Friday, January 7, 2011

The First Principles


If we want growth, we need to use credit. Everybody knows this.

If we want stable prices, we have to limit the quantity of money. Everybody knows that.

What everybody seems to miss is that the things we do all the time -- limiting the quantity of money, and using more credit -- can only lead to excessive debt that we just don't have the money to pay off.

12 comments:

Greg said...

Its so simple when you describe it like that!

I really like watching you find your way through all this, its quite impressive.

Makes me wonder why no one else seems to be able to figure this out.

I think there are too many people for whom credit is too lucrative.

The Arthurian said...

As Warren said
:)

Tschäff said...

All money is credit/debt. Banks create deposits when they make loans. Government creates bank deposits and reserves when they spend more than they tax (run a budget deficit).

Likewise when taxes are paid, or private debt is repaid, bank deposits vanish. The credit/debt is erased. So "limiting the quantity of money and using more credit" is a nonsensical statement.

The link between money quantity and inflation is hard to see. Inflation has many causes, usually each bout of inflation has it's own unique and interesting story.

The Arthurian said...

Hey, Tschäff

All money is credit/debt.

"limiting the quantity of money and using more credit" is a nonsensical statement.

50, 60 years ago there was a lot more spending-money (relative to output) and a lot less debt than there is today in our economy. What you call a nonsensical statement, I call a nonsensical policy.

To me the difference between "money" and "credit-in-use" is that you don't have to pay interest on money, but you do have to pay interest on credit in use. It is a significant difference, a significant COST difference.

Steve Landsburg claims that the Fed buying govt bonds is "the same thing" as paying down government debt, because the Treasury receives back the interest it pays on that debt (or some 95% of it anyway). I like this idea. It means that government money is not necessarily debt.

The link between money quantity and inflation is easy to feel: Rareness is associated with more value, and commonness with less value. On the other hand, Milton Friedman has those "money relative to output" graphs which so many economists love, but which I argue are evidence of nothing.

Tschäff said...

You're still thinking about money like it is some commodity, and missing the much bigger picture that it is always created as credit. By using double entry book keeping, you're able to find for every dollar that exists there is a creditor and a debtor.

The Friedman graphs broke down in the 1990's if I'm not mistaken, putting the final nail in the dead theory's coffin.

The Arthurian said...

But suppose Landsburg is right, and the Fed buying treasuries is like the government paying off debt.

Then there is a way for money exist apart from debt.

And then it becomes possible to have balance or imbalance between money and debt. And it becomes possible for debt to accumulate, relative to money.

Tschäff said...

No, never.

Think about the business card household economy. If you want to pay your taxes, you need to acquire one of my business cards. The only way I (the gov) can spend more than my income is to go into debt. So I issue 30 business cards for some chores you provide. The business card represents a contract between you and I. I am the debtor, and you are the creditor. I owe and you are owed. It is money, accepted by everyone in my household. Taxes can be paid only in the form of my business card. Thus, once you pay your taxes, however many cards are left is my debt (liability), and your credit (asset).

If you want to add a central bank, it's not much extra work. You leave your cards in the household bank and are given a bond certificate saying you'll get them back in one week with interest. Right now all deficit spending in the US has to be accompanied with a bond sale. The bond is a liability of the treasury. It's a treasury debt, and you're still the creditor, the gov is still the debtor. The only thing that has changed is now you'll be paid interest. Note the causality here, the currency must first be issued (the gov must go into debt) for you to save, pay taxes or buy a bond.

Now lets say the central bank buys back the bond it holds before it matures. What happens? You are given cards again. Bonds are just like a savings account at the Fed.

If the government ever wants to pay down the debt, it must tax more than it spends. This is not the equivalent of the central bank buying bonds. The former reduces net assets of the non-government sector, the latter changes the term structure of them. The effects on the economy are dramatically different.

Tschäff said...

No, never.

Think about the business card household economy. If you want to pay your taxes, you need to acquire one of my business cards. The only way I (the gov) can spend more than my income is to go into debt. So I issue 30 business cards for some chores you provide. The business card represents a contract between you and I. I am the debtor, and you are the creditor. I owe and you are owed. It is money, accepted by everyone in my household. Taxes can be paid only in the form of my business card. Thus, once you pay your taxes, however many cards are left is my debt (liability), and your credit (asset).

If you want to add a central bank, it's not much extra work. You leave your cards in the household bank and are given a bond certificate saying you'll get them back in one week with interest. Right now all deficit spending in the US has to be accompanied with a bond sale. The bond is a liability of the treasury. It's a treasury debt, and you're still the creditor, the gov is still the debtor. The only thing that has changed is now you'll be paid interest. Note the causality here, the currency must first be issued (the gov must go into debt) for you to save, pay taxes or buy a bond.

Now lets say the central bank buys back the bond it holds before it matures. What happens? You are given cards again. Bonds are just like a savings account at the Fed.

If the government ever wants to pay down the debt, it must tax more than it spends. This is not the equivalent of the central bank buying bonds. The former reduces net assets of the non-government sector, the latter changes the term structure of them. The effects on the economy are dramatically different.

Money will always be an asset AND a liability. All IOU's have a creditor and debtor, and money is always an IOU. It is critical to understand this, to build on any theory of money. A gang of thinkers starting with Aristotle and persisting to this day think of money just as some commonly accepted commodity (with no explanation of how it comes to be). This giant debate between the austrians/monetarists and chartalists persists to this day, and it is hugely significant to the understanding of the economy.

The Arthurian said...

The Blogger message system is a little glitchy sometimes.

If I am a contractor, doing work for the government, and I get paid for my work, the money I receive is not an IOU unless you insist on defining it that way.

If the exchange is "my time and effort" for "their money" that's an even swap. When the contract work is completed and paid for, the deal is done.

Now you want to come back and say but the money you got paid is an obligation of the government. As if the government still owes me something, because the money we use is issued by the government.

To me -- to use your word -- that's nonsensical.

Tschäff said...

Ah, this is good, I feel we are getting to the bottom of this. Money is always someone's liability, so by definition it is debt. The only exception is if you use cowrie shells, cigarettes, or some other commodity.

What I say is happening is you are confusing the theater ticket for the show. The money the government pays you, shows up on their books as a liability, for you it is an asset. Just like when the theater gives you a ticket it is your asset, you are owed. They have the liability (debt/IOU) to give you the show, they owe. The government promises to accept this IOU in payment of your taxes, although the govt debt is useful for more than just that!

I think I wasn't totally fair earlier. If the central bank buys all the treasury liabilities and exchanges it for their own liabilities (reserves and cash) it's true that the interest payments will be refunded back to the treasury, rather than go into the hands of the non-govt sector, although since 2008 the fed has paid interest on reserves, so this minor distinction between interest bearing debt vs non-interest bearing debt is limited just to cash.

The Arthurian said...

This is definitely interesting.

Before your last comment, I said the exchange of time-and-effort for money is an even swap, and concluded from this, that when the deal is done the government does not owe me anything. I objected to the view that "the government still owes me something simply because the government issued the money."

I expected you to come back and say: "No, the government doesn't owe the holder of the dollar. The government owes the holder of the asset that backs the dollar."

And then I would have said, 'Yes, but what if it is the Federal Reserve that holds that asset?"

But your comment does not say what I expected. You say the dollar is a liability to the government and an asset to me. Well, it is hard to deny that a dollar is an asset...

But again, you say the dollar is a liability to the government. I am tempted to say that the dollar they pay me is no longer on their books at all. Maybe it is on the books at the Fed, but not at Treasury. So then, you are confusing the two sets of books, I think.

Tschäff said...

"The government owes the holder of the asset that backs the dollar."

We left the system when the government promised convertibility of dollars to gold/silver entirely in 1971. This was a game changer regarding government's ability to finance itself, but most economists (textbook writers) have yet to update their models. The limit to govt spending changed from how much gold the govt could borrow or acquire to how much productive capacity exists in the economy. Inflation became the de facto spending limit.

Regarding the separation between the treasury and central bank, that is a big detailed topic for another time- but the inescapable conclusion is both the tsy and the fed spend by crediting bank accounts, and tax by debiting them. We can go into detail here, but believe me it is hugely complex.

Check out this blog to see the balance sheets that we were discussing. It is also interesting to net out the assets and liabilities of the treasury and central bank.