Gov’t ask Fed for xDollars

Gov’t gives Fed xTreasuryBonds for xDollars

Gov’t promises to repay xDollars plus Interest

Gov’t owes xDollars+Interest

Interest doesn’t exist

Monetarism is a paradox as only the principal exists in the money supply, so if the principal+interest is owed, where does one find credit to pay the interest?

If every debt in The United States was settled, there would be no money, correct?

How can anyone see this as healthy?

i would hope that at some stage in the not-so-distant-future, that the present monetary disorder becomes so chronic that there emerges a parallel money (gold/silver/platinum?). naturally the state will resist this mortal threat to its last breath, and so this means that it is likely to remain a specie- only money. (ie gold contracts, electronic gold deposits etc. are not going to be welcomed).
this may have the positive effect of re-accustoming people to dealing in physical money. if eventually the state decides to incorporate gold into the official payments structure, then at least people will have had plenty of experience of dealing in tangible money, and perhaps may approach paper money with a good deal more circumspection than is the case today.

money supply in this situation would be merely the total number of oz of easily recoverable precious metals in the country. i’m assuming that deposit accounts are are treated legally as bailments, not as loans.

In the free banking world that is possible, wherein you have one account for your assets, a wealth account, and you pay people by liquidation, by debits and credits, what’s the meaning of the supply of money?

If anyone can issue promises and these can be used as means of payment, what’s the meaning of the supply of money?

Why does a rational prudent banker do this if it ultimately drives him out of business? Why not let the other guy go out of business and then expand and pick up the pieces? In this respect, banking is no different from any other industry. The good firms do not necessarily imitate what the bad firms are doing. There are insurance companies that underwrite bad risks, but the good ones do not do this simply to get ultimately unprofitable business.

I keep trying in my mind to model how fractional reserve banking works or does not work, and I think at the moment that the notes follow a non-linear valuation pattern as the bank adds loans while holding constant its reserves. If it adds reserves as it adds loans, then it can counteract the declining portion of the curve.

The value of a note first rises as the bank provides the services of clearing and checking and paper money. To pay for these, it lends some of the deposits and maintains the rest as reserves. The lending provides the return that flows through to the depositors. It also provides some profit. The convertability enhances note value and helps keep it at par. If the bank’s loans are collateralized, that helps too. If they are callable, that helps. If the called assets are liquid, that helps. As the bank adds loans without adding reserves, the note value will reach a maximum (where the marginal value of the additional loan income equals the marginal cost in terms of the chance of having to suspend conversion.) At that point, the note value starts to decline. To avoid that, the bank has to build up reserves. They enhance the value of the conversion, or lower the marginal cost of suspension. The bank might pay higher interest on its deposits, and that too might enhance note value.

The ownership and control structure of the bank will make a difference. So do the compensation methods. Many banks have quite a bit of inside stock ownership. This gives the management a longer-run perspective. Otherwise, they may try to maximize their short-run salaries and bonuses, especially if they are compensated by incorrect metrics such as loan growth. If they have too much inside ownership, they will tend to consume more perquisites, but they also may be more conservative. The mutual form of ownership may be better than stock ownership. It worked better for S & Ls. There were more failures in stock-owned S & Ls than in mutuals.

i don’t have any problem with the mutual fund/ hedge fund set-up you’ve described. my problem is essentially semantic. “bank deposit” means just that, a non-interest bearing, fee-accruing account. and a “bank” is the institution that provides such a safekeeping service.

it’s only fair to apprise the public of the nature of the institution (through common language), many would be wary of keeping ready money in a mutual fund or hedge fund, but tolerate bank accounts because the risks are obscured (or socialized, as seems the case today).

i believe bank and deposit have common meanings much the same way that bleach and cornflour don’t need to be explained because they are understood in common parlance.

i like to think of the quantity theory as like a rubber band linking the supply of money and its value. there’s a lot of stretch and no predictable short-term relationship. the decay may be retarded and then a spectacularly rapid catch-up may occur, probably overshooting. but over longer periods the correlation becomes more reliable.

“Why make a movie about something one understands completely? I make movies about things I do not understand, but wish to.” (Seijun Suzuki.)

Some thoughts on money. The context is a FREE market, entirely free, no central bank, no legal tender laws, anyone can issue promises to pay in any form whatever. There is enforcement against crimes.

Almost anything can serve as a medium of exchange. We could price everything in terms of Hershey candy bars and exchange them. Gold can serve. Silver can serve. Copper can serve. They all can serve at the same time. In the American colonies, there were sometimes 3 or 4 different coin prices for an item, depending on what the exchange medium was. Plus they used wampum, paper, furs, and hides.

Using these items is not essentially different from bartering. They are divisible, portable, and of reasonably known value as they carry their backing in the item itself. Money is really barter of a more convenient form. Attempting to define a money supply and controlling it both seem like fruitless endeavors.

A promise to pay can be money too. The value of it depends on fulfillment. A barber can pay the grocer with a ticket good for a haircut. This is like barter too, but a more abstract form of it. A bank’s note has to be a promise to pay something or else no one will accept it.

I have been told that Wal-Mart gift certificates are being used as money. Being paid a bonus in these avoids taxation. They are accepted because of Wal-Mart’s promise to redeem them. And people believe the promise will be fulfilled. Wal-Mart has the money paid for these gift certificates, just as American Express has the money paid for travelers’ checks. They don’t segregate it. They use the float. They know that not all the certificates or checks will be used or presented at one time. They’re good for the promise, but there is a chance of temporary suspension.

A market I know offered free gifts each week by a coupon. It sometimes ran out of these gifts because it didn’t know how many people might use the coupons. Then, to maintain credibility, it had to pay them the following week. It suspended payment and then restored the next week.

A bank cannot get its notes accepted without people believing it has backing. But there has to be convertibility to act as an assurance that the backing is genuine.

People do not always operate on there being perfect assurances. They use all sorts of methods to measure the validity of a promise or an assurance. They will pay more for an assurance that is more certain, and less for one that is less certain. Most debts can default, and the pricing of them depends on both the chances of default and how much can be recovered when there is a default. Meanwhile the debts circulate and are traded.

People often use credit cards. They buy something with the promise to pay, even though they do not have the money at the time they buy. Companies do the same when they issue debt. The creditors believe, for various reasons, that the debts will be paid. But they also price in the risk that they will not be paid. They accept the risk because they are compensated for it in higher interest.

A bank cannot issue notes convertible into gold and have anyone accept them unless it compensates people for the risk of non-conversion. If it gave them nothing in return, they may as well hold the gold themselves. Gold would dominate holding the note.

The matter depends on the costs of holding and using gold versus the costs of holding and using a bank account. Using gold coin and silver coin has its drawbacks and its advantages. Coins get worn, clipped, stolen, and lost. The user has to verify their goodness. Storing them in a 100% reserve location is such that you pay for storage. You also pay for transfers. Adam Smith describes this in detail in his account of the Bank of Amsterdam.

A bank in a free market perhaps offers clearing and checking services. Sometimes it pays explicit interest. Its paper money is easier to carry. It can be counterfeited, but may be easier to check than gold. The customers weigh the pros and cons of using paper money. The bank promises to redeem on demand, but there is a chance it will suspend. There is a chance of outright loss. All these things get priced in when people decide to use the bank account or not. I am speaking of a FREE market here, not the existing situation. It’s important not to confuse them.

There could be an entirely new kind of bank arise in a free market. This would be a bank that united all one’s accounts: bank, brokerage, mutual funds, pension holdings, money market funds. You would have all your securities in this account. The value would vary daily. When you bought something, the bank would do the clearing. It would liquidate some of your money market fund (or if you had none some other holding per your instruction) and debit your account while crediting someone else’s account. Transfers would be by debits and credits. Defining money in this system would be well-nigh impossible. There would be no authority to create money.

You could have overdraft privileges, and that would be a loan to you. Where or who from? Who are the creditors? Other persons could indicate that they are willing to make loans of certain types. They do this by buying shares in a mutual fund that offers these kinds of loans. You could buy shares in a fund that offers automobile loans. It is more than a fund, as this takes management. It is really a finance company. By buying, you are supplying loans to those who want them. The bank is now a clearing house for these brokerage transactions that are capital market transactions. So far, everything is 100% reserved.

A mutual fund can start up with the following terms. You buy shares in it. The fund then is enabled to lend your money to others. Furthermore, it can issue more shares to entrepreneurs that it thinks will succeed at their businesses. The entrepreneurs agree to repay the shares and loans with interest. This fund is a fractional reserve bank.

“my problem with rbd is not the gold backing part, it’s where the backing becomes some other, less rare asset. mike uses the example of bonds, and we’ve discussed real-estate in various blogs. i am not convinced by mike’s arguments over convertibility, either. without convertibility, the backing valuation becomes problematic.
convertibility really narrows down the backing asset because of issues like divisibility, homogeneity etc.”

We agree, so you may argue that with Mike Sproul I have. I’ve argued it above too.

“re: backing, if you over-issue your convertible 100oz paper bills, you will suffer redemption demands (basically a run). your notes will plummet in value as people rush to convert. the unknowable is how long it will take before this occurs. trading at parity might last for a while, if the public faith is maintained, or it may not. it is certain that ultimately this model fails (absent government guarantee, or sanction to suspend redemption).”

Actually, people often seem to trade a depreciating note and/or currency for considerable periods of time and they don’t plunge to zero right away. If the note is worth $0.90, that much damage is already done. The question then becomes how much more will be done and when? Or how much has been done that hasn’t yet been revealed? There is an evaluation of the worth of the backing, whatever it may be. I’m personally very risk-averse. If I am out of a stock when it falls 7%, I’d be out of a supposedly safe bank note even faster if it fell! It always surpises me how long people will hold on to assets that have lost value. I suppose there are costs to changing, and so people drag their heels.

I doubtless wouldn’t trust banks unless they were utterly transparent and published information daily about their asset value. If they had unlimited liability, that would comfort me. I trust a money market fund far more than a bank.

I don’t know what you mean by “it is certain that ultimately this model fails.” What model do you mean? Fractional-reserve banking? You may be right. I think I’ve seen someone argue that in enough time, every such bank must fail because of the risk of ruin. The same may be true of all companies and maybe even of all stock markets and all economies. If these things follow random walks, then random events may take them to ruinous lows as they randomly aggregate. Comforting thought, isn’t it?

A 100% gold reserve bank can fail too, although the chances of it are smaller. There can be theft, fraud, secret lending, expropriation, and loss in time of war.

re: backing, if you over-issue your convertible 100oz paper bills, you will suffer redemption demands (basically a run). your notes will plummet in value as people rush to convert. the unknowable is how long it will take before this occurs. trading at parity might last for a while, if the public faith is maintained, or it may not. it is certain that ultimately this model fails (absent government guarantee, or sanction to suspend redemption).

my problem with rbd is not the gold backing part, it’s where the backing becomes some other, less rare asset.
mike uses the example of bonds, and we’ve discussed real-estate in various blogs. i am not convinced by mike’s arguments over convertibility, either. without convertibility, the backing valuation becomes problematic.
convertibility really narrows down the backing asset because of issues like divisibility, homogeneity etc.

“the language betrays the deception. why not call the depositor a bank creditor”

You may be right, or wrong. It may be that somewhere in the past, clever bankers decided to deceive creditors with the term “deposit”, or not. That’s a matter for scientific study. You are stating an hypothesis. If there was a fraud, then you have to prove deception and intent. But really, if depositors thought their money was being held in a safe and segregated way, why would there be bank runs? Why would there be deposit insurance? Why would banks fail? Wouldn’t depositors notice this? Why would banks have separate safety deposit boxes?

“i cannot see why, over time, an increase in the issuance of money will not see its purchasing power decrease.”

The issuance of money CAN cause its value to decrease. The question is WHY this occurs or how to understand it. The two ideas in this thread (quantity theory and the backing model) give two different ways of explaining it. The backing model says that if you issue promises to pay without there being the ability to pay (the backing), they will go down in value. This makes perfect sense! The quantity theory — well, I’m not sure how it explains it. I think it says that the supply is more than what is demanded, and so the price of money falls. Somewhere hidden in the bowels of that approach there have to be people who demand higher prices when they see people coming at them with more notes and people who are willing to pay higher prices because they have more notes. So prices rise. But, you see, the latter is not always true. Suppose the notes represent secure promises to pay in gold, even if there are more of them, then even though there are more notes, their purchasing power need not decline. The demand for a note known to be worth $100 in gold is horizontal at a price of $100. No one will pay more than $100. If the price were $99, everyone would rush to buy it and make $1 profit. So the price has to be $100.

Even the bankers during a bank run, who are a side of this legal argument, never had the courage to utter nonsense like this. Only the delusional crank theorists like you.

“The quantity theory is too crude for attaining a correct understanding of money’s value because it ignores too many factors that influence the value of a currency. It does this in its “other things equal” catchall.”

“Other things equal” is needed for explaining only “nominal changes”. The increase of the money supply may not always effect the nominal price of money.but it ALWAYS decreases the real purchasing power of money. No other things needed.

comment # 2:
what you’ve illustrated is the advantages of a clearing house, no money creation is involved, your example only economizes on cash by offsetting debits and credits. extending credit can have no lasting effects on prices, because it’s merely transfering buying power between one party and another, to be reversed at a later date. one party economizes, one party spends.

the quantity theorem doesn’t work in a simple, mechanistic way, nor did i maintain this, but i cannot see why, over time, an increase in the issuance of money will not see its purchasing power decrease.

On quantity theory, there are many substitutes for money that people use. This disturbs any simple relation between the quantity of money and the prices of goods.

One example:

Suppose that two brokers trade, and A and B each owe the other a sum. A owes B $20 and B owes A $30.

a. Each asks for full payment from the other. Each writes a check. That takes $50.

b. A sends B $20. B then returns the $20 with $10 more of his own. That takes $30.

c. They meet and set off their debts. B gives A $10. That takes $10.

Suppose M sells $100 worth of shoes to W. W pays him $100. That takes $100.

Suppose instead W signs a bill promising to pay $100 in 90 days. That takes $0 right now. But then W endorses that bill and uses it to pay for $100 worth of leather, rather than use cash. That takes $0 rather than $100. The leather man then endorses the bill and uses it to pay $100 to the seller of hides. That takes $0 rather than $100. Finally the hide seller is paid $100 by W. If they used money, it would take $300. Instead, it takes $100.

Thus credit in the economy substitutes for money.

In these examples, there is no relation between the money used and the money values of the transactions.

The quantity theory is too crude for attaining a correct understanding of money’s value because it ignores too many factors that influence the value of a currency. It does this in its “other things equal” catchall.

The English ideas that we use in America about a deposit account being debt go back hundreds of years. They were certainly crystallized over the last 160 years at a minimum. It is simply wrong for Rothbard and others unilaterally to declare that the depositor has title to the money he deposits in an American bank.

In a free market, we will soon discover whether people want to use banks with 100% reserves or banks with less than 100% reserves or both. I think they will use both. Each provides a different set of services.

I agree with you that banks today in the existing system do not function properly.

you say:
“A bank could offer media of redemption that included claims to its loan portfolio, and that would be a type of conversion privilege that would link note value to asset value. But the notes would no longer be money. They would be claims to a loan portfolio. Not everyone wants to accept such claims as a medium of exchange. Thus, I think that this kind of note would gravitate into the hands of investors and not be used as money.”

why are banks necessary? what useful purpose do they serve that could not be served by warehousing (for depositors) together with loan-brokers (for term-borrowers/lenders)?

I thought that there is no place for the “=” sign in economics, thus no place for “equations”: