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 
These economies will NOT be identical — relative price relations will be systematically shifted/adjusted by a growing stock of money flowing into particular places in the economy, systematically shifting/adjusting price relations across the time structure of coordinated production and consumption plans, CHANGING output plans, e.g. changing preferences for output from production processes that promise greater output as production time is lengthened.
Hence, the important difference from the point of view of causation and patter change is systematic and structural: change in “price level” is of relatively superficial significance.
“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.”
Min: “That’s why, IMO, you need to talk about the limits of validity, about context and errors.”
Yes, maybe I should have done, in this post. But it would have been a lot longer post, and not as clear. I just wanted to lay out the QT, not give it a critique. And I might have needed to lay out a number of alternative theories too, because all theories have errors, some the same, and some different, and we can only really judge a theory by seeing if and when it does better than alternatives. And that would have been a whole book, and one I’m not up to writing.
“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.”
In one sense, the US, as a country that can print the money it owes, cannot be forced into bankruptcy. “$1zillion Federal debt? Just print $1zillion banknotes, and pay it off.” But, under some circumstances, that would be hyperinflationary, and in economic terms equivalent to bankruptcy, whatever the lawyers might say. The us would pay back the debt, but using paper that is worth on 1 cent on the dollar in real terms. And that distinction between real and nominal magnitudes is one that many MMTers (and others, perhaps) seem to me to slide over.
A year or so back someone at the Economist (RA?) put forward a “Ketchup Theory” (more of a metaphor really). You can’t get the ketchup out of the bottle, so you keep hitting it harder and harder, and then all of a sudden it all comes pouring out in a rush. The US keeps on adding debt, and while the economy is in its current state it seems to do nothing whatsoever. People are willing to hold very large amounts of debt and money at very low interest rates. But there might be a “tipping point”, either endogenous or exogenous, and all of a sudden people want to start spending again, and don’t want to hold all that money and debt. And the US would need to redeem money for debt and raise interest rates to persuade people to hold that debt rather than spend, and so prevent inflation. And at that higher equilibrium interest rate, the US might face an ugly choice between massive sudden fiscal austerity, or legal default, or economic default via hyperinflation.
Now, I certainly do not have any fully worked-out theory of this tipping point, but I also recognise that things do change. If something, anything, does cause some people to start spending again, there is a more-or-less well-understood Old Keynesian multiplier and accelerator effect that would cause others to increase desired spending too, and it could well snowball.
And MMTers do not seem even to recognise this possibility, because: they are very sloppy on the distinction between real and nominal magnitudes; do not recognise the standard role of real interest rates via a substitution effect on desired saving and investment. So they think that the US can set any real interest rate it wants, even in the long run. Their IS curve is vertical, while everyone else’s IS curve (or equivalent) slopes down.
I cannot rule out the possibility that those who fear default, in economic terms, might be right. There is something to be scared about.
Someone like (say) Paul Krugman would understand what I’m talking about, but think the risks of expanding the deficit to get us back to normal quickly would be less than the risks of reducing the deficit. He might be right. But I would prefer using monetary policy to try to reduce both risks. So would Scott Sumner. So, I think, would Paul Krugman, if he were more optimistic about what monetary policy could do. But I don’t see any sign that Functional Finance people in general, and MMTers in particular, have any grasp of these issues at all.
“An identity is like a conservation law in physics.”
Not really, unless I have a different understanding of conservation laws in physics. Those conservation laws in physics are normally understood (I think) to be telling us something about the real world. They are telling us something that needs to be tested, and that might be wrong. Identities are simply mixes of definitions about how we use words, plus some math to rearrange those definitions.
Mike: but how does that handle the objection I put forward in Part 2? Governments typically issue money when they want to spend more than they collect in taxes. So I give out 11 bits of paper per person and only make them pay back 10 to avoid a beating. So nobody gets beaten up in equilibrium. So even if my conditional threat is credible, those conditions are never met. They accept the 11 bits of paper, give 10 back, and leave 1 lying on the sidewalk. The paper isn’t scarce.
Greg: In a steady, fully-anticipated, inflation? That is ABCT, and I have never understood it. Yes, if the government spends the seigniorage revenue/inflation tax/central bank profits on extra tanks, the relative price of tanks is bid up, and there are more tanks and fewer other things produced. If the government gives that seigniorage revenue back as lump-sum transfers, it’s a wash.
Plus, that seigniorage revenue is peanuts anyway, as a percentage of GDP, unless we get serious about creating inflation. The Bank of Canada’s profits are around $2B per year, in normal times, at 2% inflation and 5% NGDP growth.
Moi: “That’s why, IMO, you need to talk about the limits of validity, about context and errors.”
Nick Rowe: “Yes, maybe I should have done, in this post.”
Sorry, Nick, I did not mean you personally, I meant the generic you. 🙂
Nick Rowe: “In one sense, the US, as a country that can print the money it owes, cannot be forced into bankruptcy. “$1zillion Federal debt? Just print $1zillion banknotes, and pay it off.” But, under some circumstances, that would be hyperinflationary, and in economic terms equivalent to bankruptcy, whatever the lawyers might say.”
The point is not so much what the lawyers say, as how lay people interpret the claims of imminent bankruptcy. A quick look in the dictionary shows the legal definition and the metaphorical one, but not the equivalency to hyperinflation. I also checked The New Palgrave Dictionary of Economics Onlne ( http://www.dictionaryofeconomics.com/dictionary ), the Babylon Economics Dictionary ( http://www.babylon.com/define/35/Economics-Dictionary.html ), and Economypedia ( http://www.economypedia.com/ ). Many ordinary citizens came to believe that the US was running out of money, that it was going broke. The fear mongers had a great rhetorical success, imposing a pall over public policy discussions that greatly influenced last year’s elections and still exists. In the current circumstances, a number of prominent economists have spoken up, but the best time to do that was over a year ago. when the false claims were first trumpeted.
Moi: “An identity is like a conservation law in physics.”
Nick Rowe: “Not really, unless I have a different understanding of conservation laws in physics. Those conservation laws in physics are normally understood (I think) to be telling us something about the real world. They are telling us something that needs to be tested, and that might be wrong. Identities are simply mixes of definitions about how we use words, plus some math to rearrange those definitions.”
The fact that formal identities are tautological truths is not a mark against them. Failure to be consistent with a conservation law may be because the law is disproven, failure to be consistent with a formal identity is simply a mistake. Scientists should denounce such errors when they occur in public debate and not gloss over them.
One thing I wanted to indicate is that conservation laws, like identities, may not suffice for prediction. For instance, the click of billiard balls colliding is only partially explained by the conservation of energy and the conservation of momentum. Those two laws tell us that the energy of the collision is typically greater than the kinetic energy of the balls’ motion. Some of the excess energy is dissipated as sound waves. Hence the click. But in a vacuum no such sound waves would be generated. And back in the days of celluloid billiard balls, sometimes the energy would be dissipated in an explosion. 😉
When politicians say that both the public and the gov’t should tighten their belts while maintaining a strong currency, don’t you wonder if they know what they are talking about?
“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”
Sorry, short of time so I just scanned comments, at the risk of Rowe wrath….
1) It looks like your QTM model is also based on a closed economy. China etc, is able to credibly force its citizens to hold U.S. dollars. In other words, the value of the dollar is externally determined as well as internally determined.
2) Why do economists include spending on capital goods in their definition of ‘savings’ so that it needs to be subtracted by including investment (S-I)? Why bring the real economy and real resources to an equation that essentially describes the financial economy and financial resources and in particular vertical money? Does keeping both S and I in the equation really provide more insight than confusion?
Nick, what if it was stated as savings of net financial assets? I think, but don’t quote me, this is what MMT really says (RE: your ire of the camp who ostensibly misstate accounting identities already known to all economic schools of thought).
If you think of the Govt sector, the domestic private sector, and the foreign sector in a situation where the govt deficit spends $100 (which by accounting identity is $100 more in NFA), and the private sector net sends out $30 to the foreign sector, then the govt sector has a net deficit of -$100 in NFA, the private sector has net savings of NFA of $70, and the foreign sector has net savings of NFA of $30. If it was simplified to closed economy, then the govt deficit of $100 = private sector savings of NFA of $100.
Nick, If cash has value because it was once backed by gold (but never will be again), does gold have value because it once backed cash (but never will again?) My hunch is that the answer is that about 1/2 to 2/3 of the value of gold derives from its history, the fact that it once backed cash.
But there might be a good counterargument—platinum—so I’d be interested in your view.
The government is the network effect? The gov’t doesn’t just use its “or I’ll beat you up” power to take away (and often in return provide what you wouldn’t be able to get), it also provides cover for private transactions to be completed, even when parties don’t know or trust each other all that well. Sure, in most places they can agree ahead of time to settle the transaction however they please, but if they don’t bother to do that, and a debt is incurred then the courts will only use their “or I’ll beat you up” power to extract payment in legal tender. In a dispute, the court won’t AFAIK, take your car (for example) and give it to the other party and call it even. They’ll tell him to give you money (which may for him to sell his car).
It’s like we all agree that we’ll have one enforcer for debt payments, and he will only agree not to beat you up if you pay your debts with legal tender (in the absence of other prior arrangements), and even if he does beat you up he’ll make you bleed legal tender. Since it’s cheaper and easier to just use the shared enforcer and the medium of exchange he recognizes, most people do just that.
This probably has nothing to do with QTM, but it seems to me to be a big part of why people use (or don’t) a nations currency within its borders.
Min: on the fearmongers. If they said “the US will face a choice between default or a hyperinflation that would destroy the monetary system”, it’s not that much less scary that their saying “the US will default”. (Whether they are right is, of course, a separate question, and whether their reasons for saying that are right, is a third question.)
I wish I could say their conclusions are clearly BS, but I can’t.
“the number of my children = the number of my sons + the number of my daughters” is to demographic theory what S-I=G-T (closed economy) is to economic theory. It can sometimes help us make sure we are adding things up right, but it tells us nothing about what determines what. That identity is true in every logically consistent theory of economics which includes S,I,G, and T. It is, for example, consistent with a theory that says increases in G cause equal decreases in I, and cuts in T cause equal increases in S, so increases in G or cuts in T don’t increase AD and Y.
Winslow:
Yeh. I’m a bit sorry I lost it with TC. He’s a good guy. But oh man. Someone like Scott, or me, has spent most of our time for the last 40 years reading or listening or thinking about economics. Doesn’t mean we’re right. But it does mean we’ve learned lots of ways to suck eggs.
1. The closed economy thing is no biggie. I just mentioned it for completeness. It’s OK to simplify. Does the QT assume a closed economy? Not really. It should generally work about as well in open or closed. Sure, there may be cases where an open economy throws an additional spanner (wrench) in the works.
2. Defining “S'” the way every other group of economists defines “S-I” is a problem. Sure you can define words how you like. And different definitions may sometimes work better for different theories or purposes. But it sure makes communication with others hard. And arguing with others very hard. I have already seen one major case of needless confusion caused by this peculiar MMT definition of S’. Both MMTers and all other economists sometimes see differences where there really are none. In this case, everything in MMT could easily be re-stated in standard economic definitions that every economics student learns in first year.
The original reasoning behind the standard definition of S is that S is that part of people’s disposable income which is not consumed, and so can be added to our wealth. This is a useful definition if an individual faces a choice between consuming today, or saving and consuming tomorrow. We can then ask what determines the desired mix between C and S for an individual. And we may need to know the answer to that question, if we want to understand AD.
Also, the Keynesian vision was that households choose how much to save, and firms choose how much to invest. In a very simple model, closed economy, no government, that leads us to the question: “what, if anything, ensures that households’ desired savings equal firms’ desired investment?”. And the whole of Keynesian (for example) macroeconomics was built around this question. Is it income that adjusts to equalise desired savings and desired investment, or is it the rate of interest? An awful lot of ink was spilled in answering that question. And we don’t want to have to re-open all those debates simply because someone wants to re-define S’ as S-I. It’s hard even to restate the old problem in that new S’ language.
Yes, we really do need to keep S and I separate.
(And notice, by the way, that I was very careful to say desired S and I. An awful lot more ink was also spilled on understanding the difference between S=I as an accounting identity and as an equilibrium condition.)
wh10: “Nick, what if it was stated as savings of net financial assets?”
Yep. Maybe not an ideal choice of words? But I get your drift.
But it does throw together two very different sorts of decision-making entities, households and firms. (OK, even though some investment is done by households). Plus, even if it’s a household doing the investing, the reasons behind the savings decision are very different to the reasons behind the investment decision. There are two questions:
1. How much do I want to consume today vs save and consume tomorrow?
2. Do I want to save in financial assets or buy real assets like machinery?
There’s also a theorem (“The savings-investment separation theorem”??, my memory has gone) that says under certain conditions those two decisions are totally independent. Paradoxically, how much I want to invest is totally independent of how much I want to save.
So, S-I bundles together two very different choices.
Scott: my logical brain says “no”, because gold isn’t used as medium of exchange, so there’s no demand for gold based on its history as money.
But my gut says “yes”. Gold, because of its history, is something more than an industrial commodity. It’s got some sort of symbolic value. As jewelry, obviously. But maybe jewelry is just a symptom of something more.
I would trust my gut more in this case.
Old masters would be my metaphor for gold. Nobody buys them because they are beautiful. A good reproduction is just as good. We buy them for their history. And because everyone else wants them, so it’s another network effect.
Patrick: maybe. It could be hard for governments to enforce transactions in strange monies. (And, IIRC, in some forwards/futures/whatever markets governments allow settlement in cash rather than goods, despite what the contract says???). You could also think of the national currency as the “default option” in contracts, which simplifies things all round.
Historically, the chines gov’t made peasants use paper money in the 10th-11th centuries by telling them that the paper soldiers used for paying food would be accepted for tax payment and did so.
For those who fear hyperinflation:
HI never happened because some CB suddenly woke up some morning and multiplied monetary base or any other forms of currency in circulation. It always come from a sudden real shock. It may be war(Central Europe after the collapse of the Austro-Hungarian Empire), foreign occupation followed by general strike (Ruhr 1923), tin miners strikes collapsing the exchange rate ( Bolivia any time you can think of) or toal collapse (reckless voluntary destruction ot the agricultural sector in Zimbabwe).
If there isn’t any goods left, the price will jump to infinity whatever happens on the monetary front.
In 1996 in Sept-Îles. the heavy storm known as the “déluge du Saguenay”
http://fr.wikipedia.org/wiki/D%C3%A9luge_du_Saguenay
http://www.google.ca/search?q=d%C3%A9luge+du+saguenay&hl=fr&rls=com.microsoft:fr-ca:IE-SearchBox&rlz=1I7GGLD&prmd=ivns&tbm=isch&tbo=u&source=univ&sa=X&ei=AeoxTrXdK8Th0QGqnuXaCw&ved=0CC8QsAQ&biw=847&bih=485
destroyed the road leading into the town. Within 3 days, the price of milk had decupled on the de facto black market… Soon enough people would have exchanged their 8-year-old daughter for a can of beans. When the first relief ship came in, prices crashed in a few minutes. No CB was involved and yet all the signs of HI were there.
Is there are separate demand for paper money rather than electronic money — i.e. deposits? Can $1 of deposits be worth more or less than $1 of paper money?
But households, in aggregate, can easily convert their paper money into electronic money (e.g. deposits) by depositing cash. What fool would bid up the price of a good to get rid of his paper money when banks are offering to pay interest to take it? Similarly, if households want to get rid of electronic money, they can easily do so by purchasing bank equity. That converts a deposit claim on a bank into an equity claim on the bank.
They can also convert to other claims on banks — e.g. bond claims, commercial paper, repos — there are all sorts of ways that households can lend money to banks.
Again, what fool would bid up the price of goods in an effort to get rid of his deposit when he could obtain an interest bearing bank bond instead?
Not a single good needs to be purchased for households to cut their money holdings in half, or by 2/3, or whatever they want.
You are confusing the question of what powers the government needs to have with what the government needs to actually do given its powers.
And “the government is spending its money, and the money is worthless” is self-contradictory. Either the government is spending its money or it is worthless, can’t be both.
Jacques: “Historically, the chines gov’t made peasants use paper money in the 10th-11th centuries by telling them that the paper soldiers used for paying food would be accepted for tax payment and did so.”
Did the govt also say that each bit of paper would be equivalent to a fixed amount of gold (or silver?) in payment of taxes? If so, that would make it a convertible currency, because you can, in effect, convert it into gold at tax time. And there’s no problem in understanding why a convertible paper money has value. Canadian Tire money has value too, because I can pay my CT bill with it, and so it’s, in effect, convertible at a fixed price into Loonies, just at CT rather than Revenue Canada.
Zimbabwean prices increased a zillion-fold (whatever). The money supply increased a qillion-fold too, and the rate of increase of the money supply increased a pillionfold. What happened to food production? Did it halve? Peanuts, compared to what was happening to M, Mdot, and P. Food production was a rounding error, in comparison.
Saguenay, I can see as a real shock. What happened to food supply? Probably dropped 90%? More?
Again, the QT does not say that M and Mdot are the only things that matter.
Nick Rowe: “on the fearmongers. If they said “the US will face a choice between default or a hyperinflation that would destroy the monetary system”, it’s not that much less scary that their saying “the US will default”. (Whether they are right is, of course, a separate question, and whether their reasons for saying that are right, is a third question.)
I wish I could say their conclusions are clearly BS, but I can’t.”
I happened to follow the rhetorical assault of the fearmongers pretty closely last year. Their early claims (in the spring) were obvious BS. The early onslaught had the effect of turning the public discussion away from jobs and recovery to fears of the long term debt. The early claims had not been debunked, except for a few voices, but were no longer being made (by June or July). Instead, less unreasonable claims and concerns were being discussed. But the climate of fear remained. I think that it is these later claims that you are referring to.
To be sure, hyperinflation is scary, but I think that it is less plausible to TCMITS (The Common Man In The Street) than the gov’t running out of money and being unable to pay its bills. Had the initial rhetorical attack said that we are in danger of hyperinflation, I doubt if it would have achieved its effect.
Nick: “the number of my children = the number of my sons + the number of my daughters” is to demographic theory what S-I=G-T (closed economy) is to economic theory. It can sometimes help us make sure we are adding things up right, but it tells us nothing about what determines what. That identity is true in every logically consistent theory of economics which includes S,I,G, and T. It is, for example, consistent with a theory that says increases in G cause equal decreases in I, and cuts in T cause equal increases in S, so increases in G or cuts in T don’t increase AD and Y.”
The same goes for the law of conservation of energy. As we know it can sometimes be violated, but when it is not, it does not really say anything about causality. If I pull back on a bow string, I may shoot an arrow, or I may break the bow. Energy is conserved either way. 🙂 Conservation laws tell us about constraints on the system. They reduce its degrees of freedom.
Not to beat a dead horse, but the identity S – I = G – T has four variables, but there are only three degrees of freedom. That’s how it acts like a conservation law.
rsj: “Is there are separate demand for paper money rather than electronic money — i.e. deposits? Can $1 of deposits be worth more or less than $1 of paper money?”
There is a separate demand, but because deposits are convertible on demand at a fixed price they stay priced at $1 (as long as people believe they are convertible, and if not, they trade at a discount, from historical experience, I think).
I did say that when there’s an excess supply of money, people will try to spend or lend the excess. You are assuming they lend the lot. OK, but if aggregate Ms is fixed (as I assumed) that will create an excess supply of loans, force down r, and that will lead people to try to spend. So prices get bid up.
Max: “You are confusing the question of what powers the government needs to have with what the government needs to actually do given its powers.”
You lost me there, sorry.
“Either the government is spending its money or it is worthless, can’t be both.”
OK. Let me say the same thing in a different way. “The government is offering its money in exchange for goods, but the money is worthless, so it gives up its money and gets no goods in return”.
Nick: The Chinese gunmint used Gresham’s Law but in reverse. The peasants, fearing paper would turned worthless,used the new currency and hoarded silver. But the gunmint kept accepting paper till the peasants were convinced of its value and safety. After all, unlike Europe , where metallic coins were routinely altered, the Chinese gunmint was efficient and honest.
The gunmint then began to buy back silver. In part, because before the Great Isolation, the Emperor was sending huge fleets abroad (Asia, Africa, probably America). Silver, unlike paper, could serve as foreign currency (border effect).
Zimbabwe is a low-income low-GDP country. Most of GDP and consumption is food. Price elasticity is low and there may be a Giffen effect. Even a slightly lower production ( and reduction seems to be rather high by anecdotal evidence, no data can be trusted) will send prices skyrocket. Most exports were agricultural, so they crashed, sending the exchange rate down ( bolivian tin miner strike effect) and so every price go up. Taxable income disappear,tax collection not being either efficient or honest to begin with, the CB prints money and off you go. Obama may be half-kenyan but do anyone outside the Tea party believe 75% of GDP and 99% of export will magically disappear next Tuesday?
I really cant believe that serious, thinking people can even consider that the US could possibly go down the road of ZImbabwe.
ZImbabwe had what micro percentage of world GDP? How many people on their best days had ever transacted or were saving in their currency? Have they ever had a bond market to speak of?
The US is currently debating over what level of govt spending/borrowing (Ill use the term even though the US NEVER borrows to spend) to continue with. Cuts of 10-20% in some programs like SS and Medicare are being considered amongst other things, even though those two programs are virtually fully funded by special taxes. So in an economy of 15+ trillion annually we are talking about less then 10% of current GDP that is the ballpark range of considered spending adjustments. This is NOT hyperinflation numbers boys.
And will Nick or Scott please tell me exactly how these bond traders will reject the US dollar and why? When you get rid of something there has to be a market for it, so by definition if these guys are getting OUT of dollars, someone else is getting INTO dollars. They wont just burn their bonds, not these money grubbers. Zimbabwe and Weimar Germany didnt have a bond market, didnt have a CB that was coordinated with the rest of the world , they were island economies essentially isolated from the rest of civilization.. Comparing the US to either of those is absurd beyond belief. You should both lose your doctorates for even bringing them up in serious discussion about the US fiscal situation.
Nick,
But I am arguing that aggregate M_s cannot be fixed if bank deposit liabilities are accepted as payment. And that creates a bit of a funny situation because nominal interest rates are not going to fall — as they reflect expectations of future short rates. (nominal) income, rather than rates, is going to decline.
Another way you can see that directly is that if I use my income to purchase consumption, then I am supplying income to someone else. But if I use my own income to lend to someone else, then that is a capital transaction, and the rest of the economy’s income declines by the amount that I lend.
And in this sense, there is no difference between purchasing a deposit or purchasing a bond with my savings — the fact that I have refrained from purchasing consumption means that the rest of the economy’s (nominal) income has declined by the amount that I have saved.
Similarly, there is no difference between borrowing to purchase consumption or selling an existing asset to purchase consumption. In both cases, the (nominal) income of everyone else increases to due to my purchase.
If you believe that changes in nominal income affect prices of consumption goods, then as many people attempt to lend rather than purchase consumption, the resulting decline in (nominal) income should result in a decline in prices, whereas your mechanism of getting rid of excess money balances by purchasing goods results in an increase in prices. Both methods result in a clearing of the excess money balances — in once case, deflation in consumption prices raises the return for holding money, and in the other case, inflation lowers the real quantity of money. For some reason, you are only looking at the latter possibility.
“Max: “You are confusing the question of what powers the government needs to have with what the government needs to actually do given its powers.”
You lost me there, sorry.”
I just mean that the fact that the government needs to have the power to demand more currency than it puts into circulation doesn’t prove that it ever needs to do so, not even when starting a fiat currency from scratch. If the government is credible then people will begin saving immediately.
Gizzard:
“And will Nick or Scott please tell me exactly how these bond traders will reject the US dollar and why? When you get rid of something there has to be a market for it, so by definition if these guys are getting OUT of dollars, someone else is getting INTO dollars. They wont just burn their bonds, not these money grubbers.”
This is a good place for me to explain to you the distinction between an equilibrium condition and an accounting identity.
1. “Acres of land sold = acres of land bought” That’s an accounting identity. It’s true by definition.
2. “Acres of land supplied = acres of land demanded”. That’s an equilibrium condition. It is not true by definition. Something (like the price of land most likely) has to adjust to make it true. It means “The acres of land that people want to sell = the acres of land that people want to buy.
There cannot be more land sold than land bought. That would violate the accounting identity 1.
But there can be more land supplied than land demanded. That would violate the equilibrium condition 2. What happens next? Most probably, the price of land will fall. And it will fall until the acres supplied decreases enough and/or the acres demanded increases enough that the two are equal at the new, lower, equilibrium price.
An excess supply of dollars means people want to sell more dollars than people want to buy. So the price of the dollar falls. I.e. the price of other things rises, in terms of dollars.
rsj: I’m getting a bit tired. This may not be a full answer.
I think you misunderstand me.
Simplest thought-experiment. Start in equilibrium. Then double everyone’s money by helicopter. People don’t want to hold that extra money. They want to spend that extra money and/or lend that extra money. Suppose they want to lend it. That does not mean their desired spending (on consumption) declines. It means they want to go on spending as before, and lend more than before. They want to lend out that stock of excess money. But they can’t, of course, because everyone else is trying to do the same. So there’s an excess supply of loans, so r drops, so now desired C and I increase relative to the old equilibrium levels.
OK, I understand, but a helicopter drop of money is fiscal policy.
What I mean by that, is that a helicopter drop increases nominal savings. When you pick up $100 bill that you find lying on the ground, your nominal savings just went up by $100. When you sell a $100 bond that you previously owned for $100 in deposits, your money holdings increase, but your nominal savings are unchanged. There is a difference.
So yes, if nominal savings are too high, I agree that everyone starts bidding up the prices of consumption goods. But they do so because their nominal savings are greater than the amount demanded, not because their money holdings is greater than the amount demanded. The quantity of money is just irrelevant in a modern economy.
However, if nominal savings are too low, and money holdings are too high, then people lend their excess money and do not consume. Still, they succeed in eliminating excess money holdings, but in this case prices fall, they don’t increase.
It seems that you are either implicitly assuming that money = nominal savings, or that whenever money holdings are more than the level demanded, that savings must be more than the level demanded as well. But the two are completely different. I think you are omitting the case of households being satisfied with their money holdings, but not being satisfied with their nominal savings.
Scott, Nick: here’s how I see the price of gold:
Above ground gold is currently worth about $7.5Tn. The global money supply is about $50Tn. The ratio of those values, 15%, is the expected value of future gold backed currency. So it’s a market assessment of the probability that the world will revert to the gold standard. It’s kind of backward looking since we would be unlikely to expect the gold standard if we hadn’t had it before. But the value is really just a forward looking probability.
“Simplest thought-experiment. Start in equilibrium. Then double everyone’s money by helicopter. People don’t want to hold that extra money. They want to spend that extra money and/or lend that extra money. Suppose they want to lend it. That does not mean their desired spending (on consumption) declines. It means they want to go on spending as before, and lend more than before. They want to lend out that stock of excess money. But they can’t, of course, because everyone else is trying to do the same. So there’s an excess supply of loans, so r drops, so now desired C and I increase relative to the old equilibrium levels.”
Nick, I can’t give you a sophisticated argument, but some people with a sophisticated understanding of financial markets would say treasuries are very valuable as collateral, incredibly liquid, and result in credit creation several times over. The result is that they are effectively equivalent to currency, such that the economy is not meaningfully inhibited or slowed down in spending by holding treasuries. In other words, holding treasuries or not has little impact on desire to spend in the form of C or I. The Fed deliberately has 20 Primary Dealers making a deep, liquid market for treasuries, and they purchase them using repo markets, such that it’s effectively not a zero-sum game.
Some of this logic and more is here at point 7. I recommend you read it (point 7), if you haven’t already, and would request commentary if you care and/or have time :)- http://neweconomicperspectives.blogspot.com/2011/07/qe3-treasury-stylego-around-not-over.html
Maybe we could create a hypothetical scenario where treasuries aren’t as equivalent to deposits, and “swapping them” would lead to meaningful price changes, holding all other variables constant, but my feeling is it would have to be quite extreme relative to most real world situations.
Wow- Sorry Nick. That is only tangentially relevant to the quote. You may ignore.
Nick: in Sept-Îles 1996, given the turnover in inventory now common, food publicly supplied ( food already at home is hoarded) may have dropped by 90% over 3 days. Fresf food,such as meat and vegetables was gone almsot within the first day.
Today, arrangement are in place (new pier in various cities along the North Shore and priorities to food and other essentials on the ferries from the South shore)to mitigate the problem. When Katrina hit in 2005 ( it wreaked havoc all along the East Coast), we got road cuts once again. Within a day , ships were in. Life went on without any oppotunity for controlled experiment in monetary theory.
As Mike Davis said in his “Late Victorian holocausts”
http://en.wikipedia.org/wiki/Late_Victorian_Holocausts
A drought is a meteorological event. A famine is a political one.
Sorry to be snarky, but you don’t need all this angels-on-pinheads economic theory to realise that the answer to the question in your first sentence is “no”.
Assume that the central bank has monetary policy independence (which MMTers may deny but is the political reality in most serious countries at present), and further, can call on the government for more capital if necessary (albeit unlikely, as I shall explain). Then, whatever happens, the central bank can hold the value of its currency as required (ie typically in terms of a basket of consumption goods) by trading backing assets, as Mike Sproul says. If the government stopped taking the domestic central bank’s money in tax payments, the demand for, and hence the value of, the currency may decline, but the central bank can fix that by selling assets (including not rolling over loans). Normally, a central bank will have slightly more assets than liabilities (not least because central banks tend to hold earning assets against zero or low-yielding liabilities), so the central bank should not need recapitalisation, but if it can call for more capital it can maintain the value of its currency in practically all circumstances. In fact, it is not hard to imagine circumstances in which the central bank can drive the value of its money to infinity, regardless of whether or not the government accepts its money in payment of taxes.
How about that for an atheoretical argument?
wh10. Yes, it’s slightly OT, but the “are T-bills money?” question is also an important and interesting one, that I have tried to wrap my head around, and failed. Sometimes I do “blue sky” thinking, and imagine a world we are maybe trending towards, in which all of our wealth, from houses to cows to labour, is monetised, in some literal sense. “Money=wealth” is, generally, totally false. But people’s desire to make their wealth as liquid as possible, and “Finance’s” attempt to satisfy that desire, seems to create a trend in that direction over time. A chequing account at a bank effectively monetises the bank’s assets. But why should Finance stop there? And 2008 was just a rather large hiccup in the road towards the eventual destiny of the monetisation of everything. ?
rsj: “What I mean by that, is that a helicopter drop increases nominal savings.”
Re-phrase it. An ongoing stream of helicopters, dropping a flow of money, would be creating a flow of transfer payments (negative taxes), which, if people did nothing with, and just stuck under the mattress, would mean that the flow of saving had increased. S=Y-T-C, and if T falls and Y and C stay the same, means S increases.
But my thought-experiment is different. A single one-time flight of helicopters drops a stock of money at a point in time. Thereafter, until people start trying to get rid of that extra stock of money, S,C,Y, and T, are all the same as before.
K. Wow! Makes good logical sense. But I don’t believe it!
Rebel: neat argument! I like it! A determined and independent central bank, if it has enough assets, can always control the value of its money to whatever it wants, by adjusting the quantity. So unless that central bank wants taxes to affect the value of money (and whyever should it want that?), they won’t!
Rebel: I’m surprised Scott Sumner didn’t make the same argument you just made. It’s right up his street. It’s a variant of an argument he has made before, I now realise.
Nick: “Wow! Makes good logical sense. But I don’t believe it!”
That’s cause you don’t believe in the EMH! Even when it provides a perfectly consistent explanation for a phenomenon, you choose to believe in irrational gold fetish or nostalgia. Anyways, it’s a falsifiable theory: If the value of gold ever rises above the value of all money, I’ll be wrong. Otherwise, you’ll be wrong!
Nick
Thanks for the response.
I actually think your answer supports my general point. I understand that all that needs to happen is for there to be an overwhelming preponderance of bond sellers and not actual buyers for the price to plummet. The bond traders know this well too. Explain to me why they WOULD in fact act so irrationally (a huge run on the sell side) when in fact what they want are MORE dollars. I say this because everyone is calling for interest rates to rise in response to the bond vigilantes. A rise in interest rates means bond traders would get MORE dollars not less. This shows a demand for MORE dollars not less. The bond traders are not nor will they run FROM dollars, they want things that will give them more.
Guys who have hundreds of millions in bond wealth will not act to destroy that wealth, simply because their govt is quibbling over whether or not to pay granny a couple hundred more bucks a month. The numbers being talked about in the debt ceiling/budget debates are peanuts relative to the total wealth/output of the US econopmy.
Hyperinflation talk is absurdly irresponsible and you and any economist with ANY sense of decency should squelch it.
Gizzard: I don’t fully understand your comment. But I’m going to make two stabs at it that might (or might not) be helpful.
There are two paradoxes:
1. Right now, a bit of fear of inflation, by the people and not by the policymakers, is exactly what the doctor would order. Keynesians like Paul Krugman understand this, and so do Monetarists. If people thought there would be more inflation, they would try to get rid of money and/or bonds, and try to buy more goods. This would increase the demand for output, and that would increase the demand for labour, so output and employment would rise. Which is what is so desperately needed right now, in the US especially. But if the policymakers fear inflation, and the people don’t think there’s going to be any, then the policymakers will tighten monetary and/or fiscal policy, which is exactly contrary to the doctor’s orders. (Keynesians and Monetarists might disagree on whether it’s fiscal or monetary policy that really matters most, but both would agree on this.)
It’s weird. We want the people to fear inflation but we don’t want the policymakers to fear inflation.
2. If everybody tries to get rid of land, or bonds, by selling it, they must fail. They can’t find buyers, because everybody wants to sell, and nobody wants to buy. So the only thing that happens (roughly) is that the price of land, or bonds, drops.
But money is not like land, or bonds. Money is really weird. At least at times like now, when there’s lots of output and labour that firms and unemployed workers want to sell but can’t, because they can’t find buyers.
Even if the amount of money that exists is fixed, like land, so people can’t in total get rid of it (except by burning it, which they won’t), if everybody tries to sell more money they will succeed in doing so! They can’t, in total, get rid of money by selling it, if the total amount is fixed, because it just goes from one person’s pocket to another person’s pocket. But they can still sell more, even if everyone else is trying to sell more. They buy output and labour from the unemployed, who are only too happy to “buy” that money in exchange for their labour. But then those newly-employed workers turn right around and “sell” that same money again for all the goods and labour they want to buy, and so more unemployed get hired, and so on.
Money is weird. It’s not like land or bonds or any other good. And understanding why it is weird is what could help get us out of this mess. And that’s why “quasi-monetarists” like me are so fixated on money. And why we get so totally picky about understanding stuff like this properly.
Now do you see where I’m coming from?
Nick: As a quasi-monetarist, are you that different from the “eclectic Keynesians” that Pierre Fortin tried (and succeeded) to turn young uns like us into back in the 70’s?
Jacques: I’m not totally familiar with Pierre Fortin’s perspective. But in the big scheme of things, I would say I’m not that different. We are in the same ballpark. I am probably much more fixated on money as the medium of exchange than he is.
At grad skool the two profs that had the biggest influence on my macro perspective were David Laidler and Peter Howitt (though I had other good teachers like Michael Parkin and Joel Fried, and also Don Patinkin, briefly).
David is thought of as a monetarist, and he is. But he’s a British monetarist. American monetarists used to jibe that British monetarists were really just sensible Keynesians. And I could never figure out if Peter Howitt (like Robert Clower) was really monetarist, Keynesian, or neither. It didn’t seem to matter much.
I played with Austrian ideas by myself, was initially enamoured by the New Classical thinking of Lucas et al, then got very involved in the beginnings of New Keynesian thinking in the mid 1980’s. Then veered back closer to my monetarist and Howitt/Clower and Yeager roots over the last couple of years. Bit of a mess, really.
Maybe, like Pierre Fortin, I’m eclectic enough to try to grab ideas from anywhere, and try to meld them into a vaguely coherent whole. Nearly every approach has something interesting to say. But fitting it all together into a coherent big picture, which is the very essence of macro, is the hardest part.
Doing macro is like looking at one of those Escher drawings of a staircase. Each flight of stairs may make sense. But does the whole picture add up?
Nick Rowe: “if everybody tries to sell more money they will succeed in doing so! They can’t, in total, get rid of money by selling it, if the total amount is fixed, because it just goes from one person’s pocket to another person’s pocket. But they can still sell more, even if everyone else is trying to sell more. They buy output and labour from the unemployed, who are only too happy to “buy” that money in exchange for their labour.”
Nick, I am not picking on you, but from what you say, it seems that in your thinking everybody does not include the unemployed. From what I have seen, that viewpoint does not seem to be uncommon among economists.
Min: good point. You could correctly say that the unemployed are trying to “buy” money. But, and this is important, because it is why money is different, that does not mean the unemployed want to hold more money. They don’t want to hold money. They want to buy money, then immediately sell it again, to buy food, clothes, furniture, etc.
Nick,
That is what I have been trying to explain to MMTers over on Sumner’s blog for the last two days. Money is weird. They don’t get it.
Lee: I don’t blame them for not getting it. It’s hard, even in a really simple pretend world. (And they don’t like those simple pretend worlds). I keep thinking I’ve got it. Then I screw up, and make a mistake like the one Min spotted just above.
Nick: “If everybody tries to sell more money they will succeed in doing so! They can’t, in total, get rid of money by selling it, if the total amount is fixed, because it just goes from one person’s pocket to another person’s pocket. But they can still sell more, even if everyone else is trying to sell more. They buy output and labour from the unemployed, who are only too happy to “buy” that money in exchange for their labour.”
How about we turn your statements the whole way around.
How about: If everybody tries to BUY more money they won’t succeed in doing so! They can’t, in total, get rid of LABOUR AND OUTPUT by BUYING MONEY, even if money’s total amount is increasing, because money just stays in a few people’s pocket. But they can still BUY more labour and output, even if everyone else is trying to BUY more of it. They SELL MONEY TO the unemployed, who are only too happy to “SELL” LABOUR AND OUTPUT in exchange for their MONEY.”
or when you say this:
“But, and this is important, because it is why money is different, that does not mean the unemployed want to hold more money. They don’t want to hold money. They want to buy money, then immediately sell it again, to buy food, clothes, furniture, etc.”
How about: Because it is why money is different, that does not mean the unemployed want to hold more money. They don’t want to hold money. They want to SELL LABOUR AND OUTPUT, then immediately sell it again, to buy food, clothes, furniture, etc.”
You get my point? I just turned your statements around, to look at it from the other side – the side not of people trying to get rid of money, but of people trying to hoard goods and services. I did not change the implications of your statement, but I changed the viewpoint. . But now it makes sense to think of increasing money as not necessarily resulting in inflation. It may just end up lowering people’s value for goods and services, labour and output. Hence, it can lead to a deflation. It can lead to less transactions. It can lead to less velocity. Less people trying to get rid of goods and services, labour and output.
Nick,
You’re right, of course. It’s still tiresome.
Nick Rowe: ” this is important, because it is why money is different, that does not mean the unemployed want to hold more money. They don’t want to hold money.”
Thanks, Nick. 🙂 That makes things clearer.
rogue: I’m not quite getting it.
You are trying to see what happens in reverse, when instead of trying to get rid of money everybody wants to get more money?
Try this:
If everybody wants to hold more money, they first try Plan A. In Plan A, everybody tries to buy more money. They all try to sell more labour and output, to buy more money. But since nobody wants to buy more labour and output, they fail. Plan A fails. So now they switch to Plan B. In Plan B, everyone tries to sell less money. They all try to buy less goods and labour. Plan B is a total success at the individual level, and a total failure at the aggregate level. Everybody succeeds in buying less goods. Nobody can stop you from buying less goods, if that’s what you want to do. But at the same time as people are selling less money, they find they cannot buy as much money. Because everybody else is selling them less money than before.
We get a recession, in other words.
Nick, yes that’s the situation I was getting at, without trying to squeeze the point into your earlier statements. Essentially, more money may not necessarily lead to inflation as an end. The future expectation of inflation could lead to less activity.
Or as we saw in 2008, actual increasing inflation (due to greater demand, money stock was increasing greatly too in 2008 because of the savings glut, the excess credit creation, and the derivatives growth) eventually led to a demand collapse, particularly in oil-intensive industries.
Actually, that’s two different kinds of recession due to inflation – the demand collapse of 2008, where buyers stopped buying.
And the situation where sellers stop selling, due to future expectation of inflation. Perhaps we can lump gold owners as well as Vancouver homeowners in this.