Because it's Sunday.
"Green" money has positive value; "red" money has negative value. (An overdraft in your chequing account is red money.) We live in a red/green world with both types of money, so we ought to start thinking about money supply and demand in a red/green world. The red/green world is the real world.
For simplicity, consolidate commercial banks and central bank into One Big Bank.
In the green world, the bank issues green bits of paper worth plus $1 each. If you buy $10 worth of apples, the buyer must give the seller 10 green bits of paper.
It doesn't make any difference if people keep their green bits of paper in a cardboard box at the bank, instead of in their pockets. It doesn't make any difference if the bits of paper and cardboard boxes disappear, if the bank keeps a record in a ledger.
In the red world, the bank issues red bits of paper worth minus $1 each. If you sell $10 worth of apples, the seller must give the buyer 10 red bits of paper.
It doesn't make any difference if people keep their red bits of paper in a cardboard box at the bank, instead of in their pockets. It doesn't make any difference if the bits of paper and cardboard boxes disappear, if the bank keeps a record in a ledger.
There is a symmetry between the green world and the red world. Both worlds have a Cash-In-Advance constraint. In the green world the buyer of goods must have green cash to give to the seller; in the red world the seller of goods must have red cash to give to the buyer. But there is also an asymmetry: in the red world the bank must impose collateral constraints to put a limit on how many red notes an individual can hold, otherwise an individual would want to accumulate an unlimited number of red notes, and die holding more red notes than his wealth.
The red/green world is a composite world where both red and green notes are used as money.
The bank ensures that one red note is always worth exactly minus one green note, in exactly the same way that banks ensure that one $20 note is always worth exactly two $10 notes. The bank will freely swap one green note plus one red note for nothing, and vice versa. Just as banks will freely swap one $20 note for two $10 notes, and vice versa.
Define the "gross" money stock as the number of green notes plus the number of red notes. Define the "net" money stock as the number of green notes minus the number of red notes.
The bank has four monetary policy instruments:
- Open Market Operations. If the bank buys $100 worth of bonds (or buys $100 worth of anything), this increases the net money stock by $100.
- Collateral requirements. If the bank tightens collateral requirements, and if those are binding constraints, this will reduce the gross money stock but not the net money stock.
- The green interest rate (which may be positive or negative) it pays on holdings of green notes. Increasing the green interest rate increases the demand to hold green notes.
- The red interest rate (which may be positive or negative) it charges on holdings of red notes. Increasing the red interest rate reduces the demand to hold red notes.
The red interest rate cannot be below the green interest rate, or the bank would create arbitrage opportunities. The red-green interest rate spread cannot fall below zero. If you like, we could replace the fourth monetary policy instrument (the red interest rate) with the red-green spread.
The demand for gross money will be an increasing function of the volume of transactions and will be proportional to the price level. It will be a decreasing function of the degree of synchronisation of payments and receipts, and it is costly to synchronise your payments and receipts. Standard Quantity-Theoretic stuff.
The demand for net money will be an increasing function of both red and green interest rates. The demand for gross money will be a decreasing function of the spread between red and green interest rates.
In a representative agent model, where payments and receipts of money are perfectly synchronised by assumption (if I buy $100 worth of goods from others, then others buy exactly $100 worth of goods from me at exactly the same time) the demand for gross money will always be zero. (In Michael Woodford's "cashless" representative agent model, the demand for gross money is always zero, and the central bank ensures the supply of net money is always zero, and sets the spread between red and green interest rates at zero.)
The bank controls the net money supply via open market operations, and controls the net money demand via red and green interest rates. An open market purchase increases the net money supply, and an increase in red and green interest rates raises the net money demand. So the bank can use open market operations and interest rates at the same time in an offsetting way without affecting the excess demand for net money.
If collateral constraints are non-binding, the bank controls the net money stock, but individuals determine the gross money stock. Any individual can go to the bank and ask to be given one green note and one red note. The only way the bank can reduce the gross money stock is by tightening collateral requirements, or by increasing the spread between red and green interest rates. With zero spread, and non-binding collateral constraints, individuals are satiated in gross money, but may or may not be satiated in net money.
I think that's right.
Worthwhile Canadian Initiative 
I do think it is useful to consider a pure red money world to check logic – not only for the mixed world, but even for the usual green money world.
Suppose I am employed in the red money world, and I get paid at the end of the month.
On those dates, I get paid by transferring red money to my employer. Basically, I get my compensation by saddling him with my liabilities. So my money wealth increases each time that happens.
Suppose I come to one of those pay dates and I’ve run out of red money. So I have no means of getting paid.
I need red money.
So I go to the bank.
In return for my issuing my own red money liability to the bank, the bank issues me a term deposit which is repayable by the bank at maturity through the transfer of red money from me to the bank.
This expands the banking system balance sheet, which consists largely of red money assets and term liabilities that are issued and settled in red money.
No green money is involved.
And I get paid by transferring newly created red money to my employer.
A few interesting things about this I think:
First, it is the opposite asset-liability orientation of conventional green money banking, where banks are thought to borrow short and lend long. This happens frequently through accounting entries where loans and green money deposits are established simultaneously at the point of the loan advance.
Here, banks borrow long and “lend” short in the form of red money.
Returning to the example, the red money banking system responds to the need for liquidity by expanding the supply of what are essentially transferable, highly liquid bank assets / customer liabilities in the form of red money.
Finally, I notice that this is a very weird variation on the 1930’s “Chicago Plan” design for banking. The very essence of such plans which continue to be promoted today is that commercial banks be precluded from issuing green money and that they should instead issue term liabilities to protect their own liquidity.
Note:
I can imagine refined arguments and debates about whether red money is a form of “liability”. I don’t see that as an important discussion. The important point is that for purposes of simple, comparative balance sheet representation, red money will show as a bank asset and a customer liability – opposite to the case of green money.
Jussi,
“How do you ensure that people won’t die without assets and with some (then defaulted) red notes?’
People who issue red notes would need to have good credit-worthiness checkers, just like bank do today.
“People who issue red notes would need to have good credit-worthiness checkers, just like bank do today.”
Indeed. But are the red notes then truly medium of exchange if the credit-worthiness needs to be checked at the time the payment is made?
JKH: “I do think it is useful to consider a pure red money world to check logic – not only for the mixed world, but even for the usual green money world.”
I totally agree. It helps us see symmetries, and also possible asymmetries.
The role of banks, in the red world, is to certify that their customers are able to hold red notes. The bank guarantees their customers. I think that’s right.
“The role of banks, in the red world, is to certify that their customers are able to hold red notes. The bank guarantees their customers. I think that’s right.”
That is the same as in green world – but what kind of transaction can be then done only in red/green world but not in green-only world?
@Nick Rowe:
The role of banks, in the red world, is to certify that their customers are able to hold red notes. The bank guarantees their customers. I think that’s right.”
But the critical issue is that this type of credit risk becomes embedded in the velocity of red money.
Each transfer of red money assigns the credit risk anew to the payee that received the liability.
It’s not just the credit risk on the red money as originally created – it’s the re-assignment of that credit risk to a new counterparty (for the bank) every time that money is used in a new transaction.
You’ve captured this in one sense with across the board collateralization limits for individual agents.
But this aspect may warrant more attention.
JKH: “But this aspect may warrant more attention.”
I think that’s right.
When there is One Big Bank, it’s relatively simple. The bank decides every individual’s red money limit. When there are multiple banks, it is decentralised. I get rid of my overdraft at BMO by selling my car to you, so you now have an overdraft at TD. Two banks were involved.
(The red world is one where nobody has a positive balance in his chequing account.)
JKH: “But this aspect may warrant more attention.”
I think that’s right.
When there is One Big Bank, it’s relatively simple. The bank decides every individual’s red money limit. When there are multiple banks, it is decentralised. I get rid of my overdraft at BMO by selling my car to you, so you now have an overdraft at TD. Two banks were involved.
(The red world is one where nobody has a positive balance in his chequing account.)
Nick Rowe: “We can imagine a red/green bank with zero net money, where the only asset is red money and the only liability is green money. If net money > 0, then the bank must hold some non-money assets, which are non-money IOUs signed by someone other than the bank (e.g. govt bonds, mortgages). If net money < 0, the bank must have some non-money liabilities, which are IOUs signed by the bank (banks issue bonds).”
Yes, we can imagine this and that, but you claim that we actually live in a red/green world. Bank overdrafts are the only real world red money that you have identified. What else?
I think that the example from a recent comment ( http://worthwhile.typepad.com/worthwhile_canadian_initi/2015/12/what-is-a-cashless-economy-anyway.html?cid=6a00d83451688169e201b7c7f9c4a8970b#comment-6a00d83451688169e201b7c7f9c4a8970b ) is an example of local red money. There is a frontier town with very little green money. There is no bank, but the general store acts like a bank with red money. Nearly everyone owes money to the general store. What they owe is like a bank overdraft and is thus a kind of red money. From time to time, green money comes to town, and it is nearly always used to pay the general store what people owe it, reducing their red money. The store then uses the green money to order more goods, and the green money leaves town. The towns people pay each other as a rule with IOUs, which the general store accepts and decreases the red money in the account of the person to whom money is owed and increases the red money in the account of the person who owes money.
This still doe not get us to anonymous red money notes, does it?
Given all above I think we can say that targeting quantity of net money (OMOs) is not very effective given mixed world if the amount of red money dwarfs the amount of green money. Then amount of red money (credit limits) will mostly determine how easily the transactions can be made. This also explains nicely why business cycles are so tightly correlated with credit conditions. Can we say anything about red/green world and the alpha-beta bank distinction?
Min: “Bank overdrafts are the only real world red money that you have identified. What else?”
You mean bank overdrafts are not enough?
The very centre of the Canadian monetary system is a red/green system. Commercial bank accounts at the Bank of Canada are red/green accounts. The red interest rate is the Bank rate; the green interest rate is the deposit rate. Clearing houses operate on a red/green basis, I think.
Maybe JKH has a better answer.
For ALL OF YOU: not all financial liabilities are red money (just as not all financial assets are green money). It has to circulate as a medium of exchange to count as money.
The credit risk issue shows why the liquidity position is different. In the red world, what matters is not the buyer’s holding of money, but rather the willingness of his bank to allow him to accept more money. And the seller’s balance of red money shouldn’t constitute a liquidity constraint, because the creation of new red money to facilitate the sale should not depend on the credit of the seller.
I agree central banking can be interpreted as a real world case of the red/green idea in operation, with corresponding interest rates.
“The very centre of the Canadian monetary system is a red/green system. Commercial bank accounts at the Bank of Canada are red/green accounts. The red interest rate is the Bank rate; the green interest rate is the deposit rate. Clearing houses operate on a red/green basis, I think.”
“For ALL OF YOU: not all financial liabilities are red money (just as not all financial assets are green money). It has to circulate as a medium of exchange to count as money.”
I think one source of confusion is that not all money is equal in all respects. E.g. clearing house accepts collateral or (green) money against negative positions. But are negative (mark-to-market) positions red money or just a sort of liability? Do they circulate – it is just a transfer wihtout a corresponding (goods) transaction, it just pays the reprincing of positions? Does that count as medium of exchange? Yet the asset pledged as collateral can be rehypothecated (https://en.wikipedia.org/wiki/Rehypothecation) – to cover many kind of liabilities (and surely not all of them are red money) – and transactions! Is collateral green money if used as medium of exchange or is the respective short position red money? What if there wasn’t any short position to start with? Or is collateral actually a sort of loan (along paying with red money)? I think the definitions are not that clear cut.
I was thinking more about the red world/green world stuff.
If you imagine a world where everyone has a bank account and where all transactions are electronic then then a bank could record people’s positions in terms of either credit or debt. A sale from A to B could be seen equally as either a movement of credit from B balance to A that increases A’s credit balance and reduces B, or a transfer of debts from A to B that reduces A’s debt balance and increases Bs. The first is like green money the second like red money. Both are different ways of recording the same transaction and as long as the bank allows overdrafts of either credit amounts (first scenario) or debt amount (second scenario) there is no problem. A $100 credit balance would be the same as a -$100 debt balance (-$100 = negative debt), and a sale of something worth $20 by the account holder could be either a $20 inward transfer of credit increasing his credit balance to $120, or an outward transfer of $20 of debt reducing his debt balance to -$120 of debt (he now owes negative $120).
If you move from electronic transactions to one using physical tokens, then I think things map pretty much exactly. A sale from A to B could either be a movement of green tokens from B to A, or of red tokens from A to B. If people run out of tokens then the bank will (if the appropriate overdrafts are in place) handover more on demand. In this the tokens that people hold, plus the overdraft records that the bank hold, would correspond exactly to the electronic records in the cashless version.
If a bank chose to track people’s account value in debits rather than credits and issued red rather than green cash then any interest payment it made to those in credit would appear as an increase in their negative balance of debits.
Nick E: my head is not clear on this yet.
“In the red world, what matters is not the buyer’s holding of money, but rather the willingness of his bank to allow him to accept more money. And the seller’s balance of red money shouldn’t constitute a liquidity constraint, because the creation of new red money to facilitate the sale should not depend on the credit of the seller.”
In the green world, the bank will not create $100 green money to let me buy a house worth less than $100 (unless I have other assets).
In the red world, the bank will not create $100 red money to let me sell a house worth less than $100 (unless I have other assets).
It looks symmetric.
JKH: Yep. What about clearing houses? And who sets the limits on red money? Any thoughts?
MF: Yep. That was pretty much my thinking too. (The only problem with red tokens is it’s very hard to stop people throwing them away, or accumulating too many).
I’m not following: “In the red world, the bank will not create $100 red money to let me sell a house worth less than $100 (unless I have other assets).’
Why not? I have a house worth $50 that I want to sell for $100. In the green world this is clearly a great deal d and poses no risk to the bank. In the red world the same thing surely must apply. Suppose the sale happens electronically – even if I have no red money at all, why would the bank not be happy to allow me to send $100 of debt to my buyer and change my balance to reflect an extra -$100 of debt. I’m $50 richer and have $100 less debt, and that’s not a risk to the bank in the red world any more than the green one.
If I wish to make it a cash transaction – I go the bank and get them to give me $100 in red notes that I use to make the sale. When they give me the $100 in red notes they must change my balance with an extra -$100 of debt. This seems counter-intuitive but must be true since the cash transaction has to end up the same as the electronic version as far as my balance is concerned.
MF: by “worth less than $100” I mean you can’t sell it for $100.
OK.
If I have more than $100 in debt in my red bank account then my red bank will have no problems (if they trust me) of giving me $100 in notes to try and make the purchase and if I only sell for $50 I can either keep the extra notes or pay them back into my account.
If I have a negative debt balance (that is: I have a positive credit balance) why would they act differently ? They give me $100 in red notes and increase my negative net balance by a further $100. If I sell my house for only $50 they get to pass on $50 of debt to my buyers bank, and even if I just keep the notes under the bed it doesn’t mater to them if they choose to charge interest on red money holdings.
Nick,
In a red / green monetary world can the central bank successfully set the net spread between the value of red notes and the value of green notes? Yes they can set the interest rates on the various note types but I don’t think they can ensure that a positive $1 green note is always equivalent to a negative $1 red note.
A premium may develop between the two types of notes based upon group preference. For instance, the central bank may pay 5% on green notes and charge -5% on red notes, but individuals may prefer to either pay $0.95 in green notes or receive $1 in red notes when purchasing a good (or vice versa). People may discount one note versus the other even if the interest rates on both are equivalent.
That premium may arise as the result of fiscal action (taxes are always paid in green notes not by accepting red notes), limitations on transfers (green notes are inheritable, red notes are not), inflation / deflation expectations, or other factors.
Frank: read the post. I said:
“The bank ensures that one red note is always worth exactly minus one green note, in exactly the same way that banks ensure that one $20 note is always worth exactly two $10 notes. The bank will freely swap one green note plus one red note for nothing, and vice versa. Just as banks will freely swap one $20 note for two $10 notes, and vice versa.”
Do not reply.
Nick,
You write
“Green” money has positive value; “red” money has negative value. (An overdraft in your chequing account is red money.)”
and
“In the red world, the bank issues red bits of paper worth minus $1 each. If you sell $10 worth of apples, the seller must give the buyer 10 red bits of paper.”
If we assume that the overdraft in the chequing account is $10, then we could have the apple seller giving a buyer $10 plus title to the overdrafted chequing account. Some apple buyers would be willing to make that trade.
This would be very similar to my example: “sometimes a home owner with debt-owing-on-the-home will sell the home and debt to a new buyer.” I think this is also a red world transaction.
But here is the important point: In both examples, the red money (always linked to collateral) has a link to a ledger. The ledger is held by a third party who retains a record of how much collateral has been pledged and retains a right to that collateral should the red money not be repaid.
Now you might consider this question: If the red money is reduced to a “bit of paper”, is the link to the third party (probably a bank) and collateral preserved? I would assume the answer would be “yes”
“The bank decides every individual’s red money limit.”
“In the red world, the bank will not create $100 red money to let me sell a house worth less than $100 (unless I have other assets).”
I think we should define red money better. It is either prearranged credit line (credit card comes to mind) or it can be case by case “issued”.
The latter is IMO problematic from medium of exchange point of view – as every transaction needs third party credit analysis (e.g. whether sold house is fair valued or not).
The former might not be fraud proof?
I reckon it does make a difference… what with me storing both gasoline and matches in the same cardboard box as the red paper… yeah, could make a real big difference to my bottom line.
Bits of paper, gosh anything could happen!
But what you are really saying is that using the bank ledger is 100% compulsory (for red note holders) because giving away red notes would be crazy, you must get the receiver to sign off on receiving those red notes and be sure to update the bank ledger (and that’s what really matters, and ultimately is authoritative). In reality then, the paper notes don’t actually exist, the bank ledger exists, and only the bank ledger.
Certainly, and whatever that limit should be, every individual would be attempting to die with that amount of red notes. Also, whether the red limit is the same for all people, for corporations (I can always whip up a few extra corporations to hold my red notes for me), etc.
And of course, whether those interest rates are equal for all people. For example, regular folks don’t get to borrow from the Fed at 0% interest, if I could I’d certainly keep borrowing.
Please don’t talk to me about risk premiums, you can have 10x the collateral in assets and still you get the same “market” interest rate that surprisingly isn’t 0% interest. That’s kind of what you expect from a cartel system… but until economists start to model that, they won’t be anywhere near to how a modern economy operates.
Nick,
“In the green world, the bank will not create $100 green money to let me buy a house worth less than $100 (unless I have other assets).
In the red world, the bank will not create $100 red money to let me sell a house worth less than $100 (unless I have other assets).
It looks symmetric.”
I agree.
Although here is one nuance:
In the green world, the bank simultaneously creates a term loan and green money. The reason the bank needs collateral is that it is left with the term loan with credit risk after the customer spends green money on the house.
Compare that with the red money case. First, I think I was right in suggesting above that the corresponding banking transaction has to be the simultaneous creation of red money and a term deposit, respectively issued and held initially by the same customer. When he sells his house, that customer transfers his red money to the house buyer.
Unlike the green money case, it is not the bank that created the red money that needs the house as collateral. That bank can use the term deposit as collateral in effect – because it can simply extinguish the deposit liability and write it up to equity if the customer fails to deliver red money at the maturity of the deposit. It’s pretty weird.
It is the house buyer’s bank that now needs the house as collateral – because it has no such deposit arrangement with the customer who bought the house. That bank only has a red money asset.
Not sure about your clearing house question.
The central bank typically undertakes the clearing house function.
“In the green world, the bank will not create $100 green money to let me buy a house worth less than $100 (unless I have other assets).
In the red world, the bank will not create $100 red money to let me sell a house worth less than $100 (unless I have other assets).
It looks symmetric.”
In the green world, you do not first need $100 assets to buy a house, because the bank does not just give you $100. They release the $100 against the transfer of title to the house. You are never in a position where you can change your mind and spend the $100 on something else. The bank does not care what assets you hold as collateral to cover the period between giving you $100 green notes and you owning the house, because commercially this period is a fiction.
In a similar way, in the red world the bank does not care what assets the seller has provided that the red notes arise only on sale (which is effectively what happens with overdraft banking). As long as the red notes are only created when the sale is unconditional, the seller is never on the hook for them.
The difference is that in the red world, all sales can be done this way, whereas in the green world it only works for purchase of assets that can be used as collateral (like houses).
(Having written this, I just read JKH’s comment on this and I think it might be along the same lines.)
“if the customer fails to deliver red money at the maturity of the deposit.”
Good point. Yet that shouldn’t be the case even (respectively in the green world no one is giving out free assets).
“It is the house buyer’s bank that now needs the house as collateral – because it has no such deposit arrangement with the customer who bought the house. That bank only has a red money asset.”
In the red world money can be created without collateral (if banks are trusted) but transactions need to be supported by collateral. Is red money then a real medium of exchange?
Tel: In the green world you need a rule that only the bank can create (its) green money.
in the red world you need a rule that only the bank can destroy (its) red money.
In the green world you cannot take green money from someone without permission.
In the red world you cannot give red money to someone without permission.
See my old post I linked in the post above.
JKH and Nick E may well be right.
The underlying question is this: does the green world economise on information compared to the red world?
My hunch is that the green and red world are perfectly symmetric when everybody trusts everyone else. But the green world requires less trust than the red world.
If my hunch is correct, that would explain why green is more common than red. And it would also tell us that a red/green world is “unstable”, and would get more unstable the more red it contains. Because trust can break down.
My hunch is too unclear at the moment.
Just thinking more out loud here about what has become a very interesting thought experiment:
Households in the red world use red money liabilities as the medium of exchange.
Suppose you took all of the residential mortgages outstanding and chopped them up into units called red money and used these units as the medium of exchange.
These units would be collateralized by claims on houses. Divisibility becomes an issue if the bank wants to sell its collateral, but that’s a moot point in the context of the weirdness of the entire thought experiment.
Problems happen if people accumulate too much red money relative to their pledged real asset collateral. This can happen if they spend too much and pay for it by receiving more red money in exchange. But they can literally work their way out of this by transferring some of their red money to their employer on pay day.
Red money is always on the move. The question is where does the risk lie?
Somehow the answer must involve interest payments.
Red money pays a rate of interest to the bank.
So the risk is that the bank won’t allow a red money holder to pay his interest in the form of more red money that the bank itself would have to create (which creates bank equity at the same time). That becomes Ponzi after a while. It’s a basic bank credit adjudication function. Just that it’s on red money as a bank asset.
But its kind of weird to consider what actually becomes the binding constraint in that process. The customer doesn’t need to find green money to pay back the bank in a pure red world. What makes the bank say enough is enough?
That seems a strange part in itself.
Beyond that, and to the degree that there is such a credit risk function involving a highly mobile medium of exchange, such a collateralization attachment must be mobile as well and transferable to successive recipients in the turnover of red money.
……….
“Problems happen if people accumulate too much red money relative to their pledged real asset collateral. This can happen if they spend too much and pay for it by receiving more red money in exchange. But they can literally work their way out of this by transferring some of their red money to their employer on pay day.”
In the pure green world they can also “work their way out” – until they can’t. That seems obvious risk and “trust can break down”. It looks obvious risk to me. I think Nick’s unclear hunch is right.
“What makes the bank say enough is enough?”
If the banks’ asset side (most of it is red money) doesn’t move in value, banking seems too weird business – can they charge interest premium (red money interest minus term deposit interest) from reverse maturity transformation? I think a green bank would emerge and take over all the business.
“Beyond that, and to the degree that there is such a credit risk function involving a highly mobile medium of exchange, such a collateralization attachment must be mobile as well and transferable to successive recipients in the turnover of red money.”
Having such a mobile collateral system it would be more straightforward to use the assets as medium of exchange.
@JKH,
I have a number of questions/comments on your comment:
– “Suppose you took all of the residential mortgages outstanding and chopped them up into units called red money and used these units as the medium of exchange.” If I understand this then in theory a bank could create red money via red OMO – “buying” illiquid debt like mortgage debt, and creating liquid red money that people could use for selling stuff. Unlike green OMO where the loan as an asset is bought in this case the loan as a debt is involved.
– “So the risk is that the bank won’t allow a red money holder to pay his interest in the form of more red money that the bank itself would have to create (which creates bank equity at the same time). That becomes Ponzi after a while. It’s a basic bank credit adjudication function. Just that it’s on red money as a bank asset.”. I’m not following why this is any different from the normal green world. Banks will put limits on people who they consider have too high a positive red balance, just as they put limits on people with too high a negative green balance in a green world. Why is the red world different ?
“The customer doesn’t need to find green money to pay back the bank in a pure red world. What makes the bank say enough is enough?”. The customer doesn’t need green money, but will need to find a way to keep their red money balance to a level agreed by the bank (by selling as much as they buy), or the bank will stop accepting any more red payments ,and may even go after their collateral if thy can’t cover the interest payments. This is exactly analogous to a green bank bouncing checks and bankrupting people when they exceed their overdraft limits and fail to reduce it fast enough.
So overall I think the red and green worlds are rather similar. In an electronic-only banking world they would just be 2 identical ways of looking at the same set of transactions. In both worlds no transaction goes though unless the buyers bank approves, the only difference is the direction of the payment and how balances are thought of (red where debt is recorded as positive, or green where debt is recorded as negative). In a world of hand-to-hand currency things are more awkward because people have to hold debt (rather than assets) in a liquid form. This is challenging for banks as they almost certainly will have to charge interest to hold “liquid debt” red money and this is complicated. (In a world of deflation where the real interest on cash is positive, banks might actually prefer red money that pays only 0% ?). And unlike in a green world where you may assume your buyers cash is good, in a red world you will need to make sure the buyers bank will accept the additional red money before competing the sale, and if the red notes pay interest your bank will have a stake in that decision as well
Finally , it strikes me that no-one has to be a net debtor in a red money world. Everyone could have negative red money balance and it still works. If people with negative red money balances at the bank need red cash – they arrange with the bank to “lend” it to themselves, and in return the bank increases their negative red money balance further. The banks will charge more interest on the loan than they do on the negative balance so will make a profit on people’s. .
@Jussi: In a green world, people are never “in” to have to work their way out. Financial liabilities in a green-only world do not circulate, so someone in particular accepts the counterparty risk.
We can kick-start a green-currency world by having a central bank issue pieces of paper in exchange for a real asset. This is exactly how we got to paper money from a specie system, via gold and/or silver certificates initially redeemable on demand. Green pieces of paper in circulation are liabilities of the central bank, against which it holds assets.
We can’t kick-start a red-currency world in the same way, since nobody would be willing to take an initial allotment of red notes. To get to circulating red notes from nothing, we need to force someone to take red notes. This can happen either if the central bank has an initial endowment of real assets that people want (giving us our general store ledger), or it can happen if the central bank is backed by a government (giving us a chartalist “money is for taxes” view.)
Another asymmetry is that nominal wealth is unbounded in a green money world, but not in a red money world. I can always accept more green money, and it is always to my benefit to do so. However, my nominal wealth in a red money world is given by my capacity to accept red notes, and that capacity cannot increase without a transfer of some illiquid asset for collateral.
That collateral limit ultimately means that we can’t have a red-money-only world. Something else has to circulate as collateral.
Imagine that I’m a red-money Warren Buffet, and I wish to make a penniless person fabulously wealthy. I can’t do this: I can take any red money they’re carrying with them, but I can’t through purely monetary charity give them any additional capacity. I can achieve my aim if I also give him a binding promise to accept red money in the future, but then “a promise to accept red money in the future” is a securitizable asset that could circulate like green money — and we’re suddenly in a red/green world.
The equivalent to the collateralized red money world is a green money world where there is a hard limit on the amount of currency that one can hold.
@Fiscalist:
I’m a bit cautious on the notion of symmetry between the green and red worlds. But symmetry is always a great question for the testing of thinking.
Green banks are organized to transform credit risk – from risky loans to less risky green money. Any notion of credit risk on green money is oriented to the natural reduction of it via green banking.
The nature of credit risk on red money is still not clear to me. Red money is a red bank asset. But that doesn’t mean there can’t be red bank loans. And the credit risk on those loans intuitively should be the same, independent of the medium of exchange.
So the full balance sheet structure for the two types of banking could be quite different. One would think that would open the door to some non-trivial asymmetries somewhere along the line.
Majromax,
“In the green money world, everyone holds a strictly nonnegative value in the most-liquid asset.”. Isn’t an overdraft in a green world a negative value in the most-liquid asset?
Good thinking out loud from JKH.
Additional “thinking out loud” – way out loud.
When the bank earns interest on an asset which is the medium of exchange, that is inherently Ponzi in the bank’s favor. The only way interest on red money can be paid with red money is to increase the red money balance by the same as the amount of interest. That’s obviously not usually the case when a bank is paid green money interest on a regular loan. In that case, the payment of interest on a loan destroys a green money deposit. There is an effect similar to red money interest compounding in the case of interest paid on green money deposits. But the net loan/deposit interest margin effect is a destruction of green money and an increase in bank equity. So net green money Ponzi is precluded by the profitability of green banks.
Something must constrain bank Ponzi in the red world.
And I guess it must be regulatory/credit limits.
Maybe the true underlying risk in all of this is inflation risk at the macro level.
I’m not sure how individual risk would become binding on banks otherwise given the open ended Ponzi opportunity for both banks (earning compound interest) and their customers (spending like crazy by accepting red money in exchange). It’s not even clear to me how the rationale works for collateral seizure and sale when limits are busted.
I’d agree that trust is at the heart of this.
Assuming a single monopoly bank, a payment is a tripartite arrangement involving payer, payee and the bank. The advantage of green money is that the bank is indifferent to the payment, so it need impose no restrictions on payer and payee. Green notes therefore have a negotiability that is one of the key benefits of money.
Some degree of negotiability can be achieved with red money, but the bank will want to impose limits. Payer and payee may be free to novate red money, provided neither ends up holding more than an amount specified by the bank. These limits are crucial in the red world, but are not needed in the green world.
I normally try to read other comments closely and respond where appropriate. But this topic is sufficiently challenging and mind blowing that it requires substantial up front investment just to try and work out one’s own starting views.
Nick E.,
I lied. I just read your comment.
“These limits are crucial in the red world, but are not needed in the green world.”
In fact, banks are known to have deposit concentration limits foe individual customers – a liquidity risk mitigation exercise.
As a corollary to that, I suspect the academic economics community would be surprised to know just how critical liability management is to bank liquidity management.
Nick Rowe: “not all financial liabilities are red money (just as not all financial assets are green money). It has to circulate as a medium of exchange to count as money.”
Right. I’m still waiting.
JKH,
That is true. In the interbank, banks will also sometimes restrict borrowing from specific counterparties so as not to tie up lines. But I think that goes way beyond the issues here.
Is my understanding correct that you are distinguishing between money which enters the economy via an overdraft / borrowing and money which enters via an asset purchase by a (central) bank?
If so, then some thoughts:
If I borrow money via an overdraft, then I have green money plus a red debt (the money I borrow is not red, at least once it changes hands. The payee couldn’t care less whether I borrowed money to pay him / her or whether I earned it). So I pass on the green money in exchange for something of equal value but the debt remains between me and my bank. I can only get rid of my debt by repaying the bank and in doing so, cancel out both my debt as well as the corresponding asset of the bank. To the extent that I pay back with green money, the banks is left with green and red money which cancels out / disappears, thus diminishing the stock of gross money. To the extent that I pay with another asset, say a house, the red money disappears but the green doesn’t, so gross money is displaced by net money.
I can see how asset purchases allow the bank to exogenously determine the amount of net money extant. And I can see how that would be important from a quantity theory perspective. But I’m personally not (yet) convinced it’s that important for the economy. A decreased demand for monetary savings is more than offset by the increased demand for non-monetary savings.
The other thing that struck me, which you mention two posts before, is that you do not distinguish between things that banks buy. I assume that holds in the red & green world as well? Government bonds, corporate papers, real assets (say bridges) as well as consumption goods and services are all the same. What matters is the total stock of money, red + green.
What would that mean for the banks, I thought? Real world banks can only expand their balance sheets by purchasing financial assets. For most central banks, purchases are restricted to assets of their owners. No banks own and run bridges or highways, nor do they issue new money for staff haircuts or crates of bananas for board meetings. The simple explanation for the latter two examples being, imo, that potential returns do not accrue to them / they would make a loss. Banks don’t tax, nor do they collect tolls or other revenue. They do earn money with financial assets they purchase, though.
So, financial asset purchases mean banks earn money with existing assets while expanding their balance sheet. The earning would otherwise have accrued to the non bank sector. Other purchases mean they lose money, all else equal. Red money / credit means banks make money with new assets (the loan did’t exist before). So, even from a quantity theory perspective, there is reason to argue that what banks buy, matters from both a stock as well as a flow perspective.
I seem to have veered off topic. But I hope it makes some sense nonetheless.
I’ve learned a new word: “Verb 1. novate – replace with something new, especially an old obligation by a new one”
JKH: “In fact, banks are known to have deposit concentration limits foe individual customers – a liquidity risk mitigation exercise.
As a corollary to that, I suspect the academic economics community would be surprised to know just how critical liability management is to bank liquidity management.”
I’m surprised. But it makes sense now you say it.
But that’s liquidity risk, whereas the main risk we are worried about in red and green (a)symmetry is (I think) default risk.
Aside from the purely intellectual side of this discussion, there is also (I think) a fairly immediate real-world application: most clearing houses (I think) run on a red/green system where net money is very small (maybe zero) relative to gross money. But if the participants fear that one party may hold too many red notes at the end of the day, the whole thing could seize up.
Nick E., Nick R.,
Quite right. Somewhat peripheral.