Since it’s the weekend, I’m going to take a break from my attempts to reinvent (essentially) the existing macroeconomic paradigm from the ground up using debt (and collateral) as the backing for money and do something much easier–bash Austrians. This is from a recent post on The Money Illusion.
I constantly hear conservatives complain that elderly savers can’t earn positive interest rates because of the Fed’s “easy money” policy. Is there any time limit on how long you will make this argument, before throwing in the towel and admitting rates are low because of the slowest NGDP growth since Herbert Hoover was President? Or is your model of the economy one where decades of excessively easy money leads to very low inflation and NGDP growth?
In other words, is there some sort of model of monetary policy and nominal interest rates that you have in your mind, or do you see easy money everywhere and tight money nowhere? What would tight money look like? What sort of nominal interest rates would it produce?
If you have spent any time at all reading econ blogs you should know exactly what answer you will get to this without bothering to check the comments section. But in this case, you don’t have to wade too deep into the 266 (and counting) responses before you get it. On the second comment Old Reliable, Major_Freedom, supplies it for us. (I bet when people see “Free Radical” they expect me to be like that guy but it’s partly tongue-in-cheek!) Read more…
Okay, yesterday I set out to explain how the value of a dollar is determined and monetary policy functions under my collateral-backing theory. I typed for two hours and felt like I didn’t get half way there (much of it is just rehashing what everyone else already believes). So I am going to try to slice off a smaller piece again. This time I won’t promise to fit everything else into the next post (reflecting on the fact that Sumner has been trying to explain that nominal rates are not a good indicator of the stance of monetary policy for five years…). I will just take it one bite at a time and see what, if anything, people want to argue with and go from there.
So in this installment I basically want to deal with this criticism by J.P. Koning.
2) What anchors the price level? Why does $1 buy one apple and not $10 apples? Does a Canadian dollar by 0.98 US dollars because there are less debts to settle in Canada?
Frankly, I am a bit perplexed by this question because this is exactly the problem that I think his theory (and essentially every other theory I am aware of) has and which, in my mind, my theory solves quite nicely. So in a sense, I feel like that’s what I’ve been explaining. Somehow, I haven’t gotten my point across (maybe because I haven’t explained it well enough or maybe because there is a flaw that I don’t see), but I’m not exactly sure where the disconnect is so once I start trying to explain I tend to want to try to come at it from every possible direction and cover everything under the sun related to money. I will try to resist that temptation here by avoiding a detailed discussion of how monetary policy functions.
So let me start by attempting to more clearly explain what I am trying (and not trying) to do here. First of all, I don’t think I am overturning everything everyone ever thought about money and monetary policy and macroeconomics. I think that monetary policy functions in essentially the same way that most economists do. I just think that, on a basic level when you get to questions like “why is money valuable in the first place?” the explanations typically given are not the whole story. In fact, I think they miss the most important piece of the story.
Once you fill in this piece of the puzzle, I do think that you can see some things that are a bit fuzzy without it more clearly and I do think that there are a few implications (or at least possible implications) that arise from this view which are missed by other simpler models of money creation though it takes a lot of analysis to get to them. But this doesn’t mean, for instance, that I don’t think the CB can affect the value of the currency by buying and selling assets.
Now the answer to “what determines the price level at any given time,” on some level, has got to be the same for any theory. It is determined by supply and demand. At any given time, there is a certain number of dollars in circulation and a certain quantity of goods and services (or potential goods and services) and the dollars circulate at some velocity which is based on peoples’ willingness to hold them relative to other assets and this determines a “price level.” This basically has got to be the case regardless of why you think the money has value.
The real question underlying this, which I have tried to answer is “why are people willing to hold money at all?” Whatever the answer to this question, it will determine some willingness to hold money (which is to say a “demand form money” which depends on the cost of doing so) so people will hold money until the marginal benefit (from liquidity preference) is equal to the marginal cost (foregone return on other investments). The higher the velocity, the higher the marginal liquidity preference will be (or vise-versa) and there will be some equilibrium price level.
Now, any theory about the demand for money also has to acknowledge that the willingness of people to hold money today depends on their beliefs about the value of that money in the future. This is what makes everything complicated. We know people must believe it will be valuable or else they wouldn’t hold it at all (and probably that it won’t be dramatically less valuable or nominal interest rates would be really high). The question is: why do they believe this and, probably more importantly, is it reasonable to believe it? Another (more rigorous) way of putting this is to ask whether the equilibrium is based on beliefs that are rational off the equilibrium path (is it a subgame perfect NE)?
For instance, if peoples’ willingness to hold dollars is based entirely on the belief that others will be willing to hold them in the future, and the value of them (either now or in the future) is not anchored to any real goods in any way, then if people started to question that belief, for whatever reason, you could see the willingness to hold them drop dramatically, possibly substituting other goods for use in exchange (essentially allowing P to decouple from M, V, and Y), and the price level could shoot off to infinity and the dollars become basically worthless in a Weimar/Zimbabwe-style hyperinflation. This seems to be what most people who think the dollar is backed by nothing fear, and that fear would be reasonable if it were actually backed by nothing .
Similarly, if you think that the dollar is “backed” by the expectation that the CB would be willing to trade real goods for dollars to prevent the real value of the dollar from falling, then one must wonder whether they have enough such assets to do this if people “lost confidence” in a manner similar to that described above. It is hard to see how this theory can explain a total value of the dollars which is much beyond the value of the real goods that the central bank has available to trade for them (accounting for a liquidity premium) without relying on the same type of logic, i.e. people know the CB couldn’t cash out all the dollars for gold at the current price of gold but they just hope that, for some reason, people will keep being willing to take the dollars at the current elevated value and so the CB will never have to do this.
The willingness of the CB to buy and sell a little on the margin does not seem to rectify this problem, if the promise to go all the way is not credible (due to insufficient real assets). A classic Ponzi-scheme works for a while because the person perpetuating it stands ready to cash out people who demand their money but once it becomes clear that they do not have enough money to cash out everyone, it collapses.
I think what I have done is provide an explanation for why it makes sense for people to expect the dollar to continue to be in demand that does not rely on any kind of belief that could suddenly evaporate at any moment but instead is based on real exchange rates between dollars and real goods that are fixed in long-lasting, legally binding contracts. In order to explain this further, let me start by defining what I mean by “money.”
Going forward, when I say “money” or “dollars” I mean anything that can be directly (without being converted to another form) used to repay debt from a bank. I think the line may be a bit blurry in some cases but for the most part this includes, essentially cash and bank deposits (checking and savings). I don’t count stocks or bonds because these must be sold at a market price for money before debt can be repaid. Some things like money market funds or certificates of deposit are a bit tricky but I don’t want to get too distracted by this issue for now.
The important thing to notice is that I am coming at the “money supply” from the opposite direction of people who begin their reckoning from the money base. This is only significant because they often talk about the willingness to hold money as the willingness to hold currency (cash) whereas I am talking about the willingness to hold dollars in any form. Since currency and deposits can be converted into one another at any time at par, the composition of peoples’ “money holdings” between the two will be determined by the different liquidity of each. While this willingness to hold cash has an important mechanical function in determining the amount of total “money” which will be created from a given quantity of base money at a given nominal interest rate, and is therefore important for modeling the effect of CB policy, this is not what I am after and so this distinction between cash and deposits is not of particular interest for my purpose.
So let us acknowledge that the CB has tools that can alter the quantity of money which is created at any given time and put the discussion of what those are and how they work aside for now. It is true that people are willing to trade real goods for dollars and hold some quantity of those dollars. This means that they must believe the dollars will be sufficiently valuable in the future (given their other options for holding wealth). The question is why does this belief make sense?
The reason for the reliance on “network effects” to explain this, I think, stems from the Macro 101 view of the role of money in the economy. This is essentially that money circulates through the economy like a perpetual, circular river and the CB simply determines how much water it wants and pours it into the system. It can add water or take it out but it essentially has no purpose but to circulate and is not directly connected to the value of any real goods except by the seemingly arbitrary rate at which people choose to push it perpetually through the system.
I think this does serve as a reasonable approximation of how money functions but that the fundamental nature of this money is somewhat different. I am saying that money does flow through the economy in this way and the quantity is determined by CB policy but that the meaning of those dollars is in fact anchored to specific real goods because of the way the dollars are created.
The CB does not just print dollars “out of thin air” and dump them into the economy. Dollars are created when someone borrows. CB policy does limit the extent to which this process can go on but that is what I’m trying not to get into here. So I see the fundamental economic function of the banks as manufacturing liquidity. Under a gold standard, if you don’t want to lug your gold around, weigh it for every transaction, slice it into pieces etc. you can take it to the bank and convert it into a more liquid form (bank notes) which are easier to use for transactions.
But this is not the only–or even the most significant–form of transaction cost that banks help people overcome. For instance, if you are a shoemaker and you want to trade half the shoes you will make over the next twenty years for a house, you can offer this to the owner of the house but they will likely be reluctant to take it for several reasons. For one, they don’t know you and don’t know if it is credible of you to promise this. For another, they don’t want that many shoes and would have to be constantly re-trading them for the stuff they did want.
But you can overcome this by going to the bank. The bank will verify your income, asses the value of the house and offer to lend you the money (or part of it) to purchase the house in return for a promise to repay some amount of money in the future or else lose the house. You then trade this newly created money for the house. The seller of the house now has an account representing the value of the house he just gave up which he can use to purchase other goods (including other investments) in whatever form or quantity and at whatever point in time he wishes. You, on the other hand, are obligated to work (presumably producing shoes) for the next twenty years to get those dollars back to pay off your loan and keep your house.
So the question then is, why is the seller able to take those dollars and trade them to third parties for other goods? The answer is that they know that somewhere out there is a guy who is obligated to produce shoes and trade them for those dollars in the future (as well as a bunch of other people producing other goods). In this way, money is created by converting other real goods into a more liquid form. This more liquid form of wealth then circulates in the economy in the way commonly understood and the willingness of people to hold it determines a velocity and a price level. But that willingness to hold money, based on the belief that someone else will be willing to trade real goods for it in the future is “anchored” by all the people willing to trade “shoes” to get dollars and the rate at which they are willing to trade shoes is “anchored” to the rate at which they are contractually able/obligated to trade those dollars for their houses. This rate, again, is nominally denominated and fixed (doesn’t fluctuate with market conditions or “confidence” in the dollar or anything like that).
So at any point in time there is some quantity of dollars circulating and there are people trying to get the dollars and “retire” them by paying off debt and there are people creating new dollars by securitizing new real assets and this determines the change in the quantity in circulation. The CB can “steer” this quantity by altering the constraints on the creation of new credit (changing the money base for instance) or potentially by doing other things which I don’t want to get into.
Naturally, when someone enters into a long-term debt contract, they do so with some beliefs about market conditions in the future which will affect the price of the goods they intend to produce. This depends largely on the rate of growth in the money supply relative to output and this depends on some belief about CB policy going forward. Just how to model this becomes a complicated question which I will leave for another time but the central point remains that the real value of the dollar is inextricably “anchored” to real goods by these contracts.
This, I believe, is why we don’t see sudden losses of confidence leading to dramatic declines in the value of the dollar. On the contrary, at times of financial panic (to put it dramatically) we tend to see the opposite. People try to liquidate other assets and hold dollars, leverage dries up and we see defaults. I suspect that if we drilled down, we would find that there are actually not enough dollars to pay off all the debt but doing so is not as easy as I first thought.
Finally, it should become clear how exchange rates are well defined here. There are some quantity of US dollars circulating in the US which are “backed” by real goods in the US and represent claims on those goods and indirectly on the goods and services provided by the people holding the debt contracts on those goods. This quantity along with the liquidity premium and associated velocity defines a price level in terms of US dollars in the US and the same process is going on in Canada with Canadian dollars.
When someone in Canada wants to buy shoes from the shoemaker in the US, they have to trade Canadian dollars for US dollars and vise-versa. The flows of trade between the two countries, along with people speculating about future flows of trade and credit conditions in the two countries make a market for the currencies and the relative price is determined by supply and demand in that market in the way commonly believed. But both currencies are “anchored” to real goods by debt contracts denominated nominally in their respective currencies and securitized by real goods.
Okay, I got some good comments from J.P. Koning and others, for which I am grateful, on my “debt chartalism” theory explaining the value of fiat money. I set out to answer them all in one post but as I dig into it I realize that there is a lot there that I take for granted that probably deserves a more careful explanation so I will begin here with a more thorough discussion of the fundamental nature of fiat money relative to a convertible currency explicitly backed by a hard asset. Then in a future post, I will try to delve into monetary policy, inflation, determining the specific value of a dollar etc.
The important thing to notice here is that the nature of fiat money is actually not that different from “hard” money. To see what I mean, let me start with a bank issuing gold notes and go through some minor alterations that I think most people would agree would not destroy the value of those notes. In what follows I will represent the banking sector with a single bank. The relationship between the CB and individual banks raises a bunch of issues which I don’t think are necessary to make my point (and are distracting) so I will abstract from them for now.
We start with a bank that has no assets and some people who have gold and want to exchange it for bank notes because the notes are more liquid (easier to use for transacting). People take their gold to the bank and the bank creates notes “out of thin air” which they, or anyone else, can return at any time and exchange for “their” gold. Most people seem (rightly) to have no difficulty seeing why these notes would be valuable.
Now imagine that instead of taking your gold to the bank and getting notes, the bank comes to your house, verifies that you have the gold, issues you the notes and tells you that in one year, you have to “redeem” the notes or else they will take your gold. These notes may be convertible by anyone at any time at the bank or they may not be. In the first case, of course, the bank will have to have some other gold in their vaults to deal with these redemptions but as long as there is sufficient demand for liquidity relative to the quantity of notes in circulation, most of the notes will float and redemptions will be limited. But the important point is that you have not turned a perfectly legitimate enterprise into a Ponzi scheme by letting people hold the gold in their individual vaults rather than the bank’s vault. The gold is still backing the notes because of the nature of the contract that created them.
Looking at it this way, hopefully we can see that it is not the universal convertibility that gives the notes value. This, of course, may give them somewhat more value but mainly it is a mechanism which imposes discipline on the bank and inspires confidence in the holders of their notes. This is a discussion for another time. But consider whether these notes would still be valuable if the bank withdrew the universal convertibility. By this I mean that you still have to have 100 oz. of notes in one year to keep your gold (let us call this individual convertibility) but if you trade the notes to someone else, they can’t just take them to the bank and cash them in for gold.
Will these notes still be valuable? The answer I think is yes because they are still convertible. It is just that they are only convertible at a given time by a specific individual. But because there are some individuals who are able to “convert” the notes to gold at a fixed rate, those individuals will always be willing to trade real goods and services for those notes. In this way the gold is still “backing” the value of the notes, it is just that the convertibility has been changed from a general obligation to a specific obligation between the bank and certain individuals.
Finally, imagine that the bank accepts other goods besides gold to back their notes. This raises the issue of denomination. You could have “silver notes” and “ruby notes” and “corn notes” because these are essentially commodities but these notes would make general exchange somewhat more complicated (everyone would have to keep track of the relative values of all of these things) and you could not create specific notes for idiosyncratic goods like “house notes” and “car notes” and “boat notes” because one man’s house is not worth the same as another’s.
One solution to this problem is to denominate all notes in a single good. So if you want to convert your house into notes, instead of the bank issuing you “house notes” they issue you gold notes for a quantity of gold equal to the value of the house (or somewhat less). Then you have the right to “redeem” some quantity of “gold notes” for your house at some point (or points) in the future at a specific, predetermined rate. In this case, even though the notes represent a value denominated in gold, it is your house that is actually “backing” those notes.
But if the notes are not universally convertible into gold, the denomination is arbitrary. The bank can just as easily issue you notes denominated in “quatloos” and say that you need to return 1,762 quatloo notes in order to keep your house. People can put up whatever assets they want, the bank can assess their values in quatloos and issue notes which are redeemable at various rates for various asset. As long as these notes are interchangeable and denominated in the same units (even if that unit is completely arbitrary), they will be able to trade them amongst themselves and there will be a somewhat stable demand for them because there are always people who can “redeem” them for real assets at various rates.
In this way, the quatloo notes are still backed by real goods, it is just that those goods are not as obvious because the type of goods and the rate of convertibility vary from person to person. To get a better feel for the similarity between the creation of universally convertible notes and individually convertible notes, note (haha) that under a classical gold standard with fractional reserve banking, the two actually exist side by side.
Let us return to our bank which starts with no assets. The bank attracts some “depositors” who deposit 100 oz. of gold and are issued universally convertible gold notes. The gold goes on the bank’s balance sheet as an asset (obviously) and the notes go on as a liability because the holders of the notes can bring them in at any time and redeem them for gold. The balance sheet then looks like this:
Gold: 100 oz. Notes outstanding: 100 oz.
Now imagine that somebody else comes into the bank and wants a loan worth 100 oz. to buy a house. The bank creates “out of thin air” another 100 oz. of gold notes and lends them to this person and accepts the house as collateral. The bank’s balance sheet then looks like this.
Gold: 100 oz. Notes outstanding: 200 oz.
Acc. Receivable: 100 oz.
The accounting is the same except the asset which goes on the books is an account receivable instead of gold. But there is a real asset behind that account receivable, namely the house. The house is backing the notes of the bank in the same way that the gold from the first guy is. The fact that the bank does not have enough gold to redeem all of its notes does not make it insolvent. This is where Rothbard’s people go off the rails. Fractional reserve banking is not based on deceiving people into thinking that there is more gold in the vault than there actually is. It is just a method of turning various types of assets into a more liquid form. The total assets backing that money grow along with the supply of money.
If the house burns down and the borrower defaults, then the bank will become insolvent. There will be too many notes outstanding for the total assets on the bank’s balance sheet. Then people may rush to redeem their notes and find out that there is not enough gold. But this only happens because the demand for notes from the borrower becomes removed from the market without reducing the number of notes (or delivering the house, which could be sold for notes, to the bank). (Of course, a bank could become illiquid without being insolvent but this is a matter of demand for notes, liquidity preference, etc. that is well-understood, and not worth getting into here.)
In this case, you have a situation where anyone can redeem notes for gold and one person can redeem notes for gold or for a house. The gold-redeemability only keeps the value of the notes anchored to the value of gold. This prevents the bank from issuing so many notes that the value of them falls. If they issue enough notes that the risk/liquidity premium on them relative to gold becomes negative, then people will start redeeming them for gold. If this is not the case, the notes will float and the bank will be able to keep issuing more. But the gold is not the sole source of backing.
Of course, the more loans a bank makes in this way, the more other assets will make up the “backing” of their notes. If at some point, they drop the universal gold redeemability, the value of a note will no longer be anchored to the value of gold but it will not just evaporate into thin air because there will still be a large amount of other assets “backing” it. People will still have individual convertibility in various assets. In fact–especially if it is a monopoly–the bank may be able to accumulate profits over time which can allow it to basically absorb the value of the gold on its balance sheet.
So this change from convertible gold notes to fiat money is not as dramatic a shift as many make it out to be. Once it is accomplished, the value of a dollar comes down to flows of credit–how much new credit is being created relative to how much needs to be paid back (and of course expectations about the future matter a lot). The CB can influence this in various ways. I will try to dive into that discussion soon, though I admit up front that I don’t have everything perfectly pinned down yet.
J.P. Koning has a post (make that two posts) about the IOU nature of bank notes. While I agree that bank notes (fiat money) are not a Samuelsonian bubble asset, I think he still comes up short of the full explanation of why these are valuable. Of course I think that I have that explanation but first let me explain why I think his is not fully satisfactory.
The meat of his argument is this.
So in the case of the two central banks that I’m most familiar with, banknotes are ultimately claims on whatever stuff the central bank happens to have in its vaults. This means that on the occasion of the winding down of the Fed or the BoC, note holders are entitled to receive real assets, in the same way that a bond holder or stock holder would have a claim on a company’s property, plant, & other assets upon the dissolution of that company. Banknote holders have an added bonus of being senior to other claimants, since notes provide a “first claim” in the case of the BoC, and a “first and paramount lien” in the case of the Fed.
But this does not fully address the problem. This is because the process of unwinding a central bank, along with a currency, is fundamentally different from unwinding another type of entity. Consider an individual bank that issues dollar-denominated bonds and uses the money to buy assets including some “real assets” (land, buildings, gold bars etc.) and some financial assets (loans) and imagine that the default rate on the loans is unexpectedly high and this causes the bank to become insolvent and need to be unwound.
The bonds, in this case represent a senior claim on the remaining assets of the bank. The question is how much of those assets are the bondholders entitled to? The answer in this case is straightforward because the bonds are denominated in dollars and the value of a dollar is determined independently from the state of this individual bank. In other words, you can just liquidate all of the assets (convert them into dollar terms) and then assign that value to the various claimants in the order of seniority relative to the size of their claims in dollars.
If you are unwinding the central bank, you are unwinding the dollar itself. So let’s imagine that the CB has some amount of gold in its vaults and it has some amount of notes outstanding which are denominated in dollars. Those dollars are said to be a senior claim on the assets of the bank (the gold) and let us assume that there are some other claims (these may be dollar denominated debt or undenominated equity). But the notes do not entitle the bearers to a specific quantity of gold. So how much of those assets are they entitled to?
In this case the assets cannot be converted into dollar terms and divvied up in the same way as with an individual bank because the value of a dollar is not clear. The whole market for dollars which forms the basis for the valuation of the assets relative to the various claims in the former case is the very thing being unwound in the latter case. So how much of the gold goes to note holders versus other claimants? The answer is not at all clear. So it is hard to see how this claim serves as any kind of foundation for determining the value of a dollar.
The actual explanation for the value of fiat currency, which I have been trying to argue, (also here) I think is actually fairly simple but seems to be absent from all discussion of the topic. One dollar is precisely what is required to extinguish one dollar worth of debt. When money is created, there is always a corresponding debt created. The central bank creates base money by buying government debt or MBS or lending to banks. Banks then “multiply” this money (create additional money) by making loans to businesses and consumers. But these loans eventually need to be paid back.
When a person takes out a mortgage the money supply (some measure of the money supply at least) increases. But this also sets in motion a 30-year process by which that person must grab money back out of the economy and pay back the loan. If they don’t do this, they will lose their house. In this way the increase in money is accompanied by a built-in increase in demand for money in the future. And in this sense money is “backed” by real assets. In this case the borrower is able to “convert” dollars into his house at a specific rate. It is just that this rate, and the convertible asset, varies from person to person rather than applying uniformly to everyone.
This demand for money to repay loans is fundamentally different and separate from the demand for liquidity (though demand for liquidity also factors into the value of a dollar). It is also not based on any kind of “greater fool” or “bubble” mentality. It is (at least to some degree) stable in the sense that it does not depend on mysterious, arbitrary feelings about the value of a dollar. The amount of debt owed is a real number that is denominated in dollars. It is the product of actions that have taken place over a long period of time and it doesn’t suddenly change drastically or disappear because people “lost confidence” in the dollar.
This in fact explains why people don’t lose confidence in the dollar. If the value of the dollar were based only on the expectation that someone in the future would accept the dollar at a given rate in exchange for goods and services and that belief were suddenly called into question for some reason, the “bubble theory” leads us to believe that everyone would start trying to get rid of the dollars and the value would plummet. But if this happened, we would find that many (most) people would actually try to take advantage of the newly weak dollar by exchanging newly valuable (in dollar terms) goods and services to get the dollars to pay off their debt. In this sense, that demand is backstopping the real value of the dollar and because of this, that scenario never occurs (at least in major “developed” economies).
This also solves the unwinding issue. Imagine that we wanted to abandon the entire system of central banking we currently have and replace it with nothing, no new fiat currency, just whatever the market wanted to use. We stop creating new dollars and set a date by which all current debt obligations have to be settled using the current supply of dollars. These dollars would not become worthless, people would be trying to get them before that date to pay off their debts and keep their homes, cars, boats, businesses, etc. This would mean that there would still be a market for them in terms of other (real) goods. You might have to refinance your mortgage in some other terms (gold, silver, Yen, whatever) but this would be better than defaulting and losing it all together. The quantity of dollars would not exactly match the quantity of debt (I suspect it would actually be much less but haven’t been able to quite figure out the right way to observe this) so there would probably need to be some method of settling the excess dollars/repossessed property, and the whole thing would admittedly be pretty messy, especially the issue of how to treat government debt which is not collateralized and makes up the bulk of CB balance sheets, but when you look at it this way, I think you can see that dollar denominated debt (and the collateral backing it) is the main factor guaranteeing the value of the dollar.
In this way a dollar can be said to represent an IOU but I see it as exactly the opposite. Rather than an IOU from the bank, it is a means of extinguishing an IOU to the bank. It can be seen either way because the two look the same on the bank’s balance sheet. If the bank takes in gold and hands you an IOU redeemable in gold the gold goes on its balance sheet as an asset and the IOU as a liability. If you take out a loan, you are essentially writing an IOU to the bank for a quantity of dollars and the bank hands you the dollars. In this case, the loan goes on as an asset (account receivable) and the dollars go on as a liability to balance out the new asset. The gold IOU in the first case is a liability because it can be brought back and redeemed for the asset (gold). In the second case, the dollar is a liability because it can be brought back and redeemed for the asset (debt). In both cases the rate at which this redemption occurs is fixed and not subject to market fluctuations. The accounting is the same but the meaning is somewhat different and this seems to me to be why people have difficulty seeing dollars as an IOU.
This post is inspired by the following question on Twitter.
Does anything need to be done to deal with the loss of jobs due to technology or outsourcing?
To which I replied:
short answer: no (long answer more than 140 characters)
The poster then pointed out that the long answer would fit in a blog post, which was a good point, so here we are. Let’s start with the long version of the short answer.
In a free market it would not be necessary to do anything about this. This assertion is standard fare in introductory econ classes and is based on the notion of comparative advantage. Essentially, the disconnect between economists and others on this issue comes down to a difference in thinking about the labor market. Many people think about the market being made up of a fixed supply of jobs that have to be distributed among some number of workers. They then conclude that these things reduce the number of jobs. This is not a very good way to think about a market.
Economists see an exchange between two parties with a supply and demand for labor. In a free market we expect “jobs” to exist if the cost of labor is lower than the value of the produce. Jobs that are worth more will pay more and people will find their most productive occupations by seeking the highest wage/compensation.
Essentially, if there were a totally free market, it would make no sense to say jobs were created or lost. If someone invented a robot that could build widgets really cheap and all the widget makers got laid off, they would simply find other jobs. Their comparative advantage would go from making widgets to making something else. This may make those individuals worse off (though it may not) but the total output of society and the total benefits would increase because it would get cheaper to make widgets which would make them cheaper and everyone would be able to have more of them. (The same argument applies to outsourcing.)
By the way, these concerns have been around for hundreds of years and so far technology has not destroyed the working class.
Now for the actual long answer.
As I said, the above analysis assumes a free market. In reality, what we have is far from a free market. There are a ton of laws and regulations which gum up the works of this process. Here are some examples
Minimum wage: If the value of your labor in your most efficient production is less than the minimum wage, you’re out of luck. You might be willing to work making widgets for $6/hour and somebody might be willing to hire you and it might cost people in China $6.50/hour worth of other goods, but if the minimum wage is $7.25 then the widgets get made in China anyway and you end up unemployed. This makes you worse off as well as the consumers of widgets who must pay more for them.
Unions: Similar situation. You might be willing to work at a certain wage but the union won’t let you because they have “negotiated” a higher wage for themselves by creating barriers to entry to keep you out.
Licensing: Let’s say after losing your job at the widget factory your new comparative advantage is as a hair stylist. But you can’t just go out and do that. You have to go to beauty school for two years, pay a bunch of fees and pass some tests. Don’t have the time/money for that? Too bad for you.
Labor Laws: So you could make a widget cheaper than the Chinese but in order for someone to hire you to do so, they would have pay a bunch of taxes, get insurance incase you stub your toe on the way to work and try to sue them, comply with a million OSHA regulations, provide you with healthcare etc. If the benefit of your labor is not great enough to make it worth it to them to do all of this, again, you are out of luck.
Here are some cases from an older Stossel show. The moving company who had to get permission from their competition to enter the market is my personal favorite.
So the real answer to the question “should anything be done” is yes, we should liberalize the labor market by getting rid of all these ridiculous regulations which are designed to protect some special interest group. If we did that, then no further meddling would be necessary. Of course the other side will argue that we have to do a bunch of other interventions in the economy to try to mitigate the damage that they blame on things like outsourcing and technology but that damage is really the result of those things combined with all the interventions we already have.
The next installment of my organic credit model, following on from these previous posts.
II. Banks and Credit
III. Credit Expansion
Remember, this is intended to describe a decentralized free-market economy with free-market (commodity) money. The connections between this and our current economy are not entirely straightforward.
Loans and Savings
When most people think about banks, they think of an entity whose function is to allocate capital by borrowing from people who wish to put off consumption until some point in the future and lending to people who would prefer to consume or invest today and pay for it with future goods. And of course banks do perform this function. However the function described above serves a different purpose. In our model so far the purpose of the bank is purely to provide liquidity by allowing people to use bank credit as a medium of exchange in place of hard currency. It is my assertion that this is the primary function of banks as it is the function which distinguishes them from other institutions which also serve to allocate capital such as stock markets, corporate bonds, mutual funds, venture capital firms, etc. But since these two functions are bound up together, we must take a moment to distinguish between them and see how they interact. Read more…
A commenter on an older post about hyperinflation says the following:
“deflation is not the end of the world, and there are different kinds of deflation, too.”
Then he posts links to a bunch of Austrian posts about inflation and deflation. They are highly confused and I want to go through them point by point. First though, let me say that I agree there are different types of deflation. This is what I have been trying to say all along. If money were an organic and decentralized phenomenon, then there would most likely be steady mild (price) deflation at most times. This is altogether different from what happens when we have a central bank regime which encourages a highly leveraged society and then tightens monetary policy (or fails to loosen it sufficiently to keep the leveraging going). I’m not confusing these two, Austrians are confusing them. When they say “deflation is not the end of the world” they (seemingly) are talking about the first kind. But they say this in contexts which have nothing to do with that type of regime. They don’t see the difference. Deflation in a highly leveraged economy is the end of the world. Read more…