I was reading Frosti Sigurjonsson's proposal for monetary reform in Iceland. [Click on the document thingy halfway down the page.] His proposal is a variant on 100% reserve banking. I got stuck on page 72 and footnote 66, where he discusses overdrafts.
This post is just my attempt to get my own head clear on some of the questions this raises. My head is not 100% clear yet.
(Iceland's financial crisis was much worse than other countries', which concentrates their minds to consider radical reforms. But it would be wise for all countries, and that includes Canada, to keep at least one eye on the possibility of radical reforms. We don't really know why Canada has been relatively "lucky" so far.)
Suppose we stop keeping our money in our pockets. Instead we each have a box with our name on it at the Bank of Canada, where we keep our paper banknotes issued by the Bank of Canada. When I buy something from you, I send an email to the Bank of Canada, cc'ing you, instructing the Bank of Canada to take a $20 banknote out of my box and put it in your box. The Bank of Canada sends a reply-all email confirming it has done this. Then the boxes and paper banknotes all get destroyed in a fire. But it doesn't matter because the Bank of Canada has a computer record of how many notes are in each person's box, so everything carries on just as before. Paper money that we keep in our pockets is functionally equivalent to electronic money, except for convenience, muggers, etc.
100% reserve banking is exactly like that (all money is central bank money), except that there is limited decentralisation so that commercial banks manage some of the record-keeping and communications. Most proposals for 100% reserve banking require each commercial bank to keep a record of how much is in each customer's box, and the central bank to keep records of the totals for each commercial bank (with an occasional audit to check that the two sets of records match up). Frosti's proposal requires the central bank to keep records of how much is in each individual's box too (the commercial banks just handle the communication).
What happens when we introduce overdrafts into an economy with 100% reserve banking?
There are green notes worth +$1 each and red notes worth -$1 each. If you buy something for $20, you either have 20 green notes taken out of your box or 20 red notes put into your box. There is a limit to how many red notes you may have in your box, to prevent you buying unlimited amounts of goods, and accumulating an unlimited number of red notes. If you have only red notes in your box we call it an "overdraft".
Introducing red notes raises some interesting questions:
1. Who decides the limit on the number of red notes each individual may have in his box? Can it be decentralised so that commercial banks set those limits? If it is decentralised, is the commercial bank liable if the individual holding red notes becomes insolvent? If no, then commercial banks face moral hazard in setting that limit. If yes, then commercial banks can go bust despite 100% reserves, unless the commercial banks are required to hold green notes in their own boxes equal to their customers' holdings of red notes.
2. If the central bank: creates one green note plus one red note on demand; and destroys one green note plus one red note on demand, then the value of one red note will always be minus the value of one green note. (For the same reason that a $20 note will always be worth two $10 notes if the Bank of Canada swaps one $20 note for two $10 notes, or vice versa, on demand.) But then what particular monetary aggregate does the central bank control? Is it the the net stock of notes [the number of green notes minus the number of red notes]? (That is the direct equivalent of the Bank of Canada controlling [10 times the number of $10 notes plus 20 times the number of $20 notes].)
3. If the central bank controls the net stock of notes [green notes minus red notes], and commercial banks control the gross stock of notes [green notes plus red notes], then commercial banks do control the stock of money in one important sense, despite 100% reserve banking. Because red notes are media of exchange too. We can imagine an economy where the net stock of notes is zero, but the gross stock of notes is unlimited. (The simple New Keynesian model is like this.)
And that's as far as I've got.
Worthwhile Canadian Initiative 
Oliver,
Do you assume the Central Bank can only buy government papers? The (Central) Bank can buy/warehouse almost anything against money (its liabilities), gold, food or labor if we go really primitive. And the government can always first spend.
Frank,
“Suppose that at the end of each working day / week all of the commercial banks got together and tried to all balance their books by trading green notes and red notes. This situation would not be “real time” 100% reserves which is next to impossible, but rather fixed instant in time 100% reserves.”
I think the US banks did meet in New York quite like that before the Fed was created. And the Fed was partly created to make the system more stable in the case a bank couldn’t attract deposit or other banks’ credit. The money market (sorry Nick) and the Fed is/would be there to ensure that payments go smoothly – I wouldn’t bet against the Central Bank.
Ralph, if the government makes deposits onerous then people will seek workarounds. Example: money market funds were invented in the ’70s to circumvent interest rate caps (risk-free interest rates were >10% but banks were prohibited from paying more than 5%).
Deposits can be very safe if nobody uses them. But then, whatever they are using instead will be the new focal point of a financial crisis.
So the trick is to make deposits safer without reducing the quantity of deposits.
This system would be really rough on the colorblind.
Full-reserve banking is an oxymoron. Full-reserve banking is not banking. It is a storage/payments service.
Credit intermediation and maturity transformation will be done by entities which will not be called “banks” because they won’t take deposits, but will have exactly the same issues as existing non-full-reserve banks. We will then proceed to reinvent the entire structure of regulation that deposit-taking fractional-reserve banks are subject to, and end up with the same system that we have today.
Max,
There is plenty of truth in your claim that “if the government makes deposits onerous then people will seek workarounds.” I’d put it differently, and as follows.
Banks will always try to claim that money deposited with them is totally safe, at the same time as using that money in a way which is clearly not totally safe. Doing the latter means extra profits for banks and more interest for depositors, until the whole thing crashes and the taxpayer comes to the rescue. It’s win, win, win for banks and depositors, and lose, lose, lose for taxpayers.
Niveditas98,
I don’t agree that full reserve banks will involve “exactly the same issues as existing non-full-reserve banks”. It’s near impossible for a full reserve bank to fail, though given incompetent management, the value of its shares would decline which would make it a take-over target.
As to the safe half of the industry under FR, that cannot fail. As to the lending half, that’s funded just by shares under Kotlokoff and Friedman’s versions of FR, so that can’t go insolvent either. In contrast, the proposed Icelandic version, which is pretty much a copy of the Positive Money version, DOES INVOLVE the possibility of failure (as Positive Money admit).
However, those making deposits in the lending half sign up for the possibility of failure, thus there shouldn’t be any need for taxpayer funded rescues. However, agreeing to the possibility of losing all your money in effect makes you a shareholder, thus I don’t see the point of that aspect of the Positive Money version. I prefer Kotlikoff / Friedman.
“What happens when we introduce overdrafts into an economy with 100% reserve banking?
There are green notes worth +$1 each and red notes worth -$1 each. If you buy something for $20, you either have 20 green notes taken out of your box or 20 red notes put into your box.”
At this point in your post, you introduced disharmony into your model. You no longer have 100% reserve banking, you have a two currency banking system.
If your goal is to continue with a 100% reserve banking model, you need to link the red notes to green notes, with a goal of the overdraft flowing to one box containing green notes. 100% reserves does not preclude lending, it assigns a loser (a box containing green notes) to every loan in case of loan failure.
Jussi
Do you assume the Central Bank can only buy government papers? The (Central) Bank can buy/warehouse almost anything against money (its liabilities), gold, food or labor if we go really primitive. And the government can always first spend.
No, no need for that assumption. But I do assume that central banks do not bid on primary markets for whichever assets they buy. So food or labour are not on the menue. The central bank as the government’s bank is a special case. But the fact remains that you don’t get transfer payments or any other payment in cash or reserves. Bank money comes first and then you can exchange it for central bank money on demand. The creation of new means of payment ex nihilo (as opposed to swapping some existing asset for means of payment) is the product of a tripartite transaction between two private entities and a commercial bank. Credit where credit is due.
Ralph, I don’t mean that full-reserve “banks” will have failures — I mean that other entities will spring up to perform the economic function that fractional-reserve banks currently do, and they will create the same issues. It is fantasy to believe that the failure of these entities will not cause problems because they are funded by “equity”.
Fractional reserve banks when they originally arose did not have deposit insurance. Deposit insurance was created to mitigate the economic stresses caused by their failures, and it has worked quite well.
Fractional reserve banking serves a useful economic function, which is why it exists. I think of it as essentially providing insurance: after all, why do people want to hold their savings as deposits? It is because of uncertainty around when they will need money. Just as it is more efficient to pool resources in an insurance company to provide fire insurance, rather than each homeowner attempting to self-insure, it is more efficient for depositors to pool their deposits together and lend out the excess — their money needs are uncertain, but pooling reduces the uncertainty of how much money the depositors in aggregate will actually withdraw at any point in time.
Oliver,
I don’t quite follow you. It seems to me that the discussion is now mixing theory and practice.
You were first asking: “How does money enter the non-bank economy without first being credit money?”
I took/take this as a theoretical question. In theory the answer is that the government / Central Bank can purchase something (from the primary or secondary markets), spend it into existence or just give out for free.
Jussi
I specifically did not consolidate government and the central bank. I said the central bank can not buy in primary markets – the reason being that that is not its role, as opposed to what monetarists, and apparently you, claim. A theory that explains practice, as theories should :-).
Jussi’s post said:
“@TMF:
The credit card itself is instructions to issue a “green” bond to the credit card issuer.
The red money itself is instructions to issue a “green” bond to the red money issuer?
The credit card is not “green” money, is not “red” money, and is not a “green” bond. The credit card is just instructions.
When you use a credit card at a grocery store, here is what happens. You swipe the card saying I want to actually borrow demand deposits (“green” money). You sell a new (“green”) bond to the bank and buy new demand deposits from the bank. The bank sells new demand deposits to you and buys a new bond from you. These show up on both balance sheets.
Next, you sell demand deposits to the grocery store and buy food. The grocery store sells you the food and buys the demand deposits. These show up on both balance sheets.
Sound good?
David Andolfatto said:
“Nick,
I haven’t had time to read that report or even the comments above, but I’ll go ahead and ask anyway: Why would we want to permit overdrafts in the first place in a 100% reserve banking system? If people need to borrow money, there’d be a separate credit market on which they could do so. That’s the idea behind separating money from credit.
David”
Exactly, an overdraft is actually a loan for an entity that would make a mistake on its check book so that the transaction is not declined.
I have $500 in demand deposits in my check book. I write a check for $1,000 in demand deposits by mistake. I have “overdraft coverage” (a loan in advance).
$500 of existing demand deposits is moved from my account. $500 of new demand deposits is placed in my checking account and moved from my account. I now have a new $500 bond liability that moves to the bank.
There is no “red” money. The “red” money is actually a “green” bond. The “green” bond has a high probability of NOT being used as a medium of exchange. It is not medium of account either.
TMF,
“borrow demand deposits (“green” money)”
So my money account has a negative balance?
What happens is that I get a record saying I got short in demand deposits (red notes) and the store got demand deposit (green notes). Both were created by the bank almost in real time. This is how Nick once wrote red and green notes work:
“each goes to the central bank and asks for 5 green and 5 red notes, the buyer gives 5 green notes to the seller, the seller gives 5 red notes to the buyer, and they do the deal.”
(http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/02/colateral-and-the-money-supply.html)
But you are quite right that technically I cannot sell anything to pass on my used credit forward – in that sense it is only “one time” medium of exchange and thus not true red money.
Jussi, http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/02/colateral-and-the-money-supply.html
“Now suppose we add a second form of central bank currency. Red currency has negative value. If you buy $10 worth of apples, either you give the seller 10 green notes, or the seller gives you 10 red notes, or some combination of the two.”
I don’t believe I have ever seen that supposition in the real world. There are green currency, green central bank reserves, green demand deposits, and green bonds.
“So my money account has a negative balance?
What happens is that I get a record saying I got short in demand deposits (red notes) and the store got demand deposit (green notes). Both were created by the bank almost in real time. This is how Nick once wrote red and green notes work:”
Let’s assume your checking account (money account) can never have a negative balance (realistic). You can spend the existing green deposits you have. If you go over it, you have to borrow/have overdraft protection. At the end of July, you receive a statement that says you have $500 in “green” demand deposits in your checking account and “green” bond/loan balance of $0 owed to the bank.
On August 30th, you spend $1,000 in “green” demand deposits with your credit card (it may need to be a debit card). You got “short” $500 in “green” demand deposits by issuing a “green” bond to the bank (there is nothing “red”). Your statement on August 31st will say you have $0 in “green” demand deposits in your checking account and your “green” bond/loan balance will say $500, which is owed to the bank. The store got $1,000 in “green” demand deposits added to its checking account.
The $500 in new “green” demand deposits were created by the bank. The $500 in “green” bonds/loans were created by you (not the bank). The bank paperwork formalizes your “green” bond. The “green” bond/loan was created by you. The bank can not force you to issue the “green” bond (liability).
I am pretty sure this is how the accounting works.
You have a new $500 “green” bond that is both an asset and a liability to you. The bank has $500 in new “green” demand deposits that are both an asset and a liability to the bank. The overdraft triggers an asset swap. You sell the new $500 “green” bond and buy the $500 in new “green” demand deposits. The bank sells $500 in new “green” demand deposits and buys the new $500 bond/loan from you.
The demand deposits are always “green” whether borrowed or not. I hope I got everything in the right place.
TMF
That is all so obvious it is hard to believe anybody could think otherwise.
TMF,
“You got “short” $500 in “green” demand deposits.”
http://en.wikipedia.org/wiki/Short_%28finance%29
“Mathematically, the return from a short position is equivalent to that of owning (being “long”) a negative amount of the instrument.”
Jussi, I am going to say “red” currency or “red” notes are actually “green” bonds/loans. Assuming that, the central bank can’t force someone to issue those liabilities. It can’t force entities into debt. The entities have to agree to issue “green” bonds/loans.
Nick gives the impression with his supposition that “green” bonds/loans (“red” currency) can be issued by the central bank at will. I do not think that is true.
Jussi said from above: “each goes to the central bank and asks for 5 green and 5 red notes, the buyer gives 5 green notes to the seller, the seller gives 5 red notes to the buyer, and they do the deal.”
Let’s change that around with “green” bonds/loans with the central bank acting like a commercial bank for loans. Each goes to the central bank and asks for 5 green notes and 5 bonds/loans, the buyer gives 5 green notes to the seller, the seller gives 5 bonds/loans to the buyer, and they do the deal.
They both went into debt to the central bank. The 5 green notes that go to the seller is a usual “money” transaction. The buyer takes over the 5 bonds/loans from the seller, an unusual transaction. At the end, the buyer has 10 bonds/loans owed to the central bank. The seller has 10 “green” notes. It is just as if the buyer went to the central bank and got a loan (10 loans/bonds owed to the central bank and 10 “green” notes) and then exchanged the 10 green notes for goods.
I can’t see any good reason for the “red” currency or “red” notes. When looked at this realistic way (“green’ bonds/loans), it does not appear that net money equals zero and the bonds/loans will probably not be used as medium of exchange, just like the real world.
The best thing to do is say no overdrafts. Then the loan/bonds part is easier to see.
Oliver said:
“TMF
That is all so obvious it is hard to believe anybody could think otherwise.”
It must not be obvious or we would not be discussing this. I agree it should be obvious. It seems to me some other people do think otherwise. Explaining debt and banking should be obvious. It is not. Believe me.
Oliver, I think demand deposits and currency are both medium of account and medium of exchange. Do you agree or not?
Here is JKH talking about the ECB and the fed:
http://bilbo.economicoutlook.net/blog/?p=16898
““Asset based” and “overdraft” are not very apt descriptors.
The significant difference between Fed (ab) and ECB (o) systems, is that the assets of the Fed are normally claims on government, and the assets of the ECB are normally claims on banks.
The exact nature of the claim is less important to the distinction. Most Fed assets normally are outright holdings of Treasury bonds. Most ECB assets normally are collateralized lending to banks.”
“collateralized lending to banks” and “claims on banks” mean the banks are issuing a bond or bond-like instrument to the central bank (the ECB here). It is a “green” bond/loan for “green” currency and/or “green” central bank reserves.
TMF said
“The significant difference between Fed (ab) and ECB (o) systems, is that the assets of the Fed are normally claims on government, and the assets of the ECB are normally claims on banks.”
I think this is correct in ordinary times.
Off topic, but am I correct that with the last QE, the Fed traded money (green) for Mortgage Backed Securities? Of course, the Fed has no money except what it prints or keys.
In the case of the ECB, am I correct that their current QE is trading euros for national bonds? Of course, the ECB has no euros except for what it prints or keys.
In Nick’s terminology, I think both Central Banks are printing green notes and trading them for bonds. I don’t see the dual green-red note trade here.
TMF,
“I am going to say “red” currency or “red” notes are actually “green” bonds/loans.”
I do not think that is close enough. It is critical in the context that red notes are medium of exchange.
I think the red notes were introduced ONLY as an analytical vehicle to gain insight how the models / proposals work.
Oliver, I think demand deposits and currency are both medium of account and medium of exchange. Do you agree or not?
I would put it this way: in a two tier system with banks and a central bank, the cb’s money is the medium of account. It is the benchmark with which demand deposits, give or take miniscule differences in interest paid / fees charged, trade at par. If you think of bank notes / demand deposits as bank bonds, then in a system without a unifying central bank that intervenes in the bank bond market, you would not expect an outcome where one bank’s bonds automatically trade at par with another’s. And I would say means of payment not medium if exchange, that has such a bartery ring to it.
Jussi said: “I do not think that is close enough. It is critical in the context that red notes are medium of exchange.
I think the red notes were introduced ONLY as an analytical vehicle to gain insight how the models / proposals work.”
It seems to me the “red” currency or “red” notes give the impression they have no default risk, while they actually do have default risk just like “green” bonds. For example, with the 5-5 exchange. I go into debt to the central bank (5 “green” notes and 5 “red” notes). I give 5 “red” notes to the buyer of goods, give 10 goods to the buyer, and receive 5 “green” notes from the buyer. The buyer defaults on all 10 “red” currency/”green” bonds. 5 of those are my liability. I’m not going to do that scenario. The “red” currency/notes and “green” bonds won’t be used as a medium of exchange.
I am assuming “red” currency/note = overdraft and overdraft = loan.
To gain insight into how the system works, it has to be described properly. I’d say calling the ECB an “overdraft” system with “red” currency/notes is not a very good way to describe it. I’d say calling the ECB system an “overdraft” system with “green” bonds/loans from the banking system to the ECB is better.
Oliver said: “I would put it this way: in a two tier system with banks and a central bank, the cb’s money is the medium of account. It is the benchmark with which demand deposits, give or take miniscule differences in interest paid / fees charged, trade at par.”
Do the demand deposits of each of the commercial banks along with each other and currency have a fixed conversion rate (that just happens to be 1 to 1) both ways?
Roger Sparks said: “Off topic, but am I correct that with the last QE, the Fed traded money (green) for Mortgage Backed Securities? Of course, the Fed has no money except what it prints or keys.”
I don’t remember which QE it was.
What if the fed earns $50 billion in interest (existing “green” money) from its assets and then uses that to buy MBS?
TMF said
“What if the fed earns $50 billion in interest (existing “green” money) from its assets and then uses that to buy MBS?”
I think the scale of purchases is vastly larger than the interest the Fed earns. From the Federal Reserve Data Series ‘MBST’, the purchases were about $1.7 trillion over 5 years.
Do the demand deposits of each of the commercial banks along with each other and currency have a fixed conversion rate (that just happens to be 1 to 1) both ways?
What’s your question? Is the exchange rate 1:1 by chance? No, it’s a peg to the medium of account. One could also say a franchise of the medium of account. The important thing being that the cb does not control the amount of means of payment in the (non-bank) economy. The cb just manages the franchise by homogenising a tranche of its member bank books, thus enabling a smooth payment system without runs and interest rate spikes. All a very complicated way of explaining endogenous money, I guess.
TMF
from (via rwer): http://eng.forsaetisraduneyti.is/media/Skyrslur/monetary-reform.pdf
The CBI has monopoly on issuing notes and coin. Coin is manufactured for the CBI by the Royal Mint, and notes by a specialist printer in the United Kingdom.
Banks may purchase new coin or notes from the CBI in return for central bank reserves or securities. Individuals and firms cannot buy notes and coin directly from the CBI, only from banks, in exchange for a reduction in the balance of their deposit account.
…
An important function of the CBI is to be the ‘banker to the banks’. This involves providing commercial banks with accounts for holding central bank reserves. These reserve accounts allow commercial banks to make payments to each other by transferring reserves between their respective accounts at the CBI.
In addition to issuing money and providing reserve accounts for banks, the CBI provides a number of bank accounts to the government, in which funds from taxation and borrowing are temporarily held, before being used for government spending or paying the interest on previous borrowing. Among the CBI’s other duties is the setting of monetary policy (through the policy rate of interest), promoting price stability, promoting financial stability, maintaining foreign exchange reserves, and operating a domestic payment system and payments abroad.
…
In addition to issuing money and providing reserve accounts for banks, the CBI provides a number of bank accounts to the government, in which funds from taxation and borrowing are temporarily held, before being used for government spending or paying the interest on previous borrowing. Among the CBI’s other duties is the setting of monetary policy (through the policy rate of interest), promoting price stability, promoting financial stability, maintaining foreign exchange reserves, and operating a domestic payment system and payments abroad.
TMF,
“I can’t see any good reason for the red currency or red notes.”
One reason for the red money is to suspend property rights. Think of it this way:
With a single green money system – property rights are enforced in that the holder of green money has a legal protection to not be robbed of his / her positively valued assets. With both green and red money, property rights can be fully extended for green money and be nonexistent for red money. If someone steals your red money, do you really care?
Why would someone steal your red money? Because he / she wants to sell a good and can’t find enough buyers with green money, so he / she steals your red money and then “sells” the good by transferring both the good and the red money to the buyer.
Sort of “Through the Looking Glass”, but the implications are interesting.
Frank
With a single green money system – property rights are enforced in that the holder of green money has a legal protection to not be robbed of his / her positively valued assets. With both green and red money, property rights can be fully extended for green money and be nonexistent for red money. If someone steals your red money, do you really care?
The point about green money is that the value of the green asset is identical to the obligation inherent in the negative green debt. My asset is only worth something because somebody owas it to me. If debt (negative green money) is an IOU, then money (green money) is an UOI. It has value because I believe that U will honour your debt to I. The whole green and red discussion is based on the notion that U and I can be separated. It postulates UOs and IHaves. Problem is, I can only Have (and thus legally enforce) what UO.
Csissiko: “These proposals are premised on the idea that banks are “just” intermediaries between savers and lenders, so nothing will be lost by forcing debt out of the payments system.”
I think it’s more the idea that we can divide banks into two parts: one part is just an intermediary between borrowers and lenders; the second part handles the payments system.
Oliver,
“The whole green and red discussion is based on the notion that U and I can be separated.”
It goes further than that because of this note under Nick’s #3 – “Because red notes are media of exchange too.”
We need to accept that red notes are not only an obligation, but also a “negative money” in the sense that they circulate through an economy in the opposite direction that green money does. Green money goes from buyer of good to seller of good, red money goes from seller of good to buyer of good. Red money provides an additional method of allowing markets to clear. Legitimized thievery of red notes enhances this process.
We could drop the red note / green note connotation, and think of it in terms of money and debt, but this would not be your parent’s debt. This would be debt that is significantly more liquid than what exists today and would be uniform in construction – something like perpetual debt that is passed down to future generations. There would be no 30 year debt versus 2 year debt. Debt of the modern variety is often extinguished when the borrower dies (personal debt) or goes bankrupt (personal or corporate debt), while the money borrowed money can remain. Debt of the “red money” variety would presumably be passed along to inheritors or spread among the remaining citizenry after a person / company dies or goes bankrupt.
Nick: “I think it’s more the idea that we can divide banks into two parts: one part is just an intermediary between borrowers and lenders; the second part handles the payments system.”
Fair enough. I should revise that statement to read: “These proposals are premised on the idea that when banks lend they are “just” intermediaries between savers and lenders, so nothing will be lost by forcing debt out of the payments system.”
The point that I was trying to make is that these proposals assume away the possibility that an important economic role is played by banks that source the funds they lend by expanding the money supply.
“nothing will be lost by forcing debt out of the payments system.”
I do not have the answer but I think there is something in this and it should be discussed thoroughly.
Robinson and Friday were living on an island. They can just barter – a classical economy. Robinson wasn’t too keen on making any changes and he decided he will not invest at all (this was a econparadise so no depreciation either). Robinson owned everything and Friday couldn’t make any invest by himself as Robinson paid so little (just an assumption) to him that he needed to consume it all.
Then Ben came around and started a bank with his tiny capital (Ben was first giving away his notes for free to get his money adapted!). Friday talked to Ben who also liked the investment possibilities. Together they decided to go ahead and make the investments far greater than Ben’s bank capital. Ben funded it with his fountain pen – out of thin air. But this way the resources for the investments were mostly forced out of Robinson’s consumption – without his consent and through inflation if necessary. And the cost of bad investments will also be beared by Robinson; only profits are not coming his way. And all this without explicitly violating Robinson’s ownership rights!
Robinson foresaw all this and came up with a stagnant money supply proposal to avoid systemic instability that was threatening their paradise. After it Ben would need Robinson’s money to be willingly put on investment account before he could fund any investments.
I’m not sure what is the moral of the story.
Jussi: “the investments were mostly forced out of Robinson’s consumption – without his consent”
This is where you lose me. Robinson will not accept Ben’s banknotes in payment unless there’s something in it for him. If there is, then the banknotes are promoting socially valuable investment (on the Pareto principle). If there’s nothing in it for Robinson, the banknotes will never circulate.
For me the moral of the story is that at least in a three-person economy, we can expect the innovation of banking to improve, not reduce the set of possible outcomes. (Throw in asymmetric information and a few hundred more people and I would be much more cautious about this claim.)
Nick,
My thoughts on taxation in a red / green currency economy:
Government is permitted to spend only the net of green notes that it receives. It automatically returns equal amounts of red / green notes that it receives in taxes to the central bank to be destroyed / reintroduced into the monetary system. When a government receives in taxes more red notes than green notes, it either redistributes those red notes across the population or returns the excess to red money tax payers.
I would think that treating red and green notes as equals from a tax policy view has an advantage over taxation of green currency only. It provides a means for the central bank to reduce the overall supply of liquidity (matching red and green notes) without suspending green note property rights and without introducing a fixed lifetime for red note / green note pairs.
A traditional debt / money system has a timeframe over which both the money and debt exist and then are retired (private debt only, government debt with rollover complicates this). A red money / green money system would need a taxing government to give the central bank the opportunity to remove total liquidity (equal parts red and green notes) at any point without suspending green money property rights.
And so from an balance sheet sense, green notes represent an asset of the owner where red notes represent a liability of the owner. But from a liquidity and taxation sense, red notes and green notes both represent an asset. Both red notes and a green notes could satisfy payment on taxes and both red notes and green notes could be used to facilitate a trade of goods.
“This is where you lose me. Robinson will not accept Ben’s banknotes in payment unless there’s something in it for him. If there is, then the banknotes are promoting socially valuable investment (on the Pareto principle). If there’s nothing in it for Robinson, the banknotes will never circulate.”
Yes, I guess you are correct but only in this three men setup.
If we introduce an ownership class of Robinsons and worker class of Fridays, which both consist of enough people to make barter inefficient enough, then Robinsons shouldn’t refuse Ben’s notes on Pareto basis and they still be forced to pay the investments they didn’t want in the first place. And I think there isn’t necessary a (Pareto) limit for that because individually they cannot fall back on barter even if they would be collectively better off (network effect).
I think you are right that toy examples might not help us to understand how the banking works. For me it is interesting that in a simple setup banking might give us more investments and less inequality.
csissoko: “The point that I was trying to make is that these proposals assume away the possibility that an important economic role is played by banks that source the funds they lend by expanding the money supply.”
I think I tend to agree. Here is a recent post which looks very different from your two most recent posts, but which I think is heading towards the same general conclusion.
Another way of saying the same thing (I think): it is not (generally) optimal to have a world with only green money. There are two quantities that matter:
1. Green plus red money
2. Green minus red money
Nick, this is how I understand your post on fractional reserve banking, OQM, and 100% reserve banking:
You (and Friedman) are doing your analysis in a complete markets world, but the concept of liquidity is an incomplete markets concept. Because of distributional effects, it is far from clear that the Friedman Rule is generally optimal (or Pareto improving) in an incomplete markets world (where money has value for transactions purposes).
This is how I understand the situation (and I may be guilty of failing entirely to understand Friedman). In a complete markets model, liquidity is already perfect. Thus, to the degree that some contrivance is introduced into the model to induce people to hold a low return asset such as money, the ideal policy is to drive the return of that asset up so that it equals the return on the many other sources of liquidity in the model.
I guess I would say that the whole discussion is about an aversion to dealing with the incomplete markets models that are necessary to explain why people hold money. The way I understand your results in your post is that you are coming face to face with the contradiction that is the (useless) introduction of money into a complete markets model.
I am not entirely clear on how you got from the post to “Another way of saying the same thing (I think): it is not (generally) optimal to have a world with only green money.”, but I agree entirely with the latter statement. “green money plus red money” is what makes it possible for banks to lend up to the needs of the real economy, and this is much more important than the price of green money.
csissko: “You (and Friedman) are doing your analysis in a complete markets world, but the concept of liquidity is an incomplete markets concept.”
I only half agree with you there. The Old Monetarists would agree with you that the reason why people use money, and the reason why people hold money, depend on some fundamentals, and you might say those fundamentals are “incomplete markets” (or, at least, some costs of transacting in a way that would make markets complete). Now the Old Monetarists did not build those fundamentals explicitly into their models, in the way that New Monetarists attempt to do (and are to be applauded for doing). It is only because we use money that the assumption of as if complete frictionless markets does not fall flat on its face; but if markets really were complete and frictionless we wouldn’t need to use money. The Old Monetarists waved their hands, but they weren’t daft.
The question is: if we do model those fundamentals explicitly, does that really overturn the Friedman Rule in any important way? Do we need to model why people hold stocks of refrigerators to say that a monopolist producer of refrigerators should price them at marginal cost for optimality?
“I am not entirely clear on how you got from the post to….”
Nor am I entirely clear 🙂 I’m still thinking this through.
Nick would you be good enough to react to this new Bank of England study? It certainly takes a big step towards the money is an IOU perspective. Thanks. http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf
Nick,
I certainly don’t think the Old Monetarists were daft. I think they developed their intuition from flawed models, and then were over-committed to those models. When it comes to the Friedman Rule, the more I think about it the more that I conclude that the problems with it are less related to complete markets and derive more from a failure to explore the implications of heterogeneous agents carefully.
“if we do model those fundamentals explicitly, does that really overturn the Friedman Rule in any important way?”
First, it’s not even clear that we need to model fundamentals explicitly to overturn the Friedman Rule. Heterogeneity of agents alone may be sufficient: https://www.econ.iastate.edu/research/journal-articles/p1852
Second, your intuition is completely correct that, given a representative agent or its equivalent, even when fundamentals are explicitly modeled, the optimum return on a green money-type instrument will follow the Friedman Rule. (e.g. Wright and Williamson find that Friedman Rule holds here: http://www.artsci.wustl.edu/~swilliam/papers/methodsstl.pdf )
Thus, the real issue is that given heterogeneous agents it will often only be possible to implement the Friedman Rule by treating every different type of agent differently. (See here for a fairly general treatment: https://www.econ.iastate.edu/research/journal-articles/p1827 ) So the conclusion I draw from the analysis of the Friedman Rule is that optimal government management of “green money” in the real world with heterogeneous agents is not feasible — and that we need to think about other types of money.
To me the issue is less one of overturning the Friedman Rule than of reconceiving what we mean by the term “money”, and reducing the focus on “green money” which is so closely tied to the Friedman Rule. In this sense, I think we’re very much on the same page.
“Do we need to model why people hold stocks of refrigerators to say that a monopolist producer of refrigerators should price them at marginal cost for optimality?”
Money is very different from other goods, because liquidity constraints so often define people’s opportunity sets — and therefore the difference between realized GDP and potential GDP. While it is clear that a “good” (or green money) can be used to address liquidity constraints, it is far from clear that goods are the only way to address liquidity constraints, and thus it far from clear that we should be analogizing to goods at all when we talk about money.
Duncan: I did a blog post on it soon after it came out.
A financial asset is just a bit of paper (or plastic, or silicon nowadays) with some sort of IOU (or promise) written on it. Nowadays (nearly?) all money is IOUs (but not all IOUs are used as money). Bank of Canada currency is an IOU, but it’s a strange sort of IOU. The promise (though it’s written on the BoE’s website, not on the currency itself) says (roughly): “We promise to make this bit of paper/plastic depreciate at roughly 2% per year against the CPI basket, unless we change our minds. Signed Steve and Carolyn.”
csissko: imagine a world where hunters get lucky or unlucky in catching deer. Lucky hunters have a big demand for fridges, and unlucky hunters have a small demand for fridges. And the government is the monopoly producer of fridges. It might be ex ante Pareto Optimal for the government to price fridges above marginal cost, and redistribute the monopoly profits as a lump-sum transfer. It creates insurance. I think that might be what’s going on in those heterogenous agent models. But I don’t see that as a fundamental critique of marginal cost pricing. It’s a bit like the old argument that the optimal inflation tax is positive, because the government can’t tax what it can’t observe (were the hunters who caught no deer unlucky or lazy?) and tax evaders use currency.
Csissoko,
“While it is clear that a good (or green money) can be used to address liquidity constraints, it is far from clear that goods are the only way to address liquidity constraints, and thus it far from clear that we should be analogizing to goods at all when we talk about money.”
A good as a means to satisfy liquidity constraints can be durable, it can be portable, it can be easily counted / divisible, it can be uniform in construction, and the boundaries for the protection of property rights can be well defined.
That doesn’t mean that a nongood means of addressing liquidity constraints cannot be conceived of, but I would think there would be trade offs to consider.
I suppose that information could be used to address liquidity constraints.
Information is durable (with a recording mechanism), it is portable (with a recording mechanism or by word of mouth), and it is countable / divisible (units are bits / bytes).
Information is also non-uniform and property rights for information can be difficult to define.
Nick:
re: heterogeneous agent models. I don’t think I was clear. These models do not constitute a fundamental critique of marginal cost pricing — that result still stands in the models at which I have looked closely.
The critique is in the informational demands of implementing marginal cost pricing of “green money.” The problem with monetary policy is that it’s not just about the price, but also about the taxation regime that supports the monetary policy. In particular, low-information lump-sum taxation (equal across all agents) cannot be used to implement marginal cost pricing. To implement marginal cost pricing, the monetary authority needs high-information taxation that discriminates across all the different types of agents.
In a heterogeneous agent model, assume a Friedman Rule rate of interest on current money holdings and lump sum taxation. If the tax is such that the high (liquidity) needs types has enough cash, then it is necessarily the case that the low needs individual has too much cash — and will choose to purchase more than optimal bundle of goods. So we don’t have an equilibrium. If the tax is such that the high needs type has too little cash, then that type can’t purchase the optimal bundle of goods. The problem is that fiat money is not a good way of allocating liquidity, so any lump-sum taxation equilibrium has to be a second-best equilibrium. The alternative is an all-knowing monetary authority that can redistribute fiat money to implement the allocation associated with the Friedman Rule.
In short, in heterogeneous agent models marginal cost pricing is still optimal for fiat money, it’s just not obvious how a monetary authority can put marginal cost pricing of fiat money into place.
I read this theoretic problem to mean: we need banking, aka debt-based money, or in your terminology green and red money.
Frank: “That doesn’t mean that a nongood means of addressing liquidity constraints cannot be conceived of, but I would think there would be trade offs to consider. I suppose that information could be used to address liquidity constraints.”
We’re in luck, because our forebears spent the past few centuries developing banking, which as far as I am concerned is mechanism for converting information into money. So we have the solution. All we need to do is understand how it works, so we don’t destroy the mechanism.
Yes there are trade-offs to information-based money: managing inflation (much easier under a gold standard), and avoiding financial instability (mass bank failures). On the other hand, we’ve had a reasonably well-functioning bank-based monetary system for decades (if not centuries), so we can probably manage these problems if we work hard at understanding them.
csissoko: “If the tax is such that the high (liquidity) needs types has enough cash, then it is necessarily the case that the low needs individual has too much cash — and will choose to purchase more than optimal bundle of goods.”
It’s the second bit of that sentence I don’t get. If cash pays sufficiently high interest, why would the individual who is satiated in cash (relative to other assets) choose to purchase more than the optimal bundle of goods? For example, if the government produces two types of asset: bonds and cash, why shouldn’t the government set the rate of interest on cash equal to the rate of interest on bonds, so that people are indifferent between the two? Or, more simply, why produce any bonds at all? Produce cash only, and set the interest rate on cash high enough so that aggregate demand is just right?
Nick: I think what’s going on is that with heterogeneous agents, is that the economy’s aggregate transversality condition is not enough. It is equally the case that each type of agent cannot reasonably have a path of money holdings that is forever growing, but never spent (which is how I understand what you are proposing). Any agent who looks into the infinite future and expects in every future period to hold more than enough fiat money to buy the “optimal” consumption bundle will if he is self-interested decide to purchase more goods in every period instead of buying the optimal bundle — since you can’t eat fiat money.
The underlying problem is that the price that is “just right” for aggregate demand, is not “just right” for each type of individual in the economy — unless the monetary authority uses tax policy to adjust everyone’s money holdings in every period.
Csissoko,
“Any agent who looks into the infinite future and expects in every future period to hold more than enough fiat money to buy the optimal consumption bundle will if he is self-interested decide to purchase more goods in every period instead of buying the optimal bundle — since you can’t eat fiat money.”
And if the same agent looks into the infinite future and expects that all his neighbors in every future period will be able to hold more than enough fiat money to buy the optimal consumption bundle, will he refuse to accept his neighbor’s fiat money for goods? If I am satiated in liquidity (and always will be) and my neighbor is satiated with liquidity (and always will be) why would either of us trade goods for money?
Perhaps because I am selling apples that take six months to produce and he is selling airplanes that take two years to produce? There are still production schedules to consider. Does “liquidity for all” protect me if I deliver my apples and then wait another 18 months for his airplane? How does overly abundant liquidity mitigate the exchange of two goods (apples and airplanes) that have different production time frames.
I tell my neighbor I will sell him 1 million of my apples for his 1 airplane. Six months later, I give him 1 million apples, he gives me 1 million green notes. Eighteen months later I give my neighbor 1 million green notes, he gives me the 1 million green notes back and I don’t receive an airplane. I go to government asking for my airplane, government tells me “Here is some interest on those 1 million green notes”.
Nick: Correction to my previous (1:57) comment. The fact that the transversality condition is violated for the low needs type implies that the aggregate transversality condition is violated. So the basic problem is that a government lump-sum tax policy that meets the needs of the highest type results in a violation of the transversality condition (as the low needs type carries ever increasing amounts of money).
Frank: Precisely. The discussion is about why satiation is not an equilibrium phenomenon.