheets of central banks are never paid back and the interest on such bonds is simply bounced back to the central government. So, any way you slice it, there is a net increase in purchasing power.

newson June 19, 2008 at 7:23 pm

mike sproul says:
“Gold is a commodity. Supply slopes up and demand slopes down, so there’s a meaningful equilibrium of supply and demand. Paper or electronic dollars that are claims to something worth 1 oz of silver are not commodities. Both supply and demand would be horizontal lines with a height of 1 oz/$, with no meaningful equilibrium of supply and demand.”

i cannot see why paper money, merely a convenient proxy for the silver or gold, should not be subject to supply/demand, just like the underlying (obviously this applies only if they’re convertible).

P.M.Lawrence June 19, 2008 at 9:42 pm

Newson, you forget that he is pulling a bait and switch. When he talks about money denominated as a certain weight of bullion, he is perfectly willing to issue any amount of these without actually moving bullion into the reserves in step. For him, the word “bullion” is only there to keep the punters happy while he goes about business as usual. In a certain sense he is correct – once you do that, there aren’t any supply and demand constraints on the money from the bullion link, because he won’t have a bullion link.

fundamentalist June 20, 2008 at 6:49 am

PM: “there aren’t any supply and demand constraints on the money from the bullion link, because he won’t have a bullion link.”

Exactly! The only limit to the supply of money in RBD is the desire for loans on the part of businesses with collateral.

Today’s money, mostly digits, has no supply limitations at all. So when banks supply more than people want, prices rise.

Joe Stoutenburg June 20, 2008 at 7:47 am

Mike, I will react to your specific scenarios. But first I have a few comments about arbitrage pricing in general.

Arbitrage principles do not forbid the presence of arbitrage profit opportunities. Rather, they state that in efficient and complete markets, such opportunities will be fleeting because market participants will detect the opportunity and will take as large of positions as possible until prices are moved back to equilibrium. In practice, markets not entirely complete. So there is rarely, if ever, a single no-arbitrage price. Rather, there are ranges of prices at which arbitrage is unlikely.

Arbitrage principles are employed to determine relative price levels. You’re stretching them by implying absolute price levels. And you’re ignoring more basic supply/demand principles (which are at the basis of arbitrage principles anyway).

Here are my specific reactions to your scenarios:

1) This is a statement of the relationship between the value of a dollar and an ounce of silver. When each dollar is backed exclusively by an ounce of silver as your scenario implies, then their exchange will not deviate much (if at all) from 1:1. On the other hand, when the backing is silver along with other real assets, then the silver to dollar ratio may vary based upon the public’s perception of the value of the non-silver backing.

2) You might as well use this scenario to justify why bread must always cost $1. It is within this scenario that I accuse you of ignoring basic supply/demand principles. Let’s suppose that an increased demand for bread in a region manifests itself by people placing assets as collateral for new money. This will tend to drive up prices in the short term. As you note, foreign bread suppliers may start selling their bread to satisfy the increased demand. Not only that, but new domestic suppliers may open business to earn some of the profits represented by the increased price. In time, the supply and demand will settle down to new equilibrium prices (not necessarily the original ones – and not just the regional prices – foreign prices may adjust to reflect the new local demand). In reality of course, there is never equilibrium. Demand is continually changing. In an RBD banking system, demand may be manifest by new money. Both price and supply will change in order to adjust to the new demand.

This is really just econ 101 mixed with money creation backed by real assets.

3) As stated earlier, arbitrage provides no information about absolute price levels. You’ve taken the idea that arbitrage opportunities will tend to not persist and jumped to the conclusion that you can hold one price fixed and proclaim that other prices must remain constant to avoid arbitrage. Applying the mechanics of arbitrage pricing (no more complex than supply and demand, really) reveals only that prices must be relatively consistent.

All of this being said, I’m still mulling over what would happen to general price levels (tricky since “general prices” don’t exist) in response to newly created money. Differentiation must be made between money that funds productive activities and unproductive ones. And what happens to the money that goes to projects that prove to be unproductive. I’m open to the possibility that productive activities could leave general prices unaltered – that the new money will chase the new goods created. And it’s possible that money funding unproductive activities could come back out of the system. The latter cases are more complex and require more thought.

Joe Stoutenburg June 20, 2008 at 8:26 am

I meant to stress at the end of my last post that it is silly, in my opinion, to conclude that new money will have no impact on individual price levels or the supply of individual goods. I only concede that I may become comfortable with no general price increases as long as the backing retains value and production is continued.

To prime the system, allow me to highlight an unproductive activity that is allowed to continue in our economy. Suppose the government creates $1 trillion backed by bonds that promise to pay out of future tax receipts. It uses that money to build bombs. Incidentally, there has been inflation here for the price of bombs and everything that goes into them. Previously, they were zero. Now, the total price is $1 trillion.

The people employed to build the bombs are diverted from productive activities. They also keep the money paid to them and use it to buy valuable goods. There is clearly a wealth transfer here. And the money spent by these people will clearly impact the prices of the goods that they choose to purchase. However, the basic mechanism for the transfer is simply the taxation. If $1 trillion of private property were instead offered as collateral for the bombs, I would have less issue since the loan would have to be made up from real production (and people who make bombs don’t tend to be very productive).

fundamentalist June 20, 2008 at 8:39 am

Joe: “I’m open to the possibility that productive activities could leave general prices unaltered – that the new money will chase the new goods created. And it’s possible that money funding unproductive activities could come back out of the system.”

That’s fairly close to the Austrian position. If the money supply increases at exactly the rate of the increase in production, then prices won’t change. Under a gold standard, gold production would increase at about the rate of increase in total production, around 3%/yr. There is no business cycle, just steady progress. In such a system, businesses that fail, or businesses that pay off debt, don’t cause money to disappear from the system.

Under the current system with no restrictions on the supply of money, lower interest rates on loans will incourage business to borrow and expand. Since most new money is created out of thin air, and not from savings of others, expanding businesses run up against a shortage of capital goods which eventually caused the failure of some. Businesses that fail, or businesses that pay off debt, cause money to disappear from the system, which has a dominoe effect and causes other businesses to fail.

Mike has recognized in the past the fact that RBD encourages the expansion and contraction of the money supply, but sees it as a good thing. In reality, it is the business cycle that people hate.

PR June 20, 2008 at 8:45 am

Arbitrage problem: Each dollar is redeemable at the bank for 1 oz, so everyone runs on the bank. The bank pays 1 oz per dollar, as contracted.

But the RBD bank isn’t obligated to pay out 1oz. silver for each dollar. (It doesn’t even have 1oz. of silver for every dollar out there, so it couldn’t do this if it wanted to.) It can hand over any asset it claims is worth 1oz. The bank has many heterogeneous assets, and it is natural that their relative prices will fluctuate even though they are all nominally “worth” 1oz. on the bank’s balance sheet. So, to punish people who try to start a bank run, it can hand over the weakest assets first.

Mike Sproul June 20, 2008 at 9:14 am

Alex:
“the bonds on the balance sheets of central banks are never paid back and the interest on such bonds is simply bounced back to the central government. So, any way you slice it, there is a net increase in purchasing power.”

You might as well claim that my credit card balance is never really paid off. Sometime before I die, I will either pay it off, or else steal the money from the credit card company. Governments live longer than people, but the ultimate payoff is made in the same way as my credit card balance.
Also, if the issue of money really gave the government the kind of free lunch you describe, then rival currencies would invade to get a piece of that free lunch, with the result that the value of the government’s money would be bid down until there was no longer any free lunch to attract rival moneys

Newson:
“i cannot see why paper money, merely a convenient proxy for the silver or gold, should not be subject to supply/demand, just like the underlying (obviously this applies only if they’re convertible).”

If a piece of paper or a computer blip is nothing but a claim to one ounce of silver (or to goods worth 1 ounce of silver), then if those papers or blips sold for 1.01 oz, then quantity demanded would be zero, while quantity supplied would be infinite. If the papers or blips sold for 0.99 oz., then quantity supplied would be zero while quantity demanded would be infinite. Thus supply and demand are both horizontal at 1 oz. It’s wrong to say, in this case, that the papers or blips are price at 1 oz. because of supply and demand. The correct view is that supply and demand are horizontal at 1 oz. because that’s how much backing the papers or blips have. Supply and demand curves are useless in this case, and if you remember your basic economics, you’l remember that supply and demand curves are always applied to commodities, not claims to those commodities.

PR:

“But the RBD bank isn’t obligated to pay out 1oz. silver for each dollar. (It doesn’t even have 1oz. of silver for every dollar out there, so it couldn’t do this if it wanted to.) It can hand over any asset it claims is worth 1oz.”

Nobody would have deposited silver in the first place unless they felt this problem was adequately handled, say by an neutral outside referee. Anyway, if the bank has issued 300 paper or checking account dollars, which it backs with 100 oz. plus IOU’s worth $200, all the bank has to do in a run is sell the $200 IOU for 200 of its own dollars, which it retires. Then it has 100 oz. backing the remaining $100.

Alex June 20, 2008 at 10:21 am

Mike Sproul:

“You might as well claim that my credit card balance is never really paid off. Sometime before I die, I will either pay it off, or else steal the money from the credit card company. Governments live longer than people, but the ultimate payoff is made in the same way as my credit card balance.
Also, if the issue of money really gave the government the kind of free lunch you describe, then rival currencies would invade to get a piece of that free lunch, with the result that the value of the government’s money would be bid down until there was no longer any free lunch to attract rival moneys.”

First, your second point. Wouldn’t I love to create a central bank of Alex, print up some Alex bonds, put them on the Alex central bank’s balance sheet and create an equal deposit account on the liability side, and then start spending this deposit. But who would take my cheques written on the central bank of Alex in exchange for goods and services? Plus, of course, rival currencies are illegal.

With regard to the difference between your credit card balance and the government bonds on the balance sheets of central banks, the credit card company requires you to repay your balance (plus interest). There is no legal requirement for a central bank to reduce its monetary base, in fact, over time, the monetary base continues its upward climb and the government bonds held on its balance sheet clmb in step with the monetary base. As old bonds mature, they are replaced by new bonds.

Say the central bank reduces the monetary base by $100, by selling government bonds from its own portfolio. At this point, since these bonds are now in the hands of the public, when the government pays interest on them, the interest will not bounce back to the government (hence taxes must be collected to pay this interest). And when this $100 of government bonds mature, the government must raise $100 in taxes to redeem them. But over time, of course, open market sales of government bonds by the central bank are swamped by central bank government bond purchases.

fusgerm June 20, 2008 at 10:25 am

Mike Sproul isn’t really saying anything very radical.

It’s simple book-keeping, basically this:

1. Money is the debt of a bank.

2. Assets = liabilities.

3. Therefore, each dollar is backed by a share in bank assets.

But he’s looking only at the balance sheet, not at the cash flow.

I.e. at solvency, not liquidity.

That’s where he departs from the Austrian approach. We saw in March what happens to asset-values when the credit markets dry up.

jp June 20, 2008 at 11:14 am

Fusgerm, I think that’s a pretty good macro view of the whole argument.

To go further, Mike points out that modern currency is backed by financial assets, not physical assets. Therefore it is not fiat.

While I don’t think Mike has all the pieces in place it would seem hard for Austrians to ignore his points about the asset side of central and commercial banking, and how this determines the value of the money liabilities these banks have issued.

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