Monetary Realism

Understanding The Modern Monetary System…

We are on a Real Estate Monetary Standard

I’ve been thinking a lot about this over last few weeks when I have the chance to think. It seems like we are on a real estate monetary standard. Much like how we can use assets like gold to create a commodity money system, it seems like we operate our current monetary system as a real estate standard.

Banks create money against real estate assets. We use this money in our day-to-day transactions, without much thought about what stands behind this money, but most loans are for residential and commercial real estate.

If we did operate under a real estate standard, we would expect to see the larger economic business cycle greatly impacted by the real estate cycle, far more than the declines in real estate activity would predict.

As Cullen pointed out over at Pragmatic Capitalism, this is exactly what we see. We see housing as a huge controlling factor for our overall economic growth. Here is a key paragraph from the paper Cullen quoted from Ed Lerner:

“For long-run growth, residential investment is pretty inconsequential, but for the wiggles we call recessions and recoveries, residential investment is very very important. To make this visually clear, I have created a series of figures that illustrate what was happening to each of the contributions to growth before and during the recessions.

Here’s more:

“Eight of the ten recessions were preceded by sustained and substantial problems in housing, and there was a more minor problem in housing prior to the 2001 recession. The one clear exception was the 1953 recession, which commenced without problems from housing.”

The contribution to recessions is extremely clear – you can take a look at the paper and see just how huge of an impact housing has on our economy, despite its size.

The larger point I’ve been thinking about is that we’re close to running out of real estate to create money against, despite the urge for our economy to grow. Ed Lerner is talking about real estate creating conditions for a recession, I am also thinking about real estate coming up to create the conditions for a depression.

Real estate is valued 2 objective ways. One is against cash flows, the other is against replacement cost. We can’t leverage cash flows much more with the low rates we have, and even worse, we can  rebuild the structure for less then the housing price. So banks are naturally reluctant to lend much more value against real estate.

This is commonly thought of as a balance sheet recession, but it seems as though thinking about our system as a “real estate monetary standard” would help us give us more insight.

I’ll have more on this at some point, but wanted to throw this out there.

(Update: What are the odds?  Here is Mark Thoma on Robert Schiller: ‘Wealth Effects Revisited: 1975-2012′)




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  • Michael Sankowski

    Hi Dan,

    Everything you say is correct. I am just pointing out our current system has a strong whiff of being a real estate monetary standard. I used a bold title to make you read the first paragraph!

    As Carola points out, it’s actually pretty close to the free banking era in terms of how the system operates. But not many people even know about the free banking era and even fewer ( including me) understand the free banking era.

    Now, the value of the money issued against the real estate can have directly different values from the value of the real estate. Money valuation is pretty complex, and I don’t pretend to understand it entirely, despite many years plumbing the secrets of the currency markets. And anyone who claims to understand the value of money is frackin’ nuts, in my book.

    So I thought it would be a good way to help people further understand our system. We create money against real estate. The money isn’t directly redeemable against the real estate, but the implied put in mortgage contracts makes it semi-redeemable against real estate.

    We are finding out, the banks act as though the money is redeemable against real estate.

  • jt26

    Bank reserves are not the (first) backstop for bank money, it’s the collateral (i.e. owner’s equity). I think that is Mike’s point. Reserves are like the ultra-ultra safe AAA tranche of CLOs :-}

  • Tom Hickey

    Right. And the financial sector knows that the collateral is implicitly or explicitly guaranteed by the govt. Which is why Warren says to regulate the asset side rather than the liability side.

  • Dan Kervick

    I think the issue is not just about backstops, jt26. Bank money is a kind of IOU. And they are not just a pro forma IOUs that are never actually redeemed. They are functional IOUs that are redeemed routinely as part of everyday business. I issue payment orders against my bank deposit balance (bank money) all the time, and as a frequent result, the bank makes a payment from its own reserve balance (USG money) to another bank. If my bank had insufficient reserves of USG dollars to make these payments, it would have to borrow them from another bank, or directly from the government at a penalty rate.

    It’s just like as the bills of exchange and banker’s notes issued by the goldsmiths and early bankers, except now the representation of the deposit liability is usually a verifiable electronic bank statement rather than signed pieces of paper, and the reserve asset that is either withdrawn, or allocated to another depositors’ account, or moved from one bank to another, is a sum of USG dollars in some form, rather than a quantity of gold.

    Government-issued dollars are not just sitting there in the background to backstop the bank dollars “just in case”. They are the actual currency of everyday bank-to-bank payment transactions. The bank depositors’ money I possess consists in claims on this currency, claims that are routinely redeemed either by direct withdrawals of USG dollars in physical currency form, or by depositor commands to their bank to transfer some USG dollars to the bank of someone the depositor has paid.

  • jt26

    Understood. I was thinking specifically about Mike’s thesis, i.e.
    – bank loan created against (real estate) owner’s equity and future cash flow
    – money moves out through the economy; settles against reserves
    – interbank settlement is not an issue, if bank losses are small (i.e. on average the owner equity is the first stop loss)
    Perhaps, the different viewpoints can be reconciled by whether one views the economy as a credit economy (Keen) or a monetary exchange economy. I tend to like the credit economy description better because it fits my everyday experience and experience with investments. (i.e. usually you only see TED spread start to rise as large bank losses are perceived by the markets).

  • jt26

    BTW my description isn’t really accurate, as technically, my cash flows are the first stop loss, but in practice, new credit creation is related to the owner’s equity, that’s why leverage varies so much across the business cycle (at the top of the cycle the worst office building project can get done for 1:5; at the bottom of the cycle only great projects get done and only at 1:1).

  • Tuhin

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