Previously, I discussed the features which distinguish money from other goods (Money as a good), why you should view most money as a branded product, and how that affects the perspective you should take on central bank actions (Money as a product). I showed that it makes sense to talk about the best quantity of a particular money in the economy. Now I want to discuss one important process that affects what the best quantity of money is.
This process is called “monetary disequilibrium”, “excess cash balances mechanism” and probably some other things as well. The Keynesian concept of the “Paradox Of Thrift” is related, though less well developed. I will first describe the process informally. In later posts I will describe it more formally. My intent here is to give an intuitive explanation of the basics of monetary disequilibrium.
The real quantity of money that people would like to hold in equilibrium can change over time. Because prices are sticky this can have real effects in the economy. To see how, consider an economy initially at equilibrium with a fixed quantity of money and prices that adjust to changes only after some time (sticky prices). Some people in the economy decide they want to hold higher money balances than they had in the past:
When people hold less money than they would like, they try to increase their holdings of money in two ways: 1) try to reduce their spending 2) try to increase their income. The quantity of money is fixed, so if one person holds a higher nominal quantity of money than before, all others must hold a lower quantity of money than before in aggregate. Prices are fixed, so this is also true for the real quantity of money. When one person reduces their spending, they reduce the income of all others in aggregate. Unless those others desire to hold less money than before, they now hold less money than they would like. Now those others also try to increase their money holdings by the same means. This is a vicious circle and aggregate spending and incomes decline. The circle ends when people no longer want to cut their their spending to achieve higher money balances.
There are two effects which determine how far this process proceeds. 1) The quantity that people want to hold is positively related to the quantity people expect to spend, so as people expect to spend less they will need to hold somewhat less money. 2) As people reduce their spending, those reductions become more painful, so will be more reluctant to trade off consumption for increased money balances.
This process reduces the real quantity of market transactions below it’s equilibrium level. The real quantity of market transactions can only return to normal when prices have adjusted to the new equilibrium, so that people can hold higher real money balances given the fixed nominal quantity of money.
This is the foundational insight of money-based macroeconomics. For some reason this process is not explained in introductory macroeconomics classes, nor commonly discussed by mainstream macro-economists. I believe understanding this logic is critical for understanding the effect of money in the economy and for understanding macroeconomic fluctuations.
Good Morning, Economics 
43 comments
Comments feed for this article
December 6, 2010 at 7:07 pm
Anonymous Coward
Well, yeah, aggregate demand will decrease. This decreases prices. Decreased prices means that lower cash balances go further, so it naturally halts the demand for more cash balances. The stikiness has nothing to do with it. It just means that there is a delay. But that’s because there is a delay in every system. Increasing the money supply will require an injection point. If that injection point is everywhere at the same percentage of holdings, then everyone has the same amount of real increase in their monatary holdings and nothing changed. If it’s at somewhere else, then it’s increasing demand in the same way the initial guy decreased demand. Prices eventually rise to compensate throughout the economy, but it takes a while too. All he has established is that the market adjusts. That’s an argument against quantitative easing, not for it.
December 6, 2010 at 7:14 pm
jsalvati
I didn’t mean this specifically as an argument for QE. Price stickiness makes it an argument for creating money when there is an increase in the demand for money because prices in the economy do not adjust immediately to changes in the demand for money. By adjusting the money supply to accommodate changes in the demand to hold it, we can avoid the ill effects of this process. I’ll cover this more in depth in a future post.
December 6, 2010 at 8:19 pm
Chris
Quantitative easing is precisely this process of creating money to avoid the “ill effects” of deflation. This deflationary process ends, and then it stops indefinitely until somebody else decides to toy with the money supply. Once people reach their “security points” (the amount of money they need to feel secure), they begin spending again. There are two converging movements that cause people to hit their security points, price deflation increasing the real value of their savings, and the increasing value of their savings due to less spending. Even if prices are sticky downwards, people will eventually hit their security points. Once this happens, there is no reason for this to ever happen again unless you adjust the money supply. However, if you do increase the money supply, you artificially decrease the value of people’s savings and increase prices at the same time, pulling everybody away from their equilibrium points. Given that most people don’t know the size of M2 or notice minute price inflation, people will go below their security points without realizing it by overspending. Once they do realize it, they will begin saving in order to catch up with their security points and you’ve just caused a boom and bust. Slow, steady inflation is impossible to maintain for this and one more reason.
The other reason is that once any factor causes a particular market within the economy to inflate faster than the rest of the economy, new money in the economy will flow there faster than into other markets, because of the promise of higher investment yields. Higher investment yields increase interest in the market and increase investment and the cycle continues. Normally this is a good thing because money flowing in must equal “value” flowing out of a given market. However, if you’re adding new money to the supply, the amount of money flowing in will exceed the value and you’ve just created a bubble. The point is that even slow, steady inflation will always result in a bubble or aggravate existing bubbles. Once people realize that the 11% year over year growth of, say, the housing market is not accompanied by a use-dependent increase in value (it’s only investment yield dependent. People were only buying homes so they could sell them later. Increasing home prices would have scared away buyers who just wanted homes to live in) and that it is unsustainable as buying incentive separates from investing incentive, they will bail and expose the problem with the entire economy. The problem was that investment artificially moved towards the high-yield bubble (attracted by new money, which essentially lied about the value of the market) and away from areas that were actually creating value and should have commanded the investments.
In summary, inflation can never be slow and steady because the amount of money actually means something to people. The amount of money tells people to save or spend, and it tells people where to invest. Inflation fudges these numbers and necessarily does so asymmetrically. This and the extra aggravation from leverage (fractional reserve banking) have been major factors in the 5-10 year cycle of boom and bust. Without monetary manipulation, individual markets can boom and bust, but the boom corresponds to a bust in an out-dated market, and the bust corresponds to a boom in a new market. The economy, as a whole, should never be capable of booming or busting without monetary intervention.
December 7, 2010 at 9:48 am
jsalvatier
I mean this as politely as possible: I think you are suffering a number of confusions. That’s ok, because monetary economics can be confusing and it’s generally very poorly taught. One of my aims is to describe monetary economics more clearly.
Anyway:
1) It’s important to distinguish between changes in the quantity of money and changes in the price level (at equilibrium). All else equal, increase in the quantity of money leads to an increase in the price level, but all else is frequently not equal. If there is an increase in the demand for money as well as an increase in the supply of money, the change in the equilibrium price level depends on the relative magnitudes.
2) I think you have your inflation and investment discussion backwards. If prices rise in one part of the economy more than others, that causes people to substitute away from that part of the economy.
3) I think you and many others have a tendency to regard money as more special than it is. The two posts I linked to may help money seem less mysterious and more like other goods.
December 7, 2010 at 6:12 pm
Chris
It’s okay if you think I’m confused. The purpose of discussion is to determine the correct stance. I actually love it when intelligent people tell me I’m confused, because if they’re right, it provides the opportunity to stop being that way :p I’m coming from the Austrian perspective here, so hopefully our discussion will answer questions for anybody else coming from that perspective. This will be a long response…
1) I agree that there are a number of effects that can affect price levels, only one of which is the supply of money. However, those other effects either don’t change appreciably, don’t change permanently, or change as a result of changes in the supply of money (making them simply delaying effects on the primary cause, changes in M2). On the other hand, the supply of money can change appreciably over time, changes permanently, and is enacted by forces outside of the economy itself. The other factors generally only serve to delay the effect of M2 on price levels. These are the other factors I’m aware of including explanations of why they can’t be appreciable in the long run, or are secondary effects to changes in M2 that only serve to delay the price effects:
a) The velocity of money – I understand that the lower the velocity, the lower price levels will be for a given M2, but believe it is neither primary nor depreciable in the long run. The velocity of money should be dependent on the 1st derivative of M2, and on “confidence in the economy”. The latter is a secondary effect to whether or not we get this argument right, as well as many other factors outside of our control, so I don’t think it should enter this argument. I’m open to arguments to the contrary. If the 1st derivative of M2 is positive (ie: we’re inflating the money supply), savers are punished and borrowers are rewarded, increasing the incentive to spend money earlier and increasing the velocity. There is a time lag here, but the trend is undeniable. There can temporarily be a decrease in the velocity of money due to low “confidence” even as M2 increases. This is due to partial dependence and time lag, but increases in M2 should increase the velocity of money in the long run. This is obvious in a hyperinflationary system (people in HI germany rushed wheelbarrows of money to sellers as soon as they got paid, because those minutes mattered when it came to how much they got for their money). You’d have to argue that there could be a constant decrease in the velocity of money to counteract the constant increases in M2 if this is capable of preventing M2 inflation from causing price inflation. I don’t see any reasons why there could be a constant decrease in the velocity of money. I do see reasons why there would be a constant increase, though, as explained.
b) The demand for money – This is a result of the average discrepancy between account balances and security points. If the average bank account is below the average security point, the demand for money is positive and people will save, decreasing prices. If the opposite is true, the demand for money is negative and people will spend, increasing prices. I think the best way to look at this is to use a ratio (savings-supply ratio) as your measurement. That ratio is the savings demand for money in $ divided by the money supply in $. Permanent changes in the SS ratio correspond to actual changes in the definition of “security” (ie: people have higher or lower bars in terms of purchasing power in order to feel secure). There can be temporary changes, due to a lag between M2 changes and actual price changes, but these must swing back to equilibrium as people move away from their security points. If the SS ratio doesn’t change, changes in M2 will still increase prices, because more money will still be circulating, even though more money is also being saved (the ratio stays the same). True, price changes will be a fraction of the change in M2, but unless the SS ratio is extremely high, it will still cause an appreciable change in prices. In other words, people will have to have continually higher and higher purchasing power necessary to feel secure in order for changes in M2 to not cause price inflation. I don’t believe such a “security inflation” would ever actually exist at a serious rate. Other permanent changes to the demand for money do exist. For instance, credit cards, which allow lower average cash balances, decrease the demand for money, and increase prices. Also, the rate of payment. If everybody gets paid daily, their cash balances will be lower than if they get paid yearly. These are one-time deals though, and they decrease the demand for money, causing price inflation, rather than the deflation you need to argue exists for your point to make sense. The last factor is population, which does increase the demand for money and cause price deflation, but given that prices are still inflating at about 3.5% per year on average (according to the CPI), the remainder of the factors I’ve pointed out must be outweighing this.
I think that’s it, actually. All I see in the other factors affecting price inflation are: dependency on M2 in the inflationary direction, one-time deals in the inflationary direction, and much slower (or even necessarily fractionally based on M2) continual processes in the deflationary direction. As I see it, only an insane population growth and a continually increasing terror (minimum level of security needed to feel secure) could counteract M2 growth enough to prevent inflation. I think this is backed by data. Booms are periods of increasing leverage, which cause increases in the money supply and correspond with inflation. Busts are periods of decreasing leverage, which cause decreases in the money supply and correspond with deflation or lowered inflation. The difficulty is that there is a lag. I admit I haven’t completely thought through the consequences of the fact that these effects lag M2 growth, but it seems they would only serve to confuse consumers and investors (and economists) even more than they already would be, and I believe my arguments in my first post still stand if the continued prescription for the economy is an increasing M2.
2) If prices rise in one part of the economy more than others, purchases for the sake of ownership will decrease, but purchases for the sake of investing will increase. If I know that houses are increasing in value 11% year over year, and have been doing so for 15 years, I will want to own a home based on the assumption that it will continue and my assets will appreciate at that astonishing rate. I thought this was clear from my argument that investment incentive and ownership incentive will grow increasingly disparate. If this investment incentive was matched by ownership incentive (like if somebody invented perpetual motion), we wouldn’t have a bubble…we’d have amazing growth and it wouldn’t end in a bust.
3) I don’t think money is special other than that our current money (fiat) does not have intrinsic value. If we increase the production of beef, all other things equal, everybody benefits by having more, cheaper beef. Same goes for all other goods. However, if we increase the production of fiat money, we only increase the availability of tinder, for burning, assuming that increase isn’t purely digital. This actually happened in HI Germany when money became more valuable as fuel than as a medium of exchange. It also became trash in that it wasn’t worth bending down to pick up a bill. What led you to believe that I think money is more special than it is, and in what way? The rules of supply and demand still work, like all other goods, but the incentive to increase production does not, unless your money has appreciable intrinsic value. I actually believe you regard money as being more special than it really is, in that you seem to be a proponent of creating more of it, even though it has no intrinsic value.
December 7, 2010 at 10:24 pm
jsalvati
I’m glad you feel that way. You may be interested to know that monetary equilibrium/disequilibrium is the Austrian phrase to describe this theory.
When I talk about the demand for money, I mean the demand to *hold* money, which is always positive or zero (can’t hold negative money); cash in your wallet, cash in your bank account etc. It’s important to remember this.
I don’t think velocity is a very good way of thinking about monetary economics; it’s better to think about people’s desire to hold money. It’s an idea much closer to the fundamentals and less likely to lead to confusion.
The Monetarists thought for a long time that they could find some measure of velocity that was stable, but they ultimately had to abandon this view when it became clear that they could not. Changes in the demand for money (which lead to changes in velocity) can be can be quite dramatic and permanent. For example http://economistsview.typepad.com/economistsview/2006/03/the_velocity_of.html . Any policy which relies on a stable demand for money or velocity is going to have problems.
This is especially true in the recent crisis when the Fed began paying interest on reserves (a good policy, but very poorly timed).
2) Lose monetary policy is neither necessary not sufficient to create bubbles. You need a special kind of focused irrationality by some market participants. In any case, the purpose of adjusting the money supply to accommodate changes in the demand for money is to avoid having to adjust to changes in the demand for money. It makes prices more predictable.
3) Fiat money is a financial asset with special uses. As long as the monetary authority accommodates changes in demand for its money, the money has value similar to the way certificates of deposit or stocks have value. It’s useful to think of the monetary authority as the Industrial Producer Of Money, they take some kind of financial assets (in our case government bonds) and manufactures them into another kind of financial asset (money).
There is a best quantity of beef for the economy to produce and there is also a best quantity of money to have in the economy, neither of these are constant or trend constant.
December 9, 2010 at 12:54 am
Chris
I agree with your definition of the demand for money (really the demand for holding money). It’s the same one I’m using. I just mis-typed. I meant to refer to the first derivative of the demand for money when I talked about it being negative or positive (ie: whether money is flowing out of savings or in). I’ll probably repost that first part with the corrections made so it’s easier to read.
1) I never tried to argue that the velocity of money is stable in the short-run, and I don’t believe that to be the case. If you read again, you’ll see that I’m saying the velocity of money is partially dependent on the first derivative of M2, which changes radically with interest rates and investment leverage, and is partially dependent on “confidence in the economy”. The link you posted actually supports that claim. The recessions have a fairly high correlation with drops in the velocity of money, especially in M2. The periods in-between correspond less well with increases in the velocity of money, but still correlate, and this would be expected when there is some sort of cutoff used when defining a recession (ie: some drops in velocity might correspond to slowdowns that don’t qualify as recessions), and when there are other secondary factors that could smudge or delay the correlation, like confidence. Also, notice that while the velocity of money swings wildly, it is still centered around a particular number and always returns to that number. This is why I was saying that this value does not progress indefinitely in one direction, like M2 does, and can’t have a long-term effect on price inflation. I’m not relying on a steady velocity of money to make my claim. I’m pointing out that it never goes anywhere in the long term. It just oscillates in a delayed correlation with the 1st derivative of M2.
So what’s left that can affect prices is the demand for money. In order for the demand for money to counteract the inflationary pressure on prices created by increases in M2, the demand for money would need to be constantly increasing faster than the increase in M2 (I explained in my last post). If you can show me that such a thing is happening, then you’re really showing me that the average person has an ever-rising bar for what constitutes security. If that’s true, eventually we’ll all be the equivalent of millionaires while we begrudgingly spend as if we’re destitute, just so prices stay the same as our bank accounts grow. Again, my assertion is that increases in M2 almost perfectly correlate with increasing prices *in the long run*. I’m still taking your word that you’re here to help educate people, but you seem to have ducked most of my argument rather than addressing it.
2) I did say “created a bubble” but really I meant “aggravated a bubble to the point of disaster”. Small bubbles exist all the time in all sorts of markets, but when they pop it doesn’t destroy the entire economy. There will always be reasons, whether due to hysteria or real production of value for one market to grow faster than others and yield higher returns. Loose monetary policy allows a greater influx of money into those markets that beat expectations for whatever initial reason, causing them to grow even faster, all without needing to take money out of other markets. It’s strange that you would call investment in a bubble irrational when individuals can and do make fortunes off of bubbles, at the expense of the entire economy. Monetary benefit from high investment yields has continually proven to be the only impetus required for investors to crowd a market. If I am an investor and I see 4% annual yields everywhere, roughly in line with inflation, but 11% annual yields in the seemingly sure-bet housing market, where do you think I will put my money? That investment is only irrational if investors know that housing is a bubble and that it will pop before they can exit with a profit. How do they know housing is a bubble? Well, they don’t. Returns are supposed to tell investors where to invest. When that metric becomes inaccurate, even the federal reserve chairmen are fooled. Greenspan didn’t realize that the dot com bubble existed on top of a housing bubble, and Bernanke didn’t realize there was a housing bubble at all until the shit hit the fan. These assertions are historically backed by interviews with both individuals and by their actions. Should all of the construction companies producing new homes have been smarter than Greenspan and Bernanke and better economists and realized that they were building unwanted products? Should they have refused to keep producing new homes? No, they had no idea, and they were operating in their own best interests as far as they could tell. Investors were going ape shit, of course, but who wouldn’t go ape-shit and take out insane loans if there seemed to be an 11% yearly growth at their fingertips allowed by a 5% yearly loan…and what banks wouldn’t loan it if they knew such a magic market existed? Again, I assert that if the product were perpetual motion, we’d all be fine, even in the face of such insane loans. Why?…because we’d all have perpetual energy instead of abandoned houses.
Also regarding 2), adjusting the money supply *changes* the demand for money. I can’t stress that enough. These “necessary” adjustments are only “necessary” because of your previous “necessary adjustments”, and will “necessitate” future adjustments. You can step out of the cycle at any time, deal with a singular recession and stop this nonsense. If you argue that economic cycles have been happening since the dawn of time, I’ll immediately respond that currency debasement has been happening just as long. Only, in the past, the kings had to re-mint their coins with less gold per coin than the previous versions and keep the excess. Now, we just type numbers into computers.
3) The things you are saying here completely baffle me, and not in a good way. I mean that I’m baffled that you could hold this viewpoint. I want to be polite here, and I’m seriously asking you to read this next section very carefully, because it is important, and the flow of information goes two ways. The argument here is simple and easy to understand. When I have money and say it has value, what I’m really saying is that the money can be exchanged for things that are useful to me. The money itself is not useful. Can I brush my teeth with it? Can eat it? Does it fuel my car? No. It acts as a medium of exchange, and it is *not* an end in itself. This is a dramatic difference between money and other goods.
If beef were falling from the sky, beef consumption would only go so far, and the remainder would be a hazard or trash. That amount consumed would actually be the best quantity of beef for the *population*. So why is that optimal quantity not the quantity produced by the economy? Easy. There are *costs* associated with producing beef, and it is *consumed*. This cost of producing beef are opportunity costs of producing other goods if the labor, capital, and resources were otherwise occupied. Perhaps a little bit of lamb would go a long way in a world drowning in beef.
Money is not consumed because it is not useful in itself. Assuming perfect divisibility, all quantities of money are equally optimal. If I magically double all dollars and double all prices in an instant, nothing has changed. All buying powers are still equal and everybody proceeds as usual, but pays 2x for everything. However, moving from one money supply to another with a specific injection point, there *will* be effects on the economy. The quantity has no bearing on the economy, but the 1st derivative of the quantity does have a bearing unless it is injected equally across all money-holders and everybody knows exactly when it happens. In that case it does precisely nothing. Money is not an asset in itself. It only serves as a medium of exchange *between* assets. Just looking at your statement comparing the *supply* of beef to the *amount* of money is ridiculous. Supply is produced and consumed because it is useful. When we talk about the money “supply” we don’t mean it is being produced at that rate in a given year. We mean that the supply is the total amount existent in the economy for use as a medium. When we talk about the “supply” of beef, we’re talking about how much of it is produced for the purpose of consumption. Really, I can’t stress this enough.
December 9, 2010 at 1:06 am
Chris
Repost to fix typos. I wish I could color the changes, but it’s not long, so you can re-read it and compare to the original to see that I’m being consistent here, but mentally referred to the 1st derivative rather than the value itself without saying so.
1) b) The demand for money – Any change in the amount of money held is a result of the average discrepancy between account balances and security points. If the average bank account is below the average security point, the first derivative of the demand for money is positive and people will save, increasing their cash holdings and decreasing prices. If the average bank account is above the average security point, the first derivative of the demand for money is negative and people will spend, decreasing their cash holdings and increasing prices. I think the best way to look at this is to use a ratio (savings-supply ratio) as your measurement. That ratio is the savings demand for money in $ divided by the money supply in $. Permanent changes in the SS ratio correspond to actual changes in the definition of “security” (ie: people have higher or lower bars in terms of purchasing power in order to feel secure). There can be temporary changes, due to a lag between M2 changes and actual price changes, but these must swing back to equilibrium as people move away from their security points. If the SS ratio doesn’t change, changes in M2 will still increase prices, because more money will still be circulating, even though more money is also being saved (the ratio stays the same). True, price changes will be a fraction of the change in M2, but unless the SS ratio is extremely high, it will still cause an appreciable change in prices. In other words, people will have to have continually higher and higher purchasing power necessary to feel secure in order for changes in M2 to not cause price inflation. I don’t believe such a “security inflation” would ever actually exist at a serious rate.
On another note, I am working hard to back up all of my arguments with reasoning. You seem to be re-stating your positions without addressing my arguments. The entire purpose of a discussion is to dive deeper to find the base contradiction between the two parties, resolve it, then work back upward to the new agreed theory.
For example:
A->123->i ii iii iv->a b c d e f g
B->124->i ii iv v ->a b c !d e f g
Once we realize we actually disagree about “d”, we can discuss that, find the truth about “d” and work our way back up to either A or B.
I’m actively doing this, but I’m not getting the impression that you are.
December 9, 2010 at 1:48 am
Chris
I Just read the other two posts you linked to and I know exactly where the error you have made lies regarding 3)
You have accepted two perspectives
1) money is simply a good
2) fiat money works like all other money
These perspectives have premises which are contradictory
1) goods can become mediums of exchange, and this is the proper way for money to come into existence. Gold, for instance has value and is “consumed* in that it either looks pretty on married fingers, etc, or it goes into circuits and stealth fighters, etc. Money is just a good that best fits the optimal criteria for a medium of exchange (divisible, fungible, unmistakable, highly valuable, highly durable). There is an optimal amount of it for consumption, because as more of it is produced it loses its high value per oz and we’d eventually stop rushing to produce it. Gold is still a good that is consumed and produced (gold rings. gold conductors, etc) with an opportunity cost to other goods every time labor is devoted to mining it or reclaiming it, People still want to mine or reclaim more gold and there is no control on this because it is difficult and the good is naturally scarce. When production is achieved, it creates more useful products to be consumed (more, cheaper pretty gold rings and more, cheaper stealth fighters).
2) Fiat money is not a good, has never been a good, and is utterly useless other than as tinder (for burning, not “tender”), a use it’s not optimized for. There is no optimal amount of fiat money because creating more of it does not create more of anything useful for society. If we wanted to create tinder, there are much easier ways and we don’t need counterfeiting laws to make it illegal. There *is* government control on the production of fiat money (counterfeiting laws) precisely because it isn’t useful, but it *is* desired, and it is potentially infinite, for all intensive purposes. If corporations just started producing fiat money at their own discretion, the economy would collapse and we wouldn’t have anything pretty or conductive or good at absorbing radar in return. The real nastiness is that the government *can* produce more of it, to its own benefit, without benefiting society in the form of supplying more of a useful good. There is no optimal amount of fiat money. The only “optimal amount” is an unchanging amount.
December 9, 2010 at 10:54 am
jsalvatier
1st/2nd Post)
1) In that graph, those are %changes in velocity, not velocity, see here for a graph of velocity http://en.wikipedia.org/wiki/File:M2VelocityEMratioUS052009.png. Many velocity is stable, but *sometimes it’s not* and it’s these times that makes monetary policy important and make bad monetary policy have negative consequences.
In any case, it’s not very productive to use “velocity” as a starting point in economic analysis because it’s not some kind of first principle or even nearly so, it’s a summary statistic of the economy. Starting your understanding from a summary statistic of the economy is always a bad idea; crass keynesians make this same mistake, starting from accounting identities and treating them as first principles. To get a technical understanding, you have to start from something close to first principles such as utility and demand.
If after you understand things from a money demand/supply perspective and you still think money velocity is a good way to think about things, then you can use that approach, but until then, you’re just going to confuse yourself.
2) That’s a better of a point: it’s definitely plausible that excessively lose monetary policy can make bubbles worse. However, excessively loose is not the same as printing money, and I think once you understand the monetary equilibrium approach, you’ll see that accommodating changes in the demand for money increases the predictability of prices.
As a side note, irrationality is required for some actors (not all) participating in the bubble because the total wealth is fixed and an increase in volatility; somebody has to lose. If people have declining marginal utility of wealth, then some people are irrationally participating in the bubble.
3) The idea that money is different than other goods because it’s a means to an end is a popular view, but it’s wrong. This is not different than other goods in this respect, many, most other goods are also means to ends and not ends in themselves. A refrigerator is also a means to an end rather than and end in itself. Here’s an Austrian paper making this point http://myslu.stlawu.edu/~shorwitz/Papers/Subjectivist%20Money%20JEEH%201990.pdf . Money is also perfectly capable of being an asset itself, for example, if we use gold coins as money, they would still be assets. Likewise, if we decided to use Microsoft stock as money, it would still be an asset (imagine they don’t do dividends in the form of money, but in the form of more stock or real goods).
I do agree it’s slightly misleading to talk about the supply of money because supplies are curves and the quantity of money is a quantity, not a curve. I usually try to use the word ‘quantity’, not supply. Anyway, money degrades only very slowly, but this is not so different than other goods, for example steel cooking spoons degrade only slowly as do brick houses, but it still makes sense to talk about the quantity that exists of both of these goods and how that relates to the economy. The same goes for money. Again, I think it’s useful to think of the possibility of private money. If we all used official Pokemon cards as money, they would still be a good and it would still make sense to talk about the optimal production of those cards.
4) If I seem like I’m less open to changing my mind, it’s because I’ve done this before, and I’ve worked out many of the kinks in my understanding of monetary economics. I *should* be less open to changing my mind, fact and theory are on my side. I know this sounds arrogant, but it’s the truth.
5) I think I mislead you a bit; I didn’t mean to argue that there was an optimal nominal (dollar) quantity of money context free which is obviously false, but rather that given recent history, there is an optimal quantity of money. Given current prices (the most important fact in this regard) and various other facts there is a quantity of money that is best. I’ll go back and try to make this clearer in that essay.
3rd Post)
I think you’re being blinded by emotionally affiliating with the Austrians, and knowing mostly about the ABC-like views on money.
One idea I think you will find illuminating is to consider the idea that it’s possible to have private money that operates very very similarly to how current US dollars work. One of my missions is to show people how government money and private money are the same and how they are different (no doubt my essays need some expansion on this point). Lots of libertarians see government money as terrible in all respects (an example of the Halo Effect http://lesswrong.com/lw/lj/the_halo_effect/); this is emotionally attractive, but wrong. Government money is not the ultimate evil and it’s not optimal money either, it is what it is. Government money and private money are similar in many important respects.
1) And fiat money can also become a medium of exchange (it is in fact a medium of exchange). You can only claim that that “x is the proper way for a good to become money” after you’ve made a technical explanation (http://yudkowsky.net/rational/technical) for why x has better properties than other ways. I strongly suspect you cannot explain this technically, because otherwise you would have already done so. That’s not a fault, I can’t technically explain all the features of the money adoption process either, but you should recognize that if you don’t have a technical understanding, you should be relatively agnostic.
2) This is simply factually wrong. People want to hold fiat money implies it’s an economic good. You can claim that it’s not as good a money as other potential monies, but, once again, you’ll need a technical explanation for why that’s the case. This is where it’s most clear that you are being overly ideological. Get out of libertarian combat mode and get into scientist mode.
December 10, 2010 at 6:35 pm
Chris
I want to get away from a topic that I feel is a digression here with a few bullets to support my reasons. Afterwards, I’ll focus on what I view to be the major points of conflict after reading your responses.
I want to halt the discussion on velocity because I believe we’ve completely misunderstood each other and it’s not leading anywhere very useful to the overall discussion. To clarify my position, I never advocated using velocity as a starting point in economic analysis. Actually, this entire time I’ve been pointing out that velocity is a secondary effect to M2 and doesn’t change appreciably in the long run. Really the only reason I brought velocity up was to turn around and throw it out the window. I don’t believe velocity is a potential reason why M2 growth might not affect price inflation long-term. A few bullets below to help show why I believe it can’t have counteracted effects of M2 growth.
*The range of velocity has been at most 2x over the last 50 years, and has recently returned to roughly the same value as seen in 1959 after a fairly brief excursion upward, as seen in your link.
*M2 is 6x over just the last 30 years, nearly monotonically upwards (http://research.stlouisfed.org/fred2/series/M2)
*The velocity of money, if anything, has had upward excursions, implying inflationary price effects from it, if any. It is not a variable capable of counteracting the effect of M2 on price inflation, and that is my sole reason for bringing it up. I’m just shining light on the causes that don’t matter so I can explain why they don’t matter, just in case you think they do.
December 10, 2010 at 7:29 pm
jsalvati
OK, I understand your viewpoint a bit better now. You’re focusing on the long term, and I’m focusing on the short term.
My reason for focusing on the short term is that in the long run, the price level is not a terribly important variable, nor even inflation, as long as it’s not huge. The difference between 1% and 3% average inflation probably doesn’t strongly affect real growth or employment, but the problems associated with poor short run monetary policy can be quite big. For planning purposes, the price level 30 years from now isn’t all that important (even neglecting the other problems with poor monetary policy), but the price level 2 years from now can be rather important. Given currently typical monetary policy, the variance in monetary policy is a bigger problem than average policy. And even if you disagree, I think you’ll agree case that that the variance of monetary policy is a problem, and the effective variance of monetary policy does not just depend on M2 growth, it depends on demand to hold money as well.
Just so we’re clear, I don’t have a strong opinion about long run monetary policy. The arguments for normal deflation seem decent (helps people plan and retain knowledge), and the arguments for having normal inflation (helps wages adjust) seem decent as well. I don’t know which effects dominate, so I don’t come down on one side or the other. Proper short run monetary policy, however, seems much more clear cut and important.
December 10, 2010 at 8:49 pm
Chris
I believe I’m narrowing in on the crux of the argument. Some of the things I’m saying below are just to cover bases and explain my current viewpoints. I’m going to only address 1) right now, because I think we can separate it from the other arguments, agree on it quickly and then move on to the others.
1) I believe you are arguing that I can’t make the statement “changes in M2 lead to changes in price” because there are other factors apart from M2 involved in price changes. I agree with your statement that other factors exist, but I disagree that they conclude that I can’t make this claim. Changes in M2 change prices from what they *would have been* if prices were left to the other factors alone, and yes this is still very useful when talking about dependent trends and pressures. True, I can’t use changes in M2 to predict actual prices in the short run (I can still do this in the limit and there is an explanation similar to my one about velocity), but I’m not trying to predict actual prices. I’m merely stating that changes in M2 cause changes in price. I don’t care if there are also other things changing price at the same time. The effects are additive. The 1st derivative of M2 directly affects the 1st derivative of prices, even if it doesn’t pinpoint prices themselves. I do have to be careful to only talk about the changes in prices though, and not the prices themselves. For instance, in an economy with rapidly falling prices due to increasing demand for cash, increasing M2 will merely slow the rate of decrease in prices. This will still have an effect on many other factors that depend on the 1st derivative of prices, and that is how I’m using this causal connection. The only refutation would be that changes in M2 kick off other changes that completely counteract the price-inflationary effects, and you’d need a pretty good argument for that.
I know now that you’re only really promoting short-term changes in M2 to counteract changes in the demand for money, but I still want to finish a point I started that I think you might have missed, which is that any given product is capable of having two different types of demand, which most economists lump into one:
I think people buy things for two reasons. X, because they personally find them useful as tools, and Y, because they see them as an investment, implying that they believe other people find them useful and will find them even more useful in the future. The sum of demand due to X and demand due to Y is the demand that actually determines prices for a given supply. In the X case, the price of the item and its usefulness are the key factors. Buyers want the object itself and don’t want to pay a ton of money. Here, money spent is an opportunity cost that can be measured in all the other available goods on the market that could have been purchased, so the higher the price, the lower the demand. In the Y case, the 1st derivative of the price is the key factor. Buyers want the product because they perceive it will be worth more in the future. Here, money spent is an investment, and is not expected to be a permanent cost. The higher and more stable the 1st derivative of the price is perceived to be, the higher the incentive to buy for this reason.
As prices in a market increase, the X incentive will retreat unless there is a similar improvement in the usefulness of the product. The Y incentive doesn’t care about the physical structure of the product or its usefulness, only its increasing cash value in relation to other products. In this case, the buyer is using the product as a rapidly appreciating medium of exchange. Some buyers will buy for both reasons, or use one to justify the other. After all, they both manifest themselves in a desire to purchase the product. Because of Y, there can be unbelievably rapid shifts in the demand for products. If the 1st derivative of the price goes below zero, the price can drop all the way back down to the price determined by the X portion of demand, or even temporarily lower, within a very short period of time. True, a high Y/X ratio in the demand should tell people that prices are unstable and that they shouldn’t enter the market, but I don’t believe people can even come close to accurately determining the Y/X ratio of the demand. All they know is their own ratio of Y to X. Even if they do have an intuitive sense that most of the demand is from people buying an investment and not a product, most people won’t really understand the implications of that on the stability of the market. This is why I don’t believe it’s acceptable to simply say that people are acting irrationally, and call that the problem. They aren’t really acting irrationally in that we couldn’t rationally expect them to do otherwise. They’re all acting in what they perceive to be their own best interests, but their perception has become distorted by something, or relies too much knowledge of economics. I believe that increases in M2 can distort those perceptions and increase the percentage of the demand that is due to Y, making prices less stable. The higher that demand gets, the more people are drawn into that market in order to buy based on Y. If we try to fix this with regulation attempting to decrease the “irrationality”, the problem will just move to another market every time we “fix” the last one. Given this, I think the best way to minimize this problem is to prevent increases in M2 or other distortions, if any, from exacerbating it. I think the issue boils down to whether changing M2 has deceptive effects on the mapping between money and usefulness or the potential increase of usefulness through concentration of labor. I believe it does, given that usefulness is the result of intelligent labor and production, while fiat money can be injected in large amounts at any time at the whim of whoever has a printing monopoly. Money and usefulness can have an arbitrarily distorted mapping if Y is in effect…investment without returns on usefulness. Notice that products with high durability and difficult appraisals seem to be hit hardest by bubbles. Stocks and Houses have a lot in common in that regard. Difficult appraisal means that all sorts of “reasons” can exist why the usefulness is actually tracking the price changes, whether it’s the power of silicon valley companies to innovate, or a radical new approach to housing loans that make houses more accessible. These and high durability allow the Y/X ratio to skyrocket over long periods of time without anybody actually knowing. It doesn’t help that investment yield is usually only tracked over periods dramatically less than ten years by most buyers. People think the markets are stable if they only look back that far.
December 11, 2010 at 2:56 am
jsalvati
1) Reading your comment, I see that you base a lot of your thinking off relationships you expect among the various variables and the derivatives of other variables, and I think it’s misleading your seriously. I’ll attempt to dissuade you from thinking like this.
a) In the space of all possible functions, continuous, differentiable functions are but a tiny region.
b) Because human decisions are optimized, when there’s a discrete change in information, there will often be a discrete change in behavior. A discrete and unexpected change in the money supply immediately affect some prices (financial market prices) and immediately affect many people’s spending decisions. In fact, a change in the money supply can affect prices and behavior long before it happens, if people expect it will happen in the future. Promising to raise the money supply by 10% in a year has many of the same effects of changing the money supply by 10% right now. People don’t have perfectly rational expectations (http://en.wikipedia.org/wiki/Rational_expectations), but rational expectations are a much better approximation than static or naively adaptive expectations. I realize now that rational-expectations type thinking is not as natural to others as it is to me. Perhaps I need to add a post on rational expectations and what it implies for monetary economics.
c) It is an empirical fact that most prices move discretely. Even financial prices frequently move discretely.
Now for some specifics on how I think thinking in terms of derivatives has adversely affected your reasoning:
a) In 1, when you talk about the derivative of M2 affecting the price level, the actual kind of effects you are alluding to is the increased interest/appreciation people expect to get on non-money assets relative to money when inflation is high.
b) I get the sense that you think of the price level P as a function and it happens to take the derivative of M2 as an argument, P(dM2/dt, …). But that’s not really how things work; what really happens is that all over the economy, people consider their understanding of their current situation, and their expectations of the future and decide whether and how much they want to raise or lower their prices. You talk about derivatives as if they are casual here rather than descriptive at most.
Make approximations only when you have to. Sure, in some situations thinking about some kind of derivative of M2 won’t mislead you horribly, but it’s not the derivative that’s the casual force that leads people to hold higher real balances, so why talk about it unless you have a good reason to?
1.1) Yes, all other things equal a permanent change in the money supply raises the *expected future price level*. It’s important to distinguish between prices now and expectations about future prices. It’s very difficult/impossible to affect the current price level, but many factors can affect expectations about the future price level. It’s important to remember, that that doesn’t mean the original expected price level is the same as the current price level nor does it mean that the original price level is the “easiest” for the economy to adjust to.
2) I don’t mean this as an insult, but this is largely a jumble, caused, I think, by thinking in terms of derivatives rather than expectations.
I hope this clarifies some things.
December 13, 2010 at 6:45 pm
Chris
In your section on quantized changes, you seem to be getting into a murky area of complete subjectivity here. I can point out that the functions we’re talking about can’t even actually be defined and that there is an infinite function space and then say that this means we can’t say anything about what will happen. This inductive and discrete measurement problem is existent in mechanical engineering too and yet I can get on a plane and fly to NY because we’re so damn good at predicting what will happen in technically unforeseen circumstances. I think you need to step away from that line of argument, because you’re starting to disagree with repeatable observations about how low-level computability and induction issues work themselves out in macro situations. Remember that supply and demand curves are really just talking about pressures and how they incentivize the average member of a group. The larger the population and the larger the number of markets, the more accurate their predictions become. These pressures are of exactly the same nature as pressures I’m talking about retarding security points and price increases. I think you have a double standard here. I think this addresses all of your points, but I’ll see if there’s anything specific I can say to clarify each of them.
a) Go ahead and reword all the “1st derivative of x” stuff to “the x delta between times t1 and t2”. Everything is an event in the short run, whether it’s an outside discrete event, or an individual’s sudden realization and influence regarding a perceived point on a continuous event. I’m not literally trying to do calculus on a discreet function, dude. I’m referring to concepts with their mathematical equivalents for simplicity…I’m not actually operating on them as if they’re nice, clean continuous functions.
b) I understand that expectations can affect spending. In that sense, what really matters here is the sum of people’s actions, which are guided by their perceptions and expectations. There is uncomputable randomness in there because people see things discretely and their expectations can be wrong in the short run, but that doesn’t destroy relationships in the system. It seems like you’re arguing something similar to the idea that quantum randomness prevents correct observations about the locations of macro objects, because each of the particles they’re composed of don’t have definite locations. Sure. Mathematically that’s true, but I can still throw a baseball at you and you can still catch it. Pressures have the same effect on seemingly random systems as they do on static or deterministic ones. The randomness in the result is just as high as the randomness that was operated on.
c) Of course prices move discretely, but I’m not talking about a single product in a single store. As far as people can tell, the overall price level’s changes are pretty much continuous. Just because a jug of milk went up by 5 cents on a particular day doesn’t mean people flip out and expect that everything they’re going to buy will be x% more expensive. Most people wouldn’t even notice the change in the price of the milk in the first place, let alone extrapolate. Price changes happen considerably more smoothly than people’s ability to detect the consequences of those price changes on the spending power of their cash holdings. This is how inflation can cause people to go below their security points for some time before suddenly realizing it and beginning to demand more money than they ever did before the inflation.
The section on how my thoughts on pressures have confused me:
a) Nonsense. *How* the price increase plays out will depend on expectations, but the price increase must play out without counter-active pressures. There is more money and there are just as many goods. Prices are just a surjective map from money spent to goods. You seem to be arguing against the pigeonhole principle here.
b) I’m not talking about a mathematical model and saying the real existents must follow. I’m saying the pressures exist, that they must be relieved via some avenue, and that there are overwhelmingly likely avenues for any given pressure to take. If the pressure exists, there must be some people that feel the pressure, and they will respond to it. They don’t have to respond rationally, but I’m pointing out what their rational responses should be. Any given individual can just burn any new money you give them, but the probability that everybody who receives new money will do that instead of spending it is basically zero. Baseballs can tunnel through your glove, but the probability is essentially zero. In an economy of four people, any irrational actor can totally destroy the logic I’m using about pressures. In an economy of 300 million people, this can’t be reasonably expected to happen.
2) Please provide an alternative explanation for why a particular market could attract buyers as prices increase. Please define the investment yield in a market without talking about the expectation of price increases. What is the investment yield for purchasing a home or a stock? Go ahead and talk about deltas instead of derivatives. My entire paragraph is about expectations of use and yield and how they are connected to real changes in prices, not some mathematical nonsense about taking derivatives of discrete functions.
December 13, 2010 at 8:35 pm
jsalvati
I apologize for over estimating how much your thinking relied on the application of derivatives. In my defense, you did mention them a lot. Since, I misunderstood your use of derivatives, I obviously also misunderstood how it was affecting your thought process.
I’d like to mention here that supply and demand curves are not about averages, an individual can have a demand curve. Demand curves for individuals are just a particular view/aspect of their utility functions (plus some assumptions). We can sum these curves up and get an aggregate demand curve (making some assumptions anyway). Just for the sake of being clear.
Now that we have settled on more reductionist language, I think we can proceed more fruitfully. I think we agreed more than I realized.
My point is that it’s expectations about future prices (not necessarily prices at just one point in time), rather than changes in the money supply per se which affect people’s desire to hold money. Expectations about the whole future path of the quantity of money affect expectations about the future path of prices.
Consider a central bank that decides to double the money supply for 2 years and then drop it back to it’s previous level and keep it there and they let the public know this. This action won’t cause the price level to rise for those first 2 years approaching the the equilibrium price level assuming a permanent 2x quantity of money and then subsequently drop back down to the previous equilibrium price level. This action won’t have much of an effect on prices at all (not none, but not much). Why? Because people have an incentive to hold on to that extra money and hold it until they can exchange it back to the bank. Similarly, if the demand to hold money drops and the central bank is expected to reduce the money supply to accommodate this, this prevents prices from having to adjust rather than making the economy adjust first one way and then the other way.
2)
Since this isn’t really the focus of the argument, and a much more difficult topic to boot, I suggest we drop the issue for the time being. You may temporarily declare victory if you like.
December 13, 2010 at 8:36 pm
Chris
On to something much more concrete than our current argument, which is starting to get into metaphysical and epistemological disagreements. Your ideas of money are easily proved wrong. Of course goods other than fiat money are a means to an end. Actually, *all* of them are. Food is simply a means to avoid starvation, for instance. However, there is still a fundamental difference betwen mediums of exchange that are only mediums of exchange (fiat money) and other goods, which can act as mediums of exchange, but are still goods. A refridgerator makes things cold. It doesn’t matter what you want cold, a refridgerator can do that for you. Fiat money, on the other hand only has value if there is something for which you can trade it. Its value is derived from a reasonable expectation that you can exchange it for something that does have a direct use. Given that there is no optimal amount of fiat money for a given economy, creating more fiat money can’t possibly create more usefulness to go around. You’re right that it does affect the economy, but the only way it can do that is by having an injection point such that some people in the economy benefit at the expense of others. This is exactly why counterfeiting is wrong. It’s not that I can’t counterfeit because I would “disrupt the proper supply of money”, it’s because I would be stealing from people. Even if the money I counterfeit is completely indistinguishable from real money, I’m still stealing. In the case of a real good, there is an optimal production, because there is a balance between the cost of producing it, and the opportunity cost of producing other goods.
The opportunity cost is a ratio of the usefulness of the good vs the other possible goods. If I find a way to produce beef with absolutely no cost, I will benefit the world by providing more beef for consumption. Same goes for houses or other true goods. This is not true for fiat money. If I create a printing press in my basement that prints fiat money indistinguishable from that produced by the government, there are some very bad consequences to my using this press. Say a pound of beef costs $5 and costs $2 to produce. If I print a $5 and it costs me 2 cents, I seem to have done the equivalent of producing a pound of beef at a cost of 2 cents. For me, that is the case, because I can go buy that pound of beef and it only cost me 2 cents, but this has hurt instead of helped everybody else in the market. I have not produced value the same way I would have if I found a killer new way of actualy producing beef for 2 cents a pound (growing and killing cows for unheard of costs). Now, if I burn all the beef I just bought (consume it all by myself), there is no beef left for everybody else and it has been replaced by money. The money isn’t helping anybody, because now it all just maps to the remaining goods available in the economy (the original set of goods minus all the beef), and everybody is worse off except me. That’s called stealing. If fiat money, in itself, were actually a good, we’d all just be printing money. The “optimal” amount of fiat money would occur when there is so much of it that the cost of producing a pound of beef and the cost of printing enough money to buy a pound of beef are equivalent.
On the other hand, If I had just burned the money instead of burning the beef, nobody else would have to know that I was sitting in my basement printing money, other than the folks who sold me the dye and the paper. Rather than people hurting for a real good, they’d hardly even notice that I did anything. How can you explain this discrepency between fiat money and the other goods within an economy?
If I’m the government and I decide to print money, I really does seem like I get to produce beef at 2 cents a pound. The production isn’t actually coming from me, though. Somebody has to raise the cows and slaughter them. The value discrepency comes from the higher prices making everything just a little more expensive for everybody else. The hard truth would become evident if I tried to buy the entire sum of goods in the economy. Printing the money didn’t actually produce value then, did it? If it did, I’d have printed an equal amount of value to the entire sum of goods in the economy, and I’d have doubled GDP at nobody’s expense, doubling everybody’s wealth. Clearly, nobody’s standard of living would improve, so this supposed value increase didn’t actually happen.
Given this, how do I determine the “optimal” amount of fiat money? For all normal goods, a producer simply finds the supply required to hit optimal profit. If his costs were zero, his profits would be positive even as people are buying beef at 0.0001 cents per pound and less. People would be using piles of beef for all sorts of weird purposes. So, if we replace the cost of production for fiat money for the cost of production of all goods, everybody would print money instead of producing real value. We’d run out of goods because we’d be consuming them without producing more.
So, why isn’t this true for money that is not fiat? It should be obvious…the cost of producing it is in equilibrium with the amount of it present in the economy. People will only mine as much gold, for instance, as is profitable, exactly as would happen with fiat money if counterfeiting laws were done away with. Gold is very difficult to mine and there is a finite amount, so the supply changes very slowly and has a limit. Also, when more gold is produced, the actual value in the economy goes up. As it becomes less scarce it will be less valuable and less useful as a currency. If this happens in the extreme, the market will select a new good that is valuable enough to once again act as a medium of exchange. If this replacement happens continually, it gives a high incentive to make the most scarce goods in the economy less scarce,one at a time, which is obviously a good thing.
In the gold-as-currency scenario, nobody can open a printing press and “create” goods at the price of printing the money, because there is a cost of mining gold that is already determining its proper supply. This is why a real gold standard (actually using gold, not just bills that map to gold) doesn’t need to make anti-counterfeiting laws and the government cannot get goods for cheap at the expense of everybody else in the economy. It can make it illegal for all others to “print gold” all it wants, but if it can’t physically print gold itself, nobody has to worry about such useless laws.
December 13, 2010 at 9:36 pm
jsalvati
1) This is not something I’ve just now though of; I’ve thought this through.
Non commodity money really isn’t different than other goods in this way, it’s like any other financial good. Financial assets have value because people expect they will be able to use them to obtain something else of value in the future, ultimately because their issuer has given some promise that they will give the assets’ holders something of value. Non-commodity paper money is the same way, governments (or similar private money suppliers if you prefer to think about that) create an expectation that their money will be valuable in the future, usually by making a credible explicit or implicit promise to maintain some kind of value. How do monetary authorities (public or private) maintain expectations of value? by buying back the bills with some other kind of asset (normally government bonds) if the desire to hold them shrinks (this is simply normal monetary policy) or by requiring people to take the bills as payment (legal tender laws). Sure these expectations can change, but they can change for other kinds of financial assets as well; companies go out of business (their stocks and bonds become worthless); people default on their obligations.
2) Note that opportunity cost is the full benefit of other available options, not a ratio or difference. See http://en.wikipedia.org/wiki/Opportunity_cost, or the comedy sketch http://www.youtube.com/watch?v=VVp8UGjECt4
Since you like this counterfeiting example I’ll collect my explanation of the issue that I gave to Silas in my debate with him and I’ll make a post.
I’ll remind you that there’s social cost both to having too much money in the economy and too little.
As far as why we’re not all printing money: it’s for the same reason we don’t all get to print IBM corporate bonds. Printing IBM bonds violates their copyrights and defraud’s them or their bond holders, depending on how IBM ends up paying off the bonds). Printing money violates the Fed’s (or private institution’s) copyrights and defraud’s them or the holders of money, depending on whether the monetary authority chooses to reduce the money supply or allow inflation. It’s not illegitimate for IBM to issue new bonds and it’s not illegitimate for a monetary authority to issue new money. IBM issuing new bonds is almost exactly analogous to printing new dollars and exchanging them for government bonds (which is the normal way to create new money); both are issuing new financial assets by exchanging a new financial asset for another kind of financial asset.
As for finding the optimal quantity of non-commodity money: when I talk about optimal I mean the socially optimal quantity, rather than optimal for Fed profit. There is some path for the money supply that minimizes the costs to society: price adjustment costs, distortions, printing costs etc. Expanding the money supply 50%/year is clearly much worse than current policy and so is decreasing it 50%/year; somewhere in the middle is a best policy (not necessarily meaning a constant rate obviously).
It’s certainly no trivial matter to determine what that optimal path is, but that doesn’t mean it doesn’t exist. Because the the Fed is a monetary monopoly, these two notions of optimality probably do not coincide. I suspect, though I am definitely not certain, that with the right kind of competitive, private non-commodity regime they would coincide.
December 14, 2010 at 2:19 am
Chris
2) sure, we can drop this, but I think it connects strongly with my views that changing M2 at all is necessarily a distortion of valuation
1) I want to directly contradict your assertion of behavior in this hypothetical situation: “Consider a central bank that decides to double the money supply for 2 years and then drop it back to it’s previous level and keep it there and they let the public know this. This action won’t cause the price level to rise for those first 2 years approaching the the equilibrium price level assuming a permanent 2x quantity of money and then subsequently drop back down to the previous equilibrium price level. This action won’t have much of an effect on prices at all (not none, but not much).” I’m actually really glad you brought this up because it is a perfect way to point out where we disagree.
Say I am an individual in this hypothetical example. If prices don’t change at all after the doubling (I know you said not much, but lets start here), then anybody in this scenario can spend all of their new 2x holdings, get 2x value of their entire holdings in exchange (because prices haven’t changed). Then, when the money supply falls back down to the original level, they can sell half of the goods they bought, recoup half the money they spent earlier, which now accounts for their entire original balance, and keep the other half. Anybody employing this strategy while the rest of the population holds onto their cash will get the value of their bank account for free, essentially doubling their net worth. Anybody who doesn’t do this while other people do, will spend somewhere between 1x and 2x for all goods purchased during the doubling period, but certainly more than 1x. Then when price levels fall back to normal, they will be out the difference between 1x and the actual price levels multiplied by the amount they actually spent. In other words, the lose. The amount won by people employing this strategy is equal to the amount lost by those not employing it, at least as far as the existing pool of value is concerned (ignoring how this whole scenario affects investment).
Given that every participant is an individual, everybody will see that they lose in the latter example, and at worst break even in the first example. If they are rational, they will all follow the first example, possibly maintaining some % of their account balance for security. Prices will rise because supplies will run short from all the buying, then people will realize when the money supply falls back downward that they all overspent and are dramatically below their security points. At that point they will all begin saving, decreasing spending dramatically lower than levels before the experiment and causing a recession. The end result is a market failure. Each individual’s best interest conflicts with each other individual’s best interest and everybody loses. They all split the current existing pool of value, but future value production is now skewed towards the non-essential. There is a massive boom in which people spend money on all sorts of things they never would have spent money on, investment goes into those areas that shouldn’t have gone there, and then suddenly nobody is spending anything anymore and all those started projects cannot finish, along with projects started in areas that produce essential goods. This is the valuation distortion that happens in our economy right now when banks swing from 100% reserve ratios to 20% and back to 100% over a 10 year period.
December 14, 2010 at 2:52 am
Chris
You’re totally right that stocks and fiat currency work on the same principles. Anybody who issues more stocks can increase the investment in their endeavors by selling the new ones. When they want to decrease the investment in their endeavors, they buy up some of the stock they previously issued. In this way, they can control the amount of debt they want to take on. If they create value with this debt, they are profitable in the market by selling this value for dollars, and the demand for their stock goes up, making it even easier for that company to raise more money. If they waste all the invested money and don’t do well as a business, the stock price falls, decreasing their ability to command new investment. Eventually, if they completely fail, they go out of business and any assets remaining go back to the shareholders under bankruptcy laws. This is a way of ensuring that as each investor seeks his own best interest, investment goes into the areas that are producing the most value for the market. Note that investment in any particular company is optional.
The difference between a stock and a fiat currency is that fiat currency is legal tender. If I don’t like a particular stock because the value keeps going down or whatever other reason, I can just avoid buying it. However, everybody gets paid in the fiat currency, and it is the only way to settle debts without the consent of the lender. When the government issues treasury bonds and sells them to the fed, they have an agreement that whatever they want to issue will get bought by the fed in new dollars. In this way, whenever money from the fed is used to buy up government bonds, anybody using the fiat currency is forced to invest in the government. When existing government bonds are purchased with new money from the fed, it is analogous to investors buying up stock in a company even if the company itself is not selling any of them. It increases the ability of the government to command investment in the future by increasing the value of its “stock”. Again, we’re all forced to invest in the government.
Sure, I can hedge my losses by speculating in all sorts of markets, but the point is it forces me to speculate in order to maintain value, because it steals my savings out from under me. I don’t have the option to not invest unless all of my holdings are in non-liquid assets, which is a disadvantage and usually involves a lot of speculation. Essentially, the government is forcing us to invest in them and then spending the money however they see fit. If they were creating tons of value, this would still be stealing, but at least the thieves would be creating new value and giving it back to the people they stole from. However, out government is pretty crappy at creating value. Much of the forced investment goes into paying ridiculous salaries (2x private) and retirement funds for practically worthless government employees. Much of the rest goes into creating things that only serve to destroy value, like bombs or other weapons. Another large portion goes into creating regulation that makes businesses harder to start and maintain, or even other means of stealing even more value, such as the IRS. Given that government is not spending the money wisely, we’re essentially looking at a company that shouldn’t command any investment. It should be bankrupt and giving assets back to the investors. However, we’re all forced to continue investing in this shitty company against our will, and the losses are monumental.
December 14, 2010 at 3:10 am
Chris
Oh, yah…and this comes back around to 2), the discussion you wanted to drop. If you don’t like your current investment strategy, you look for other investments. An inflating money supply is a bad investment and people don’t want to keep their value there. So, other mediums of exchange pop into existence that are better stores of value. They borrow properties from the fiat currency which acts as a medium of exchange for the new medium of exchange. In this way, goods in the marketplace that could never normally have become currencies because they’re not fungible or not divisible can temporarily become mediums of exchange that deflate. Houses, for instance, were deflating with respect to the rest of the goods in the economy. It was taking less and less houses to buy a jumbo jet, for instance, as houses got more expensive. Given that this new currency, houses, was appreciating instead of depreciating, like the fiat currency, people began to adopt it in exactly the same way that currencies originally erupt from goods, only even faster because the fiat currency was depreciating and the new currency was appreciating.
It didn’t matter that houses were not very liquid, they were appreciating fast enough that people were willing to put up with it. It didn’t matter that houses were not fungible, because they were granted fungibility by the dollar. It didn’t matter that they were not divisible, because they were granted divisibility by the dollar. People essentially started buying houses (or tech stock in the dot com bubble) in order to use another currency that not only maintained value, but increased in value. If the money supply were gold instead of fiat, the supply would grow slower than the total amount of goods in the economy, and gold would be deflating in comparison to other goods. This would remove the incentive people had to use things like stock or houses for mediums of exchange, which skewed investment allocation. This incentive to use goods as mediums of exchange is exactly that demand due to Y that I mentioned, demand for high yield investments, as opposed to demand due to X, demand for useful products.
December 14, 2010 at 5:19 pm
jsalvati
Great! I’m glad we found a key point of disagreement.
2) we can come back to it
1) I should note that this is not a point remotely original to me, but a well established point in conventional monetary economic theory and across the political spectrum (see for example Krugman’s 1998 paper http://www.princeton.edu/~pkrugman/japans_trap.pdf; krugman’s overly ideological, but his theorizing isn’t bad).
I think I understand your reasoning, and I think it’s based on a single error. I think you are imagining that people get their money holdings doubled at the start of the period and then halved at the end of the period, but that’s not what happens. When the central bank expands the money supply, they don’t do so by simply handing out money, they do it by buying bonds with newly created money at the market price; when they want to contract the money supply they do the opposite action. Those buyers and sellers aren’t getting something for free.
You are right that that particular scenario would cause some weird incentives (though I am not sure precisely what result it would cause). I hadn’t considered it before, and I thank you for bringing it up. I think it’s especially valuable that you bring it up because I think perhaps lots of people imagine that this is how the central bank would do monetary policy.
In the real scenario, you trade some bonds with the central bank and get some extra money. Lets try your idea: you use the money to buy some goods (any kind, real goods, financial assets etc.) at the current price level. Two years passes: you sell back half your goods and get half the money back, then you try to reverse your trade with the central bank, but now you run into problems: you only have half the money! You can’t buy back all the original bonds unless you sell all your goods, netting you approximately zero.
Your argument asks an implicit question: “why do people want to hold that extra money during those two years”? The answer is that people’s desire to hold money increases during those two years because they expect a future valuable trading opportunity when the central bank reverses it’s action.
Here’s the logic a little more fleshed out: 1) Before the supply of money shrinks again at the end of 2 years, people’s desire to hold money is at an increased level because they expect in the near future there will be a valuable opportunity to reverse the trade with the central bank. 2) Because people expect people to have an elevated demand for money right before the central bank reverses the trade, people have an incentive to hold money before that period right before so they can trade with those people, and this continues till the first increase. Because of this, when the supply of money goes up temporarily, people increase their demand for money and the equilibrium price level stays the same.
December 14, 2010 at 5:21 pm
jsalvati
If your key complaint is legal tender laws, I don’t have much disagreement with you. I don’t have a good justification for legal tender laws, and I don’t try to argue for them. I don’t know if they’re a good idea or a bad idea; I imagine it mostly depends on how good private competitive currency would work. I do want to note that this is very different from non-commodity paper money being “inherently valueless” or somesuch.
However, aside from making a private non-commodity currency regime much less likely, I don’t think legal tender laws are especially pernicious. The government makes <2% of it's revenue from minting new money, and when it comes down to it, if the government wants to force investment in them, they can, and they don't need legal tender laws to do it; it's called taxation. If we had a private competitive currency regime, would government spending go down 2%? I doubt it, they would increase taxes elsewhere.
December 16, 2010 at 1:16 pm
Chris
I’m busy these few days, so some of these aren’t completed thoughts, but I’ll come around and finish them off when I have time:
1) I think the government makes closer to 25% of its revenue from changing the money supply. I haven’t completely thought through the calculations yet, but it’s based on the % of GDP that new money represents and how big GDP is compared to tax revenue. Where did you get your <2% figure?
2) My point about fiat money supply being out of market equilibrium still stands, I believe. Even if stocks operate on the same principle, the fact that investment in them is optional completely changes the game. Also, stocks have the ability to appreciate in value, whereas fiat money is always decreasing in value because we can't opt out and the supply keeps going up. Essentially, everybody is forced into a losing investment. People don't actually want money…they only want it as a medium of exchange that they can turn around and get rid of as fast as possible by making an investment that isn't losing. The higher inflation, the faster this turnaround will be because people lose more by holding onto cash. What people really want is a good store of value or a good investment, and fiat money is neither.
3) You can say fiat money or stocks have value, but you can't use that definition of value the same way you do for goods. You can't say that we'd all be better off if more fiat money or stock slips were printed at no cost. They are just a way of keeping track of where investment lies as a % of total investment. Printing more of either does nothing if the injection is perfectly smooth, or changes the location of investments if there is a localized injection point. You *can* say that we'd be better off if any other goods were magically produced at no cost, no matter where the injection point, because it increases productivity in that particular market, freeing investment to move elsewhere. The increase in goods is a real production improvement. My point here is that you can't say that when everybody suddenly has more money that everybody is better off. This is where that statement of money being valueless comes from. This, coupled with 2, means that fiat money is pretty special, and not in a good way. It's not useful like goods are useful, and it's not an investment like stocks are investments. It has the liquid portion of what a money should be, but it's missing some key elements that exist when goods become money.
4) I didn't realize your thought experiment was assuming an injection point when making new money. Obviously, my original idea of how it plays out is not exactly correct if you assume this. It's only correct if you assume perfectly smooth injection, but I think you are assuming that in your argument in the article, because you assume new money will end up in the hands of those who are demanding it. I don't believe that is the case when there is an injection point. Taking out a loan for a new investment when you are already financially secure is a strong move. Taking out a loan when you are below your security point is a weak move, because your net worth is still below your security point but now you owe interest. We need to look at where new money goes and who is actually demanding new money. This is what the "anonymous coward" poster is referring to about injection points.
5) Another perspective on the same investment skewing argument. Changing M2 is really just a way of delaying loan defaults. In a constant money supply, not everybody can pay back their loans with interest, because there isn't enough money. You'd need M+MI money and you only have M. Some people will default and some people will pay off. This rapidly forces investment out of bad areas and into good areas. However, if you increase the money supply, you can allow defaults to be delayed. This does save some companies that just needed the extra time, but it also prolongs investment in necessarily wasteful areas and allows them to remain or even grow as long as the money supply keeps expanding. Once it stops, the defaults begin, new loans slow down, and all sorts of industries that thought they were creating value are now forced to go bankrupt.
6) We need to distinguish between two different processes regarding changes in money supply. One is via fractional reserve banking and new loans. The other is through the fed's creation of money that banks can expand upon. You seem to mostly be referring to the latter in your statements, but the former allows dramatic swings in the money supply. Are you a proponent of both?
December 16, 2010 at 2:49 pm
jsalvatier
1) No. See table 1 http://research.stlouisfed.org/publications/review/92/03/Seigniorage_Mar_Apr1992.pdf
2) People want cars only for using them too, and they normally depreciate as well. Money, even non-commodity money is a good that has asset like properties and consumption good-like properties, same as a car or a washing machine. There are certainly things that make money better or worse as a good and as an investment. The point is that non-commodity money is not categorically different from other money. It has different properties, but the difference is a matter of degree rather than category. It’s an analytical mistake to claim otherwise. I want you to seriously consider the possibility that you’re actively looking for an argument that makes non-commodity money and commodity money fundamentally different because you want there to be a difference rather than because you already see one. This is called “motivated cognition”.
3) I do not assume that money is given to the people who want it. I do assume that the banking system, financial system and regular trading will direct money to those who want to hold it most; not a strong assumption: that’s basically the point of the banking and financial systems. Here’s a simple illustrative story, lets say guy A wants to hold more X money than before. The CB decides to expand the money supply and they trade X of new money with bank B for X worth of bonds. The bank B doesn’t particularly care to hold money, so they lend out X to guy A who offers attractive terms because he would very much like to hold more money.
4) It’s very very important to distinguish between wealth and money. You can be the richest man in the world and hold 0 money, you just own other very valuable assets. If you are in particular need of money, as opposed to other goods or assets, taking out a loan or selling off an asset to acquire more money is a perfectly reasonable strategy. This kind of action is unbelievably common, people and businesses do it all the time.
Not sure what your terms “strong move”, “weak move” or “security point” mean.
5) Not at all clear on what you’re arguing here.
6) Yes, I am a proponent of both (though I think with a proper money system you probably wouldn’t have much fractional reserve banking). However, it’s analytically easier to talk about a pure base money system (non fractional reserve), and it doesn’t change things all that much.
December 16, 2010 at 5:05 pm
jsalvati
On second reading, I realized something:
I think you’re reading too much into the term ‘good’. When I say something is a ‘good’, I don’t mean all agents have increasing utility in the good, I simply mean that it’s a property of the world that affects people’s utility. Changing that property of the world could be good for a particular person could be good or it could be bad. Either way, economic analysis is still a useful way of analyzing behavior and welfare related to that property. I call such properties economic goods because I don’t have a word that conveys my meaning better; economists conventionally call such properties ‘goods’ and the term is reasonably descriptive.
I don’t think you will deny that the quantity of money is a property of the world that affects people’s utility. By calling money an economic good, I do not mean to imply increasing the quantity of money is universally better, I mean it is a property of the world which affects people’s utility and which can be the subject of economic analysis.
December 16, 2010 at 8:35 pm
Chris
How have you gotten this far without previously asking me what a security point is? A quick search in chrome shows I’ve just now used the concept for the 19th time. This doesn’t give me confidence that you’re reading my answers with a serious attempt at understanding them, which is sort of depressing given how long this discussion has been. Perhaps the best thing I could ask you to read at this point is all the stuff I’ve already posted to see if a little more of it is interpreted correctly this time?
Regarding your most recent post, I think you need to be extremely careful here. You’re using two homonyms with very similar, but different meanings and I think you might be using them inappropriately. I don’t care what you call fiat money, but you shouldn’t call it an economic good. Its use is not optional, unlike stocks. Its quantity doesn’t represent a localized investment, unlike stocks. Unlike goods, having more of it doesn’t mean that there is more of anything for people to consume, because as there is more of it, everybody needs more of it in order to accomplish the same task.
As I’ve mentioned, the only other “goods” that have this property of more=same are investment slips like stocks, which are optional purchases and represent investment in a particular industry out of the whole. As the number of slips of a particular stock increase, it means that more of the total investment potential of our economy has moved into that market first at the discretion of every investor and then ultimately at the discretion of the company or industry itself. This means that more labor and capital can be allocated to that market, at the expense of other markets only if the investors want it that way and the company decides to use it. When the number of dollars increases, it doesn’t represent a single business or industry, but the entire economy. You can’t increase labor and capital investment into the entire economy because there’s only so much to go around. So, what happens is that the injection of the new money ends up temporarily increasing the capital and labor investment at that injection point and through the pathways the new money takes into other markets. This is at the discretion of those who receive new money, not at the discretion of every investor or the companies they choose to invest in. Of course this also isn’t for free and it decreases the capital and labor that can be invested elsewhere. The Injection points and pathways are unpredictable, as exemplified in the many varieties of bubble in the past *and* the new investment is shared by everyone. An increase in stocks changes which goods I can expect to buy in the future. An increase in money changes how much of *any* good I can expect to buy in the future because I can’t opt out, I don’t get to choose the location of the new investment, and I’m forced to use speculation as a “store” of value as my best approximation of “opting out”.
Again, fiat money is not a good in the way a stock is a “good” (people wouldn’t ever normally say that anyway. stock is an investment), and it’s not a good in the way rice or houses or any other real economic good is a good. I’m completely baffled that you’re calling these arguments “motivated cognition”. In order to use all of these concepts labeled “goods” interchangeably in this discussion, YOU need to prove that they are in-fact interchangeable concepts in the context. I think I’ve shown that they aren’t interchangeable, and I’m still waiting for you to address that…
December 17, 2010 at 12:31 am
jsalvati
1) I had assumed you were using this term in a loose way to refer to people’s desire to hold money, I didn’t not realize you had some technical meaning in mind (which I still don’t see). I claim to have a technical and coherent way of understanding money (applying the same economic tools used to understand other goods), and as far as I can tell you do not. Given this, I recommend against inventing new terms without having a clear reason to do so as this is likely to confuse both you and me.
2) It sounds like you are using the lay term ‘good’ and I am using the technical, economics term ‘good’. I am using the standard economist definition (http://en.wikipedia.org/wiki/Good_(economics)): “a good is a product that can be used to satisfy some desire or need.” The only difference being that I wouldn’t limit goods to products. Note also that ‘bads’ can be thought of as ‘goods’ by reversing the orientation (i.e. garbage is a bad but lack of garbage is a good). In economist speak a good is any property that affects the utility of any agent and can be affected by an agent.
I had assumed this usage was obvious given the context, so I apologize for claiming you were engaging in motivated cognition. I’ll update my articles on money to be more clear on this point.
Stocks, bonds and money are all perfectly good examples of economic goods. People want to use them for various things, deferring consumption, collateral, convenience etc. thus they are economics goods.
There are many other goods that have this same property that it’s very difficult to opt out of using them. For example, it’s very difficult to opt out of using food, as well as air, as well as roads. The difficulty of opting out of fiat is interesting and has implications for the economics of fiat money, but it’s hardly a unique property.
As a side note, you actually can opt out at a high price: you can move to a different country where they use a different currency or choose to become self sufficient and not engage in any monetary transactions.
3) As for the “injection point” objection to monetary policy, Bill Woosley does a better job than I will of going though examples to show why its wrong (http://monetaryfreedom-billwoolsey.blogspot.com/2010/04/austrian-business-cycl
e-theory-2.html).
The basic logic is this: there’s nothing particularly special about the “injection point”, nobody gets a special deal (the transaction takes place at the competitive market price) a special deal and once the money is in the economy the banking and financial system do their job to get the money to the people who have the greatest desire for it.
December 17, 2010 at 8:25 pm
Chris
There are many sets of definitions for the same words out there, so i’m trying to make it clear which concept I’m using when I use a specific word. I believe my point still stands, independently of how widely accepted this terminology about economic goods is. The term “economic good” doesn’t differentiate between all of the different ways in which goods can be useful or how that affects their valid uses in the “algebra of natural language logic”. Saying fiat money is an economic good might be a semantically correct statement if that’s the definition you want to use, but it says nothing meaningful about how fiat money works. Clearly, I’m trying to do more than list tautologies by diving into how the specific traits of fiat money affect its role in the economy.
True, there are other goods you can’t opt out of, but those goods differ wildly from fiat money in other respects, so I’m not sure where you’re going with this. It seems at first glance that you’re just using faulty set logic, but perhaps you have another reason for bringing this up? Cars and planes are both heavier than ear, but that doesn’t mean cars can fly. I’m saying that fiat money as a whole is different from any other “economic good”, not that each facet is unique.
Regarding your side-note, thinking of the things governments do as social contracts allows all sorts of nightmares as long as every country is equally nightmarish. It also says nothing about whether the practice in question is good or bad for the country adopting it and I don’t think it has any bearing on this discussion.
I’ll put the injection point article on my to-read list and get back to you. I’m still working on the seigniorage paper.
My initial reaction to your summary is that there is a special deal happening in that money is easier to get. People who might have otherwise had a hard time getting funding (for whatever reason, but likely because they don’t have a good way to spend it) can go get cheap loans. For instance, during the housing bubble, tons and tons of people got new money to buy houses with…and we now know that they never should have been given the money in the first place. They were simply investing in a bubble. I’ll read the article, though, and get back to you.
December 17, 2010 at 9:34 pm
Chris
BTW, I really don’t think your theorizing about my ability to think logically is helping this discussion. All you need to do is point out the inconsistencies in my position themselves, if they exist. You seem to commonly resort to overall attacks of my position or my ability, which makes me think this is an escape avenue you use when you don’t know how to attack anything specifically. (see how useless it is when people theorize about why you say things instead of just addressing your points?) For the sake of future discussion, I think you should stop saying things like this: “I recommend against inventing new terms without having a clear reason to do so as this is likely to confuse both you and me.” Rather than asking what my definition is and why it’s useful, you assume I don’t have a coherent definition or good reason for using the term, and then tell me to stop being incoherent and making up words.
Now, to actually talk about security points. Firstly, there’s nothing wrong with labeling concepts as long as you let everybody know what you did and you remain consistent. Secondly, I defined security point in my very first post. Thirdly, I didn’t make it up and it’s used commonly in Austrian Econ. Lastly, it is not just a way to refer to the total demand for money. There are some people who demand money for purposes of investment, while others demand for purposes of security. Those who demand money for investment generally can take advantage of new money in the form of loans, because they have security to spare and can take on a liability for the sake of investment. Those who demand money for security generally can’t take advantage of new money in the form of loans, because they can’t afford the extra liability. This was my point.
December 17, 2010 at 9:39 pm
jsalvati
1) I agree with the general gist of this. I think maybe I see where part of our misunderstanding lies. When I say “money is an economic good (including government money)”, I am claiming that it is amenable to ordinary economic analysis; it can be understood with the same fundamental tools we use to understand the economics of other kinds of goods. With that claim I am not trying to claim much of anything about the properties of the good, though I do that later. I am trying to get people into a mode of thinking about money in a similar way to how they think of other topics of economic analysis. I apologize if I misled you into thinking I was trying to claim something more substantive than I was.
For one reason or another, people have a very strong tendency to jump to conclusions very quickly when it comes to thinking about money and be quite emotional about those conclusions. I can’t say I’ve fully understood why. My goal in Money As A Good is to get people to think carefully about the properties of money and resist leaping to conclusions. If we start this way, we can understand the economics of money much more surely and have a much better chance of avoiding serious errors.
2) When I point out that other economic goods have the properties you noted, my intent is to argue that the specialness of money derives from the properties I described in Money As A Good rather than the properties you mentioned. Not that those properties you mentioned can’t be important, but they also don’t form the analytical starting point for understanding money in general. Understanding the effects of those properties is something you tackle after you understand the general economics of money.
Legal tender laws do affect the economics of money, but there is still much that can be said about the economics of money regardless of whether the money in question is legal tender or not. This includes most of the fundamental economics because legal tender laws are like a monopoly grant, the effects of monetary policy on the economy are likely to be the same regardless of whether the the money is legal tender or not. Legal tender laws primarily affect monetary policy rather than the effects of monetary policy on the economy. You have to understand the effects of monetary policy before you can make a judgment about what kind of monetary policy is best.
By the way, I would like to note that non-commodity money and legal tender money are different things. Non-commodity money is money that isn’t ‘backed’ by a standard commodity (and is not itself a commodity) but may instead be based on financial assets in the same way the US dollar is. It’s possible to have fiat money commodity money and it’s possible to have non-fiat non-commodity money. I often took your use of ‘fiat’ to mean ‘non-commodity’ because it sounded like that is what you were describing (wiki says it can mean either). It will be helpful to me if you distinguish between these two properties.
3) I didn’t mean that adding more money to the economy doesn’t have effects on the economy as a whole, obviously it does. I don’t think it’s very helpful to think of those effects as “special” or not, as this word carries implicit judgement, and you don’t yet understand the economics well enough to make such a judgment. My point was that the first people receiving the new money are not getting a special deal, they don’t get “free money” or a special profit or anything like that.
December 17, 2010 at 10:15 pm
jsalvati
Fair enough. I probably have been too rude and dismissive.
I’d like to make some comments about the term ‘security point’.
1) It doesn’t sound like it pays enough attention to the difference between money and assets in general. Many assets are very readily convertible into money and not themselves money such as stocks and bonds. If security points are specifically about money rather than liquid assets in general, being below your security point does not necessarily imply you “cant afford” things. If security points are about liquid assets in general, then the discussion becomes more complex, for example, creating new money does not itself create more liquid assets for people to use (new money is swapped for bonds which are themselves a liquid asset), and you will have to elaborate on your point for me to understand it.
2) You’re missing at least one important category of reasons people hold money: to facilitate transactions.
3) Even poor people have access to credit (payday loans, credit cards, lay-away etc.). If poor people want to hold more cash (as opposed to having a higher net worth) they have access to it.
January 10, 2011 at 8:18 pm
Chris
It’s been a little while and I’ve been distracted by holidays and work, but I do want to continue this discussion.
We have a lot of points floating around, but one of them stands out as a relatively large disagreement that is easy for me to tackle now. I read the article on injection points that you posted (http://monetaryfreedom-billwoolsey.blogspot.com/2010/04/austrian-business-cycle-theory-2.html) and that I believe you have completely misinterpreted it. The author is saying that the physical dollars themselves cannot be tracked as being demand that wouldn’t have otherwise existed. He is *not* saying that the injection point is not important. The distinction is between the existence of new demand and the traceability of that new demand by just pointing to the red dollars. I made a comment at the bottom of his page that explains this in more detail.
To really hit home on the fact that the injection point is important, If I give new money to Intel, I can reasonably guess what sort of purchases it will go towards. I can pretty much rule out mining equipment. For US steel, I can pretty much rule out computer engineers and silicon wafers. The point here is that money represents a call to resources (labor, products, raw materials). The injection point of new money determines whose call to resources has just increased (even though there aren’t suddenly more resources to call upon). So, while we can’t track the new demand with the new red dollars, we *do* know that there was new demand and that it came from the receiver of the new dollars in the form of purchases (or deposits that wouldn’t have otherwise been made, which ultimately always leads to purchases). After that, to track the new demand, we literally have to look at every transaction and guess how the new money affected demand. So it is effectively untraceable where the new money goes (this is the point of the author). However, just because the path is untraceable doesn’t mean that it doesn’t exist (this seems to be your error). We know that the company receiving the new money increased its total demand, but this means nothing about any particular demand that company made unless we have a complete enumeration of the algorithm that company is using (if people are uncomputable, so are companies, so that’s not possible).
In fact, the injection must distort demand in a way that is dependent on the point of injection, and it all happens without the consent of any real investors. If investors buy stock, they’re just temporarily transferring a call to resources from themselves to a company (an investment), with the hope that the value created by that company will even further increase its call to available resources, as a percentage of the total. The new call was willingly given, at the expense of all possible alternatives, because there are only so many resources to go around at any given time. In the case of new dollars, however, there is suddenly a new call to resources without an equivalent increase in the resources available, and this all happened without anybody’s consent. People will pay for this investment at some point, but they never consented to it. Saying that it’s all okay because the loans were offered on the free market is like saying that it’s okay for me to steal from somebody and offer their things on the open market. A call to resources was stolen. This is exactly why counterfeiting is illegal. Even if it is impossible to determine exactly who is stolen from, we can still know that somebody was stolen from.
One of the side-effects of new money that is commonly believed to “improve the economy” involves unemployment. The idea is that there really are resources sitting idle and that new money can be used to call upon those resources and put them to use. The problem here is not that the resources were sitting idle. We could pay them to run around in circles if we wanted, and they wouldn’t be idle anymore. The problem is that nobody has demanded them yet because they are uncertain about where they should be allocated. This is a problem of allocation (ie which businesses are creating the most value, have the highest possibility of new value in the future, and need more labor). When the money supply increases, these people become employed, but it doesn’t solve the problem, which is that we have no idea where they *should* be employed.
To put it in terms that we’re less likely to be biased towards, I’ve got a scenario. Say you have a computer and there is a program running on it that you want to run as fast as possible, but this program has a lot of conditionals and you can’t seem to keep your processors fully occupied. Firstly, it would be odd for you to say that this is even really a problem if you didn’t have something specific in mind that the processors should be doing to fill the void. The “problem”, therefore, is not that you have idle cycles, but that there is an opportunity cost coming from not knowing what to do with them. You could identify some subroutines in the program and modify it so that they execute speculatively, which will certainly lower the number of idle cycles, and will probably do some useful work towards the completion of the project. Your thought here is that as soon as the original program has something useful to do with the cycles you’re using speculatively, you’ll hand them back over as a resource, so you’re not hurting anything. However after you write the speculative portion, you realize that you have no way of distinguishing between cycles that are being used by the program itself and those that are being used by your new speculative code within the program. So, you can’t throttle back the speculative execution once it’s started and you’ve created contention for the same CPU cycles between your completely useful program, and your only mildly useful speculative execution. This is a problem, and you’ve probably actually slowed down the execution of the program you were trying to speed up. The problem is that the good use of cycles can’t be computed once the bad use of cycles exists. Any attempts to compute which one is which, so you can perform your throttling is only further eating up cycles, and this time these cycles can’t be throttled, because you’d need yet another program computing when to throttle that one. It’s pretty clear that ultimately you’d end up hurting your original goal unless the initial load on your CPU was almost always below a threshold and you had everything above that threshold to use for speculative execution.
Taking this example back to the economy, things are even worse. Not only are we unable to tell when resources are being employed usefully, but people are constantly trying to figure out whether or not resources are being employed usefully, and they do that based on price increases in those markets (investment yields). This is as if your original program conceded cycles to the speculative program based on the number of cycles the speculative program was using, naively thinking that if it was using more cycles, that that meant it needed more cycles. If unchecked, the speculative program would take up all your cycles. You’d have to have some way of determining when you’re actually doing something useful vs just burning up cycles so that you could throttle the speculative program. In the economy, we do this by personally looking at how valuable something is for consumption, and eventually it dawns on us that we messed up (tulips aren’t really worth as much as sailboats, websites and houses aren’t infinite sources of value). This causes a bust and leaves resources idle the same way killing your speculative code would leave cycles idle until the real program got a chance to figure out how to use them. It is computable to determine how best to use those cycles, but it happens at runtime, so you can’t improve upon simply running the original program.
If you’re a computer guy, you might be thinking “but we do use speculative execution and it does make things faster”. True, but it’s done in hardware, and we track which instructions are speculative and which aren’t, something you can’t easily do in software, and something we can’t do in the economy. If we could do this, it would mean exactly the opposite of what your link was pointing out. It would be as if tracking the red dollars through the economy actually let us figure out who should be repurposed as the green dollars demanded the people occupied by the red ones. Obviously, that’s gibberish…we can’t track them. We destroy our exit strategy (yielding speculative execution to real execution) as soon as we implement the speculative execution in the first place.
I’ll try to get to any other disagreements later in another post, but I think this might occupy us for a bit.
February 2, 2011 at 10:42 pm
Optimal currency areas are nonsense « Good Morning, Economics
[…] for money can cause such a temporary decline in production and has a negative effect on welfare (explanation). Any given recession might be due to monetary disequilibrium  and/or other […]
February 2, 2011 at 10:48 pm
jsalvati
I thought I had replied to your comment a while back, but I guess replying in email didn’t work. Anyway, here was my response:
Perhaps I was unclear about my claim: my claim was that his examples illustrate how the injection point is of very minor interest because the people who receive the money first trade something of essentially equal value to get the money. They are not receiving some special gift.
Money then flows from people who want to hold money less to people who want hold money more. If there has been an increase in the demand for money then money will flow to the people who want to hold more of it. To the extent that this represents an increase in the resources people are willing to save, the increased money supply expands the resources available for investment outward, and this is right and proper.
If you would like to claim that his examples do not illustrate this, I am all ears.
I am not certain what it means for something to be “a call to resources”. Is a corporate bond a “call to resources”? I deny this phrase is useful, and don’t think reasoning from it is a good idea. Do you mean “something of value”? It is easy to create things of value without an increase in wealth or even any important result in the economy: for example, we can both write up legally binding contracts that say “I owe the holder of this contract a billion dollars” and then agree to exchange them, now we both have assets worth a billion dollars (as well as liabilities). The same is true of money: US dollars are a liability to the US Federal Reserve, if dollars drop significantly in value the Fed will step in to trade some of those dollars for other assets (bonds) in order to make sure dollars maintain some value; they are also a liability to people who accept US dollars in exchange for goods.
February 2, 2011 at 10:49 pm
jsalvati
Also, https://goodmorningeconomics.wordpress.com/2011/01/10/financial-assets-money-and-representation/ was partially a response to you.
February 4, 2011 at 4:59 pm
Alden
In that last referenced article you say, “The US dollar has value because there are implicit (but credible) promises that it can be exchanged for something of value. These promises come from two sources: 1) the general public because they currently accept money as payment for other things of value 2) the Federal Reserve because they implicitly promise that they will trade dollars for something else of value in order to make sure that dollars continue to be valuable. Like other financial assets, its value has nothing to do with whether it represents real assets or not, and whether the economy would be better off with more or less of it has nothing to do with whether it ‘represents’ real projects.”
I certainly agree with the first point here. Money in this sense is a clearing house for the exchange of value. It allows people to trade it for a good, and then the seller to turn around and trade it for another good. It’s not a *store* of value until it can be held between transactions with some reasonable expectation its purchasing power staying the same. Clearing house is without the time component, store of value / currency is with it. So yeah, the first point is correct.
The second point, that the federal reserve gives the dollar value, I don’t understand: maybe it’s not what you meant. The Fed offering dollars for something else of value doesn’t add value to the dollar. It just says that the Fed wants what it’s buying, that the Fed values this other thing. If the Fed was going to help the dollar have value, it should be burning them (or selling things), making them more scarce. Fewer dollars chasing the same number of goods means prices rise, meaning the dollar is worth more.
I ran across this podcast today about some common fallacies of monetary theory: http://www.econtalk.org/archives/2011/01/boudreaux_on_mo.html You can listen to it or read the transcript, which I admit, is a bit hard to read (there are two people and no reference to who is speaking). The discussion only mentions in passing how money ripples through an economy and that the injection point matters, but I hope that bit is helpful. The particularly relevant part is this:
“I think by far the most dangerous consequences of inflation go well beyond that, even fully-anticipated inflation and accurately anticipated changes in however we define the general price level are dangerous. For reasons that Chicago economists overlook. Inflation is not created by helicopters hovering above and distributing money evenly. Money is injected into the economy at certain points. And wherever it’s injected it causes those prices to rise first; and as the money works its way through the system, it causes prices to rise. So it causes distortions in relative prices. When people make economic decisions, there is no price level to look at. When you are deciding whether to buy an extra gallon of gasoline or milk, build a house or not, borrow money for consumer or commercial, you look at relative prices. If relative prices are being distorted by changes in the money supply. If relative prices are being distorted, that leads people in the economy to make decisions that they would otherwise not make and that they shouldn’t make were the relative prices more accurately reflective of the true resource scarcities in consumer demands. So people misdirect resources. Resources get misallocated.”
This is what Chris is referring to when he refers to a “call to resources”. A call to resources is basically the shuffling of money. When someone has money, they can trade it for the resources that others have produced. When someone who only wants tanks has all the money, then everyone starts producing tanks and the resources required for tanks. Your contract for a billion dollars is a call to resources (in as much as someone believes you will pay it). But it’s not a creation of value. It doesn’t produce anything. And when someone starts making decisions based on the idea that they’ll get a billion dollars from you. If you don’t pay, then it turns out that they have been misallocating resources. This is what inflation does, it’s just a slightly different mechanism, but it sends the same signals.
February 4, 2011 at 9:05 pm
jsalvatier
@Alden
1) I probably wasn’t very clear.
You are entirely correct that making dollars worth more requires getting rid of them. Believe it or not, the Fed does this on a regular basis. Any talk about “defending the dollar” or “constraining inflation” requires doing this. The way they do this is by selling financial assets they already own in return for dollars, which they then get rid of. This is the precise opposite process of the way they create money. My point was that the Fed implicitly promises that if the demand to hold money decreases significantly, so that the equilibrium value of the dollar given no change in the money supply drops significantly, they will make sure the dollar retains at least some value by reducing the quantity of money through open market operations (or equivalently, reducing increases in the quantity from what they otherwise would have been).
It’s probably more precise to say that the Fed’s implicit promise gives the dollar’s value stability; it prevents the dollar from varying too erratically because to some approximation they promise to make more money when people want to hold more and get rid of it when people want to hold less. I talked a bit about this here (https://goodmorningeconomics.wordpress.com/2011/01/10/financial-assets-money-and-representation/#comment-2087).
2) The notion that money creation (and presumably destruction) is necessarily distorting because of ” new money flowing through the economy” is popular, but it’s mostly wrong. Not to disparage the Econtalk guys; they’re smart (though a tad ideological for my tastes), but it’s very easy to be terribly confused about monetary economics if you don’t have the correct framework for thinking about it.
The first thing to remember is that the people who buy or sell bonds to the government are not getting a “special deal” (nor is the Fed). They buy or sell bonds *at the market price*, and this price already reflects the expected future increase or decrease in the money supply because central banks always announce their actions before they undertake them.
The next thing to realize is that the economy has a very effective method of moving money people who would like to hold money relatively less to people who would like to hold it relatively more: the banking and financial system, this is one of it’s primary functions.
When people want to hold more money instead of consumptions goods, and the central bank accommodates this by printing money, this produces a net shift out of the resources available for investment. The result is that people consume fewer consumptions goods and more resources are used on investment projects (Woosley illustrates this process http://monetaryfreedom-billwoolsey.blogspot.com/2010/04/austrian-business-cycle-theory-2.html, I think I’ve linked you to it before).
When people want to hold more money instead of other assets, and the central bank accommodates this by printing money, this produces a shift in the mix of financial goods. The net result is that the demand curve for the assets which are used to create money (most commonly government bonds, but there’s nothing conceptually special about them, copper or corporate stock could be used instead) shifts out and the demand curve for other kinds of assets shifts in.
In both cases, *this is what is supposed to happen*, people want to use more of some kind of good and resources shift in that direction and out of other things.
It’s useful to think of the central bank as using some kind of financial asset (again, usually government bonds) to construct another financial asset, money. When people want to hold more of that asset, it’s natural to build more of it. When people want to hold less of it, it’s natural to recycle some of it.
I hope that seems somewhat responsive to your concerns. I still don’t understand very precisely what a “call to resources” means if not “asset” or a “medium of exchange” what distinguishes it from these technical terms?
February 10, 2011 at 6:44 pm
Chris
A medium of exchange, a call to resources, and an asset are all the same, but the emphasis is different. I’m using the term because I want you to pay attention to a particular facet of the money asset. A medium of exchange is an asset that is typically only used to trade for other assets that have specific functions (capital, food, etc). When I call it a call to resources, I’m pointing out the fact that there is a limited amount of these other assets with specific functions, and that the amount of each that is supplied and demanded is important for the proper functioning of the economy.
—
I want to try to understand your position more, because it is difficult for me to get where you’re going. I’m going to try to summarize your position to make sure I understand it correctly. Please correct me if I’m wrong about anything, and feel free to add to it. It really does make a lot of sense, but my worry is that it’s oversimplified. Below is what I believe you’re saying:
When people want to hold more money, it is a primary problem that can be resolved simply by creating more money to satisfy the demand. After all, when people demand more cars, the producers of cars simply create more of them, which satisfies that demand, and also has the side-effect of lowering the value of cars for those holding them (car inflation, if you will). Money is equated with other assets by noting that each is demanded by people for specific uses (dollars for trading, storing value, looking bling, burning, etc. cars for driving, looking bling, blowing up in movies, possibly trading, possibly storing value, etc), and that they are all interchangeable at some rates via free trade. Therefore, the statement about car supply still stands if you replace “car” with “dollar”. “When people demand more dollars, the producers of dollars simply create more of them, which satisfies that demand, and also has the side-effect of lowering the value of dollars for those holding them (dollar inflation, if you will). ” Cars and dollars are simply economic goods that people have some demand for, and dollars are not special. There is no reason why the issuer of dollars should be restricted in terms of that issuance any more than the issuer of a stock should be restricted in terms of that issuance. If the issuer of dollars issues too many, he may damage the value of the dollar, hurting himself and everybody holding them as confidence in their value is lost. If he issues too few, some people who really want to use dollars might demand them, but be unable to obtain as much as they demand (think Google or Berkshire Hathaway stock, of which many people can’t afford a single share.) If he’s constantly flopping the dollar supply around without telling anybody, people will see this as a liability, and the dollar will lose value.
So when banks lend new dollars to people, they are offering dollars at interest in the same way you might lease a car to somebody. The borrower controls the asset for a while, and by the time the term is up, the borrower has given the asset back plus installment payments to account for any depreciation in the asset over the term, and an added payment to make it worth the lender’s while (often not distinguished, but really they’re both always there). That asset can be any asset, including the money asset, and as long as people are willing to borrow it under the terms and the law, and the lenders are capable of supplying it under the terms and the law, the two should match up and do business. It’s all happening on the open market, so the same loans/leases are available to everybody, and no harm is done, but this opens the opportunity for people who demand dollars to invest them how they see fit, and it allows the possibility of smoothing out fluctuations in the value of the dollar which would otherwise happen in concert with changes in demand.
Is that a pretty good explanation of your position?
February 10, 2011 at 7:45 pm
jsalvati
@ Chris,
You’ve certainly got the right notion that “money is just another good”, but I want to make a couple of clarifications.
1) I additionally claim that changes in the quantity of money that accommodate changes in people’s desire to hold it do *not* affect the equilibrium value of the currency. You could also say that the change in people’s desires and the change in the quantity of money have opposite effects. I also argue that it’s people’s *expectation* of these changes that’s critical, not their actual occurrence (though these are naturally usually related).
Perhaps an extreme example will help: lets say there’s a small isolated island that uses stone tokens as money. Then one day, they start regular trade with Americans. People see the Americans using US dollars and most of them think that the US dollars make much better currency than stone tokens (lets say dollars are easier to count). 90% of the islanders start using US dollars instead of tokens. 10% are crotchety and still use the stone tokens. Two things can happen: A) The island central bank does not reduce the quantity of tokens on the island (and people expect this). The equilibrium value of the tokens is about one 10th of what it used to be. This has a number of predictable effects, people try to quickly get rid of the tokens they have as quickly as possible leading to an increase in economic activity (this post describes that process). Merchants also have to undertake the process of changing their prices. B) The island central bank reduces the quantity of tokens (say by selling financial assets for tokens and destroying the tokens they receive) to about one 10th of what it used to be (and people expect this). Now the equilibrium value is about the same as it used to be. Economic activity remains about the same.
2) I think it’s best to stick to money creation-destruction by the owner of the money brand (for example the Fed for US dollars). You are correct that I don’t think fractional reserve banking is especially harmful (though I suspect with better monetary policy you wouldn’t have much of it in practice), but it’s a separate issue.
February 10, 2011 at 7:48 pm
jsalvati
By the way, I am always interested in understanding how to explain things better, so if you find particular arguments more enlightening than others or have a better way of conveying some insight I’ve conveyed to you, please let me know!
February 22, 2011 at 2:03 pm
Chris
Sorry. I didn’t want to give you the wrong impression. I was putting that description forward as a representation of what I believe is your stance, not as a representation of my stance. I want to make sure I completely understand yours to make sure I’m actually arguing against it, rather than some misrepresentation of it. I don’t think there’s a better way than to put it into my own words and have you check to see that it’s actually representative of your position.
I’d like to add one more part to my understanding of your position and give you another opportunity to fix or elaborate on any part of it before I get to what I think is obviously wrong with it.
Again, below is regarding what I understand of your position, not my own:
On the creation/destruction of money, there’s another major reason for satisfying the demand for it (i.e. not issuing too few dollars). If the demand for money goes up too high without more supply that it can cause a demand shock for goods as money leaves the market and is saved, leading to a downward spiral in spending, production, employment, and prices. Indeed, this was the very point of the article that sparked this argument. Monetary adjustments should take place to avoid a decrease in demand during that period when prices are sticky downwards. Essentially, consumption shouldn’t be decreased simply because people are holding on to more money, so we should create more money to satisfy the new, higher demand for it, whatever the reason for that demand.
February 22, 2011 at 2:11 pm
jsalvatier
Yeah, that is a fair characterization of my views.
I did understand that you’re describing my position rather than agreeing with it. I just meant that if you do find parts of my arguments compelling or novel, tell me.