Post by oliver on Oct 26, 2018 7:36:49 GMT
A matter of interest
I recently reread the following papers by Alfred Mitchell-Innes:
What is money
The credit theory of money
I was quite intrigued by their depth and prescience and I can recommend them to anyone. Maybe they can give you, JP, a better idea of where Antti and I are coming from than the things we've written ourselves. They tie in nicely, I find.
There is one critique raised by the host of that website:
So, mustering all my hubris, I thought I'd remedy that shortcoming by whipping up a chapter on the subject myself, illustrating it at times with the language of my previous post, namely that of red and green paper money.
A quick recap to begin with:
Green money is bank money as we know it. Red money is the corresponding debt held by someone else. Red and green bits of paper are netted against one another if they belong to the same person / institution. There is an individual cap to the amount of net red money any person may hold which is determined by the bank.
People receive green money (from the bank; ex nihilo, if you like) when they give away goods but do not receive goods in return. The receivers of goods receive red money (also from the bank; ex nihilo, if you like) along with the goods. To get rid of their obligation (red money), they have to sell goods to someone with access to green money or someone able to receive more red money as per their individual debit limit. If you think of a two person economy, a first sale will produce an equal amount of red and green money. In a second transaction involving goods of the same value, the creation of both red and green money can be reversed, leaving both with a different set of goods as to begin with but with both accounts at zero (no money, no debt). The net effect of such a closed credit circuit is identical to a barter transaction. It is the 'sanctity of the obligation' or 'the law of debt', to quote Mitchell-Innes, i.e. the assumption that the goods given up in the original transaction can and will be returned at some point, that gives the bits of paper their value, whereby red and green values are inverse.
Until now, interest rates have not entered the story. I have assumed that all goods given will be returned 1:1 and that neither time, nor risk nor any other 'disturbance' enters the equation. In order to start thinking about interest rates, I think risk is the place to start.
Going back to the two person economy from above, one can imagine that, after the first sale, things do not go as planned. The person who received the goods might not come up with the goods of equal value within the agreed timeframe. The timeframe could be the duration of a loan, or, in the case of an overdraft, e.g. the lifetime of the person (death) or corporation (bankruptcy). It is insubstantial whether we think of one transaction being reciprocated or a chain of transactions.
There are three sides to each transaction. There is the obligee, the creditor and an institution which transforms an ordinary loan / overdraft (red money) into what we call money (green money).
So the input is an imperfect promise to sell goods in the future whereas the output is a paper that promises to be exchangeable for goods in the future but with no risk to the bearer (or let's say: as little as possible). Something, or more like someone, has to give. In this case, it is the obligees who agree to give more goods than they have received. They collectively make up for those obligees who fail to make good on their promises in order to make money a 'riskless asset'. i.e. to make creditors (including themselves) 'whole'. To illustrate that, let's imagine an economy consisting of, say thirteen people, one creditor and twelve debtors. Two in twelve debtors are expected to die before paying back any of their debts, leaving the ten others to come up with 1.2 x the goods they originally received. The creditors thus can recoup all twelve goods they originally gave up, again leaving all accounts at zero. In terms of red and green money, this can be thought of either as a drain of green paper from debtors to compensate for the red papers of the dead debtors so that they can be written off, or, more morbidly, a transfer of red money from the dead to the living.
Of course, the projection of how many debtors will 'die' / 'come up short' is just that - a projection - and thus will turn out to be somewhat imprecise. To compensate for that imprecision, creditors are invited to pledge a portion of their green papers, allowing them to partake in the upside but also downside risk involved in making those projections. Those special credits are called bank equity. If a bank 'uses up' its equity cushion, it can either close (break the buck) or find someone to pitch in new equity. In the special case of the state owned bank, see the previous post on central bank equity by Antti.
The nominal amount of credits demanded from debtors per year above the amount of the principal loan is an interest rate. In theory, it is the only interest rate necessary to keep the system up and running. Also somewhat theoretically, it is determined separately for each loan or, in the case of an overdraft provision, for each transactor. Competition among banks prevents them from raising rates too far above that necessary rate.
We can also compare this to bilateral lending. In that case, there is no separation between holders of 'money' claims and equity holders. The bearer is always both as she directly bears the risk of the lender.
Until now, I have silently assumed that the nominal purchasing power of the green bits is sufficiently stabilised by the system described above. In reality, this may not be the case. For reasons that are beyond the influence of any bank, the value of green and red bits as measured in real goods may deteriorate or improve over time (abruptly or continuously).
In the interest of keeping the real value of money claims as stable as possible - I assume this to be a primary goal and in fact the raison d’être of money as such - a policy making bank can use its power to set interest rates to compensate for any such unintended change. If prices are observed to be rising at say 2% annually, banks can debit the accounts of net debtors at the same rate and credit net creditors accordingly, thus keeping real purchasing power constant. And of course, a policy making bank can follow other objectives than just aiming at price stability, and it also has other tools at hand, for example discounting government bills, to target the above or any other goal.
Whether such a policy influences the economic behaviour of market participants or whether it itself influences the real value of money claims and thus creates feedback loops is beyond the explanatory power of this simple theory (as far as I understand it) and it's probably best left to empirical researchers and psychologists. They might find that higher lending rates diminish the appetetite for new loans and possibly push some borrowers into insolvency for example. On the other hand, higher interest paid on monetary savings may have the opposite effect. I don't think monetary theory can tell us, which of the two effects is more potent. It may also depend on other circumstances.
Since I’ve done a quick sketch of monetary policy (setting rates / discounting government bills), I might as well finish off with an equally quick and dirty dip into fiscal policy.
When a government spends, it does so in the name of its tax payers. Any debt accumulated by government can only be serviced by the taxpayer.
It is often said of ‚fiscal stimulus’ that an increase in spending is identical to a tax cut in terms of the effects it has on the economy. I don’t know about the effect, again that is a matter of empirics (or politics), but in light of the above and also the previous discussions on this board, I think we can be more precise about what it is the is going on in either case.
Taking the credit cycle as the basic economic building block, an increase in spending is in effect the opening of a new circuit. Goods are purchased by government (from someone), incurring a new debt on the taxpayer.
When taxes are reduced, no goods change hands. Instead, similar as with monetary policy as described above, the terms of existing (and potential new circuits) are changed. In one case, it is the interest rate that changes, in the other it is the payment schedule. In both cases, the ‚burden‘ for producing higher economic activity (measured in new credit circuits), is on the individual taxpayer - unlike when government spends itself. Otherwise, it just remains a new tax burden.