The Backing Theory of Money v. the Quantity Theory of Money

Mike Sproul and Scott Sumner were arguing last week about how to account for the value of fiat money and the rate of inflation. As I observed in a recent post, I am doubtful that monetary theory, in its current state, can handle those issues adequately, so I am glad to see that others are trying to think the problems through even if the result is only to make clear how much we don’t know. Both Mike and Scott are very smart guys, and I find some validity in the arguments of both even if I am not really satisfied with the arguments of either.

Mike got things rolling with a guest post on JP Koning’s blog in which he lodged two complaints against Scott:

First, “Scott thinks that the liabilities of governments and central banks are not really liabilities.”

I see two problems with Mike’s first complaint. First, Mike is not explicit about which liabilities he is referring to. However, from the context of his discussion, it seems clear that he is talking about those liabilities that we normally call currency, or in the case of the Federal Reserve, Federal Reserve Notes. Second, and more important, it is not clear what definition of “liability” Mike is using. In a technical sense, as Mike observes, Federal Reserve Notes are classified by the Fed itself as liabilities. But what does it mean for a Federal Reserve Note to be a liability of the Fed? A liability implies that an obligation has been undertaken by someone to be discharged under certain defined conditions. What is the obligation undertaken by the Fed upon issuing a Federal Reserve Note. Under the gold standard, the Fed was legally obligated to redeem its Notes for gold at a fixed predetermined conversion rate. After the gold standard was suspended, that obligation was nullified. What obligation did the Fed accept in place of the redemption obligation? Here’s Mike’s answer:

But there are at least three other ways that FRN’s can still be redeemed: (i) for the Fed’s bonds, (ii) for loans made by the Fed, (iii) for taxes owed to the federal government. The Fed closed one channel of redemption (the gold channel), while the other redemption channels (loan, tax, and bond) were left open.

Those are funny obligations inasmuch as there are no circumstances under which they require the Fed to take any action. The purchase of a Fed (Treasury?) bond at the going market price imposes no obligation on the Fed to do anything except what it is already doing anyway. For there to be an obligation resulting from the issue by the Fed of a note, it would have been necessary for the terms of the transaction following upon the original issue to have been stipulated in advance. But the terms on which the Fed engages in transactions with the public are determined by market forces not by contractual obligation. The same point applies to loans made by the Fed. When the Fed makes a loan, it emits FRNs. The willingness of the Fed to accept FRNs previously emitted in the course of making loans as repayment of those loans doesn’t strike me as an obligation associated with its issue of FRNs. Finally, the fact that the federal government accepts (or requires) payment of tax obligations in FRNs is a decision of the Federal government to which the Fed as a matter of strict legality is not a party. So it seems to me that the technical status of an FRN as a liability of the Fed is a semantic or accounting oddity rather than a substantive property of a FRN.

Having said that, I think that Mike actually does make a substantive point about FRNs, which is that FRNs are not necessarily hot potatoes in the strict quantity-theory sense. There are available channels through which the public can remit its unwanted FRNs back to the Fed. The economic question is whether those means of sending unwanted FRNs back to the Fed are as effective in pinning down the price level as an enforceable legal obligation undertaken by the Fed to redeem FRNs at a predetermined exchange rate in terms of gold. Mike suggests that the alternative mechanisms by which the public can dispose of unwanted FRNs are as effective as gold convertibility in pinning down the price level. I think that assertion is implausible, and it remains to be proved, though I am willing to keep an open mind on the subject.

Now let’s consider Mike’s second complaint: “Scott thinks that if the central bank issues more money, then the money will lose value even if the money is fully backed.”

My first reaction is to ask what it means for money to be “fully backed?” Since it is not clear in what sense the inconvertible note issue of a central bank represents a liability of the issuing bank, it is also not exactly clear why any backing is necessary, or what backing means, though I will try to suggest in a moment a reason why the assets of the central bank actually do matter. But again the point is that, when a liability does not impose a well-defined legal obligation on the central bank to redeem that liability at a predetermined rate in terms of an asset whose supply the central bank does not itself control, the notion of “backing” is as vague as the notion of a “liability.” The difference between a liability that imposes no effective constraint on a central bank and one that does impose an effective constraint on a central bank is the difference between what Nick Rowe calls an alpha bank, which does not make its notes convertible into another asset (real or monetary) not under its control, and what he calls a beta bank, which does make its liabilities convertible into another asset (real or monetary) not under its control.

Now one way to interpret “backing” is to look at all the assets on the balance sheet of the central bank and compare the value of those assets to the value of the outstanding notes issued by the central bank. Sometimes I think that this is really all that Mike means when he talks about “backing,” but I am not really sure. At any rate, if we think of backing in this vague sense, maybe what Mike wants to say is that the value of the outstanding note issue of the central bank is equal to the value of its assets divided by the amount of notes that it has issued. But if this really is what Mike means, then it seems that the aggregate value of the outstanding notes of the central bank must always equal the value of the assets of the central bank. But there is a problem with that notion of “backing” as well, because the equality in the value of the assets of the central bank and its liabilities can be achieved at any price level, and at any rate of inflation, because an increase in prices will scale up the nominal value of outstanding notes and the value of central-bank assets by the same amount. Without providing some nominal anchor, which, as far as I can tell, Mike has not done, the price level is indeterminate. Now to be sure, this is no reason for quantity theorist like Scott to feel overly self-satisfied, because the quantity theory is subject to the same indeterminacy. And while Mike seems absolutely convinced that the backing theory is superior to the quantity theory, he himself admits that it is very difficult, if not impossible, to distinguish between the two theories in terms of their empirical implications.

Let me now consider a slightly different way in which the value of the assets on the balance sheet of a central bank could affect the value of the money issued by the central bank. I would suggest, along the lines of an argument made by Ben Klein many years ago in some of his papers on competitive moneys (e.g. this one), that it is meaningful to talk about the quality of the money issued by a particular bank. In Klein’s terms, the quality of a money reflects the confidence with which people can predict the future value of a money. It’s plausible to assume that the demand (in real terms) to hold money increases with the quality of money. Certainly people will tend to switch form holding lower- to higher-quality moneys. I think that it’s also plausible to assume that the quality of a particular money issued by a central bank increases as the value of the assets held by the central bank increases, because the larger the asset portfolio of the issuer, the more likely it is that the issuer will control the value of the money that it has issued. (This goes to Mike’s point that a central bank has to hold enough assets to buy back its currency if the demand for it goes down. Actually it doesn’t, but people will be more willing to hold a money the larger the stock of assets held by the issuer with which it can buy back its money to prevent it from losing value.) I think that is ultimately the idea that Mike is trying to get at when he talks about “backing.” So I would interpret Mike as saying that the quality of a money is an increasing function of the total asset holdings of the central bank issuing the money, and the demand for a money is an increasing function of its quality. Such an adjustment in Mike’s backing theory just might help to bring the backing theory and the quantity theory into a closer correspondence than one might gather from reading the back and forth between Mike and Scott last week.

PS Mike was kind enough to quote my argument about the problem that backward induction poses for the standard explanation of the value of fiat money. Scott once again dismisses the problem by saying that the problem can be avoided by assuming that no one knows when the last period is. I agree that that is a possible answer, but it means that the value of fiat money is contingent on a violation of rational expectations and the efficient market hypothesis. I am sort of surprised that Scott, of all people, would be so nonchalant about accepting such a violation. But I’ve already said enough about that for now.

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34 Responses to “The Backing Theory of Money v. the Quantity Theory of Money”


  1. 1 JP Koning June 9, 2014 at 8:39 pm

    While we’re on the topic, I’d like to enter this post into the discussion.

    http://jpkoning.blogspot.ca/2014/05/from-corporate-bonds-to-fiat-cpi.html

  2. 2 PeterP June 10, 2014 at 4:02 am

    The value of money is determined by the state. Say the state taxes everybody 100 D units per head. Before any D units are spent, everybody is unemployed looking for work paying D units. Then the state decides to spend some D units into existence by paying say 2 units for a carrot and 1 unit for an hour of labor. The price level is set. It could have decided on 20 and 10 units respectively. That our governments act like price takers adds to the confusion. A monopoly supplier is the price setter, it should set the price and let the quantity float.

  3. 5 Frank Restly June 10, 2014 at 9:56 am

    David,

    “But what does it mean for a Federal Reserve Note to be a liability of the Fed? A liability implies that an obligation has been undertaken by someone to be discharged under certain defined conditions.”

    “The willingness of the Fed to accept FRNs previously emitted in the course of making loans as repayment of those loans doesn’t strike me as an obligation associated with its issue of FRNs.”

    A means of exchange should have the following desirable properties:

    1. Divisibility – Cows = bad, sheets of paper with numbers / electronic accounts = good
    2. Portability – Cows = bad, foldable sheets of paper / electronic accounts = good
    3. Fungibility – Cows = bad, identicle sheets of paper / electronic accounts = good

    The Federal Reserve Note is a liability of the Fed because it is in charge of choosing the means by which tax liabilities are discharged (cows = bad, paper = good). The choice of means will alter the effectiveness of the federal government in its ability to collect taxes.

    The obligation of the Fed is continuous and thus never discharged – like saying your prayers and eating your vitamins.

  4. 6 Tom Brown June 10, 2014 at 12:06 pm

    David, I also found Mike Freimuth’s post on this interesting:

    http://realfreeradical.com/2014/06/06/sproul-and-sumner-on-backing-and-quantity-theory-of-money/

    In it, he argues that ““backing” and QTM are not exactly mutually exclusive.”

    I also find the following approach interesting, from which the QTM is a special case (when the slowly varying information transfer index, kappa, of an economy is equal to 0.5: see equation 6):

    http://informationtransfereconomics.blogspot.com/2014/03/how-money-transfers-information.html

    When kappa ~= 1, then dP/dM ~= 0 (more like the situation in Japan and Switzerland, if the theory is correct). Mike Freimuth comments on this approach in the response to me in the comments. He’s not exactly sold.

    Also, you might take a look at this post by Nick Edmonds:

    http://monetaryreflections.blogspot.com/2014/06/bank-lending-and-value-of-money.html#comment-form

  5. 7 Philo June 10, 2014 at 8:14 pm

    “[M]aybe what Mike wants to say is that the value of the outstanding note issue of the central bank is equal to the value of its assets divided by the amount of notes that it has issued.” If Mike is failing to distinguish between the central bank and the government as a whole, the assets in question (*net* assets?) will be those of the government. Since the government has a rather indeterminate power to tax, and thus an indeterminate claim on private wealth, it will be hard to pin down the extent of the government’s “assets.” In any case, this way of determining the value of the unit of account is obviously defective: the intersection of the supply and demand curves for a dollar need not equal the government’s assets (however determined) divided by the number of dollars issued.

    “[T]he quality of a particular money issued by a central bank increases as the value of the assets held by the central bank increases . . . .” In practice, this factor seems to be of negligible importance.

  6. 8 Mike Sproul June 10, 2014 at 10:04 pm

    Start by looking at the DENOMINATION of the central bank’s assets. The Fed’s assets can be denominated in ounces of gold, or they can be denominated in dollars. When assets are denominated in gold, things are easy. Assets are worth 100 oz., and the Fed has issued $100 in currency. $1 is therefore worth 1 oz., and the Fed redeems its FRN’s for 1 oz. worth of assets on demand. Everyone agrees that FRN’s are a “true” liability of the Fed because the Fed is “required” to redeem $1 worth of FRN’s for 1 oz. worth of assets. Nothing complicated yet.

    We can even go further and assert that the Fed could triple the quantity of dollars issued, from $100 to $300, and as long as the Fed also triples the quantity of its assets from 100 oz. to 300 oz., and always stands ready to redeem $1 in FRN’s for 1 oz. worth of the Fed’s assets, then the tripling of the money supply would cause no inflation. I daresay that most quantity theorists would actually agree, given these conditions, that the backing theory is correct: More money does not cause inflation as long as it is adequately backed and convertible. We would all probably hasten to point out that if the extra $200 was not wanted in the circulation, then it would reflux to the Fed to be redeemed in gold, but this is still pretty uncomplicated.

    But now let’s make things difficult. What if the Fed issued that extra $200 of FRN’s, not for 200 OUNCES worth of bonds, but for 200 DOLLAR’S worth of bonds. There’s nothing financially illegitimate about this. The Fed still stands ready to redeem its FRN’s, not for 1 oz. worth of assets, but for 1 dollar’s worth of assets. The public still values $1 at 1 oz. Quantity theorists might not be comfortable with the idea, but the plain fact is that changing the denomination of the Fed’s assets is just changing a name. The Fed, we suppose, originally issued the $200 of FRN’s for 200 OUNCES worth of bonds. The Fed still has the same 200 oz. worth of bonds, but they have removed the tag that said “200 ounces worth of bonds”, and replaced it with a tag that says “200 dollar’s worth of bonds”. Nothing else has changed.

    I even have some math to go along with this. Let E=the value of the dollar (oz./$). Setting the Fed’s assets (100 oz plus bonds worth 200E ounces) equal to liabilities 300 dollars worth E ounces each) yields:

    100+200E=300E

    Solving, we find E=1 oz./$. The dollar is still worth 1 oz., even though the Fed is now backing its dollars with dollar-denominated assets.

    Now suppose that the public wants to hold $300 of currency during the Christmas season, and $250 the rest of the year. At the start of Christmas, $50 of FRN’s will be issued in exchange for $50 of bonds, and after Christmas, the Fed will sell $50 of bonds to soak up the unwanted $50 of FRN’s. That $50 could have just as easily been issued and soaked up in exchange for the Fed’s gold, and the dollar would remain worth 1 oz. either way.

    But then David makes this argument:

    “when a liability does not impose a well-defined legal obligation on the central bank to redeem that liability at a predetermined rate in terms of an asset whose supply the central bank does not itself control, the notion of “backing” is as vague as the notion of a “liability.”

    This is an incorrect usage of the word “liability”. I occasionally write IOU’s to my friends that say something like “IOU $10 for the movie tickets you gave me”. This IOU creates no “well-defined legal obligation”, but it is my liability just the same, and every accountant would enter that IOU on the liability side of my balance sheet. It’s the same with the Fed. Maybe Fed officials stand ready to buy back $50 of FRN’s after Christmas because they think a policeman will arrest them if they don’t. Or maybe they are afraid that Congressmen and historians will say mean things about them if they don’t. It doesn’t matter that Fed officials feel under obligation to buy back that $50. It only matters that they do buy them back. That’s all that it means for FRN’s to be the Fed’s liability, and that’s why every accountant worthy of the name will enter FRN’s on the liability side of the Fed’s balance sheet, even when gold convertibility has been suspended.

  7. 9 David Glasner June 11, 2014 at 10:12 am

    JP, Thanks for the link. Interesting story, and you tell it well. But I’m still not convinced.

    PeterP, And what determines the rate of change in the price level?

    Frank, OK, so you are treating the Fed and the government as a single entity. I am ok with that. You are saying that FRNs are a liability of the Fed/Treasury, because the Fed/Treasury obligates you (me) to discharge your (my) tax obligation to the Fed with FRNs.

    Tom, Sounds like Freimuth and I may be saying something similar. Will have a look. Thanks for the other links as well.

    Philo, Just guessing, but I think that Mike might say that people are forming estimates of what the available assets of the Fed/government really are worth and the value of money is in some sense a reflection of those estimates.

    Why do you think the value of the assets held by (or available to) the central bank are of negligible importance to the real demand for the money issued by the central bank?

    Mike, The difference between you and the Fed is that for you to discharge your IOU (regardless of the what you are legally required to do) you have to obtain FRNs with which to “redeem” your IOU. It is not clear to me or to anyone what constitutes redemption by the Fed.

  8. 10 Mike Sproul June 11, 2014 at 7:55 pm

    David:
    “Redemption by the Fed” is clear in the case of gold convertibility. 1 dollar of FRN’s is redeemed for 1 oz. But if the dollar has a long-established value of 1 oz, then the Fed could just as well redeem $1 of its FRN’s for a $1 bond that is itself denominated in dollars, rather than ounces. In a standard open-market purchase, the Fed issues $1 million in FRN’s for a bond that could have traded in the market for $1 million. The next day, the Fed could sell that $1 million bond for $1 million in FRN’s, thus redeeming the FRN’s.

    This question of “redeeming a dollar for a dollar’s worth of bonds” seems to be at the heart of our argument. Probably worth a few blog posts by itself.

  9. 11 Frank Restly June 12, 2014 at 7:04 am

    David,

    “OK, so you are treating the Fed and the government as a single entity.”

    In the sense that regulating money is a shared responsibility between the Fed and government – yes.

    More to the point, I was trying to illustrate that not all liabilities have a fixed term over which they are discharged. Some liabilities are continuously maintained.

  10. 12 sumnerbentley June 12, 2014 at 7:18 am

    David, I didn’t know that not knowing the precise date of the end of the world was “irrational” or “inefficient”. So when will the end of the world occur? Or (more likely) did I misunderstand your final paragraph?

    You also left off the second half of my answer, which is that there are cases where the end of the world is known, say Germany in 2001, and in those cases the public does believe currency is “backed.” German marks were backed with euros.

    I had the same view of Mike’s hypothesis as you do. I thought that “backing” meant that central banks held bond assets equal to their monetary base liabilities. He has informed me that this is incorrect. If the Fed does not have any window for “reflux” this does not represent backing in his view. Hence our current money base is unbacked, and OMPs can be inflationary, even if the Fed purchases an equal amount of bonds.

  11. 13 Mike Sproul June 12, 2014 at 12:22 pm

    Yes, it’s important to understand that assets don’t really back the currency unless currency holders have some way to get those assets. A bank that holds 100% assets but provides no reflux channel is actually providing 0% backing. At the other end of the spectrum, a bank that has open reflux channels, but has no assets, is also providing 0% backing. Reflux operates through the various types of convertibility that a bank might offer, and these are surprisingly varied. Convertibility (and reflux) can be instant or delayed, certain or uncertain, denominated in commodities, foreign money, or in the bank’s own money, at the customer’s option or at the bank’s option, etc.

  12. 14 Nick Edmonds June 13, 2014 at 10:19 am

    Mike,

    In your mathematical example, what happens if the Fed (holding 200 dollars of bonds) sells off all its gold for dollars? Does the value require that the Fed holds some gold, even if it is a vanishingly small amount?

  13. 15 Mike Sproul June 13, 2014 at 1:01 pm

    Nick:

    If the fed holds no physical assets, then the value of the dollar is indeterminate. The less obvious problem is that the potential volatility rises as the fed holds less gold.

    Example:

    When the fed holds 100 oz plus $200 of bonds as backing for $300 of FRN’s, the equation is

    100+200E=300E, so E=1 oz/$

    But if the Fed is robbed of 30 oz (a 10% loss of assets) then the equation becomes:

    70+200E=300E, or E=0.7 oz/$

    In other words, a 10% loss of assets causes a 30% inflation. This “inflationary feedback” effect is more pronounced as the fed’s holdings of gold fall relative to it’s ($ denominated ) bond holdings.

  14. 16 JP Koning June 13, 2014 at 5:49 pm

    David, it’s too bad that I didn’t manage to convince you. At what point did you stop buying my argument?

    ” But what does it mean for a Federal Reserve Note to be a liability of the Fed? A liability implies that an obligation has been undertaken by someone to be discharged under certain defined conditions. What is the obligation undertaken by the Fed upon issuing a Federal Reserve Note.”

    What sort of obligation has been undertaken by company x that has issued non-dividend paying shares? Company x is not legally obligated to redeem its shares for gold at a fixed predetermined conversion rate, but that would probably not prevent us from saying x hasn’t assumed some sort of liability to shareholders. If not, its shares would most likely be worthless.

    I’d argue that the circumstances under which x is required to take action to discharge its obligation to shareholders are very similar to the circumstances under which the Fed is required to take action to serve its noteholders & depositors. Because there is no qualitative difference between the two circumstances, only a difference of degree, the same principles apply to the both.

  15. 17 David Glasner June 15, 2014 at 9:40 am

    Mike, Thanks for the suggestion. I will keep it in mind as I continue to think about the issues you raise.

    Frank, The Fed’s ongoing responsibility is unspecified, and it has complete discretion over how it discharges that responsibility. That is entirely different from a contractual or legal obligation to perform certain actions.

    Scott, My point is that if the existence of the end state is known, the timing question is irrelevant under the standard rationality assumptions, which entail backward induction. Once you know the value is zero in the last period, it’s trivial that the values are zero in the preceding ones, regardless of how many there are. If rational expectations and EMH mean that market prices today anticipate the equilibrium (fundamental) value in the future, persistent deviation from the long-term fundamental value seems involve some irrationality. I can live with that; apparently you can too. But I am surprised that you are so blasé about it.

    Why is the transition from the D-mark to the euro analogous to the end of the world? It’s not the end of the world, just a conversion from one currency to another at a known predetermined exchange rate.

    Mike (and Scott), I think that you sum it up well. When there is no fixed (and enforceable) convertibility commitment, the valuation of the currency becomes highly conjectural, which provides a channel through which the issuer may be able to control the value of its currency.

    Nick, Fischer Black wrote a paper a very long time ago about a gold standard with zero reserves, “A Gold Standard with Double Feedback and Near Zero Reserves” reprinted in his book Business Cycles and Equilibrium.

    JP, When the corporate bond becomes redeemable only in terms of an asset that the corporation itself issues in potentially unlimited quantities.

    Shares confer ownership rights to the assets of the corporation. The value of those rights are tradable and are valued at whatever people think they are worth. What ownership rights to what assets are conferred by holding US currency?

  16. 18 sumnerbentley June 15, 2014 at 10:43 am

    David, I meant the end of the world for the German Mark. It was removed from circulation. But it was backed when it was removed.

    My comment on your end of the world example is that it does not apply to a scenario where there is 1/1000 of a chance of the world ending each year. In that case there is nothing to apply backward induction to. And that seems to me to be the most plausible way to think about the actual views that people have regarding the end of the world.

  17. 19 David Glasner June 15, 2014 at 1:07 pm

    Scott, I know that’s what you meant about the German mark. The backward induction argument is not about the end of the world for the German mark it is about the end of the world period.

    The point of the backward induction argument is that the probability of the world does not stay at 1/1000, but eventually becomes very high. I think that physicists are pretty sure that the world will come to an end within a couple of billion years, so at some point, the probability of the world ending in the next time period will certainly approach one.

  18. 20 Julian Janssen June 16, 2014 at 5:57 am

    David,

    I’ve been away a while, but I think I may have a minor point to contribute… As I was thinking about your discussion of the obligation of a central bank under the gold standard, I think there is little difference between the gold standard and how the federal reserve operates with regard to whether federal reserve notes are a liability for the fed. What exactly happens if people want to offload their gold in exchange for currency in a gold standard? They can exchange them for notes with the central bank. If they want to redeem gold for the notes, the bank is will make the trade, if the target price for gold is met by each transaction. Now think of what the fed does today… It generally decides what yields will be on treasuries in order to provide adequate support to aggregate demand while not giving rise to excessive inflation. And to affect the yields, the bank buys and sells treasuries through OMO. In effect, to get a given yield, the bank sets the price of the treasuries and will credibly buy or sell them, as appropriate, to reach the yield target. This is much like a gold standard, except that rather than having an open-ended commitment to keep the price of gold fixed, the bank is essentially making a short-run commitment to keep treasury prices at X in order to achieve Y yields. Obviously, it is not as much an obligation of the fed than under a gold standard, but there is effectively an obligation it places upon itself.

  19. 21 Tom Brown June 16, 2014 at 9:50 am

    David, not just the world, but it’s a good bet (according to modern physicists/cosmologists) that the universe will end. The rate of expansion is supposedly accelerating rather than slowing down… which indicates a long cold future. So maybe not “end” but an infinite future with highest temperature to be found asymptotically approaching absolute zero?. But that’s the long term. Mid term, a super-nova-ing sun should make it rather toasty in these quarters (not to mention the heat thrown off by the imminent collision the milky way is supposed to have with our neighboring galaxy). One way or another, the smart money is on doom and gloom mid to long term (even if physicist Michio Kaku is right, and we’re on the brink of achieving “immortality” via personality and memory capturing electronic recordings of our brain states)

  20. 22 JP Koning June 16, 2014 at 4:18 pm

    David: “What ownership rights to what assets are conferred by holding US currency?”

    The ownership rights conferred by holding US currency are the same ownership rights that are conferred by holding highly liquid perpetual bonds issued by a corporation.

    “When the corporate bond becomes redeemable only in terms of an asset that the corporation itself issues in potentially unlimited quantities.”

    If a corporation only redeems a bond with another bond, then it has created perpetual bonds. But perpetuals are fairly common financial instruments. No one would say they have no fundamental value.

  21. 23 David Glasner June 16, 2014 at 8:31 pm

    Julian, The Fed is free to choose whatever target it wants for the interest rate it is setting. Under the gold standard, the bank is legally committed to keeping the price of gold pegged at a prescribed rate.

    Tom, I agree, but the world will come to an end before the universe does.

    JP

    You said:

    “The ownership rights conferred by holding US currency are the same ownership rights that are conferred by holding highly liquid perpetual bonds issued by a corporation.”

    And in the blog post to which you provided a link in your earlier comment you said:

    “The market values these no-interest bonds in the same way they do the normal bonds. Both have first dibs come final liquidation.”

    Can you tell me where it says that holders of US currency have any liquidation rights over the assets of the US government? Sorry, but I think it is preposterous to say that there are any rights to the liquidation of the US government.

    Perpetual bonds are common financial instruments, and they are all promises to pay a perpetual stream of payments in the currency of some sovereign government, not in instruments issued by the same corporate entity that is issuing the bond.

  22. 24 Julian Janssen June 17, 2014 at 5:36 am

    David,

    You are absolutely right about that, but if the fed is in the short-run committed to a given target interest rate, it is essentially akin to setting a short-run price for gold. If the fed wants to meet that target, it will have to conduct open market operations to keep the bond prices and hence the bond yields “on target”.

    Maybe I’m missing a deeper point here, but I don’t think I’m wrong.

  23. 25 JP Koning June 17, 2014 at 7:30 pm

    “Can you tell me where it says that holders of US currency have any liquidation rights over the assets of the US government?”

    Not over the assets of the government, but over the assets of the central bank. Here is the fine print from central bank legislation.

    “Perpetual bonds are common financial instruments, and they are all promises to pay a perpetual stream of payments in the currency of some sovereign government, not in instruments issued by the same corporate entity that is issuing the bond.”

    I’m not sure I agree. We can imagine a corporation that issues perpetual bonds and promises to pay a stream of interest payments that are to be payable not in currency but in units of the corporation’s own perpetual bonds. The corporation’s perpetuals will still have fundamental value despite the fact that interest is provided in terms of those very same instruments. (The firm will either issue new perpetuals to pay interest, in which case the new perpetuals displace shareholders’ claims on liquidation value, or it will repurchase existing perpetuals [or earn them] and use this income to pay interest, which is what central banks like the Fed do).

  24. 26 Frank Restly June 18, 2014 at 12:28 pm

    JP,

    “We can imagine a corporation that issues perpetual bonds…”

    Perpetual corporate bonds imply that a company has a monopoly enterprise.

    “The corporation’s perpetuals will still have fundamental value…”

    That fundamental value would be the liquidation value of the company. But if the company has a monopoly position, then it can never face liquidation. Hence perpetual bond buyers can never realize that liquidation value and so perpetual bonds only have value when they make interest payments in the medium of exchange.

    Perpetuals that pay interest in perpetuals have no value at all because of the implicit assumption that the company issuing the perpetuals will never be liquidated.

  25. 27 Tom Brown June 18, 2014 at 1:02 pm

    David, O/T: If I recall correctly you’re a critic of the way micro-foundations are sometimes promoted or insisted upon, correct? You might enjoy this way of looking at the issue:

    http://informationtransfereconomics.blogspot.com/2014/06/what-if-money-was-made-of-vinegar.html

  26. 28 Mike Sproul June 18, 2014 at 1:14 pm

    Frank:

    Land yields a rent in perpetuity. A company that owned land could issue perpetual bonds, and wouldn’t have to be a monopoly.

  27. 29 Frank Restly June 18, 2014 at 1:34 pm

    Mike,

    But if there is more than one land owner, an individual parcel of land may not yield a rent.

    A company that owned land and competed with other companies that owned land would not be able to issue perpetual bonds.

    It could issue fixed term bonds where those bonds would give the owner the liquidation value of the land if the company could not find enough (any) renters to make the interest payments on the bonds.

  28. 30 Mike Sproul June 18, 2014 at 4:47 pm

    Frank:
    “But if there is more than one land owner, an individual parcel of land may not yield a rent.”

    This needs clarification, since most land this side of Antarctica would rent for a positive amount.

  29. 31 Frank Restly June 18, 2014 at 6:47 pm

    Mike,

    “But if there is more than one land owner, an individual parcel of land may not yield a rent.”

    “This needs clarification, since most land this side of Antarctica would rent for a positive amount.”

    A company that owns land may demand a rent higher than what anyone is willing to pay. It’s not a question of whether the land has value. It’s a question of whether in a competitive marketplace for land rents, all companies looking to rent will find willing renters.

    Can a company that consistently demands rents higher that what people are willing to pay issue perpetual bonds?

    Believe or not, there are poorly run companies out there.

  30. 32 Mike Sax June 30, 2014 at 7:43 pm

    Hi David. Fasicnating topic. Off the beaten path, I recently bought your book on Free Banking online-how much do you agree with the views you represented there? How much do you no longer disagree?

  31. 33 Mike Sax June 30, 2014 at 10:40 pm

    I wasn’t familiar with this whole backward induction idea till I checked out the link.

    I think though that you could make the same argument with any commodity money as well. You could imagine a time when say gold wouldn’t be recognized as money-though I tend to think that back then nobody could imagine it.

    This fact makes me think that maybe fiat money has enabled to see its true essence better-it’s not a question of the ‘use value’ of the currency as a commodity-this is irrelevant for its use as a currency. The belief that it did matter was what created the prevalence of what Lerner called gold fetishism

    On BW I can’t resist asking: is the fact that you and I will die one day mean we are really dead today already and should others in society treat us this way?

  32. 34 Mike Sax June 30, 2014 at 10:41 pm

    I do think that it’s reasonable and rational to presume within our time horizons, that US dollars will continue to provide us what we need in a currency.


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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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