jt26 Says it Better

Once again, a reader says it more concisely.

jt26 said:

“I see your argument. In essence, your point is if liquidity is not an issue how can the MOE function be more important than the MOA function.”

That’s a great way to put it. Creating loans is not the problem. Our banking system can always create more loans. So what is happening with the balance sheet and collateral of the world – and therefore the MoA function of monies – tends to dominate what happens in the MoE functions.

Ok, you sticklers on actual banking practices – banks cannot always create more loans, but the constraint is far less binding than “going out and finding deposits so we can make this loan to builder X”.

This improved re-statement of my own argument by a reader has happened to me before, and greatly helped to advance the idea. It’s a collaborative process, so much thanks to jt26!

Note, this helps to explain something which is simply skipped over by Scott Sumner. Here is something from his recent post:

“Suppose Zimbabwe goods are priced on gold terms, and a strange phenomenon causes 1/2 of all the gold in the world to disappear.”

Well, it sure seems to me figuring out what could make 1/2 of the money supply vanish would be highly important. In our world, we can begin to identify how this happens. We know that most loans are backed by some form of collateral, be there visible today (like real estate) or claims on future cash flows (like credit card debt).

We spent a ton of time going over S = I + (S-I) here, and I did a few posts on Money-Like Instruments. It’s clear we can take almost anything and repo it out to get cash money. When money-creating banks are part of the repo market, the demarcation between money and collateral becomes extremely blurred.

Gorton points out using private collateral in the money creation process is inherently unstable. It’s because there is default risk baked into private collateral creation. It’s part of the contract specs, using my old futures product development terminology.

Of course, there are ways to think about this more clearly. I wrote a long rant on the distinction between debasement and default. I’ve softened my stance on default in a sovereign issued currency. I think it’s “possible” under very unusual circumstances with particular institutional setups.

But, I still consider this distinction to be at the heart of our problems – we do not recognize the important difference between debasement and default.

Scott Sumner is only looking at only the “debasement” side. They are looking at how money changes in value, without regards for how this money came into being, or why it might be destroyed.

 

Comments
  • jt26 November 5, 2012 at 11:30 am

    “When money-creating banks are part of the repo market …” you nailed it.
    I’m beginning to think that banks+repo+money markets is another unholy trinity like banks+securitization/SPV/SIV+passive investors. (I ignored the ugly little brother of securitization; ratings agencies!) The banks+repo is more complicated, as it is not clear (to me) whether (in all cases) the banks are extending credit (creating money). For example, mechanically, when a hedge fund buys an asset does it first buy on margin from a bank/PD, then repo’s it and repays the PD? (This question probably applies to the PD’s own inventory … was it financed through repo or it’s own money creation?) (PS Thanks for the title!)

    • Michael Sankowski November 5, 2012 at 2:36 pm

      They are not creating money for repo transactions. JKH knows more about how all of this fits together.

  • beowulf November 5, 2012 at 1:55 pm

    “I’ve softened my stance on default in a sovereign issued currency. I think it’s “possible” under very unusual circumstances with particular institutional setups.”
    Like that time Russia dropped a ton of bricks on Warren’s head (the Russian government had monetary sovereignity, as Rodger Mitchell would say, but it defaulted anyway.

    “I’m beginning to think that banks+repo+money markets is another unholy trinity like banks+securitization/SPV/SIV+passive investors”

    Does it even add value to the economy or is it more like financial pollution, just begging for a Pigouvian tax?

  • Greg November 5, 2012 at 3:11 pm

    Ok, you sticklers on actual banking practices – banks cannot always create more loans, but the constraint is far less binding than “going out and finding deposits so we can make this loan to builder X”.

    Isnt the only constraint finding someone with a reliable income stream who wishes to leverage it now instead of saving it and spending later? Yes, theoretically, there could be conditions where no one has an income but the lack of lending is way down the list of concerns in that situation.

    His comment on gold you quoted reminded me of a comment he made in a post last year. I had to go back and find it but it really floored me when he said this, and then Nick Rowe backed him up. I’d be interested in your thoughts on this comment.

    It was in a post about how prices are determined.

    “I have a very simple question: What is the MMT theory of the price level? The MMTers that come over here tell me nonsensical things, like the price level is arbitrary, or Japan doesn’t really have a price level 100 times higher than us, as they use a different currency! Or the wage rate determines the price level. How can one even have a discussion if faced with those arguments?”

    So I said

    “Japans price level isnt 100 times ours, thats absurd. If we priced our stuff in pennies it would be 100x more but it wouldnt be any more expensive!”

    To which Nick Rowe added

    “Yes. But that exact same insight is what is at the root of QTM. It goes all the way back to David Hume (and, no doubt, earlier). If we added a zero to all the dollar bills, so a $1 became a $10 bill, and a $10 became a $100, etc., then we would need to add a zero to all the prices to get back to equilibrium. Increase M ten-fold, and we increase equilibrium P ten-fold too”

    Now , is it me, or is this totally whack? If I write a prescription for “1 gram of Penicillin” on Monday and then Tuesday I rewrite it as 1000 milligrams I havent increased anything. Yet Scott maintains that if we relabel our national debt as
    1.5 quadrillion cents we have increased our debt level. He says Japan has a higher monetary base by a factor of 100 even though the yen is just the same as a penny…… and Nick thinks he’s right!

    No one is suggesting we just add couple zeros to our currency to make things better although interestingly the NGDP guys seem to think that if the fed just relabled all asset prices higher we could just get back to 2006.

    Interested in your thoughts Mike……. or anyone.

    • Tom Hickey November 5, 2012 at 3:46 pm

      Greg, I stopped reading that stuff. It made my head hurt. Also, the only time I ever saw JKH lose his composure and swear was dealing with Nick.

      • Greg November 5, 2012 at 4:27 pm

        “Greg, I stopped reading that stuff. It made my head hurt.”

        Let me order you 1 gram of Tylenol with Codeine Tom, that’ll help…….. better yet Ill order you 1000 milligrams and then you wont get a headache for 3 years!!

    • Michael Sankowski November 6, 2012 at 7:34 am

      I do not understand how Scott could be so dense, because he does call his blog the money illusion. I read that post about MMT as well and realized he does not understand the real/nominal distinction and links very well. You’d think it would be second nature to him, but it does not appear to be so.

      Either that or he was not arguing in good faith. His blog is called the money illusion, which according to wikipedia is:

      “The money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value (nominal value) of money is mistaken for its purchasing power (real value). This is false, as modern fiat currencies have no intrinsic value and their real value is derived from their ability to be exchanged for goods (purchasing power) and used for payment of taxes.”

      In nominal terms, he is correct. The nominal price level of Japan is roughly 100 times higher than it is in the United States. But the real price level is not 100 times that of the United States. I don’t wonder which of these price levels the MMT people were using in the discussion because it was obvious they were using real price levels.

      He named his blog the Money Illusion. How can you take someone seriously who is willfully disregarding the name of his own blog to score points against someone – or doesn’t understand the Money Illusion?

      I don’t have much to say on NGDP right now. NGDP futures are a bad idea.

      • Greg November 6, 2012 at 9:36 am

        “I do not understand how Scott could be so dense, because he does call his blog the money illusion. I read that post about MMT as well and realized he does not understand the real/nominal distinction and links very well. You’d think it would be second nature to him, but it does not appear to be so.”

        And Nick Rowe was right there with him, sad.

  • beowulf November 5, 2012 at 8:43 pm

    Mike, then how would we tally values of MOE and MOA (or your mystery third Medium— call it MOX). Can we glean anything from the relationship of these values? To this end, Berglund’s grand ratio model is worth pondering.
    http://monetaryrealism.com/the-medium-of-account-dominates-the-functions-of-money/#comment-10571

    • Michael Sankowski November 6, 2012 at 8:36 am

      lol why are you giving me more homework?!? I am trying to do the readings!

      I am always floored by this vision of how to use the government budget:

      “The core message of the doctrine of Functional Finance is that the government budget should be regarded a means to attain real-economy goals like maximum output and employment. The size of the budget deficit and government debt does not matter per se; the budget should be assessed only in the light of its impact on the real economy.”

      This is such a great way to think about the topic of the government debt – heck it’s a good way to start thinking about nearly every part of government.

      • beowulf November 6, 2012 at 2:57 pm

        Those aren’t rhetorical questions, I’m not sure of the right answers. You’re a CFA so I’m confident your answers will be worth cribbing. :o)

  • Fed Up November 8, 2012 at 6:16 pm

    “We know that most loans are backed by some form of collateral, be there visible today (like real estate) or claims on future cash flows (like credit card debt).”

    It seems to me all loans are claims on medium of exchange. This is the being able to make the monthly (mostly) payments (usually interest and principal) part. The collateral is only there for default.

    Besides credit card debt, I am pretty sure companies can issue unsecured debt.

  • beowulf November 8, 2012 at 9:04 pm

    Fed Up, you should check out this Paul Davidson paper…

    “In Keynes’s view, The sanctity of money contracts is the essence of the entrpreneurial system we call capitalism. Since money is that thing that can always discharge a contractual obligation under the civil law of contracts, money is the most liquid of all assets. Nevertheless other liquid assets exist that have some lower degree of liquidity than money since these other assets cannot be “tended”, i.e., handed to the other party in a contract, to discharge a contractual
    obligation. Nevertheless, as long as these other assets can be readily resold for money (liquidated) in a well organized and orderly financial market, these other assets will possess a degree of liquidity…”
    http://www.aeaweb.org/aea/2011conference/program/retrieve.php?pdfid=557

    • Fed Up November 8, 2012 at 9:19 pm

      beowulf, I’m not sure what point you are trying to make.

  • Fed Up November 8, 2012 at 11:03 pm

    “Well, it sure seems to me figuring out what could make 1/2 of the money supply vanish would be highly important.”

    It’s all about the demand deposits!