Monetary Realism

Understanding The Modern Monetary System…

The Medium of Account Dominates the Functions of Money

Scott Sumner says something interesting about money being the medium of account:

“I argue that money is the medium of account.”

I agree. We spent a lot of time ere at MR with the equation S = I + (S-I), and one of the conversations about this idea (Thanks again Steve R.) was about how there are tons of assets sitting on the balance sheets of the world, all valued using the medium of account, where the medium of exchange has very little impact on what happens with these assets. These assets all matter for S and I.

Many of our more important transactions in the financial world do not involve exchanging the medium of exchange. They involve the valuation of assets in the medium of account, and promises to provide (possibly) some medium of exchange later in compensation. For example, an interest rate swap doesn’t involve much or any exchange of the medium of exchange at the initiation of the trade. Yet, plain vanilla IRS define much of our financial world.

IRS are bookkeeping entries until something changes in the real world, so how can they be considered to be using the medium of exchange? IRS use the medium of account.

Then, taxing agencies don’t just tax transactions which use the medium of exchange. They also tax transactions which involve gifting of real estate, compensation received as options on corporate equity, or payment in kind. These transactions must be given values in the medium of account, which then require taxes paid in the medium of exchange.

Also, much of our current recession has been caused by transactions which did not involve the medium of exchange. The revaluation of ABS – clearly one of the precipitating forces of the tragedy in 2008 – were simply bookkeeping entries on non-traded bonds. The reason banks stopped lending the medium of exchange was due to changes in valuation on untraded bonds in the medium of account. Similar bonds may have traded, but some large majority of the ABS revaluation happened in a few dozen (maybe a few hundred) spreadsheets around the world, not in millions of recorded exchanges of these bonds for money. There were literally no trades for these ABS, no “exchange of medium” for specific bonds, so the valuation changes must have come from valuation changes which happened in the medium of account.

Note these spreadsheet-only valuation changes directly caused the lending problems in 2008.

My take is the accounting function of money dominates the exchange function. It’s hard to see when you don’t think about accounting much, but accountants rule our world, because they define it.

(Update: The internet bubble was an MoA driven phenomenon, and the mid 2000’s refi-boom was a MoA phenomenon.In the intenet bubble, many transactions were exchanges of equity with zero MoE involved. Any refi equity extraction involves guessing the market value of a parcel of real estate and then giving someone MoE in exchange for that new value. The MoE is available when the MoA valuation changes. )

 

 

 

 

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78 Responses

  1. The Arthurian says

    Oh, this is the part I wanted to quote:

    “I too think this is Sumner issue, the stock of money has been confused with the flow of economic activity that money can finance over time.”

    Yes… but this is not just Sumner’s confusion. It is a confusion embedded into policy by the wealthholders we elect.

    Art

  2. beowulf says

    “as I see it is that our financial institutions do much of their transacting behaving as if the stock they hold that has a price tag of 100$ is the same as a 100$ bill. This is completely unreasonable, because this price is at the level it is within a certain range of sellers to buyers”

    Not just stocks, if mortgage-backed securities and US Treasury bonds were both give a AAA rating, it stands to reason they’re equivalent. :o)

  3. Oilfield Trash says

    ‘I think Monetarists like Sumner want our “million dollar stock portfolio” to be equivalent to a million dollar bill and that just cant be so except for a few of the portfolio owners at THIS moment.”

    Greg

    I too think this is Sumner issue, the stock of money has been confused with the flow of economic activity that money can finance over time.

  4. Greg says

    I may be at odds with my own opening statement above but after thinking more about this important topic I have a couple more comments;

    Medium of account as I understand it can be thought of as how things are priced. What numeraire is used. In the US we use the “dollar sign” to price things and “the dollar” to pay for things.

    People should intuitively understand the difference between a dollar bill and a price tag with a dollar on it and not confuse them but I think they do.

    On our balance sheets we do have a variety of things which determine our wealth level. Some are dollar balances in checking accounts, some are dollars owed to other people and others are prices, in dollars, of things we own. The most volatile are the prices in dollars of the things we own. They can change drastically in a minute if they are a stock or commodity.

    The problem, or A problem, as I see it is that our financial institutions do much of their transacting behaving as if the stock they hold that has a price tag of 100$ is the same as a 100$ bill. This is completely unreasonable, because this price is at the level it is within a certain range of sellers to buyers. If everyone at once wanted to get their 100$ a share for the stock, and tried to sell, the price would plummet and few would get their price. So at any given time only a percentage of people with the 100$ stock can convert it to a 100$ bill so to speak.
    The rest must hold or turn it into a 50$ bill.

    When panics happen everyone is trying to get their 100$ bills and only a few can be successful. Another fallacy of composition.

    So it is important to distinguish between a dollar price tag and dollar bill. You cant really buy much with just a dollar price tag unless there is a barter exchange. Most of the time we need to convert first to a dollar bill and then make the exchange. The strength of the relationship between price tag and “bill-ness” is liquidity.

    I think Monetarists like Sumner want our “million dollar stock portfolio” to be equivalent to a million dollar bill and that just cant be so except for a few of the portfolio owners at THIS moment.

  5. Fed Up says

    “The Collateral is future earnings.”

    I don’t consider that collateral. Future earnings is about making the interest and principal payments. I consider collateral to be an asset that can be seized and sold to repay the debt if people default. With most? credit card debt, there is no asset to seize.

  6. Oilfield Trash says

    “You have to have money to borrow money.”

    No all you have to do is prove to the bank they can make a profit on the money they loan you and you get the loan. The bank runs the risk of being wrong but hedges this risk with some form of collateral, the cost for all of this is priced in the interest rates they charge you.

  7. Tom Hickey says

    ” There is plenty of property controlled by banks right now (and at most times) and they will likely make profits off the property by mortgaging it to someone new in the next few years.”

    What they are doing is bundling it and selling it off to deep pocket investsors for rental and eventual flipping. So the properties don’t come on the market and undercut existing prices. Some developments are just being bulldozed.

  8. Oilfield Trash says

    I guess the point I am trying to make very poorly, is banks do not care much about the form of collateral. They only care about what it will cost them to settle a default.
    Collateral IMO is nothing more than an insurance policy for payment of the money borrowed, and to maximize the profit of a loan banks prefer the insurance policy with the lowest premium over the duration of the loan.
    I do not want to speculate on what Scott is talking about, but I think he could make the argument that if the FED was the lowest cost premium to settling the default of private debt enough good collateral would be available to support loans; or at least the haircut is smaller on the collateral the banks would accept, which should allow for an increase in purchasing power for the borrower.
    The bum who walks into a bank did not get a loan because he has no collateral, since he would pledge the same home if that is what his loan is for. He is denied a loan because he has no income or not enough to service the cost of the debt, which makes him a huge profit risk.

  9. Tom Hickey says

    But, Mike, what about during the height of the housing bubble, when banks were lending on dodgy collateral, inflating appraisals, and doing NINJAs?

  10. Greg says

    Dont take my statement to concretely. I dont mean to suggest that any individual banker simply wants your house when he makes a mortgage to you, but the fact remains, he HAS your house til you make the last payment, and if you stop making payments he gets it, it wont happen otherwise. Additionally it is the house which makes the loan possible. Maybe control of asset, is a better word than ownership. There is plenty of property controlled by banks right now (and at most times) and they will likely make profits off the property by mortgaging it to someone new in the next few years.

    I agree they are in the business of making money but they do that by leveraging real assets that they get control of. Is this not so?

    To paraphrase Mikes comment

    You have to have money to borrow money.

  11. Michael Sankowski says

    Did we ever get in contact with Tay?

  12. Michael Sankowski says

    I fully agree. Bankers are out to make money, and they do this by making money on the interest rate spread.

    The collateral is part of the “trade” which makes the entire loan work. The trade cannot happen without the collateral – it’s a necessary part of the transaction. The loan happens because the collateral exists and has a value.

    My claim is that this is the important part of the loan. Of course people want loans, and bankers want to make money. I cannot imagine otherwise. But a bum walking into a bank doesn’t get a loan why exactly? Because he has no collateral is the reason.

    So yeah, we can go back and forth about confidence fairies, or we can look at the impact of policy on the most important part of the loan, the underlying collateral which allows loan officers to make money out of a few keystrokes.

    Scott S does not consider this function to be important – that somehow there is always enough good collateral. Gorton destroys this idea in his writings – absolutely destroys it.

  13. beowulf says

    “Yes, if creating loans are not constrained by deposits, then what constrains loans?”
    Capital requirements.

    “Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and 6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel III also introduces additional capital buffers, (i) a mandatory capital conservation buffer of 2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators to require up to another 2.5% of capital during periods of high credit growth. In addition, Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. The Liquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress.”
    http://en.wikipedia.org/wiki/Basel_III

  14. Oilfield Trash says

    Collateral can take many forms and is used to reduce the loss of profits to the bank due to a default by the borrower. I would argue CDS, and MBS are a form of collateral. Most MBS carried the same AAA rating as US treasuries; some would even make the argument that if not for this AAA rating the growth of RE and CRE loans could have never happened.
    Having worked around a lot of loan officers in banks, if you ask them what motivates them to make a loan they will tell you it is to generate profits for the banks they work for. Their main tool for this is the interest rate they charge for the loan, and the three considerations for the rate they offer is the risk of default by the borrower, the value of time, and of course the profit motive.
    I have not run into any many bankers who loan money to acquire the collateral that backs them. Not saying this does not happen, but would suggest it is not significant.
    The FIRE sector makes loans to move at a profit some % of the income flows in a monetary economy to its sector.

  15. beowulf says
  16. Tom Hickey says

    Greg “Essentially what people are borrowing when they go into debt is their OWN future earnings. Which is why, as I see it, that the private money system is unstable. Every person involved in borrowing must be able to accurately forecast their future earnings.”

    And when employment was stable, with people staying in the same job, perhaps for life, it was possible to assess future earnings with some degree of assurance. That model of employment security has now shifted pretty radically, even in paternalistic Japan, making such assessment more difficult, if not a stab in the dark wrt lots of workers.

  17. Greg says

    Yes. Essentially what people are borrowing when they go into debt is their OWN future earnings. Which is why, as I see it, that the private money system is unstable. Every person involved in borrowing must be able to accurately forecast their future earnings. And the banking system is motivated to encourage us to be over optimistic about our futures, which makes them more likely to blowup.

    Its a trade off between living in the present and paying off the past. I just finished a refi and was able to take $2100/month worth of house/car/vacation prop payments and reducing them to 750$. Now if I make the minimums and pay the term I will pay much more in total now but I now have over 1300$/month of present consumption I can do. I want to live more in the present so its worth paying more overall to not be paying off past debts faster. Living for today, living in the present moment has a cost.

  18. Michael Sankowski says

    The Collateral is future earnings.

  19. Michael Sankowski says

    I really like Chris Cook’s ideas and views. I don’t always agree with them – for example, I don’t agree with his idea that an energy based money system would be a good idea.

    But he’s an insightful guy, and this is a good point. Money isn’t really debt – it’s a credit. It starts off as a credit, because someone somewhere is crediting an account.

  20. Michael Sankowski says

    Yes, I find their ideas hard to follow in some ways. It’s probably because they mostly use thought experiments.

  21. JKH says

    That debate revolves most around competing interpretations where the MOA and the MOE are not the same. Mike has expanded the scope to what may be described loosely as Minsky balance sheet proportions and effects, which I don’t see addressed in the Rowe/Sumner debate.

  22. Fed Up says

    “The word money should be banned from the economic vocabulary because its use tends to causes more fights than forward progress. ”

    Exactly!!!!! I suggest going with currency, central bank reserves, and demand deposits.

  23. JP Koning says

    I’ve been following this debate and I think it makes more sense if you ignore any claims that Sumner/Rowe have about “what is money.” Just pretend that the word “money” doesn’t exist. If you do then the debate boils down to an interesting exchange on the interaction between the MOE, MOE, and various assumptions about stickiness.

    The word money should be banned from the economic vocabulary because its use tends to causes more fights than forward progress. Words like MOE, MOA, and unit of account are far better specified.

  24. Greg says

    “The constraint is all balance sheet, and not liquidity. The banks don’t need cash money to multiply – they can get it any time from the fed. They need collateral which can hold or increase its value, so they feel secure in making the loan.”

    Kind of getting back to “why” a bank creates money in the first place. It seems its simply for it to acquire real stuff (collateral) the same reason any entity creates money, to move a resource to their (the money creators) sector. Dont banks intend to keep a certain portion of their collateral? They know there will be a 2-3% default rate and they look to have the highest quality of collateral.

    You may have stated this somewhere already but couldnt liquidity be thought of as the ratio between the MOA “value” and the MOE “value”. Cash is always 100%

  25. Fed Up says

    When you do get to that one, check my questions at the November 1, 2012 at 2:28 p.m. post.

  26. Fed Up says

    World? Not sure. USA? Not sure but thinking 800 billion to 900 billion. I believe that is expected future (mostly wage) income, which may or may not come true.

  27. Michael Sankowski says

    We can’t go there. 😉

  28. Tom Hickey says

    As I recall, Chris Cook was responding to the idea that “money is debt,” i.e., somebody’s IOU. He said it was more accurate to say that money is credit in that money is created by crediting accounts.

    Compare Warren’s idea of currency as a tax credit, and bank money a franchise that the govt gives banks to generate tax credits within the franchise rules. He calls this “leveraging” the currency, that is, expanding the amount of tax credits over what the govt itself creates through fiscal policy and cb lending.

    I think he would say that once money is created through credit, then it can function as a medium of exchange, a store of value, and a record of non-bank credit denominated in the unit of account. But these are subsidiary to money creation, which occurs by crediting accounts.

    But this is only my understanding of Cook’s view expressed in my words.