Does the value of an intrinsically worthless (paper) money depend on the government's power to tax? I am going to answer this question from a quantity-theory perspective. The short answer is "yes". But the full answer is different from some other theories that also answer "yes".
Those of you who already understand the modern quantity theory of money will find nothing new in Part 1 of this post. I'm just trying to explain the standard story as simply as possible, without any math or jargon (I have even carefully avoided using the words "real" and "nominal"). You may find Part 2 more interesting.
Part 1.
The quantity theory of money says that the value of money depends on the quantity of money. If you double the stock of money, other things equal, the value of money will halve (i.e. the price of goods in terms of money will double).
Most quantity theorists recognise that prices of most goods don't adjust to equilibrium instantly. So it may take time for a doubling of the quantity of money to double prices.
(Strictly, the quantity theory only works for something like a paper money that is useless except as money. Because the monetary units don't really matter. If you add a zero to every $1 bill, so it becomes a $10 bill, and add a zero to all the prices, so $1 becomes $10, etc., then nothing has really changed in the economy. If you were in equilibrium before the change, you are still in equilibrium after the change. So you increased the stock of money tenfold, and each unit of money is worth one tenth its original value, and the equilibrium price level has increased tenfold. If money were gold, and dentists could use it, things wouldn't be exactly the same if you doubled the stock of gold and doubled all prices. Because dentists would use more gold to fix people's teeth, and the cost of getting your teeth fixed wouldn't exactly double.)
But the quantity theory also says a lot more than that. The current stock of money (the money supply) is not the only thing that affects the value of money. The value of money also depends on the demand for that stock of money (money demand). The demand for money is like the demand for an inventory. Money flows into and out of our pockets, so the amount we hold fluctuates hour by hour, but we demand to hold a certain average stock of money, because it makes shopping easier.
A doubling of the supply of money, if demand is initially unchanged, means that people are holding more money than they want to. They will try to spend or lend the excess. But if the total supply of money stays the same, even though each individual can spend or lend his money and pass it onto someone else, it isn't possible for all people to do get rid of their money this way. But their attempts to get rid of it by spending or lending are what causes the demand for goods to rise, and the prices of goods to rise. And when the price of everything doubles and people's money incomes and expenditures double, they will want to hold exactly double the amount of money for shopping, So prices adjust to make the demand for money double to match the doubled supply.
And that demand for money will depend on many things, including the cost of holding money. Because demand curves slope down, and the higher the cost of holding money, the less money you want to hold. You might spend the same amount of money per year, and earn the same money income per year, but you want your inventory of money to turn over more quickly, so you want hold a smaller stock of money on average. And the cost of holding money depends on how quickly that money is losing its value. (It depends on the expected rate of inflation, in other words).
And, just as the level of prices depends on the level of the stock of money, so the rate of change of prices over time will depend on the rate of change of the stock of money over time. The faster the stock of money is growing over time, other things equal, the higher will be the rate of inflation. So, the value of money today depends not just on the quantity of money today, but also on how quickly that quantity of money is growing over time.
Take two otherwise identical economies, with the exact same stock of money today, but the first economy has a growing stock of money and the second economy has a constant stock of money. The first economy will have a higher price level today, even though it has the same quantity of money today.
When governments spend money they must either get that money from taxes, or else borrow it, or else print it and increase the stock of money in circulation. Taxes reduce the stock of money in our pockets. For a given amount of government spending, and a given amount of government borrowing, the higher are taxes the smaller will be the amount of money printed and the slower will be the growth rate of the stock of money. And the slower the stock of money is growing over time, the higher will be the value of money today.
Take two otherwise identical economies, with the same quantity of money today, and with governments spending the same percentage of national income and neither country borrowing. But the first economy has taxes as a lower percentage of national income than the second. The first economy will have a higher price level than the second economy, even though they are otherwise identical, and have the same quantity of money today. Holding government spending and borrowing constant, higher taxes increase the value of money, because they reduce the growth rate of the money supply, reduce the rate of inflation, reduce the cost of holding money, increase the demand to hold money, and so increase the value of money.
There's a second way that taxes may affect the value of money, that is associated more with a Keynesian approach, but can nevertheless be incorporated into the quantity theory of money.
For a given level of government spending, and a given growth rate in the money supply, a reduction in taxes means the government has to borrow more. It has to issue more bonds. That increase in government borrowing may increase the equilibrium rate of interest on government bonds. If money pays no interest, but bonds do, then the foregone interest on bonds is the opportunity cost of holding money rather than bonds. So a reduction in taxes will cause an increase in the opportunity cost of holding money, reduce the demand for money, and so reduce the value of money.
Take two identical economies, with the same stock of money, and the same growth rate of money, and the same government spending as a percentage of income. If the first has lower taxes as a percentage of income than the second, the first will have a higher price level.
Part 2.
But this still leaves a puzzle. Paper money is only useful for shopping if it has value. If it has value, people will find it useful for shopping, and so there will be a demand to hold an inventory of money for shopping, and that demand (and supply) will determine its value. But if it didn't have any value at all, it wouldn't be useful for shopping, so there will be no demand for it, and so it won't have value.
There are two equilibria. In one equilibrium people leave the worthless bits of paper lying on the ground. In the second equilibrium people use those same bits of paper for shopping and they are valuable. Why are we in the second equilibrium, rather than the first?
Or, if there are red bits of paper and green bits of paper, what determines whether people will use the red, or the green, as money?
One possible answer to this puzzle is that the government requires people to pay the government 10 bits of green paper per year, as taxes. Does this answer work? Maybe, it depends.
If the government is spending 10 bits of green paper per person per year to buy goods, and collecting 10 bits of green paper per person per year in taxes, that means the government is using that green paper to do its shopping. But that does not eliminate the equilibrium in which green bits of paper are worthless. The government spends 10 bits of paper at the beginning of each year, gets nothing in return because the paper is worthless, and then at the end of the year people simply give the green bits of paper back to the government.
Hell, even I could do that. "Here are 10 bits of green paper per person. Unless I get all 10 back at the end of the year I will beat you up. How much will you give me for them?". "Nothing" is one possible answer, even if my threat is credible.
Let's try Plan B. "Here are 9 bits of green paper per person. Unless I get 10 back at the end of the year I will beat you up. How much will you give me for them?"
Plan B works. I have created an excess demand for the bits of green paper. 10% of the population will get beaten up, whatever happens. But each individual can avoid a beating by outbidding others for those bits of paper. The value of each bit of paper will be one tenth of the value of avoiding a beating for the person at the tenth percentile of the distribution of willingness to pay to avoid a beating.
And once the green bits of paper have value, people might also use them to do their own shopping, if they are more convenient to use than other media of exchange.
But Plan B only works because the government is trying to reduce the stock of money in circulation, by trying to collect more in taxes than it spends. Governments don't usually do this. When governments issue money, they normally do so because they want to spend more than they collect in taxes.
And Plan B only works because the intrinsically worthless paper money is now no longer intrinsically worthless. It is a convertible currency, at the margin. 10 bits are convertible into one avoided beating, and an avoided beating is a valuable good.
Plan B is therefore just a specific example where the puzzle is solved by supposing than an intrinsically worthless paper currency was initially, when first introduced, convertible into something intrinsically valuable. And it doesn't have to be the government that issues the money, or makes it convertible. And though people are likely to choose to use the same money that the government uses, it's also true that governments are likely to choose to use the same money their people use. The government is a big shopper, and one that has more powers than most. But the money people use isn't always the one issued by their own government, and in which they pay taxes.
Suppose that paper money is initially convertible into gold, or some other good that has at least some positive value independent of its use as a medium of exchange. Then people get used to using paper money as money. Even if convertibility is eventually suspended, and so the equilibrium where paper money is worthless becomes one possibility, people will continue in the second equilibrium, where the paper is valuable, simply because that's the equilibrium they are already in. It's a network effect, like speaking a particular language, or using a particular word processing program. I use Canadian dollars for shopping because everybody I shop with uses them too. And because we use them, they are valuable. And because they are valuable, we use them.
Plan B made me think of this:
Worthwhile Canadian Initiative 
Economics = Attempt to mathematically model human psychology.
Kevin: and this post = an attempt to mathematically model without math 😉
What if paper money also has value in terms of traceability of transactions (a negative transaction cost)? Right now in my neighborhood, people are having decks built and landscaping put in by fallow school teachers and off-duty firemen, and they are being paid under the table in cash. They are buying their building supplies in cash, and I doubt they have a business or GST number. Then, faced with the option of getting landscaping from a legal business that would charge for the work at a factor of 1+T, my neighbor is buying the good with a value X(1+T) for only X or even less. Even if my neighbor pays for it with cash taken from his HELOC, T>k so the interest charge is still worth it. And of course there is the personal satisfaction of helping others avoid taxes (not that I would ever do such a thing). I know this is not the core of the economy and that this is impossible for many transactions, but it contributes to the demand for paper.
Nick, I missed something. Are you saying that money has value because of the power to tax, or that the power to tax is one factor than could give money value? It seems to me you’ve shown the latter, but not the former.
Suppose a society of people stranded on a Pacific island agree to use Monopoly money for transactions. There is no government. Would that money have any value? This is not a rhetorical question, as I actually don’t know the answer.
My instincts say “yes,” but I am not certain.
Shangwen: the fact that currency may make it easier to evade taxes will increase the demand for currency relative to money in the form of chequing accounts. Chequing accounts may (or may not, it depends) pay interest, and are sometimes more convenient than currency (sometimes less), and are harder for thieves to steal. So there are different balancing motives for preferring currency vs preferring chequing accounts, and most people hold and use both.
But, from the perspective of this post, a chequing account is just a promise to pay currency. The $100 in your chequing account is valuable because it is convertible into currency that’s valuable. But why is currency valuable, and what determines that value? It’s easier to start out imagining an economy where the only money is paper currency. Which is what I’m doing. We can bring chequing accounts in later.
Scott:
I’m saying that taxes affect the value of money. That’s Part 1.
In part 2 I explore the idea that paper money has value because of the power to tax. But I reject it. Instead, I propose that paper money has value initially because it is initially convertible. The government might be the one making it convertible, say by letting people pay 10 bits of paper in lieu of one hours labour (or to avoid one beating). But it could also be anyone else making it convertible.
“Suppose a society of people stranded on a Pacific island agree to use Monopoly money for transactions. There is no government. Would that money have any value? This is not a rhetorical question, as I actually don’t know the answer.”
I was thinking through that when you wrote that post a couple of days back. That’s partly what lead me to write this one. It’s a question I’ve thought a fair bit about on and off over the years.
Yes, if they all get together in a meeting and say “Lets all use this stuff as money” it would work. Contractarians would say that meeting is the government. But I would say that what that meeting does is pick out a focal point, out of many possible equilibria, so they can coordinate on that particular equilibrium. It doesn’t need enforcement. It’s self-enforcing. It’s like tossing a coin in public to decide whether to drive on the left or right. It’s a sunspot equilibrium.
But, historically, I don’t see that happening often. The most powerful focal point is what we did in the past. Custom. I see the current focal point as having evolved out of a past in which paper money was initially convertible, then the promise of convertibility slowly faded away but paper money remained. Menger, then Von Mises Regression Theory of Money, is basically my approach.
Selgin has done some work on banknotes in the pre-Civil War United States. The government had to actively handicap and then suppress private banknotes to get the public to use the government’s own currency.
Lee: in that case though, the both private and government banknotes were presumably convertible into gold? So the government was attempting to suppress demand for private banknotes to increase demand for its own. The examples that really contradict tax theories are where an irredeemable paper money is not used for taxes. The old Iragi Dinar is said by some to be an example. The use of US dollars in Cuba, even when illegal, is perhaps close, though Cubans could (illegally) use them in the tourist stores, or use them if they emigrated. Bitcoins, if they survive, will be a third.
Lee: on second thoughts, I see your point now. Absent prohibitions, people wouldn’t have used government banknotes as money even though they were still used for taxes.
I’ll give you +1 for a cheeky retort Nick.
But in essence that’s all economics is.
I certainly don’t mean for it to sound like that is something negative.
“The quantity theory of money says that the value of money depends on the quantity of money. If you double the stock of money, other things equal, the value of money will halve (i.e. the price of goods in terms of money will double).”
Err, that’s not other things equal, is it? I mean, the nominal monetary values in contracts has to double, as well, right?
“Take two otherwise identical economies, with the exact same stock of money today, but the first economy has a growing stock of money and the second economy has a constant stock of money. The first economy will have a higher price level today, even though it has the same quantity of money today.”
This seems to be a contradictory state of affairs. If the first economy has a higher price level, then how can it be otherwise identical? Isn’t there going to be some other difference besides the growth rate of money?
Min: That’s what the QTM says. If you are arguing about whether the QTM is exactly true or not, then yes, you have to consider a lot of things like whether nominal debt contracts are also redenominated, because otherwise the distribution of wealth will change, and that may or may not have an aggregate effect, and may mean the price level will either more or less than double. There’s also the question of whether it’s just the total stock of money that doubles, or whether each individual’s stock of money is doubled.
All theories are false. Some are useful.
See Mises’ regression theory for the origin of the value of money (gold in particular). Yesterday gold was used exclusively for cups, let’s say, and not for money. Today somebody had the idea of holding on to surplus gold cups for trading purposes, and it catches on. But we have a pre-existing value from the gold cup when none of them were money. In the future there is a combined supply and demand for both money and non-money gold and money is so useful that the monetary value eventually predominates.
The same thing applies to cigarettes in a prison camp. The starting point for the value of a cigarette as money is also its value before any of them become money. The key point is that an arbitrary value cannot be assigned for a new money.
Regards, Don
Don: I agree. I really like von Mises Regression Theory. I was hinting at it in my part 2. See my reply to Scott above.
Min: “If the first economy has a higher price level, then how can it be otherwise identical? Isn’t there going to be some other difference besides the growth rate of money?”
If you are going to tackle that question rigourously, you have to build a model and decide what’s going to be exogenous (so can’t be different by assumption) and what’s endogenous, and then figure out which of the endogenous things will change too. I prefer to work backwards, informally. The first has a higher inflation rate, and a lower M/P (real stock of money) according to the QTM. OK, so what would those things also cause to change? Well, if M/P is lower, but people had the same real income and expenditure, they must be rolling over their inventory of money more quickly. So they have more hassle in shopping. Their shoe leather wears out more quickly. Restaurants are having to change their menu prices more frequently, so costs of printing menus are higher. Etc.
Most agents in the economy do not spend government money. They spend bank deposits.
“10% of the population will get beaten up, whatever happens”
Yes, it is called unemployment.
Segei: but bank deposits are (usually) convertible into government money. So their value is determined by that of government money. (Actually, there’s more simultaneity than that, of course, because the availability of bank deposits as a substitute affects the demand for government money.)
Unfortunately, you can’t avoid unemployment just by paying your taxes.
“But if the total supply of money stays the same, even though each individual can spend or lend his money and pass it onto someone else, it isn’t possible for all people to do get rid of their money this way”
No, it is possible. Higher spending means higher taxes.
“bank deposits are (usually) convertible into government money”
Yes, this how we have setup our financial system. There is no law which says it can only be this way. And even this system fails once in a while.
Besides this, government creates very little of bank deposits. Banks create the majority of them.
“Unfortunately, you can’t avoid unemployment just by paying your taxes”
It is the basic claim of MMT that if government does not spend enough, then unemployment will result. In your words “10% of the population will be beaten up, whatever happens”.
Sergei: but then the supply of money is not staying the same, and I just assumed it was. For a simple example, assume that taxes are 40% of income, and government spending is the same 40% of income, and there’s no government borrowing. Then as people’s spending rises, both taxes and government spending rise by the same amounts, so the money the government is taking in rises, but the money the government spends out rises, so the total amount of money stays the same.
Sergei: “Yes, this how we have setup our financial system. There is no law which says it can only be this way. And even this system fails once in a while.
Besides this, government creates very little of bank deposits. Banks create the majority of them.”
Agreed.
“It is the basic claim of MMT that if government does not spend enough, then unemployment will result.”
Agreed; MMT does say that, AFAIK.
Nick: “but then the supply of money is not staying the same”
Exactly! The act of spending reduces the supply of money due to taxes. You can not separate one from another. So by spending people in aggregate can reduce the supply of money.
“so the total amount of money stays the same”
Sounds like equilibrium to me. Why should prices increase if everything stays the same?
“Take two otherwise identical economies, with the exact same stock of money today, but the first economy has a growing stock of money and the second economy has a constant stock of money. The first economy will have a higher price level today, even though it has the same quantity of money today.”
Nick, questions regarding your assumptions:
1. What is causing the growing stock of money in the first? People spending more? More people starting new businesses? Government spending more? Or does the money stock just automatically rise?
2. If money stock is automatically rising, what is causing it? Helicopter money? Banks automatically lending out new reserves from the central bank?
3. If the two economies have the same quantity of money today, why does the first already have a higher price level today? With what are the people paying for the higher prices today?
Sergei: but I assumed the supply of money is staying the same. And in my example in my comment, where both taxes and government spending are the same 40% of total spending, the total supply of money is indeed staying the same, just as I assumed. If the government does not borrow, then government taxes reduce the stock of money, and government spending increases the stock of money, and if government spending and taxes are equal, the net effect of the flow out and the flow in on the stock of money is zero.
rogue:
1 and 2. Why is the stock of money growing over time? Either the government is spending more than it takes in through taxes, or else the government is printing money to pay down its debt (or the banking system is expanding if we are talking about bank money, or counterfeiting 😉 ).
3. The supply of money today is the same in the two economies. But the demand for money is lower in the first economy than in the second. That’s because people in the first economy know that the stock of money is growing over time, and so prices are rising over time (inflation), i.e. money is depreciating over time, so they don’t want to hold as much.
How can they buy the same amount of goods at higher prices with the same amount of money (all compared to the second economy)? That same stock of money has to flow more quickly. It has to change hands faster than in the second economy. The velocity of circulation is higher. If I hold one months income and spending in my pocket, my money has to circulate 12 times faster than if I hold one year’s income and spending in my pocket.
From Part 2: “Hell, even I could do that. “Here are 10 bits of green paper per person. Unless I get all 10 back at the end of the year I will beat you up. How much will you give me for them?”. “Nothing” is one possible answer, even if my threat is credible.”
I don’t think “Nothing” is a realistic answer. I’ll offer you something for your 10 bits of paper (and for 100 more of them) because I know I can sell them to other people who will need to give them back to you at the end of the year. The scarcity, combined with their practical application, creates value.
I don’t think this means that taxes are in themselves necessary to create a value in currency – taxes are just one of many ways to establish the network effect which you have described.
And in Part 1, I don’t believe taxes intrinsically give the currency value either. In this model, taxes are simply a way to reduce government borrowing – which reduces the broad money supply. But any other reduction in borrowing would have the same effect; if companies decided to fund more of their investment from retained earnings and less from borrowing; or if people bought houses with cash instead of mortgages.
The value of the currency arises (partly) from the desire to use cash instead of debt – government is just the biggest of many agents who can independently make the decision to do that. Taxes aren’t special.
Ah – reading your reply to Scott, I think we are both saying the same thing.
Leigh: if the supply is 10, and the demand (to pay taxes) is also 10, they aren’t scarce, unless some people want to hold onto some of them to do their shopping instead of paying taxes, but they won’t do this if they think they are worthless.
But yes, one individual might buy more than 10, and act as a monopolist just before tax time. To get around your response I would have to make the supply 11, the demand for taxes 10, and assume lots of small people, so none could corner the market.
You’re forgetting about the desire for savings. People might be scared they cannot pay the 10 piece of paper per year tax. That’s why governments don’t have to tax more than they spend, and why plan B works in the real world.
I’ll admit it is a bit funny watching Scott Sumner go through MMT 101. Taxes provide the initial demand for currencies, but not the final demand for currencies. It forces people to use the currency as a medium of exchange. After that, demand for savings in the medium of exchange is more important – this is the demand for money that we see in the real world.
Plus, wait until they figure out that Private Savings = Government deficit, and that it’s also equal to the money supply. Mindblowing.
Isn’t the more important story here the fact that real taxes are typically levied as a proportion of the value of a transaction, rather than per capita? This forces the use of the currency as the medium of account, and you get out of the zero-value equilibrium through the same historical process as you described in part 2. As someone observed above, the medium of exchange is usually bank deposits, not dollars. Is it really ready convertibility that’s important, here, or just the fact that deposits are denominated in dollars?
Please identify an ‘official economic’ version of the following :
The generally accepted concept of the supply of money is fundamentally flawed.
Money is not consumed by its involvement in an exchange. It merely is instantaneously transferred from one owner to another. A single piece of money can only have one owner at a time.
This means that money is not a consumption good, but, for lack of a better term, is a ‘rental’ good. This means that the real scarcity of money comes from its total time of possession, not its total dollar amount alone. With a fixed amount of money, there is no limit in theory on the number and size of exchanges that are supported, given fast enough computers with flexible scheduling. To spend $1000 I need to have it first, but only for a nanosecond before I spend it. If I hold it longer, 1 day or 30 days, more and more other people are prevented from holding and spending. The key is that the supply of money must have dimensional units like dollar-days per month. The total money supply will be DOLLARSx30 days per month, where DOLLARS is the conventional supply of money in dollars.
Let’s say you have a fleet of 1000 rental cars. Your maximum capacity of providing rental services is 30,000 rental-days per month. This is a much more important number than 1000 rental cars. Because of timing conflicts you can’t ever get to the maximum ( you might have 1000 people wanting the same rental day), but it’s the same for money.
Regards, Don
TC: “Plus, wait until they figure out that Private Savings = Government deficit, and that it’s also equal to the money supply. Mindblowing.”
I-S+G-T+X-M=0
where I=investment, S=savings, G=government spending, T=taxes, X=exports, M=imports.
Rearrange, assume a closed economy, and S-I=G-T.
That accounting identity is what you (incorrectly) describe as “Private Savings = Government deficit”
I LEARNED THAT AT AGE 16 IN HIGH SCHOOL!
Sorry for shouting, but you really need to understand that this is NOT NEWS to ANY economist. I have taught this same accounting identity at least once a year for the last 33 years, mostly to first year students, though I remind the second year students about it, in case they have forgotten.
I am also sure that Scott Sumner learned this same accounting identity many decades ago, and has almost certainly taught it a dozen times since.
I, and Scott, also understand the difference between an accounting identity and an equilibrium condition, and that stating an accounting identity says absolutely nothing about what variables determine what other variables.
“…and that it’s also equal to the money supply.”
No it isn’t. (And Scott understands that it isn’t either). The government deficit (in nominal terms) is equal, not to the money supply, but to the annual growth in the stock of monetary base plus the annual growth in the stock of bonds in public hands.
And we teach this in second year too (and sometimes in first year).
Look TC, sorry to get over-excited by this, but many (not all) of you MMTers really don’t have a clue. You think you have discovered something that nobody else knows. So you come across as a cult, saying “the number of children = the number of sons + the number of daugters, and this equation is what determines the number of children people have, and all those stupid demographers don’t get it!”
(The top, serious, MMTers do, I am pretty sure, do understand that we all know this. It’s mostly the camp-followers who don’t get it, and find it a stunning new insight.)
I will calm down in a few minutes and maybe respond to the rest of your comment.
Nick: “That’s because people in the first economy know that the stock of money is growing over time, and so prices are rising over time (inflation), i.e. money is depreciating over time.”
So is MV=PQ a snapshot of price level at a certain point in time, or a description of the movement in price level over time? I ask because it’s hard to get your mind around “Take two otherwise identical economies, with the exact same stock of money today, but the first economy has a growing stock of money and the second economy has a constant stock of money.” How can you say both economies have the same stock of money when one has a growing stock?
Take for example: “How can they buy the same amount of goods at higher prices with the same amount of money (all compared to the second economy)? That same stock of money has to flow more quickly.”
If we assume a point in time when both economies’ stock of money is at the same level, then price levels haven’t risen yet. Once it has risen, it would be at a point when the amount of money is already higher. The same stock of money flowing more quickly should not in itself lead to higher price levels unless people are bidding up the prices while getting rid of money. And people can only bid higher if they already have more money to pay with. Am I missing something here?
Alex: “Isn’t the more important story here the fact that real taxes are typically levied as a proportion of the value of a transaction, rather than per capita? This forces the use of the currency as the medium of account, and you get out of the zero-value equilibrium through the same historical process as you described in part 2.”
Hmmm. Interesting theory. If, every time you buy something, you have to pay government money equal to (say) 10% as sales tax on the transaction, you might as well use government money for the whole transaction, so it becomes the medium of exchange.
Logically coherent theory, I think. But I don’t believe it! Aren’t broad-based sales taxes fairly recent?
“Is it really ready convertibility that’s important, here, or just the fact that deposits are denominated in dollars?”
Well, the value of what’s in my chequing account is determined by the fact that I believe the bank’s promise to redeem (convert) it at a fixed rate into central bank currency.
But if I have a chequable account in a stock mutual fund it would be different. There, the value of my account would be determined by the real value of the company shares I own.
On part 2: I think you’re right. I had just assumed this was the standard explanation.
Just like the government can increase the demand for health insurance by mandating that everyone buys health insurance, they can also increase the demand for bits of green paper buy mandating that taxes be paid in bits of green paper. That said, I do not think that explains why the equivalent of green bits of paper are the media of exchange today, it merely provides another reason why fiat monies do not immediately collapse. I think the main reason is that modern fiat monies benefit from the residual networks effects of commodity-backed ancestors; this is what I think you claim too.
However, perhaps the tax effect on money demand explains why national borders are also monetary borders — as soon as you cross an arbitrary line, something else is the medium of exchange. This strikes me as inexplicable unless taxes and other regulations are exerting their influence.
Don: I’m not sure. But isn’t everything you say there consistent with MV=PT ? You are saying that “money” should be measured as a flow, which means MV ?
rogue: “I ask because it’s hard to get your mind around “Take two otherwise identical economies, with the exact same stock of money today, but the first economy has a growing stock of money and the second economy has a constant stock of money.” How can you say both economies have the same stock of money when one has a growing stock?”
This is easier explained with a graph:
Put time t on the horizontal axis and the stock of money M on the vertical. Draw a red horizontal line about halfway up. Draw an upward-sloping blue line that crosses the red line about in the middle of the graph. At time t*, which is “today”, the blue and red lines cross. Red and blue economies have the same stock of money today, but the blue economy has a growing stock of money and the red economy doesn’t.
Now draw a second graph directly below the first. Put time on the horizontal axis again, and the price level P on the vertical. The red line will be horizontal, and the blue line will slope up, as before. But at t*, today, the blue line’s P will be above the red line’s P.
What’s happening is that V is higher in the blue economy than the red economy, even though Y and M are the same, at t*.
Lee: I don’t think there is a standard explanation for my Part 2 question. (Maybe many economists don’t even see there is a question, since it doesn’t get talked about much.)
“I think the main reason is that modern fiat monies benefit from the residual networks effects of commodity-backed ancestors; this is what I think you claim too.”
Yes, that’s my main preferred explanation. Though I wouldn’t rule out other possibilities, historically.
“However, perhaps the tax effect on money demand explains why national borders are also monetary borders — as soon as you cross an arbitrary line, something else is the medium of exchange. This strikes me as inexplicable unless taxes and other regulations are exerting their influence.”
Something that’s always puzzled me too. There is currency substitution, internationally, especially near “borders”. But there’s less than one would expect, prime facie. Compare it to language shifts, near borders, since languages also have network effects. Does money have a sharper cutoff than languages, at national borders? The tax and regulation explanation seems roughly plausible.
Nick,
It’s a question which has occurred to me before, and I am not an economist. I had just assumed there would be some standard answer and this was it.
In any case, how do you explain, say, how France changed over from francs to euros? The euro was conceived a fiat money; it never had a commodity-backed ancestor, right? Was it just because everyone knew that the French Government would soon begin collecting taxes in euros?
Lee: suppose (as in Canada) they withdraw the $1 note and replace it with the $1 coin. The old note was convertible into the new coin. And 5 new $1 coins are convertible into a $5 note. People think they will have exactly the same value, so they do, unless something else changes. It’s not so different with a currency reform. Or with the introduction of the Euro, followed by a long period of fixed exchange rates. “The King is dead, long live the King!” The focal point of who we obey just follows the line of succession naturally. Unless there are two competing claimants for the throne, and nobody knows who everyone else will obey, so nobody knows who to obey.
Nick : “Don: I’m not sure. But isn’t everything you say there consistent with MV=PT ? You are saying that “money” should be measured as a flow, which means MV ?”
I can’t see any way in which what I am talking about can be described as a flow. If there is $100 of money in a 4 person economy, then that $100 is fully distributed among the 4 every day of the month. This is a static concept for each day.
The re-distribution of the money overnight (for simplicity only) is only limited by the fact that the total ending distribution must remain at $100 total.
If one person, for some reason, decides to hold $97 dollars each of the 30 days of the month, then there are only $3 available for the other 3 people to hold in total for each of the 30 days of the month.
Let’s say Congress, in its infinite wisdom, decides to pass a new law (separate versions for the House and the Senate). The House mandates that everyone paying either a mortgage or rent must deposit their payment in a holding account exactly 1 day before payment is otherwise due. The Senate version is similar, except that the holding account must be filled 21 days in advance.
If the Senate version is passed, as opposed to the House version, is it not clear that the demand to ‘rent/hold’ money will be much greater and the resulting unit value of money will likely be much higher? Remember that the passing of the new law or not, and which version, have NO effect on the mortgage/rent exchanges.
Regards, Don
Nick, so how does this prove that MMTers are wrong?
Don: I’m still not sure I’m following you. I’m going to make another stab in the dark. This may be tangential, or may be what you are getting at.
Suppose each individual can buy and sell whenever he likes. So each individual has a desired pattern of daily ups and downs in his desired money balances. What, if anything, is there to ensure that when we add up those daily ups and downs of each individual, the aggregate comes out nice and smooth over the month?
A small number of monetary economists, I believe, look into questions like this. I’m not one of them. I think there are four answers:
1. By sheer fluke, with randomness, and enough people, it may come out smooth in aggregate. Unlikely.
2. If prices were perfectly flexible, on a daily basis, prices could adjust daily so that individuals desired ups and downs cleared all markets and so money supply equals money demand at both the individual and aggregate level on a daily basis. Also unlikely.
3. The banking system allows enough flexibility in the aggregate money supply to let individuals’ plans add up. This certainly does happen on a seasonal basis, ever since central banks decided to allow it. And IIRC this eliminated seasonal fluctuations in some asset prices/interest rates that previously followed the agricultural cycle. There’s a literature on this, but I’m not familiar with it.
4. The very nature of an inventory is to act as a buffer stock to absorb unexpected shocks to flows in and flows out. If I unexpectedly arrive at a car lot, and buy a car, the dealer’s car inventory is lower than he planned, and his money inventory is higher than he planned. He is willing to accept that extra money temporarily, even though he doesn’t wish to hold it. It’s a hot potato, that he gets rid of as soon as it’s convenient for him to buy what he wants.
In general, if something coordinated all our plans so that each of us got paid just before all our bills were due, we would all demand to hold a smaller average stock of money than we do now. But in a decentralised economy, and ones where people’s plans are always changing, and where it is costly for me to visit the supermarket at exactly the time the supermarket wants me to shop there, it is very hard to do this. And that’s why we all hold buffer stocks of money, and the supermarket holds buffer stocks of milk, and I hold buffer stocks of milk in the fridge, etc. Money, like other inventories, saves us the costs of having to coordinate our plans.
That’s my take anyway.
But I may have missed your point, again.
Here are a few random thoughts: if the central bank is independent, then government bonds are no different from corporates as assets of the CB. Both are just a risky nominal asset backed by the revenues (taxes in the case of government) of an unrelated third party. And if the cb has some equity, the valuation of its liabilities become a very standard capital structure valuation problem, and there is nothing particularly Ill determined about it. But if it’s not independent from government and the balance sheet is backed by tbills, then it’s backed by taxation just like those tbills on its balance sheet.
Another random thought: The proper way to run a cb is as an independent organization whose assets form as broad a cross section as possible of the investable capital assets of the economy. When you did you blue sky post I argued that all money (including bank deposits) should be replaced with money created this way. These latest, really excellent, posts of yours have only convinced me more.
Lee. I’m not really trying to prove the MMTers, or the Fiscal Theory of the Price Level, or Real Bills theorists, or New Keynesians, or anyone else, are wrong in this post. I’m just trying to lay out the QTM.
I’m not 100% clear on how MMT exactly relates taxes to the value of money. That may be because they aren’t exactly clear, or it may be because I haven’t read them carefully or fully enough. I thought it would be more productive if I tried to lay out the QTM version of the relation between taxes and the value of money as clearly as I could, because that’s something I’m better at. I wanted to go further than just say something like “Paper money has value because the state has the power to tax”.
I could put forward my own opinion on exactly what the MMT view is on this question, and why MMT, as I interpret it, is wrong. But I wouldn’t trust my interpretation. And the whole debate would just dissolve into a hopeless mess anyway, over terminology, stocks and flows, real vs nominal variables, the shape of the AS curve, accounting identities vs equilibrium conditions, etc.
This stuff is hard. Rogue, for example, is making a good-faith attempt to really get his head around some of the things I’m saying, and is not finding it easy. If it were a debate, with people committed to their own views, it would be even harder.
K:
Your first paragraph has two possibilities: the first describes the “Real Bills Doctrine” (as interpreted by Mike Sproul for example — see my last post for the link to Mike); and the second describes the Fiscal Theory of the Price Level. Great random thoughts! Both give very different theories than the QT.
Second paragraph. Sometimes I think that’s a good idea too. Monetise everything! And thanks!
It’s actually the same idea as SDRs. We replace the USD as the international currency with units which we create by exchanging national currencies (“capital assets”) for units of a fund (the CB) in whatever quantity is demanded at the market price of those currencies. The fact that units are created and destroyed on the demand of anybody with currency is what would make the real bills view incontrovertible.
Look at Bitcoin, it came to existence and acceptance without any tax/beating up threat or convertibility in the first place. It is the convenience (e.g. buying illegal drugs etc.) and low transaction costs (and thereafter the network effect) that make Bitcoin a medium of exchange. If governments let it go, Bitcoin or similar protocols may well become a true international currency one day. I think a big shortcoming of monetary economics is the disregard of the technological aspect.
Giang: yes, if Bitcoin survives (and if I understand it correctly) it would be one of the purest examples of a quantity-theoretic money. It has value because people want to hold it because it makes their shopping (for certain goods) easier. No backing, no taxes, no convertibility. Period.
Nick Rowe: “Well, if M/P is lower, but people had the same real income and expenditure, they must be rolling over their inventory of money more quickly.”
Thanks, Nick. That’s pretty much what I guessed. 🙂
Nick Rowe: “All theories are false. Some are useful.”
You can prove anything from a falsehood. 🙂 That’s why, IMO, you need to talk about the limits of validity, about context and errors.
Nick Rowe (@ TC): “Look TC, sorry to get over-excited by this, but many (not all) of you MMTers really don’t have a clue. You think you have discovered something that nobody else knows.”
I think that that phenomenon reflects the (IMO) parlous state of much public economic discourse in English. Economists is the past year have said that the US is going bankrupt. Legally, that is incorrect. However, they may be speaking rhetorically. Still, their lay audience on the whole thinks that they mean it legally, and that scares them.
Last year, when the debt/deficit hawks began their onslaught, a few economists called them on their BS, based upon the identity that you learned when you were 16. But their voices were not prominent. Most of the economic profession remained mum. What evidence would a layman have that the economists who remained mum were aware of that identity?
BTW, this is related to theory. An identity is like a conservation law in physics. To me, that makes the lack of a general response by economists against the falsehoods of the debt/deficit fear mongering last year somewhat surprising. (Not that there are no real concerns, but they are different from the false fears raised in the initial rhetorical onslaught.)
Nick:
Your ability to beat people up is your asset, and the money you issue is your liability. If the present value of all your future beatings is 1000 oz. of silver, then you could issue as much as $1000 of paper money, and each paper dollar will be worth 1 oz. If you issue $2000, each dollar will be worth .5 oz. If you lose 40% of your assets, each dollar will drop in value by 40%. Your dollars are valued just like any ordinary liability, and you don’t need weird quantity theory concepts like money demand, velocity, etc. to explain their value.