I have been developing a theory of money and banking for a while and I noticed that Scott Sumner did a post on why fiat money has value in which he listed five theories explaining this and mine wasn’t among them. This made me think it might be kind of novel so I want to try to get it out there and see what people think about it. First I will make a few points relating to Sumner’s post, then develop a model of banking under a specie standard that leads to an explanation of fiat money having value. Read more…
I have already done this post, but I want to try it again (I will link to past attempts at the bottom in order to encourage readers to try this one first). I have a strange fixation with Austrians’ notion of “marginal utility.” I think it’s partially because, when I was a first-year graduate student, I thought the same thing and tried to argue it to my micro theory professor and he assured me that it was impossible to verify (or justify) diminishing marginal utility. I was pretty sure it was possible but he was one of the few professors I’ve ever had that I was pretty sure was smarter than me so I gave him the benefit of the doubt and applied myself pretty hard to figuring out what he meant. In the end, it turns out he was right and understanding why was really the key, for me, to understanding the purpose of utility in economics.
In addition to my personal history with this issue, there is the fact that this represents a point of convergence for several Austrian misconceptions. This is important to me because I am what I would call an “Austrian sympathizer.” I am a big proponent of free markets, I want to end the Federal Reserve and have free money, and I have little use for most empirical economic research (I think it goes too far to say there is no role for observation in economics). That being said, the Austrian School tends to be a sort of intellectual abyss that sucks in reasonably bright people and essentially takes them out of the fight. It gets ahold of people when they are sophomores in college and essentially tells them that everything they don’t understand about mainstream economics in fact doesn’t make sense because of a few supposed fundamental flaws underlying it. This gives them an intellectual escape route by which they may avoid developing a level of understanding of mainstream economics which would be sufficient to offer any real pertinent criticism. As a result, Austrians end up talking mainly to other Austrians about how great Mises and Rothbard were, while occasionally lashing out and being mostly ignored on mainstream economists blogs and producing little to no original research. So I think that if I can figure out how to get this point across to a thoughtful reader, I may be able to save some people from this fate.
So this will be a specific response to this post but the exact same issue comes up all the time in Austrian circles. The issue is whether diminishing marginal utility follows logically from the axiom that “humans act.” I have no argument with the notion that human action is axiomatic but this does not imply diminishing marginal utility. I will try to make three points. First, I will try to clear up some confusion about what utility actually means. Second I will try to use Austrian-like reasoning to show that the logic used by Austrians is flawed. Finally, I will try to explain what mainstream economics really does with utility and why there is nothing inappropriate going on there (not even anything that violates any Austrian beliefs… except for using math, that is), show mathematically that you cannot infer diminishing marginal utility from it, and attempt to demonstrate how careless the Austrian approach is in comparison.
Utility vs. Value
Austrians are essentially conflating the mainstream concepts of utility, and value. (The Wikipedia page on value, alas, is not that great.) Let me say, at this point that I am working from mainstream definitions. There is no right or wrong definition of a term and I have no interest in debating which word is best used to mean something so I will explain the difference in mainstream terms and then go on to explain how the Austrian argument doesn’t make sense for either. Mainstream economics uses the term value to represent the amount of other goods someone is willing to give up for something. Utility refers to a mathematical representation of a person’s ordered preferences over different bundles of goods. I will get deeper into what this means in the third section but there is an important distinction worth bringing up now. Value measures the willingness of someone to undertake a certain action in relation to real-world variables. If a person’s value of a cheeseburger is two pieces of pizza, this means that if the price of that cheeseburger were 1.9 pieces of pizza, they would trade for it and if it were 2.1 pieces, they would not. Utility is not a tangible, real-world thing, nor does it bear any relationship to such a thing. If I say that someone’s utility of a cheeseburger is 6, this means nothing, unless you knew that person’s utility of other things as well. If I tell you that their utility of a slice of pizza is 5, then I’ve told you that they prefer the cheeseburger to the pizza. But if I tell you that their utility of a cheeseburger is 2 and their utility of a slice of pizza is 1, I have told you the exact same thing, the numbers don’t matter. They don’t measure how happy you are to have a cheeseburger or a pizza. If your utility of a hamburger and a slice of pizza are 2 and 1 respectively, it doesn’t mean that the cheeseburger makes you twice as happy. In other words, it is an ordinal measurement, not a cardinal measurement.
Okay, now here is the crazy thing. Austrians are well aware that utility is only appropriate as an ordinal ranking. In fact, they frequently criticize mainstream economics for using cardinal utility. Here is someone from Mises.org:
Mainstream economists such as John Hicks believe otherwise; for them, DMU means that d^2U / dx^2 < 0. (I.e. the second derivative of utility with respect to units of some good X is negative.) Naturally, Hicks thought that the ordinal approach to utility would make the law of DMU nonsensical.
But for Austrians, DMU doesn’t mean that “the increment in utils gets smaller as you add more units of a good.” Rather, it just means that, say, the 4th unit of a good is more valuable than the 5th unit. No unit of utility is required to make this claim, just as we can say an apple is preferred to an orange without relying on units of utility.
Translation: when we say “utility,” we really mean value. When we say we don’t believe in cardinal utility, we mean we don’t believe in utility.
Austrians think that ordinal means you can’t do math on it (that’s why they like the idea so much haha…) and this is sort of true. The thing is, economists are using a cardinal function to represent an ordinal utility function in such a way that the conclusions derived from the mathematical model are consistent with an ordinal utility function. If you don’t get what this means, I don’ blame you, it’s kind of subtle, but it doesn’t mean that mainstream micro is nonsense, it just means you don’t get it. It’s worth trying to understand (I will try to explain more a little later).
But then, after complaining about the mainstream using cardinal utility, which they don’t, they go on to make a purely cardinal claim about utility, namely that it is diminishing. The word “marginal” means the change in something when something else changes. The marginal utility of a good means the magnitude of the change in utility when the quantity of the good consumed increases. So claiming that marginal utility is decreasing means that the magnitude of the difference between the utility of the fourth unit and the fifth unit is smaller than the magnitude of the difference between the utility of the third and fourth units. But the notion that there is a magnitude associated with these differences at all is a fundamentally cardinal notion.
When confronted with this contradiction, Austrians just say “well that’s not what we mean by marginal utility” ala my favorite South Park episode but in reverse (see above quote). But that is what the words mean…. http://s0.wp.com/wp-includes/images/smilies/icon_sad.gif
Anyway, going forward, I will assume that what they mean when they say “marginal utility” is marginal value (again, see above quote) and I will refer to it as such. With this in mind, I will proceed to point out that diminishing marginal value does not follow logically from human action in the way claimed.
Diminishing Marginal Value
The claim which has been made is that diminishing marginal value follows directly from the axiom of human action. The way this was demonstrated was by telling a story where it was intuitively plausible that value would be diminishing. But this doesn’t logically prove that value must always be diminishing. By the way, this is the problem with refusing to use math, you end up considering things “proven” when you don’t feel like putting any additional effort into thinking of a counterexample. Luckily, I will provide a couple. First, let me say that mainstream economists do assume diminishing marginal value (or at least things about utility which amount to the same), and I think it is a very reasonable assumption. And observation, for the most part, backs this up. So it’s hard to make an example where you would say “yeah there clearly wouldn’t be diminishing marginal value in that case.” All I’m doing here is showing that you can’t prove diminishing marginal value in the way Austrians claim you can.
1. The value of the use to which the last unit is put may depend on the previous units.
A rancher has some free-range cows grazing on his land. There is an adjacent plot of land owned by his neighbor which he would like to keep his cows off of. The boundary between the two plots is 1 mile long (let’s just assume this is a straight line and the rest of the property is enclosed by a natural boundary. Can we prove logically that the value of the first foot of fence must be greater than the value of the 5280th foot?
2. The options available may change depending on the quantity at hand.
A man has some amount of grain and a (fertilized) chicken egg. It takes 10 lbs. of grain to raise a chicken to point that it’s worth eating, and let’s say it takes 10 lbs. to keep the man alive long enough to raise the chicken. As most people are aware, raising animals is less calorically efficient than just eating their feed (the quantities here are completely made up and bear no relation to reality). It is obvious that if the man has only 10 lbs. of grain, he would eat it all, assuming he doesn’t want to die. If he gets an 11th lb. he will eat it as well, along with the egg, since it’s not enough to raise the chicken to maturity. This will be true until he gets 20 lbs. Now assume that when he has 20 lbs. he decides to raise the chicken. Can we prove that the 20th lb. must have been worth less than the 19th lb.?
3. A variation on #2 which relied on a discontinuity in the budget constraint (he couldn’t convert small amounts of grain into small fractions of a chicken). We can get a similar result without this feature.
Assume the same man can trade grain for chicken at a price of 10 lbs. of grain/lb. of chicken. So he can use the chicken for one of two purposes, eating or trading for chicken. Let’s assume that this is for a period of several days. When he has ten lbs. he eats it all. Therefore, this must be the highest value use right? When he has 20 lbs. he eats 15 lbs. and trades 5 lbs. for 1/2 lb. of chicken. When he has 40 lbs. he eats 10 lbs. and trades 30 for 3 lbs. of chicken. When he has 100 lbs. he trades it all for 10 lbs. of chicken. Did these preferences violate the axiom of human action?
Now you may be saying “okay, but he still probably values the 100th lb. less than the 90th lb. and I agree. But look at what is going on here. The Austrian assertion that there must be diminishing marginal value is based on the reasoning that he will use the first units for the most valuable uses and later units for less valuable units. But the most valuable use may very well depend on how many units you have. If you only have ten lbs. of grain, you need the calories so the most valuable use for all ten lbs. is to eat it. This may be true up to 10 lbs. But that doesn’t mean that as you keep getting more, this will continue to be the highest value use. Let’s say this is the case for the first 15 lbs. It may be the case that when you get to 40 lbs., the 11th-15th lbs. become more valuable converted to chicken and when you have 100 lbs., even the first lb. is more valuable as chicken. Therefore, you cannot infer that someone always uses a good for highest value purpose “first.” It is true that they will always use whatever they have for the highest value purpose by definition, but the highest valued purpose is state-dependent, it can change based on how much you have. This is the fundamental flaw in the Austrian reasoning. You can’t rank “uses” independently from income, you have to rank bundles (econ speak for combinations) of goods (or uses). When someone’s income/endowment increases, they gain access to different bundles. This may completely change the relationship between the values of the individual goods within those bundles.
As I said earlier, mainstream economics assumes diminishing marginal value. We don’t claim it logically must be true. We arrive at this assumption largely by the same logic that Austrians do. The difference is that we derive a refutable implication from it and notice that it is not generally refuted, whereas Austrians assume that their theory can’t possibly be wrong so they don’t bother checking. Here’s how we do it.
First we postulate that people have preferences, which is to say that given any two combinations of goods, they would either prefer one to the other or the other to the one or be indifferent between them. Then we imagine a function into which you can put the quantities of all goods under consideration and get back a number. This is a cardinal number but the only meaning we assign to it is to rank the bundle relative to other bundles. In other words, a bundle with a higher utility is preferred to a bundle with lower utility. This is the only meaning contained in the utility function. It doesn’t matter how far apart the numbers are. This means that multiple functions can represent the same preferences. It even means you can represent the same preferences with diminishing marginal utility or increasing marginal utility. Also, you can have increasing marginal utility and diminishing marginal value (also called marginal rate of substitution).
Mainstream economists use a utility function to represent ordered preferences because it is impossible to represent the infinite number of bundles which exist along a continuum of quantities in list form. Even if you dealt only with discrete quantities it would be very cumbersome to order all possible bundles of several goods which could be available within a given budget. Also, it would be very difficult to articulate the restrictions that you were relying on to generate the results which your model was producing (you might not only have to rank all combinations of the goods but do the model with every possible ranking of all combinations to find out how changes in preferences affect the results).
It is because all of this would be very difficult and cumbersome that Austrians have chosen to avoid it by making drastic simplifying assumptions like the preference ranking of goods is independent of income (what Austrians represent as different uses for a good is typically represented as different goods in mainstream micro). Once you do this, it becomes kind of simple to list ranked preferences, you just say which uses are inherently most valuable and assume that as someone gets more and more of the good, they just move up the list. But this assumption is not only logically guaranteed to be true, it is quite obviously false once you actually think about it. To see this take Bill Gates (a rich guy). Imagine that Bill lost all of his money and was thrown out on the street with only $10. Now imagine what he would spend that $10 on. Now ask yourself: do you think Bill gates currently spends at least $10 on that good? As long as Bill gates isn’t a smoker, chances are the answer is no. The idea that if he only had $10, he would buy Top Ramen with it, does not imply that Top Ramen is the highest-valued use of $10 when he has a hundred billion.
Okay, so mainstream economists, rather than asking: what can we prove about preferences just from the axiom of human action and finding the answer to be nothing, giving up and going home, ask: what kind of preferences would generate results that are consistent with what we actually observe. As it turns out, diminishing marginal value is about the only interesting thing we are pretty confident about. The reason for this is pretty straightforward, though it is entirely unrelated to the Austrian logic. As it turns out, if people did not have diminishing marginal value (except under a very specific and unusual circumstance) they would spend all of their income on only one good. Since we don’t observe this, we are pretty comfortable going forward assuming diminishing marginal value. This doesn’t mean that value must logically always be diminishing but only that, for the goods people buy, it must be diminishing around the quantity where they are buying it or else the world would look different than it does.
It is worth pointing out that this does indeed require one to look at the universe and see if it fits with the model. All models are built on assumptions and all assumptions could be wrong. Therefore, it behooves us to check every once in a while and see if what we are saying makes sense. The notion that we can do science with pure logic without any observation whatsoever is misguided. For instance, you can start with the axiom of human action and I agree that this is a good axiom. But you had to get that axiom by looking around and noticing that people do indeed act. You say that denying it would be an action, I say yes indeed but you would still have to open your eyes to see whether or not that action took place.
One More Thing
There is one more reason I think this is an issue of particular importance. This is not a reason not to believe in diminishing marginal utility, we should seek truth for thruth’s sake, but it is a reason to be careful to make sure you have it right. The left often uses the notion of diminishing marginal utility to justify all sorts of social programs, economic intervention and redistribution of wealth. It’s an elegantly simple, yet completely nonsensical argument. If marginal utility decreases when someone gets more and more stuff, then we can increase total utility by taking from the rich and giving to the poor. I know Austrians don’t mean it this way, but frankly they are just picking and choosing the meanings they like and ignoring the ones they don’t like. This is a very dangerous intellectual game to play.
The great thing about having a blog that nobody reads is that you can make bold predictions. If they don’t come true, nobody notices but if they do come true, you can pull them out and point to them to show how clairvoyant you are, selection bias at it’s best. In that spirit, here is one such prediction on the upcoming sequester and its economic and political consequences.
The sequester will go through. Right now neither side is making a genuine attempt to avoid it. The President is committed to a political strategy, he thinks he can put the blame for it on Republicans. And he might be right. I think he has his sights on the midterms. It’s absolutely dishonest on several levels to go around and act like republicans are going to cut police and firemen, mainly because he is the one who has the ultimate say in what gets cut. Unfortunately, I fear that segment of the voting public who is not really paying any attention may be a majority at this point. This makes the real question: will the President actually follow through and cut all the worst possible things and still be able to blame it on Republicans? I don’t know, but I kind of think yes, sigh….
The real head-scratcher here is that the Republicans aren’t really shielding themselves from this. It would be pretty simple. All they need to do is put together a bill that cuts the same amount of spending but out of programs that hardly anyone would support, propose it and go all over TV saying they offered a better alternative to the sequester but the Democrats chose to shut down parks and fire first responders rather than cut subsidies to failing solar panel makers and $50 muffins at the triannual tropical retreat for the department of rubber baby buggy bumpers. I can’t help but wonder if the “leaders” in the Republican party have motives other than winning more seats for Republicans in order to shrink the government and restore a greater degree of individual liberty.
But the big problem is that conservatives don’t have an adequate macroeconomic theory. They basically think big government is bad for the economy (I agree) and therefore, shrinking it a little must be good for the economy. The problem is that our entire economy is now built on a foundation of exponentially increasing debt expanding the money supply and driving inflation. If these aggregates fall a little bit short of expectations, it can cause serious economic consequences. To be clear, I think this situation is highly undesirable and it would be good to replace it with a more natural free-market economy. But that’s not what is happening. What’s happening is politicians have put a process in place that hacks away indiscriminately at this monstrosity in a way that insulates both sides from direct responsibility. It’s almost as if neither side expects the results to be that great. I think this is the case but it’s not the loss of government services that will be the problem, it will be the effect on the overall economy caused by slowing the growth of macroeconomic aggregates.
These seemingly minor cuts, along with the general determination on the part of Republicans to reign in spending, is probably not going to actually reduce deficits but it will probably prevent it from growing fast enough to support the economy. In theory the Federal Reserve could pick up the slack by engaging in “unconventional” open market operations. However, murmurs of reluctance to do so are beginning to emerge from those hallowed halls. (Broken circle, Playing with matches)
So I actually think that the sequester will cause a serious economic downturn, or at least that a serious economic downturn will follow before the end of the year. It will be the result of a lot of things but the sequester may be the thing that finally touches it off. This will be a catastrophe for Republicans and could lead to a scenario that is so ridiculous it’s laughable. Six years after being elected and promising to fix the economy and lower unemployment, having control of the Senate the entire time and the House for part of that time, we may go into the midterm elections with double digit unemployment, negative growth, and a depressed stock market and still blame Republicans for it. If Democrats get control of both houses of congress and a 60 vote majority in the senate under those circumstances, God help us.
P.S. Did I mention that George Soros sold gold last quarter? Here’s a piece from the WSJ a few days ago.
Perhaps even more worrisome, Shaoul points out, is mom-and-pop investors aren’t shedding their gold holdings in the same fashion that the “smart money” has. Total global ETF holdings in gold rose at the end of 2012, growing by a total of 3.4%, he says.
“This indicates that there were other, dare we say less sophisticated, buyers of the metal,” Shaoul says. “The transfer of an asset class from stronger to weaker hands is a process known as ‘distribution’ and is normally followed by a sharp move downwards as the new holders discover they have rather less company than they assumed at the time of purchase.
“The unusually broad public dumping of the metal by a number of respected fund managers does therefore create a risk that sentiment towards the metal could start to deteriorate rapidly in the coming sessions,” he adds.
This post by Scott Sumner points out a lot of the ways in which government hurts the poor which most people don’t realize or think about. I think the occupational licensing laws are indeed the most detrimental. The last time I got my haircut I noticed the license displayed in my “stylist’s” workspace. I wish I could call her my barber but I found out after asking about the license that not only do you need a license to cut hair, you have to complete a college program, and that there are two separate licenses for stylists and barbers. It turns out that it is illegal to do certain things like color hair if you only have a barber’s license. Meanwhile, a stylist can do pretty much anything except use a straight razor.
Last time I told you that money does not represent a debt from the Federal Reserve and that even if it did, it would not serve as an anchor for the real value of a dollar because the assets of the Fed are also denominated in dollars. So what does money really represent and what does anchor the real value of a dollar?
In the past, paper money was created by banks. You could take gold or silver or something of the sort to a bank and they would give you a bank-note which could be redeemed at any time for some quantity of gold or silver or the like in the future. As long as people generally trusted the health of the bank, they could trade the notes instead of the gold or silver which was somewhat more convenient and also allowed for an “elastic” money supply (I’ll postpone a discussion of that topic). Originally, the government got involved in money essentially by assuming the same job as a bank. They would trade dollars for gold and gold for dollars at a given rate. In this scenario, money represents a debt from the bank or the government to the holder of the note. The gold or silver or other real good which backed the money is a sort of “anti-debt.” It is the means by which these debts can be extinguished.
Today, money is not backed by gold or silver or anything in this manner. The process of money creation is of an altogether different nature. There are a few different ways it is done but they amount to essentially the same thing.
If you buy a government bond, that represents a debt from the government to you. It is redeemable at a fixed time for a fixed amount of dollars. The dollars you use to buy the bond do not represent a debt from you to the government. They represent the means by which the government can extinguish its debt to you. At the appointed time, the government must produce the requisite amount of dollars to retire your bond or else default on its debt. The number of dollars required to do this at that time does not depend on variables such as the price level, rate of inflation, real interest rates, GDP, etc..
If you sell a government bond to the Federal reserve, the debt which the government owed you is transferred to the Federal Reserve. The dollars which the Fed prints and gives to you represent the means by which that debt can be extinguished. The Fed doesn’t owe you anything, the government owes the dollars to the Fed. When the bond comes due, the government must either get dollars from taxes or issuing more bonds in order to retire that bond, or, as they normally do, just issue another bond and give it to the Fed, which cuts out the middleman (you).
Alternatively, the Fed can loan to a bank. When a bank borrows dollars from the Fed, it’s not the Fed that owes the bank, it is the bank that owes the Fed. The dollars, again, represent the means with which the bank is able to extinguish this debt. The principle is the same, in either case, the dollar is created and traded for debt. In both cases, the debt is from someone else to the Fed and the dollar is not the debt but the “anti-debt.” This is an important distinction between modern fiat money and traditional bank-notes which, at one time were backed by gold or silver.
To see how this provides an anchor for the value of a dollar, we must go a step farther. If the Fed loans to a bank, that money becomes part of the bank’s reserves. If you sell a government bond to the Fed, you most likely deposit the money which you get in return in the bank and it becomes part of bank reserves. Alternatively, you may spend it on something else, but in this case the person to whom you pay the money most likely deposits it and it becomes part of bank reserves. I can drag this out through as many steps as you please, but the point is that most of this base money will end up as bank reserves.
The money which the Fed creates and which is able to extinguish Federal Reserve debt is the money base. Some of this ends up in people’s wallets but most of it ends up in bank vaults (or accounts with the Fed which amount to the same thing). The base money that ends up in bank vaults acts exactly like gold did in the old system. It is anti-debt. The banks then issue bank credit on top of this which is debt. This bank credit takes the form of checking accounts, saving accounts, certificates of deposits and so forth. If you deposit a $20 bill in the bank and they add $20 to your checking account balance, this is a modern form of bank credit. It is redeemable at any time at the bank for $20 in cash. Again, the cash is the anti-debt into which this bank credit is convertible.
And just like people could use bank-notes to transact, we now can use this modern bank credit. You can go to the store, buy a gallon of milk and pay with a check or a debit card. At the end of the day, the store will deposit the check with their bank and their bank will settle any balance that arises with your bank by transferring cash, just like in previous times banks would have settled by transferring gold. So what we typically call “money” and what we use to buy things is made up of both base money (currency) and bank credit. The bank credit represents a debt of base money from the bank. The base money is anti-debt opposing some debt with the Federal Reserve.
But not all bank credit is created from depositing currency. The majority of it is created in opposition to a new debt to the bank. This process is just like the one described above when the Fed creates base money. Someone goes to the bank and wants a loan. The bank may give them a loan in the form of bank credit. Alternatively, the story often goes that the bank lends cash and the borrower spends it and the then whoever they gave it to puts it in their bank and their bank lends some of it as cash and this process continues. It makes no difference which story you tell. The result is that bank credit increases the quantity of what we call money beyond the quantity of base money created by the Fed.
This increase in money comes with an increase in debt. This is the key. The debt is nominally denominated. In order to pay it off, someone must produce a fixed quantity of dollars. If they don’t pay their debts, there are usually undesirable consequences. Usually those consequences involve the loss of some real property. If you don’t pay your mortgage, the bank takes your house. If you don’t pay your car loan, they take your car. If a business doesn’t pay their debts, they go bankrupt and the creditors take their assets. It is all of these assets securitizing all of the debt which is created in the process of creating our money that provides a real anchor for the value of a dollar.
Maintaining a stable value for the dollar depends on maintaining a balance between the quantity of money and the quantity of debt. The reason that the hyperinflation scenario described by many Austrians and conservatives, in which people lose confidence in the dollar and stop accepting it and the value plummets, never happens is because people with debt need those dollars to pay off their debt. They won’t just decide not to take them. If some people suddenly lost confidence in the dollar and decided not to hold any, those people with debt would be happy to take them off of their hands. In fact they would compete over those unwanted dollars. If someone owed $10,000 on their car, and not paying would result in the loss of the car, then they would be willing to trade any possession they own which they value less than the car for $10,000, including some quantity of their labor (or the car for any amount of dollars greater than $10,000). In this way, all of those assets–the houses, cars, boats, businesses, etc.–which secure all of our debt are “backing” the dollar. Dollars are convertible into these assets at a fixed rate. It’s just that this rate varies from person to person, there’s no “car standard” or “house standard” so it’s not obvious to people.
What’s more, the process by which money is created, destroys money when reversed. In other words, when people pay off their debt, the money supply decreases. Now here’s the kicker. Here is M2 (base money plus most forms of bank credit). Here is total credit market debt owed. Notice that total debt is about five times the size of M2. Now consider what would happen if people did the opposite–that is, if people decided that they didn’t want to hold debt any more. They start deleveraging and the money supply starts to contract. As this happens the price level starts to fall. There are different ways to explain it but they amount to the same thing, people compete for the dollars that they need to pay down their debt by offering other goods and services at a more favorable rate. As the money supply contracts, it gets harder and harder to get the dollars required to pay off debt. The prices of goods fall but the value of debt remains the same since it is nominally denominated. Since there is more debt than money, it is impossible for everyone to get out of debt, some people will have to default. This can result in a mad scramble to get the limited quantity of dollars so as not to be left bankrupt and with no real assets.
This is a deflationary scenario and this is the true danger which constantly hangs over our economy. This is exactly what started to happen in 2008. Notice in the graph of total debt, that it begins falling short of the trend right before the recession. This is why the government stepped in and started throwing borrowed money at the economy to stop the bleeding. When the private sector isn’t willing to borrow enough to keep the money supply growing fast enough to keep up with (artificial) inflation expectations and hold off this contraction, the government has to do it. I’m not saying this is desirable or natural or unavoidable. It’s an artificial problem we have brought on ourselves but if we really want to have any chance of fixing it, we have to understand what’s really going on. We can’t just complain about the debt and ignore the system that makes it necessary. If conservatives every got into power and actually tried to balance the budget without completely reforming the monetary and financial system, it would cause a recession that would discredit conservatives and free-market economics for a generation (at least) and probably destroy the Republican party.
Part two will be a bit more exciting, but I want to provide some background first. I know I’ve been over this before but it’s been a while and this is probably the most widespread misunderstanding among conservatives and libertarians. And it’s not just about inflation, if the movement would start to think about money in this way, a lot of other things which are currently misunderstood would start to become clear I think.
The standard view of money is that it’s just paper that is out there circulating, backed by nothing. We take it because we expect other people to take it. They take it because they expect others to take it and so on. Somehow, because we all keep expecting each other to continue taking it, it just keeps circulating. This is essentially what they say in introductory economics textbooks (I don’t have one handy or I would quote it). This logic, quite frankly, is economic nonsense. But many on the right, sensing that this doesn’t seem like a stable situation, come to the conclusion that we are in constant danger of ”losing confidence” in the money. If a few people become unwilling to hold money, or if the Fed expands the money supply too much, the value of the dollar will go down and others will decide not to hold money and this will drive the value down further and eventually everybody would be trying to get out of their dollars and their value would plummet.
This is exactly what would happen if that story were true, that system would have broken down the moment the government tried to get it started. A slightly more sophisticated, though also misguided, approach is to say that money is “backed” by the assets of the Federal Reserve. Here is an example.
What backs the money in the present irredeemable paper system? Start by considering this brief anecdote. Joe buys some equipment from John, to be paid Net 30. We say that Joe owes John $10,000. Next month, Joe comes back and gives the money to John. Joe is out of debt, but has the debt been extinguished? No. The debt has been transferred. Now the Federal Reserve owes John the money.
But this is not true. If you hold a $20 bill, the Fed doesn’t owe you $20. The Fed doesn’t owe you anything. The story goes that the dollars represent a debt from the Fed to you which is backed by the assets of the Fed which are mainly government securities. Now to some extent, dollars are convertible into government securities because there is a market for them and the Fed, to some extent, supports this market by standing ready to buy or sell securities if the price moves outside of some range. But this is not a debt. The Fed is not legally obligated to trade you government securities for your dollars.
What’s more, this theory does not establish any anchor for the real value of a dollar since the securities held by the Fed are denominated in dollars. So even if $20 in cash were legally convertible into a $20 treasury bill, this would not do anything to fix the value of a dollar. If people did suddenly decide not to hold dollars the value of the T-bill would plummet along with the value of the cash.
I think part of the confusion surrounding the nature of money is due to the way the accounting is done. In accounting, every debit must be offset by an equivalent credit. When the Fed prints a hundred dollars and uses them to buy a $100 T-bill, they debit the asset “T-bills.” This must be offset by a credit. The way they choose to account for this is to credit a liability account representing notes outstanding. We call this a liability because in accounting terms, this account behaves just like a liability. A credit to this account offsets an increase in other assets caused by increasing the amount of notes outstanding and debiting it offsets a decrease in assets caused by decreasing the notes outstanding (selling assets and retiring the money). But legally they do not represent a liability in the sense that we usually think about one. There is no obligation to redeem these notes.
Alternatively, imagine I ran a counterfeiting ring and kept diligent accounting records (I’m not trying to make a moral connecting between the Fed and counterfeiting, just an accounting connection). I print $1000 and buy a big-screen TV. I account for this by debiting the asset account “consumer electronics” $1000 and crediting the revenue account “counterfeiting revenue.” When I prepare my income statement at the end of the quarter, this revenue will become profit which will increase (credit) “owner’s equity” by $1000. Now, of course, I could sell the TV. Let’s say I can still sell it for $1000. If I do this and burn the money that I get, I would have to credit “consumer electronics,” and debit some expense account, let’s call it “burning money expense.” Then at the end of the quarter, this would be treated as a loss and would decrease (credit) owner’s equity.
The Fed doesn’t account for money creation in this way, I presume for a few reasons. By calling the notes outstanding a liability, they do not get converted to profit periodically, they remain on the balance sheet. My hypothetical counterfeiting operation was for the purpose of generating profit. I (hypothetically) don’t really care how many of my notes are circulating. The purpose of the Fed’s operations, at least partially, is to manage the money supply. So they need to keep track of how much money is out there, so it doesn’t make sense to close out that account periodically. Furthermore, the Fed may, theoretically, at any time need to reduce the amount of money in order to achieve their goals, whatever those may be. This means that they must remain in a position to do so at all times. Calling their asset accumulation profit and remitting it to the treasury would not allow them to remain in a position to contract the money supply whenever they wished. Also, it would probably look worse to have to tell people the actual amount of real wealth that the Fed is channeling to the Federal Government. (Though in our current perpetual ”fiscal cliff” environment, there may be many who sort of wish people would notice as this profit generated by the Fed could essentially wipe out the national debt, if we wanted to. More on that later.)
But just like I am not obligated to sell my TV back and burn the money, the Fed is under no obligation to redeem dollars for treasuries or any other asset. And even if they were, it would not establish a “real anchor” for the value of the dollar. So what does provide such an anchor? More on that in the next post.