Tuesday, February 14, 2012

Encumbered Money


From Does expanding the amount of debt free money reduce indebtedness? at RALPHONOMICS:

Money can be split into numerous different categories. But one type of categorisation is to split money into so called “debt free” money, and in contrast, money which consists of a debt which is passed from hand to hand.

Central bank created money (monetary base) is essentially debt free. In THEORY this money is a debt owed by the central bank to the holder of such money, but central banks make absolutely no promise to give anyone anything (e.g. gold) in exchange for this money. Thus it is essentially debt free.

In contrast, commercial bank created money is essentially a debt which is passed from hand to hand. I’ll call this “debt-encumbered” money.

Yeah. Money that comes from the central bank is NOT debt.

In the days when you could turn in your paper and get a fixed amount of gold for it, yes, the paper was a promise to pay gold. It was an IOU for gold. It was a debt.

Not any more.

Today, the dollar has taken the place of gold. You don't get something FOR the dollar; you get the dollar. There is no more promise to pay something for central bank money, for government-issue money.

It's different with bank-issue money, to be sure. It's a heavy word, encumbered, but that is somehow appropriate, given the burden of private debt today.

//

Taking a second look at this...

I like Ralph's word "encumbered".
I like that he defines two types of money, encumbered and debt-free.
I really like Ralph's view that central bank money is not debt because there is "absolutely no promise to give anyone anything in exchange for this money." I would add that the central bank creates this money "from nothing" -- which means it doesn't ever have to be paid back!

I have just a touch of trouble with the notion that "commercial bank created money is essentially a debt which is passed from hand to hand." It isn't. If money was a debt, an obligation passed hand to hand, nobody would want it.

When you take out a loan, you and the bank create new money and new debt. That twin creation is a new use of credit. Then you spend the money you borrowed, and you are left with the debt. The debt does not circulate; the debt stays with the borrower. And the new money, well, once separated from the debt, it becomes indistinguishable from money created by the central bank.

The reason it is important to define two types of money has to do with debt. When you or I create money, we also create debt. But when the central bank creates money, NO DEBT IS CREATED. Our money is created by creating debt. Central bank money is not.

When you take these two types of money, or practical versions of them (like "spending money" and "total debt") and make a ratio of them, the ratio is an indicator of the cost of credit use, which must be compared to other costs in the economy.

Excessive cost inhibits growth.

The excessive cost of credit-use is an unnecessary cost. Rather than letting people create money and debt at the same time, central banks should provide enough debt-free money to accomplish to same amount of economic activity. This way there is no change at all, except interest costs are reduced, so cost-push inflation is reduced, so that profits and wages and living standards improve.

14 comments:

Jim said...

I believe the following quote is the premise upon which your whole argument hinges:

_________________________


And the new money, well, once separated from the debt, it becomes indistinguishable from money created by the central bank.

________________________

That statement isn't true. The money created by the central bank that you can get your hands on is the notes with pictures of dead presidents that you have in your wallet or under your mattress.
That money is distinguishable from the money held in accounts with deposit institutions.

The rest of the money created by the central bank is only accessible to banks and it is held in their accounts with the Federal Reserve Bank.

Jazzbumpa said...

Rather than letting people create money and debt at the same time, central banks should provide enough debt-free money to accomplish to same amount of economic activity. This way there is no change at all, except interest costs are reduced, so cost-push inflation is reduced, so that profits and wages and living standards improve.

Except it doesn't always work. Like right now, at the ZIRB liquidity trap. All the QE $$$$ are sitting in excess reserves, not circulating.

What is circulating is the derivatives market that I've harped on before - also debt-driven, btw. This is a mechanism for sucking rents out of the world-wide economy that nobody seems very concerned about.

JzB

LiminalHack said...

Excellent point Jim.

Art, how would you propose that this new 'debt free' money created by the central bank circulate?

Please be specific about the mechanics when you give your answer.

The Arthurian said...

Jim, yeah that quote is key. If I borrow a dollar and spend it, the debt stays with me but the money does not. And the guy who gets the dollar has no idea whether I borrowed it or earned it.

If I have money in accounts with deposit institutions, I can withdraw it as "cash" and it will have pictures of dead presidents on it then. Money is fungible.

Jazz, where did all that QE money get into reserve accounts? If I understand, it is because the Fed bought toxic assets and risky assets and whatever it thought it should buy, from people who have so much money they don't have to spend it. That's about it, right? Okay, now...

Liminal,

Let's say the Fed prints money and uses it to pay down debt for people, and keeps its books in balance by chalking it up to "good will" (which both Steve Waldman and I have recommended).

So the money that the Fed prints is destroyed by paying down debt, and that much debt is destroyed by the same act.

And the money that was circulating in the economy (money that was probably created by lending) is now no longer balanced by somebody's debt, but instead by the Fed's good will.

The amount of money circulating is unaffected by the Fed's action. But the amount of existing debt is reduced. So the people who are paying less on their debt will be able to keep more of their income circulating thanks to the Fed's action. They now destroy less of it by repaying their debts. So the imbalance is somewhat relieved.

Or, the Fed could buy up more Treasury debt, monetize that debt, and since the Fed turns back to Treasury some 95% of the interest on that debt, it is for all practical purposes NOT debt. However, this approach "aggrandizes" government, or so I've heard.

nanute said...

Art,
You said: "So the money that the Fed prints is destroyed by paying down debt, and that much debt is destroyed by the same act." I say, the debt will be destroyed, but not the money. If the government decides to pay off private debt, the money has to go to the creditor. Doesn't it? It's a bit like QEII where the government "purchased" a lot of toxic assets. Except in this case, the debt wasn't destroyed either.

The Arthurian said...

Nanute, If lending creates money, then paying down debt destroys money. (I didn't make up that rule.)

If you put a dollar in the bank and I borrow it, now each of us has a dollar. And if the Fed prints a dollar and pays off my debt, the credit-in-use ceases to exist. But you do NOT now have an extra dollar because of it. Right?

At the bank, because of the Fed's action the saver's money becomes available again for lending (if the bank needs it for that purpose). And the bank is in a better position, less fragile, because a dollar is less risky than a debt. But the bank now has fewer loans that it is making money on, because some of its loans were paid off.

I think Keynes would say that the "liquidity" is no longer tied up by borrowers, because the Fed paid off the debt.

The Arthurian said...

I said: "If you put a dollar in the bank and I borrow it, now each of us has a dollar. And if the Fed prints a dollar and pays off my debt, the credit-in-use ceases to exist. But you do NOT now have an extra dollar because of it. Right?"

If the Fed prints money and uses it to pay off debt, this is just a balance-sheet correction I think.

And just what we need for a "balance sheet recession".
Call me Koo-koo.

The Arthurian said...

I said: "But the bank now has fewer loans that it is making money on, because some of its loans were paid off."

And that is a good thing, if you think that finance is too big as a portion of GDP. The way to reduce finance is to make it a less necessary part of everyday life. If a by-product of that policy is that everybody has less debt, so much the better!

nanute said...

Art,
I would say that paying down debt, destroys debt. Your arguing that the money disappears as well? I think it (paying off debt), frees up capital(money), for more useful purposes in theory. I could be wrong, but I think the only way money can be "destroyed" in a fiat currency system, is for the government to shrink the base.
I'm not against paying down private debt. In fact I think it is necessary under current conditions. I just don't see how paying down debt destroys currency.

nanute said...

beginning of second sentence should read: you are, not your.

The Arthurian said...

Nanute,
I quoted the textbook I had for Economics 101 here: It seems logical to inquire whether money is destroyed when the loans are repaid. The answer is "Yes."

That's just a textbook. But I think... I don't DO accounting, but I think if you do the accounting, you get the same thing: taking a loan creates money, and repaying a loan destroys money. I think it has to be true, or the books won't balance.

Plus, all that concern about "deflation" arose because people were borrowing less and paying back more, with the result that the money supply was shrinking. Money was being destroyed by the repayment of debt.

The easiest way for me to see it is by symmetry. Taking out a loan and paying back a loan are opposites. So if taking a loan creates money, then paying back a loan must destroy money.

nanute said...

Does textbook make the assumption that a third party is involved in the transaction? Private lender, private debtor and government actor paying off private lender debt?

The Arthurian said...

"Does textbook make the assumption that a third party is involved in the transaction?"

No, Nute, it doesn't. But the money and the debt are not attached to each other. It's like those particles in physics that come into existence out of nowhere, and they always come in pairs...
When they come back together again, they are annihilated.

And I don't know about the particles, but with money and debt, it is the amount that matters. You don't have to pay back a debt using dollars that have the same serial numbers as the dollars you borrowed.

I think I know what bothers you about this third party thing. The NEW money that the government prints is destroyed when the debt is destroyed, but the OLD money that was lent out CHANGES from being bank-issue money, to being government-issue money. (And if you think about THAT in terms of debt-per-dollar, you can see that it reduces the ratio, which is why I keep saying it over and over.)

So the guy with money in the bank now has government-issue rather than bank-issue. But does this make a difference? I don't think it does.

The Arthurian said...

I said:
The NEW money that the government prints is destroyed when the debt is destroyed, but the OLD money that was lent out CHANGES from being bank-issue money, to being government-issue money.

So the guy with money in the bank now has government-issue rather than bank-issue. But does this make a difference? I don't think it does.


That was a little incomplete.

It doesn't make any difference to the guy who ends up with the money.

It makes a BIG difference to the guy who created that money by taking out a loan.

What's different for him is, he's not still paying interest forever on that money. Oh, and that's how we know it isn't bank money. Not paying interest.