Commercial banks are typically beta banks, and central banks are typically alpha banks. Beta banks promise to convert their money into the money of alpha banks at a fixed exchange rate. Alpha banks make no such promise the other way. It's asymmetric redeemability. This means there cannot be an excess supply of beta money in terms of alpha money. (Nor can there be an excess demand for alpha money in terms of beta money.) Because people would convert their beta money into alpha money if there were. But there can be an excess supply of beta money in terms of goods, just as there can be an excess supply of alpha money in terms of goods. If beta money is in excess supply in terms of goods, so is alpha money, and vice versa. If commercial and central bank monies are perfect or imperfect substitutes, an increased supply of commercial bank money will create an excess supply of both monies against goods. The Law of Reflux will not prevent this.
This is in response to David Glasner's good post. David has forced me to be much clearer about what it means to say there is an excess supply of commercial bank money.
Money, the medium of exchange, is not like other goods, because if there are n goods plus one money, there are n markets in which money is traded, and n different excess supplies of money. Money might be in excess supply in the apple market, and in excess demand in the banana market.
If there are two monies, and n other goods, there are n markets in which money is traded against goods, plus one market in which the two monies are traded for each other. If beta money is convertible into alpha money, there can never be an excess supply of beta money in the one market where beta money is traded for alpha money. But there can be an excess supply of both beta and alpha money in each or all of the other n markets.
Start in equilibrium, where the existing stocks of both alpha and beta money are willingly held. Hold constant the stock of alpha money. Now suppose the issuers of beta money create more beta money. Could this cause an excess supply of money and an increase in the price level?
If alpha and beta money were perfect substitutes for each other, people would be indifferent about the proportions of alpha to beta monies they held. The desired share or ratio of alpha/beta money would be indeterminate, but the desired total of alpha+beta money would still be well-defined. If beta banks issued more beta money, holding constant the stock of alpha money, the total stock of money would be higher than desired, and there would be an excess supply of both monies against all other goods. But no individual would choose to go to the beta bank to convert his beta money into alpha money, because, by assumption, he doesn't care about the share of alpha/beta money he holds. The Law of Reflux will not work to eliminate the excess supply of alpha+beta money against all other goods.
Now suppose that alpha and beta money are close but imperfect substitutes. If beta banks want to prevent the Law of Reflux from reducing the stock of beta money, they would need to make beta money slightly more attractive to hold relative to alpha money. Suppose they do that, by paying slightly higher interest on beta money. This ensures that the desired share of alpha/beta money equals the actual share. No individual wants to reduce his share of beta/alpha money. But there will be an excess supply of both alpha and beta monies against all other goods. If apples and pears are substitutes, an increased supply of pears reduces the demand for apples.
Now suppose that alpha and beta money are neither substitutes nor complements. Only in this case would an increased stock of beta money, plus a large enough increase in the rate of interest paid on beta money to ensure that nobody wants to convert beta money into alpha money, mean that there is no excess supply of alpha and beta money in terms of goods. If Canadians use only alpha money, and Americans use only beta money, and the Fed promises to convert US beta dollars into Canadian alpha dollars at a fixed exchange rate, the Fed could not create inflation by increasing the supply of beta money and making it more attractive to hold.
Purely for completeness, if alpha and beta monies were complements, if beta banks increased the stock of beta money, and increased the rate of interest paid on beta money to ensure nobody wanted to convert beta money into alpha money, this would create an excess demand for both alpha and beta money against all other goods.
Commercial banks are beta banks. They fix the exchange rates of their monies against central bank alpha money. It seems reasonable to assume that commercial bank money is an imperfect substitute for central bank money. Chequing accounts are an imperfect substitute for currency. If so, an increase in the supply of commercial bank money, with commercial banks taking actions to ensure that people want to hold a larger share of commercial bank money relative to central bank money, will create an excess supply of both monies against all other goods.
The Law of Reflux would work very well for any good except money. If producers of refrigerators stand ready to convert refrigerators into money or vice versa at a fixed exchange rate, there could never be an excess supply or demand of refrigerators in terms of money. Nor could there ever be an excess demand or supply of money in terms of refrigerators. But refrigerators are traded in one market, for money. Money is traded in all markets, for all other goods. There could never be an excess supply or demand of money in terms of refrigerators; but there could still be an excess supply or demand of money in terms of everything else.
Worthwhile Canadian Initiative 
Nick,
As preamble, I’d still like to be clearer on your asymmetric redeemability argument.
a) The central bank sells BMO currency in exchange for a BMO reserve balance debit, and BMO sells its customer currency in exchange for BMO deposit debit. Customer walks away with currency and no BMO deposit. BMO walks away with lower reserves and deposits.
b) The central bank sells BMO a reserve balance credit in exchange for currency, and BMO sells its customer a deposit balance credit in exchange for currency. Customer walks away with a BMO deposit and no currency. BMO walks away with higher reserves and deposits.
Would you agree that’s symmetric?
How does your asymmetry argument progress from that point?
JKH:
a. there are two types of central bank money: currency and reserves. The central bank promises to convert either into the other at a fixed exchange rate. This is no different from converting $20 notes into two $10 notes. We can ignore this.
b. Who fixes the exchange rate between BMO money and BoC money? I say it’s BMO. I can’t walk into the BoC, give them my BMO cheque for $100, and demand $100 in BoC notes. I can walk into BMO and do that.
“I can’t walk into the BoC, give them my BMO cheque for $100, and demand $100 in BoC notes.”
That’s an odd example in terms of “my BMO cheque”
Suppose we both bank at BMO.
I write a check to you.
You cash it at BMO in exchange for currency.
The fact that you can’t cash it the Bank of Canada is an institutional clearing constraint in my view – not an indication of a redeemability characteristic.
The Bank of Canada clears BMO cheques all the time in exchange for reserves/currency. That’s the essential redemption action – not whether you go to BMO or Royal or the central bank to get the currency.
BMO is just the clearing agent for currency.
The check gets redeemed for currency regardless of the clearing mechanics and who is acting as clearing agent for whom.
I’m puzzled by what this example demonstrates.
And I’m puzzled why you chose the direction of redemption into currency rather than vice versa.
Nick,
What I’m not getting more generally is that BMO can destroy or create its beta money in exchange for the creation or destruction of alpha money – in its capacity as distribution agent for alpha money.
I see no constraint on either alpha efflux (beta reflux) or alpha reflux (beta efflux) – except for the supply of beta reflux (i.e. BMO deposits available to be redeemed) and the demand for beta efflux (demand for new BMO deposits). I don’t see that constraint being one of asymmetric redeemability.
“not getting” meaning that’s the way I see it
I probably bungled your explanation of asymmetric redeemability as the defining feature of central banks when I attempted to explain it to Steve Williamson, but he did at least respond.
JKH: suppose BoC promised to convert BMO money into BoC money at par, regardless. So the BoC is the one that pegs the exchange rate. If I were in charge of BMO, I would then print BMO money like crazy, to make lots of profits, and if my customers wanted BoC money I would just get more from the BoC and give it to them. Or, maybe I would be public-spirited and tell all Canadians that we are now targeting NGDP, and not 2% inflation.
Wonks: I saw that. You didn’t bungle it. His response added some minor qualifications, which sounded OK to me. In particular, his bit about it depending on what the alpha bank is targeting is correct. But the alpha bank is the one that gets to choose the target.
Nick,
“suppose BoC promised to convert BMO money into BoC money at par, regardless”
It does that.
So long is BMO is up and running as a bank.
If BMO isn’t up and running, its because of bad risk management, and regulatory clamp down.
But I fail to see how that is indicative of asymmetric redeemability – that’s just shutting down a bank.
Nick,
Did you see my comments at PragCap – distinguishing between the denominator (alpha insurance) and the numerator (credit risk insurance)?
Asymmetric redeemability is about alpha insurance – not credit risk insurance.
http://pragcap.com/lets-talk-about-seigniorage
i.e. where credit risk insurance in this case means deposit insurance – same diff
Nick,
“Commercial banks are beta banks. They fix the exchange rates of their monies against central bank alpha money.”
Commercial banks are actually debtors or borrowers, rather than ‘currency issuers’ in a sort of quasi-foreign exchange market. A bank deposit is bank debt denominated in the currency issued by the central bank.
Many US banks state this explicitly in their account terms and conditions. The usual phrase used is: “our deposit relationship with you is that of debtor and creditor”.
The reason a bank deposit “exchanges at par” with central bank money is because legally a bank deposit represents a specific amount of central bank money borrowed by the bank from the depositor.
Nick,
My theory now is that I agree with what you are saying, but think that what you are saying is captured best in a framework other than “asymmetric redeemability”.
The only asymmetry I see is that over a long period of time, both alpha and beta money will tend to grow rather than contact – due to NGDP growth.
So there is a net asymmetry in term of more cumulative redemption of beta money for alpha over time.
That’s just a function of growth.
But there is no asymmetry in terms of the option to redeem in either direction at any time.
Unless a bank is shut down – then all bets are off.
The regulatory framework should aim to ensure that banking is efficient and effective in all of its aspects.
And that it is compatible with monetary policy flexibility.
So – symmetric redemption options at all times; long term asymmetry toward net growth with cumulative net redemption of beta for alpha. That cumulative growth amount will be steered by monetary policy.
JKH and Philippe: forget all the institutional details, because it only confuses things.
The BoC prints bits of paper with “BoC” written on them, and nothing else. All bits of paper are identical.
The BMO prints bits of paper with “BMO” written on them, and nothing else. All bits of paper are identical.
What determines the exchange rate between the two types of paper. It could be anything. There is nothing to say it should be one-for-one.
If BMO and BoC try to fix two different exchange rates, who wins?
Which one will adjust its exchange rate to the other’s?
“BMO” and “BoC” are just two arbitrary names, of two arbitrarily chosen banks. We don’t know which of the two banks can set the monetary policy target, until we have answered the question of who sets the exchange rate.
The one which does not choose the exchange rate gets to choose whether to target inflation or NGDP. Standard open-economy macro. You can’t fix the exchange rate and have an independent monetary policy at the same time. If the other guy fixes the exchange rate, you get to target what you want for both of you.
“Asymmetric redeemability” is just another way of stating the fact that that banks borrow money from depositors.
You can exchange your bank deposit for central bank money, because that is what the bank has borrowed from you and promised to pay you.
When you deposit central bank money at a bank, or exchange central bank money for a bank deposit, the deposit-issuing bank goes into debt to you. It borrows the money from you, and promises to pay you the specific amount it has borrowed from you.
Banks endlessly roll over the debts they owe to depositors, in much the same way that governments endlessly roll over their debts to creditors.
Asymmetric redeemability. I suspect if this is real we would see it in the market: why isn’t Goldman Sachs leasing oil tankers and filling them up with dollar bills? Where’s the arbitrage? Why isn’t someone selling a hedge?
Excess supply of bank money. This is related to the question of what constrains bank expansion, and I suspect David is mostly correct here: bank competition and declining marginal opportunities as their total balance sheet rises as a share of the economy.
Asymmetric redeemability: If I hold a commercial bank deposit the commercial bank owes me central bank money. If I hold central bank money the central bank does not owe me a commercial bank deposit.
(I’m talking about the legal fasts of the real world, not a theoretical world btw)
Holding the price level constant, an excess supply of money equalizes the interest rate on money and non-money, i.e. makes money unprofitable. A central bank could choose to issue money unprofitably, or it could reduce the quantity to maintain a desired interest spread.
Nick,
banks expand the supply of commercial bank money (CBM) by making loans, which suggests that if there was an excess supply of CBM, it could simply be used to repay loans – thus reducing the amount of CBM. Why would you want the loan but not the money?
Philippe: “Asymmetric redeemability: If I hold a commercial bank deposit the commercial bank owes me central bank money. If I hold central bank money the central bank does not owe me a commercial bank deposit.”
Yep.
” Why would you want the loan but not the money?”
Because you want to spend the money.
Max: if the price of refrigerators is perfectly flexible, the price of refrigerators will adjust to ensure the rate of return on holding a fridge is equal to the rate of return on holding money, including convenience yields on both assets.
“If I hold a commercial bank deposit the commercial bank owes me central bank money. If I hold central bank money the central bank does not owe me a commercial bank deposit.”
That’s a good way of saying it, but I wouldn’t agree that it indicates asymmetric redeemability.
The relevant symmetry or asymmetry has to do with the exchange of the two liabilities – central bank money and commercial bank money. That relationship and exchange potential is symmetric, as I described above.
In fact, if you go to the Bank of Montreal with currency, you will receive if desired a Bank of Montreal deposit – and that is ensured mostly by the fact that the Bank of Montreal will receive reserve credit from the central bank in exchange for your currency. That assumes also that the Bank of Montreal will accept you as a depositing customer, but to think of that as an impediment is a pretty far fetched objection, IMO.
What is asymmetric is the agency relationship the commercial bank executes in the two different types of redemption transactions. This operative asymmetry is inherent in the institutional structure and agency relationships of a commercial banking system revolving around a central bank. But it is not an asymmetry in the nature of the exchange of deposits for central bank money and vice versa. The institutional agency asymmetry does not interfere with financial instrument exchange symmetry.
comment in spam?
Nick, what’s the difference between “perfectly flexible” and “perfectly elastic?”
i.e.
the relevant interest is in the ability to be able to swap Bank of Canada liabilities for BMO liabilities – in both directions – symmetrically
its not in the physical location where you do the swapping, or in the perceived asymmetry in doing that in one location but not the other
i.e. the symmetry in the redeemability of the financial instruments – which is the issue – is unaffected by the asymmetry of either the agency relationship for the redemption or the redemption location
JKH,
You can swap BoC liabilities for BMO liabilities, but not with the BoC. Whereas you can swap BMO liabilities for BoC liabilities with BMO. The point is that BoC liabilities can only be passed round amongst other parties – BoC is never obliged to deliver a claim on someone else, like a commercial bank has to.
JKH,
If you deposit central bank money at a commercial bank, technically you’re not redeeming the central bank money for a deposit – you’re lending the central bank money to the commercial bank (even if in practice you never actually demand repayment, and just roll over the loan).
There may be rules stipulating that certain types of banks have to accept deposits from anyone – I don’t know. But even if that is the case, people are not legally required to become bankers. Nonetheless if you choose to become a banker or to set up a certain type of bank, you might be legally required to accept deposits. Perhaps you know more about the specific rules…
Nick E.,
My point is that the asymmetry of the agency relationship in executing the swap and the asymmetry of the location in executing the swap is secondary to the substance of the swap – which is the symmetry of redeemability of the instrument itself – that must be the central concern – who cares whether the swap is done at BMO or at the North Pole?
And the Bank of Canada is obligated to deliver reserve balances in exchange for currency and vice versa – that’s the central symmetry that guarantees the peripheral symmetry of the BMO deposit/currency redeemability feature
Nick,
” Why would you want the loan but not the money?
Because you want to spend the money.”
If you look at the non-bank sector as a whole, it has to want both the loan and the money. If it didn’t want the loan, it would repay the loan thereby extinguishing the money. If it didn’t want the money, it wouldn’t take the loan, or would repay the loan.
At the individual level, the borrower who takes a loan from a bank wants the loan so that he can spend the money. But he’ll also want the money back, so that he can repay the loan (loans have to be repaid).
What he doesn’t want is to be stuck with a loan but no money with which to repay it. And repaying the loan deletes the money.
However, whilst the borrower wants the money today so that he can spend it today, he’ll only want to get the money back over a period of time, so that he can repay the loan over a period of time. Not sure exactly what that implies for money supply and demand though, as it introduces a time element.
JKH,
I suppose it depends on how you define the word ‘redeem’. If it means ‘to pay for something’, then you could say you buy the bank deposit with the central bank money. But if it means to repay something, like a debt, then the term wouldn’t be suitable.
Philippe,
I think in the context of Nick’s general framing of the issue of asymmetric redeemability, its been about the exchange of a BMO deposit for currency and vice versa
(I think the term redemption is used most generally and usually for asset exchanges – typically redeeming a deposit for a payment – and not (or at least less so) for liability repayment)
Nick, good post.
My reading of this post is that it’s like all the other posts you’ve written on the subject. However, for the first time (that I’m aware of) you’ve included a set of competing assumptions about the nature of deposits vs central bank liabilities, ie. are they perfect substitutes, imperfect substitutes, complements, not substitutes, etc, one’s chosen assumption leading to a very different end point. In previous posts, your unstated assumption has always been that deposits and central bank liabilities were substitutes, or at least imperfect substitutes. Even though you’re now being more explicit about the menu of assumptions, your preferred selection hasn’t changed.
Set up an alternate clearing system at the North Pole.
Walk into the igloo with a BMO deposit receipt and ask for currency in exchange.
You’ll get it.
Walk in with currency and ask for a BMO deposit receipt.
You’ll get it.
Symmetry
(I wonder if anybody recognizes this as the reverse of that old Stephen Leacock short story.)
In the real world, the commercial banking system acts as a distribution system for central bank currency.
The system is set up as a hierarchy – central bank at the top, commercial banks, then customers, etc.
Hierarchies as distribution systems are inherently asymmetric in structure – the distribution starts at a focal point and spread out.
That’s the asymmetry here.
But the two-way redemption feature as it applies to the two financial instruments in question is symmetric.
Stephen Leacock probably couldn’t have created a humorous story of banking without that symmetry.
http://en.wikipedia.org/wiki/Stephen_Leacock
http://www.online-literature.com/stephen-leacock/literary-lapses/1/
JKH,
“I think the term redemption is used most generally and usually for asset exchanges”.
Ok, but when a bank issues a deposit it’s not really an “asset exchange”. The bank is issuing a liability in exchange for an asset.
Next time I borrow money from a bank I’m going to tell them they’re redeeming the money for my loan.
JP: thanks!
Yep, in the past I was never clear in my own mind about whether I was implicitly assuming perfect or imperfect substitutibility.
(Weird thing is: in the old-fashioned treatment, with required reserves, I think reserves and deposits are complements! Not mentally clear on that yet.)
Nick:” suppose BoC promised to convert BMO money into BoC money at par, regardless. So the BoC is the one that pegs the exchange rate. If I were in charge of BMO, I would then print BMO money like crazy, to make lots of profits, and if my customers wanted BoC money I would just get more from the BoC and give it to them.”
Which is what happened with the “Affaires des piastres” during the Indochina War. It was even said that it was a reason why the war lasted so long.
https://fr.wikipedia.org/wiki/Affaire_des_piastres ( a less complete text in english available by clicking the english button in the language menu on the left of the page)
I am not a monetary guy but at least I’ll play the historian…
Nick, O/T: This has to do with Beckworth’s latest post on endogenous money. I left a comment on pragcap, and (it’s pretty looking with block quotes and all), discussing how your use of the term “exogenous” might differ somewhat from Beckworth’s (based on a previous convo between you and I). Maybe you could take a glance and make sure I’m not misrepresenting you:
http://pragcap.com/crickets/comment-page-1#comment-171571
Nick, can we use the hypothetical world you established in this post of yours to also examine reflux?
http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/the-sense-in-which-the-stock-of-money-is-supply-determined.html
Recall there’s just one bank (the CB) and all transactions are in cash (no deposits), and the CB determined a perfectly interest-elastic demand curve for debt at an exogenously fixed rate of interest. Were you already assuming that people could buy their own debt back at par (thus destroying money)? What if we open a second reflux channel and allow (force) the CB to sell the debt to other parties as well, perhaps putting it up for auction? Does this kind of reflux change anything? Is there something more we can learn in regards to reflux from that old example?
“It’s asymmetric redeemability. This means there cannot be an excess supply of beta money in terms of alpha money.”
You didn’t take into account other asymmetries such as efficiencies as a means of payment. Commercial bank deposits through electronic payments are a more efficient means of payment than currency. Therefore there can be an excess supply of base relative to deposits IMO.
After reading Glasner, I’ve become (even more) convinced that much of these controversies result from treating results or identities as mechanisms. Examples being things like the money multiplier and national accounts identitities.
For instance saying “suppose the quantity of money doubled” without saying how this came about, isn’t sufficient to draw any useful conclusions. So the story about everyone waking up one day having twice as much money doesn’t shed that much light on what happens when the Fed conducts open market operations.
These tautologies are quite different from descriptive models like the Lavoie and Godley equations, which are detailed accounting flows, and these are in turn different from NK Euler equations which are exact predictive models, but need not be stock and flow correct.
JKH,
I think the point about the asymmetry is that it is mainly about who is committing to exchange instruments and who is not. Commercial banks have to carry out certain exchanges that the central bank does not.
In particular, the central bank does not have to do exchanges that involve credit asset / debit liability, which is what commercial banks do when they deliver currency in repayment of deposits. This means that commercial banks face the possibility of their balance sheets shrinking to zero, which affects how they can set their rates. The central bank does not face this constraint and so can set its rate at whatever it likes.
I’m not sure whether asymmetric redeemability is the best term for this, but I do think this is an essential feature of what makes the central bank special and I think this is equivalent to what Nick describes asymmetric redeemability as being.
“Yep, in the past I was never clear in my own mind about whether I was implicitly assuming perfect or imperfect substitutability.”
“It seems reasonable to assume that commercial bank money is an imperfect substitute for central bank money.”
So your refrigerator analogy no longer holds, at least with respect to bank issued deposits. You used to say that if people don’t want to hold more stocks of furniture, it would be impossible for suppliers of furniture to increase the stock in public hands, but that with money it was different. This post puts forward a different set of assumptions. Now banks are like furniture suppliers, they need to make their “product” slightly more attractive in order to get the market to hold it. So you’ve moved from perfect to imperfect substitutability?
JP: imagine many producers of fridges. The beta producers promise to exchange their fridges for alpha fridges at par.
Any producer, whether alpha or beta, could not even get people to accept more fridges, unless he made them more attractive to hold. Even if all producers try to expand together, they will fail, unless they make fridges more attractive to hold.
A beta producer of money can get people to accept more money, but they will not hold it unless he makes it more attractive to hold, or unless all money is perfect substitutes. If all producers expand together, they will “force” people to hold more money.
Peter N: “NK Euler equations which are exact predictive models, but need not be stock and flow correct.”
Show me an NK model which is stock and flow incorrect.
“Were you already assuming that people could buy their own debt back at par (thus destroying money)?”
They could, but they may not want to. If the bank lets people sell back their money for apples, there cannot be an excess supply of money in terms of apples, but there can be an excess supply of money in terms of all other goods.
Nick, thanks for you answer. Does your answer there speak to your seeming disagreement with David Glasner over reflux?
You guys are seemingly close on this last I checked… would he agree with your statement here about the apple market (as if the bank were buying and selling apples)? I’m having a hard time figuring out exactly how you two disagree or if you still do.
Nick (or anyone!), you write about your 3rd case (not substitutes and not complements):
“the Fed could not create inflation by increasing the supply of beta money and making it more attractive to hold.”
I assume you’re not implicitly restricting the inflation to either Canada or the US here?
And it’s a case of not substitutes or complements because only $alpha used in Canada and only $beta used in US?
But still you’re imagining some kind or arbitrage or trade across the border. Can somebody walk me through this? Say the Fed increases the supply of beta money and makes it attractive to hold… now what?
Also on the 4th example: the “complement” one. I assume that can’t be too important, since you only put it there “for completeness” … but still, why bring it up at all? I’m not sure I get what you mean by complement… not this: $beta = 1 – $alpha, right?