Flows are very very small relative to stocks. Each of us demands a flow of air to breathe, but since the flow demand is very very small relative to the stock supply of air, air is a free good. OK, that analogy is not perfect, so let me build a little "model".
Time t is continuous. There exists a stock M(t) of green bits of paper coloured bits of polymer. M(t) varies over time, but is always strictly positive.
The government prints a flow G(t) of new green bits of paper, and adds that flow to the stock.
The government also burns a flow T(t) of green bits of paper. Each individual agent must give the government a specified (by the government) flow of green bits of paper, on pain of imprisonment, which the government then burns. The sum of all agents' donations to the government add up to that flow T(t) when aggregated across all agents.
dM(t)/dt = G(t)-T(t).
Assume M(t) > 0 for all t.
Returning to my free air analogy: G(t) is the flow of oxygen produced by trees; T(t) is the flow of oxygen we consume when we breathe; and M(t) is the stock of oxygen in the atmosphere.
There exists a competitive equilibrium in which the price of green bits of paper is zero and the whole stock M(t) is lying on the sidewalk. Agents only pick up a flow of bits of paper when they need to donate them to the government, and they do so immediately, and so hold zero stocks. Since the price of bits of green paper is zero, and there is always a stock lying on the sidewalk, there is no incentive for an individual agent to pick any up until immediately before he has to pay his taxes. (Strictly, individual agents would be indifferent about when they picked up the bits of paper off the sidewalk, but if there were the tiniest cost of holding bits of paper they would leave them lying on the sidewalk until the very last second.)
Flows of T(t) are very very small relative to the stock of M(t). A demand for a flow does not mean a demand to hold the stock.
What might cause that equilibrium to break down?
1. Monopoly. One agent might try to corner the market in bits of green paper by picking them all up and selling them to other agents at a profit maximising monopoly price. But that monopoly position is highly contestible. Unless the first agent could pick up all the paper instantly, he would know that all other agents would start picking up paper as soon as they saw him trying to corner the market. So the result would be either Cournot or Bertrand oligopoly. With a large number of agents, the equilibrium Cournot or Bertrand oligopoly price would approach the cost of picking the paper up from the sidewalk. If there were any costs (including opportunity costs of foregone interest or storage) [update, of holding bits of paper] there could not exist an equilibrium in which no bits of paper were lying on the sidewalk.
2. Individual agents get some benefits from holding positive stocks of paper. Perhaps because the timing of their donations to the government are uncertain or fluctuate over time, and it is costly to pick up a large number of bits of paper in a short time, or else the cost of picking up bits of paper varies over time. So agents pick up all the bits of paper when their costs of doing so is low, and hold an inventory of bits of paper in advance of anticipated donations to the government.
Hmmm. That's starting to sound like a transactions demand for money function. But if we have a demand to hold money for transactions purposes, we can still get an equilibrium in which money is held and valued even if T(t) is always zero.
(Wicksteed said (HT David Glasner) that fiat money has value because the government requires it for payment of taxes. I'm saying that's not sufficient. And it's not even necessary, in the sense that if my local recycler accepted fiat money, even at a negligible price, that would be enough to replace T(t)>0 in ruling out the equilibrium in which fiat money has a price of zero.)
Update: David Glasner helpfully posts the relevant passage from Wicksteed here.
Worthwhile Canadian Initiative 
Why do nearly all trades in Canada use Canadian rather than US dollars?
I would say, not for ‘economic’ reasons (i.e supply & demand, trust etc.) but for legal/social reasons, the most important of which is captured in the expression ‘tax driven currency’.
Nick:
“Because accounting principles do not determine the rate of return at which assets will be willingly held…”
Empirically, rate of return has almost no effect on people’s desire to hold money. Anyway, the Mass. paper shillings generally traded at par with silver shillings (except for some later inflation), so there was no rate of return in the normal sense. The return they provided was just liquidity.
So suppose the colony will collect 5 silver shillings in taxes in perpetuity. (You’d call this a flow.) At a market R=5%, the present value of taxes receivable is 100 silver shillings. (You’d call this a stock.) The backing theory says the government could print 100 paper shillings and give them to people in the street, and no inflation would happen because 100 paper shillings are adequately backed by 100 shillings of taxes receivable. The backing theory would add that the colony could print another 200 paper shillings and spend them on foreign bonds worth 200 shillings. This would still cause no inflation, since the 300 paper shillings are adequately backed by 100s of taxes receivable plus 200s of foreign bonds. Wouldn’t your model imply the paper shillings would lose value as their quantity tripled? That would lead to all kinds of absurdities.
Mike Sproul: “Empirically, rate of return has almost no effect on people’s desire to hold money.”
Hang on. Are you saying the demand for money is perfectly interest INelastic? Or perfectly interest Elastic?
I would love to believe the former, because then I could be a really hard-line old-time monetarist treasury view type! But I don’t.
I thought that you believed the latter, since it would make your views internally consistent (in my eyes).
I think neither is true. Look at Zimbabwe. Real M/P did not fall to 0 when inflation increased and the real return on holding Zim dollars fell and became negative. But it did fall, and eventually fell to zero, when inflation got high enough. The money demand curve slopes down. You need to assume it’s horizontal for your views to work.
Nick,
What do you think about the idea that rather than government having to issue bonds, interest could simply be paid on reserves by the central bank? The overall effect would be no different, would it?
The government could then either deficit spend by just issuing new money directly (which would require major institutional changes), or the central bank could purchase all government bonds as/after they were issued.
In both cases, bank reserves would ‘pile up’ over time, but the (base) interest rate could be maintained at whatever level was deemed appropriate by paying interest on reserves. Monetary policy could be pursued much as it is at present (without having to constantly engage in OMOs). The only real difference would be that there would be no more government debt as such, no more debt crises or ‘running out of money’.
The fact that government ‘debt’ is not necessary strikes me as being the most significant Chartalist point, especially at present. We can disagree about all the other stuff – whether taxes drive money or whether it might be best to have a permanent ZIRP, for example. Recognising that government debt is something of a fabrication makes it possible to think in a more open-minded way about which policies to pursue, and to focus on ‘real problems’. What do you think?
Oliver:
“Owing to its nature as a monopolist of force as well as being the official representative of all of its citizens, a recognised government has the legal power to reverse the above logic. The liability can (must) be spent first.”
It’s irrelevant which comes first, and a monopoly of force is unnecessary. People deposit 100 oz. of silver into a banker’s vault and he issues 100 paper receipts (‘dollars’). The silver existed before the dollars, but they both became assets and liabilities to the banker at the same time. The banker then prints and lends another 200 paper dollars in exchange for borrowers’ IOU’s worth 200 oz (presumably backed by land). The land existed before the 200 dollars, but they became assets and liabilities to the banker simultaneously. A local landlord then issues 300 of his own paper dollars, each of which he promises to accept for a dollar’s worth of rent on his land. The land existed before the dollars, but in this case the liability is created after the asset. (The landlord and his rents is meant to be analogous to the government and its taxes, by the way.)
philippe: The Bank of Canada already pays interest on reserves.
Take the current system, where governments issue bonds. Then:
1. Pass a law that says that only banks may own government bonds.
2. Make the term to maturity on government bonds shorter and shorter and shorter…
And we get to your system.
1. seems to me to be unwise.
2. would certainly be unwise for a regular corporation, municipal government (or Eurozone government). It may or may not be unwise for a government with its own money. It depends on risk preferences regarding the term structure etc.
But if we ignore 1 and 2, there is absolutely no difference.
In fact, what you have just described is rather similar to the New Keynesian/Neo Wicksellian perspective.
There is no magic bullet of free lunches for Chartalism here.
@ Mike Sproul
I think you’re confusing bank assets and bank capital. The latter must be there before the bank can expand its balance sheet by creating assets (loans) and liabilities (deposits/bank notes). Example: bank A has 2’000.- worth of gold as a capital base off of which it can extend say 100’000.- in loans by issuing 100’000.- worth of bank notes to the borrower who then passes them on to the builder in exchange for a house. The house now belongs to the borrower, whose net worth remains unchanged because he is also stuck with a debt obligation to repay principal plus interest. The banks’ retained earnings from the loan go into expansion of the capital base, say by buying more gold. Etc. etc.
“My view is that when people haggle over prices, or set prices, or try to decide whether to buy or not, they always want to translate into a common unit of account. ”
I agree – my earlier point was taxation has different levels of impact on the different functions of money.
And Nick, you’re running close to violating Pyke’s Corollary of Godwin’s Law: “The first person to bring up Zimbabwe in a discussion of economics loses the argument and ends the debate.” 😉
https://twitter.com/#!/traderscrucible/status/195473348778672128
But Zimbabwe’s such a great example! It’s recent. Plus, if you want to estimate the effect of X on Y, it really helps to have some really big changes in X!
Oliver:
I didn’t mention bank capital, but of course you’re right that a banker must have some capital of his own before customers will do business with him.
LOL! I had just talked about Zimbabwe Godwin’s law this morning with a friend and here you are!
But this is a good discussion. We had a similar discussion over at MMR – we don’t think the state theory of money is complete as it currently stands. Stephanie Kelton has a paper which goes into the basics of state theory of money which might be interesting.
Click to access Bell%20The%20Role%20of%20the%20State%20and%20the%20Hierarchy%20of%20Money.pdf
Nick,
“1. Pass a law that says that only banks may own government bonds.”
Can you explain why this is relevant?
As far as I can tell, whether the bonds are owned by banks or companies or private individuals makes no real difference. In each case, people own bonds so as to receive a decent rate of return. If that comes from interest paid directly on reserves or bonds makes no difference to them. People abstain from taking their investment money elsewhere because bonds offer ‘risk free’ returns. Interest paid directly by the CB provides exactly the same service.
“2. Make the term to maturity on government bonds shorter and shorter and shorter”
This strike me as being irrelevant too, as bond holders can always sell their bonds quickly and easily if they want to spend their money or invest it elsewhere.
Owning a bond is no constraint on spending or investing in alternative ‘instruments’. People stay in bonds because they offer ‘risk free’, decent returns.
If the government were to stop issuing bonds and the CB were simply to pay interest on reserves, investors would still have the same opportunity – i.e. risk free investments with a decent rate of return. Where’s the difference?
p.s. I’m not sure it’s about free lunches.
Government deficit spending can always be inflationary, and large trade deficits are risky and problematic in many different ways. Too much government spending vs private sector spending may have deleterious effects on overall productivity.
These are some ‘real problems’ I can think of off the top of my head, not being an economist. I would appreciate further info on other ‘real’ problems. “Running out of money” or not being able to repay debts denominated in the currency you issue are not ‘real’ problems.
philippe: If 1 and 2 make no difference, then there is no difference between what governments are doing now (using bond-finance) and what you want them to do (finance all spending through reserves, and paying interest on reserves).
Yes, that is what I am suggesting, although only as regards deficit spending.
I don’t necessarily want governments to pay interest on reserves as an alternative to bond-financing, although that is an option. I simply think it might be important to realise that the two are essentially the same. If one accepts this idea, then the question of ‘debt sustainability’ becomes pretty much redundant. Other, ‘real’ concerns become more important.
Again, I would appreciate your input on this subject.
At some time in the future, inflation will be a constraint. The bigger the debt incurred now, the more taxes will have to be increased at that future time. Just because inflation is not a danger (in the US) today, does not mean that today’s debt is not a problem.
End of that topic.
If only our political leaders described the (potential future) issues as clearly as you…
Nick:
I’m saying the demand for money is interest inelastic. I didn’t think that was controversial. But I don’t normally think in terms of supply and demand for money, just as stock market analysts don’t normally think of the supply and demand for GM stock. The focus is on assets and liabilities.
You lost me on the Zimbabwe dollars. You brought that up in relation to interest elasticity right? But the question I was really wondering about was whether you think that the tripling of the money supply I described would make the paper shillings lose value.
Mike Sankowski : ‘Taxes drive the unit of account’.
What about international trade? What monetary shift happens when Iran announces that it will trade half of its oil in the currency of its trading partner rather than USD?
Or, somewhat tangentially, to say that
1) Iran – India oil trade contract is now denominated in Rupees rather than USD? (numeraire)
2) Iran will accept rupees rather than dollars for its oil (exchange medium)
Are these two substantively different wrt monetary theory?
Mike: “I’m saying the demand for money is interest inelastic.”
Seriously, you don’t believe that. If you did believe that, you would be a Quantity Theorist, but you aren’t. You believe that the demand for money is (close to) perfectly interest-elastic, whether you realise it or not.
Let i be the interest rate paid on other assets minus the interest rate paid on money. (Either both nominal or both real, it doesn’t matter).
Write the money demand function as Md(t)=P(t).L(i(t),Y(t)).
As the elasticity of Md wrt i approaches zero, that money demand function approaches Md=kPY (assuming for simplicity a unit income elasticity). Set Ms=Md and we get the crude QT.
At the other extreme, as the elasticity of Md wrt i approaches infinity, we get i=0 (or some constant), so that we get M(t)/P(t)= Present Value of dividend stream plus buybacks of money, just like for bonds or shares, that must pay the same rate of return as the market. Which is your theory.
And the Zimbabwean experience (not to mention a load of estimates of money demand functions) says that both extremes are incorrect.
If the interest-elasticity of the demand for money were zero, a doubling of the supply of shillings would halve the value of each shilling, regardless of whether backing changed. If the interest elasticity is infinite, then doubling the supply of shillings leaving backing constant would halve the value of each shilling, and doubling the backing at the same time as doubling the supply would leave the value of each shilling unchanged.
Nick, this quote explains what I was trying to say yesterday:
(Apologies for length)
Scott Fullwiler:
“Instead of the complexities of the TT&L system and bond sales, the more direct and more efficient method of interest rate support would be for the Fed to simply pay interest on reserve balances. With interest –bearing reserve balances (IBRBs), absent offsetting Treasury or Fed operations to drain excess balances created by a deficit, the federal funds rate would simply settle at the rate paid on reserve balances. The nature of Treasury bond sales as offsetting, interest-rate support rather than finance would be obvious. While the private sector is offered an interest-bearing liability of the government in the presence of a deficit to support a non-zero interest rate target, this does not necessitate that the Treasury sells bonds….
…with IBRBs replacing bond sales the Fed’s independence and ability to exogenously adjust the federal funds rate target would be uncompromised and would simply require increasing or decreasing the rate paid on IBRBs. Regardless of the quantity of excess balances, the federal funds rate would not fall below this rate and would continue to influence other rates in the economy via arbitrage…. Holders of deposits so desiring could convert to short term, private liabilities – just as they can now – the rates for which would be set primarily via arbitrage with the Fed’s target. Long term rates – just as now – would be largely dependent upon the current and expected future paths of short term rates. Those desiring fixed- instead of flexible-rate investments – perhaps banks holding IBRBs – could do so through swaps that would be priced similarly. Without Treasuries, government agency securities and swaps could emerge as benchmarks for pricing of private assets, as is increasingly the case already and for which they are better suited than Treasuries anyway. In sum, with a deficit the transmission of monetary policy via IBRBs is identical to that with non-interest bearing reserve balances and bond sales to drain excess reserves.
With IBRBs, all Treasury securities could eventually be replaced; the interest rate on the national debt would then be the rate paid on IBRBs. Treasury securities themselves are simply fixed-rate liabilities and from the private sector’s perspective not functionally different from IBRBs aside from the flexible-rate nature of the latter. Note that consideration of IBRBs demonstrates how interest on Treasury debt is determined: with IBRBs and no securities issued, the interest rate is the rate paid on IBRBs; where short-term securities are issued, as above those rates are set largely via arbitrage with the Fed’s target; as longer maturities are issued, again as above these rates are set largely via arbitrage with the expected path of the Fed’s target. The “crowding out” view of the loanable funds market is irrelevant; the rates on various types of Treasury debt are set by the current and expected paths of monetary policy and according to liquidity premia on fixed-rate debt of increasing maturity. Since long-term rates are normally higher than short-term rates, total interest on the national debt would be significantly reduced if IBRBs eventually replaced Treasuries….. Indeed there is no inherent reason for Treasury liabilities to exist across the entire term structure except as support operations for longer-term rates.
Deficits unaccompanied by bond sales are disapprovingly labelled “monetization,” although there is no meaningful difference from when bonds are issued. A government deficit always creates net financial assets for the private sector; that is, when a deficit occurs, by definition the total credits to recipient bank accounts due to government expenditures are greater than the total debits from bank accounts to pay taxes.
…..
Whether bonds are sold, the ability of banks to finance further private spending is unaffected by debiting reserve balances or deposits created through deficit spending; recall that since loans create deposits, if there are willing, creditworthy borrowers then desired spending is financed in any event. For deficits, what matters for the determination of aggregate spending and inflation is not whether bonds are sold but whether the deficit is too large given the private sector’s desire to net save.”
Click to access WP38-Fullwiler.pdf
Nick:
You are assuming the correctness of the quantity theory, which is the very point in dispute. You are also not giving the logic of the backing theory a chance to work.
Start with dollars that are backed and convertible into gold at $1=1 oz. I hold $100 for liquidity purposes. If the interest rate is 5%, that means I sacrifice $5/year in exchange for the convenience of always having $100 with me. If the interest rate rose to 10%, my $100 of pocket money is now costing me $10/year. This is still negligible compared to the convenience of always having $100, so at most I might cut my cash holdings to $95. My demand for money, with R on the vertical axis, is nearly vertical, so for simplicity let’s say it’s perfectly vertical. It does not follow that doubling the quantity of dollars will halve their value. Remember that as the issuing bank issues another $100, it gets another 100 oz worth of assets. The bank is thus just as able as before to maintain convertibility at $1=1 oz. The trouble is that you are drawing the demand for money as a function of the interest rate, when interest rates have hardly anything to do with the demand for money. You could just as well write the demand for strawberries as a function of the interest rate.
But now how do you reconcile this statement:
“a doubling of the supply of shillings would halve the value of each shilling, regardless of whether backing changed.”
with the writings of the intelligent, urbane, sophisticated scholar quoted below?
“1. Start with a monetary system where the central bank’s paper money (or an electronic equivalent) is 100% backed by gold reserves, and each note can be redeemed at a fixed price for gold…(insert 9 steps, gradually relaxing assumptions)…We now have a modern inflation-targeting central bank.”
Nick,
But for most people, including the U.S. central bank, “money” is defined as money of zero maturity which includes checking accounts and money market accounts. The M that you describe is really bank reserves, and is not “money” at all to the non-financial sector, in the sense that whatever reserves are held by your bank is not money held by you, who are in the non-financial sector.
If you consolidate the financial sector with the government sector, then changes in the quantity of bank reserves disappear. The central bank sets interest rates, and based on those interest rates (as well as transaction demand, risk aversion, etc.) the non-financial sector makes a portfolio choice of how to allocate their claims on the banking sector — whether they want to hold bank deposits, bank bonds, or bank stock.
I think it would be great to re-work all of the previous analogies in the following format: Assume that all banks are owned by the central bank, that every household has a deposit account at the one government bank. All private sector monetary transactions consist of writing checks on the CB accounts. At the beginning of each period, the CB announces an interest rate, and promises to
1) lend as much as is demanded at that rate (during the period)
2) sell as many bonds as are demanded paying that rate (during the period)
Then the growth of money (e.g. CB deposits) would be the difference between 1) and 2), which is very similar to your original model, except that the CB has no control over quantity, and only has control over the rate.
Now if a lot of people borrow from the CB making certain assumptions about what their return on investment will be, when those return expectations fail, you may get into a situation in which no one wants to borrow even at a rate of zero, just because the risk of not being able to pay the loan back is too high. That means — unless we have fiscal policy or net exports in which the government or someone else starts to borrow from the CB — that the first term is negative. Now for the total supply of money to grow, the second term needs to be positive, so that more people prefer to hold central bank deposits rather than central bank bonds. But as central bank bonds are risk free, the investment uncertainty that causes private sector borrowing to decrease does not necessarily result in a decreased demand for central bank bonds. So it may well be the case that the money supply is shrinking regardless of what the central bank does, even at zero rates.
If you dis-aggregate the CB and private banks, then you would see the above as a large increase in bank reserves that is not matched by an increase in non-financial deposit claims on banks, which is pretty much what we have now.
the above should be “2) sell as many bonds” not “2) sell as money bonds” damn auto-correct.
[I edited it. NR]
Sorry, but isn’t all demand for money ultimately a flow demand? As you say elsewhere, “everyone holds inventories of money. We buy money only in order to sell it again… I might buy a fridge even if I could never sell it again. I would never buy money if I could never sell it again.” And isn’t the opportunity cost of holding money the nominal interest rate, not the inverse price level? So the “stock demand for money” would be a function of the interest rate, wouldn’t it?