Yeager v. Tobin

In some recent posts (here, here, and here), I have expressed my admiration for James Tobin’s wonderful paper “Commercial Banks as Creators of Money.” Although the logic of the paper seems utterly compelling to me, it was, and evidently remains, controversial, because it advances the idea that the distinction between what is and what is not money is not a hard and fast one, but depends on the institutional and regulatory arrangements under which banks and other financial institutions operate.

The context in which I have been discussing Tobin is whether bank deposits created by commercial banks, unlike the liabilities created by other financial institutions, are “hot potatoes” in the sense that any individual can get rid of “unwanted” bank deposits (“unwanted” meaning that the individual’s deposit holdings exceed the amount that he would like to hold relative to his current income and wealth), but can do so only by giving those deposits to another individual in exchange for something else that the first individual would rather have instead. Thus, according to the “hot potato” view of the world, the total amount of bank deposits held by the community as a whole cannot be changed; the community is stuck with whatever amount of deposits that the banks, in the process of making loans, have created. What this means is that it is up to the monetary authority, through its control of reserves, reserve requirements, and the overnight rate on interbank loans (or its lending rate to the banks), to create the right amount of bank deposits.

Tobin argued that the “hot potato” view of bank deposits is incorrect, because the creation of bank deposits by commercial banks is not a mechanical process, as implied by the conventional money-multiplier analysis, in which bank deposits automatically come in to existence as a result of, and in proportion to, the amount of reserves provided to the banking system. Rather, profit-maximizing banks, like other profit-maximizing financial intermediaries, make an economic decision about how much of their liabilities to create (and on what terms to make them available) based on the public’s demand to hold those liabilities and the banks’ costs of backing those liabilities, inasmuch as any financial intermediary issuing a liability must make that liability sufficiently attractive to be willingly held by some member of the public. Like any financial intermediary, banks seeking to lend to the public can lend only if they obtain the funds to be lent from some source: either the equity of the owners or funds provided to the bank by lenders. If a bank cannot induce people to hold an amount deposits created in the process of making loans equal to the amount of loans it has made, it must find another source of capital to finance those loans.  Otherwise, the bank will be unable to sustain the scale of lending it has undertaken.

The amount of lending that banks undertake is governed by strict profit-loss calculations, just as the scale of operations of any profit-making enterprise is governed by a profit-loss calculation.  A bank makes a profit if the spread between its borrowing and lending rates is sufficient to cover its other costs of intermediation. And the scale of its lending depends on the demand of the public to hold its liabilities (which affects how much interest a bank must pay on those liabilities, e.g., demand deposits) and the interest rates that borrowers are willing to pay on the loans they obtain from the bank. Subject to essentially the same constraints on expansion as other financial intermediaries, banks do not simply lend without considering what costs they are incurring or what contribution to profits their loans are making at the margin. Because in equilibrium, the marginal revenue to a bank generated by an incremental loan just equals the marginal cost of making the loan, so that banks can decide to decrease their lending just as easily as they can decide to increase their lending, it makes no sense to think that bank-created money is, like central-bank currency, a hot potato. (Aside to Mike Sproul: Sorry, I know the previous sentence sounds like a nail scratching on a blackboard to you, but only one argument at a time.) As Tobin puts it:

The community cannot get rid of its currency supply; the economy must adjust until it is willingly absorbed. The “hot potato” analogy truly applies. For bank-created money, however, there is an economic mechanism of extinction as well as creation, contraction as well as expansion. If bank deposits are excessive relative to public preferences, they will tend to decline; otherwise banks will lose income. The burden of adaptation is not placed on the rest of the economy.

To me this seems so straightforward that I cannot understand why anyone would disagree. But some very smart people – I am thinking especially of Nick Rowe — are as convinced that it is wrong as I am that it is right. In earlier exchanges we have had about this, Nick has invoked the authority of Leland Yeager in arguing against Tobin, and Lee Kelly, in a comment on my recent post citing the favorable evaluation of Tobin’s paper given by Milton Friedman and Anna Schwartz in their Monetary Statistics of the US:  Estimates, Sources and Methods, a companion volume to their Monetary History of the US, specifically asked for my opinion of Leland Yeager’s paper “What Are Banks?”, a paper devoted entirely to criticism of Tobin’s paper.

I just re-read Yeager’s paper, and I still find it unpersuasive. There are too many problems with it to cover in a single blog post. But I will note in passing that in the discussion of definitions of money by Friedman and Schwartz that I mentioned in the previous paragraph, Friedman and Schwartz, while indicating agreement with the gist of Tobin’s argument, also criticized Yeager’s approach in his paper “The Essential Properties of a Medium of Exchange,” which foreshadowed much of the discussion in “What Are Banks?” So it is complicated. But I think that the key point is that, by failing to make explicit how he conceived that the price level and nominal income were determined, Tobin left his analysis incomplete, thereby allowing critics to charge that he had left the price level and nominal income undetermined or specified, in Keynesian style, by some ad hoc assumption. This misunderstanding is evident when Yeager makes the following criticism of Tobin and his followers:

Proponents of this view [Tobin et al.] are evidently not attributing “the natural economic limit” to limitation of base money and to a finite money multiplier, for that would be old stuff and not a new view. Those familiar limitations operate on the supply-of-money side, while the New Viewers emphasize limitations on the demand side. They deny crucial differences (to be explained below) between banking and NFI (non-bank financial institutions) systems regarding limits to the scales of their operations.

This paragraph is hopelessly, if not deliberately, confused. Arguing like a lawyer, Yeager attributes an absurd position to Tobin based on the label (New View) that Tobin et al. chose to describe their approach to analyzing the banking system, an approach based on economic incentives rather than the mindless mechanics of the money multiplier. Having thereby attributed an absurd position to Tobin, Yeager proceeds to discredit that absurd position, even though the quotation above in which Tobin distinguishes between currency and “bank-created money” demonstrates that he explicitly rejected the position attributed to him. And contrary to Yeager’s assertion, rejection of the money-multiplier as an analytical tool certainly was a New View, a view that Yeager spends most of his paper arguing against. The money multiplier is a reduced form embodying both demand (for reserves, by the banking system, and for currency, by the public) and supply; it is not a description of the profit-maximizing choices of banks to supply deposits at alternative prices, which is what we normally think of as a supply curve. To treat it as a conventional supply curve or as an analogue to a supply curve is just incoherent. And then, apparently oblivious to the mutual inconsistency of his criticisms, Yeager, in the paragraph’s final sentence, criticizes the New View for denying “crucial differences” between banks and non-bank financial institutions “regarding limits to the scales of their operations,” a denial completely independent of what New Viewers think about base money.

A few paragraphs later, Yeager launches into a diatribe against the New View based on the following thought experiment:

Suppose, then, that a cut in reserve requirements or expansion of the monetary base or shift of the public’s preferences from currency to deposits initially gives the banks more excess reserves.

To Yeager it seems obvious that this thought experiment demonstrates that the banks, flush with excess reserves, start lending and expand the money supply, raising nominal income and prices rise and thereby increasing the demand for money until the demand to hold money eventually equals the enlarged stock of nominal money stock. Yeager somehow thinks that this thought experiment proves that it is the banking system that has generated the inflationary process.

Even applied to the banking system as a whole, something is wrong with the idea that a decline in yields obtainable will check expansion of loans and investments and deposits. That idea overlooks Knut Wicksell’s cumulative process. As money expansion raises nominal incomes and prices, the dollar volume of loans demanded rises also, even at given interest rates. The proposition that the supply of money creates its own demand thus applies not only to cash balances . . . but also to money being newly supplied and demanded on loan. An unconstrained cumulative process can even lead to embodiment of inflationary expectations in interest rates as described by Irving Fisher. The great inflations of history discredit any notion of expansion being limited as marginal revenues fall in relation to marginal costs. The notion rests not only on an illegitimate imputation of a systemwide viewpoint to the individual banker, but also on a more or less tacit assumption of rigid prices.

The obvious point to make is that Yeager’s thought experiment postulates either an increase in the monetary base or a reduction in the demand (via a reduction in reserve requirements or via a shift in the public’s demand from holding currency to holding deposits) for the monetary base. Thus, according to the New View (or an appropriately modified New View), the equilibrium price level and level of nominal income must rise. The rise is the consequence of an excess supply of currency (monetary base) which Tobin explicitly acknowledges is a hot potato. End of story. Yeager’s outraged remonstrations about Wicksellian cumulative processes, inflationary expectations and the lessons of the great inflations of history are simply beside the point. Throughout the paper, Yeager accuses Tobin of being confused about the difference between the incentives for the banking system as a whole and those of the individual banker, but confusion here is Yeager’s.

One might say that the approach that I follow:  to determine the price level in terms of the demand for currency and the stock of currency, while allowing the quantity of bank money and its yield (i.e. the interest rate paid by banks to depositors) to be determined in terms of the demand for deposits and the cost of supplying deposits, leads to exactly the same conclusion one reaches via the traditional money multiplier analysis: the price level and nominal income go up and the quantity of bank deposits increases. But actually there are some subtle differences. According to Yeager, it is the increase in the quantity of bank deposits that generates the increase in prices and nominal income. That would seem to imply that the quantity of bank money should be rising more rapidly than the quantity of liabilities produced by non-bank financial institutions. The money-multiplier analysis also implies no change in interest rates paid to depositors, while, if inflation leads to increased inflationary expectations and increased nominal interest rates, the New View predicts that the interest paid on deposits would rise as well. According to the New View, there would be no change in the relative quantities of bank and non-bank deposit liabilities; according to the money-multiplier analysis, the amount of bank deposits should rise faster than the amount of non-bank deposit liabilities even though non-banks would be increasing the rate of interest paid on their deposit liabilities while banks did not increase the interest paid on their deposit liabilities.

In connection with the “more or less tacit assumption of rigid prices” that he attributes to Tobin, Yeager adds the following footnote:

Basil Moore, who wavers between the new and traditional views, recognizes that if all prices were perfectly and instantly flexible, an unregulated banking system could not reach a stable equilibrium.

This is just wrong; a stable equilibrium is assured by fixing the nominal quantity of currency even with a completely unregulated banking system. What can possibly be meant by “perfect and instant price flexibility” is simply a mystery to me. The only meaning that I can possibly attach to it is that full equilibrium is continuously maintained, with no trading at disequilibrium prices. Why an equilibrium with a fiat currency and a determinate price level is inconsistent with an unregulated banking system is not explained, nor could it be.

The same confusion emerges again in Yeager’s discussion of how the supply of money creates its own demand. Yeager writes:

This process that reconciles the demand for money with the supply is the theme of what J. M. Keynes called “the fundamental proposition of monetary theory” and Milton Friedman called “the most important proposition in monetary theory.” Briefly, everyone can individually hold as much or as little money as he effectively demands, even though the total of all holdings may be exogenously set; for the total flow of spending adjusts in such a way that the demand for nominal money becomes equal to the exogenous supply.

Of course, the adjustment process can work perfectly well for currency and be irrelevant for bank money; currency is a hot potato, while bank money is not, so that the nominal supply of bank money, unlike the nominal stock of currency, adjusts to the nominal demand.

In a footnote to the above passage, Yeager invokes the authority of Harry Johnson:

Harry Johnson has charged opponents of monetarism with confusion over how nominal and real quantities of money are determined and with “a tendency to discuss monetary problems as if nominal and real money balances are the same thing, and as if ordinary value theory could be applied to the behaviour of money.” The Yale theorists [i.e., Tobin et al.] “are . . . alert to this confusion but by-pass it either by assuming stable prices and confining their analysis to the financial sector, or by building models based on the fictional construction of a money whose purchasing power is fixed in real terms, thereby avoiding confusion in the analysis at the expense of creating it with respect to the applicability of the results.

Any confusion Johnson may have detected could be eliminated simply distinguishing between the price-level analysis carried out in terms of the demand for, and the stock of, currency on the one hand, and the analysis, given the price level determined by the demand for and stock of currency, of the quantity (in both real and nominal terms) of bank money and the competitive interest paid by banks on deposits. In his subsequent work on the monetary approach to the balance of payments, Johnson showed himself to be perfectly content to decompose the analysis in this fashion.

There is more to say about Yeager’s paper; perhaps I will come back to it on another occasion. But any further comments are unlikely to be much more favorable than those above.


34 Responses to “Yeager v. Tobin”

  1. 1 Mike Sproul May 9, 2012 at 8:30 pm

    Nails on a blackboard? Not at all. But I’m surprised to hear you saying that “printing press money” does the hot potato, while “fountain pen money” does not. First of all, we seem to be in full agreement about fountain pen money and how the law of reflux applies to it, so I’ll leave that alone and focus on printing press money. Like you say: One thing at a time.

    I think you’d agree that there is at least the POTENTIAL that printing press money can reflux to its issuer. The central bank does conduct open market SALES as well as purchases; it does receive repayments of loans as well as making loans, and it even occasionally sells used furniture and retires the currency received. So Tobin was being careless at least when he said that fountain pen money had a mechanism of extinction, as if to say that printing press money did not.

    The question for us to address is not whether printing press money CAN reflux, but whether it DOES. And if it does, is the reflux significant enough to protect from over-issue and inflation? I say yes to both.

    The simplest example is a gold standard with ordinary convertibility. As long as the central bank maintains convertibility at $1=1 oz, reflux works perfectly. The bank could even stop paying out gold and instead use its bonds to buy back its dollars whenever the market value of $1 falls below 1 oz. Reflux still works perfectly.

    On the other hand, if the central bank devalued 3%, so that $1=.97 oz., then people will want 3% more money, which the central bank will issue passively. Here’s where I think you might be seeing things the wrong way, and it’s a mistake Fullarton made as well. The mistake is to think that the extra 3% of money was FORCED into circulation, and the reflux failed to operate. No. The money was issued passively, and the reflux operated as it should. It’s just that the devaluation caused the public to want 3% more money, and gave the false appearance that reflux failed. (I discussed this in my “Law of Reflux” paper.)

    Now suppose the central bank did things in sort of an opposite way. Rather than devaluing 3%, the bank starts by issuing 3% more money in exchange for bonds, and then, facing the resulting 3% reflux, the bank refuses to take it back. Well, the bank can’t refuse all reflux, because then its money would lose all value. But the bank can let the currency lose 3% of its value before resuming the reflux. This case starts to look more like a ‘forced’ issuance of currency, but it’s really a 3% default by the bank, and just like the backing theory says, a 3% default is equivalent to a 3% loss of backing, and causes a 3% inflation.


  2. 2 Ritwik May 9, 2012 at 11:17 pm


    If the devaluation occurred by fiat and occurred exactly as the central bank wanted, then the resultant issuance of money cannot be claimed to be ‘passive’ in any meaningful way. If the monopoly supplier of money can so easily influence the demand for money, then economically it makes more sense to say that demand adjusts to supply rather than vice versa. The ‘hot potato’ may then just be a bad analogy rather than an incorrect theory, and the backing theory is economically indistinguishable from the hot potato.


    I always thought Nick Rowe’s position was that central bank money is special because of asymmetric redeemability. I doubt he claims that bank money can be a hot potato. If I understand him correctly, then there is not much to differentiate his position from yours or Tobin’s and all we are left with is Yeager’s unfair criticism of Tobin and Nick’s uncritical acceptance of that criticism.


  3. 3 Ritwik May 9, 2012 at 11:25 pm


    The equivalence of default and inflation can in fact be best understood in the context of the functional finance claim that a currency issuing government has no inter-temporal budget constraint – which is technically true but fails to see the equivalence between inflation and a sovereign default. This is a point that ALL neoclassical economists will make when challenged by a MMT/ Post Keynesian.

    If the backing theory can be subsumed to be the claim that inflation = default, then it is economically indistinguishable from the mainstream view or the hot potato view.

    If you disagree, you should provide an example of a government/ central bank policy action where Nick Rowe’s hypothesis about the resultant effect on money and prices will differ substantially from yours.


  4. 4 Ritwik May 9, 2012 at 11:37 pm


    Sorry for a third comment on this, but let me try and couch my objection to your position in what I think is language closer to your preferred way. The value of central bank money depends on the value of the central bank;’s assets. Fine. But you also seem to think that the central bank can unilaterally and by fiat decide the value of its assets (change convertibility).

    No other entity has that degree of freedom. If you do allow a central bank that degree of freedom, you’re not making a claim that meaningfully contradicts the mainstream/ neoclassical/ monetarist/whatever position.


  5. 5 Bill Woolsey May 10, 2012 at 6:09 am


    The hot potato effect is a disequilibrium phenomenon. You and Tobin are describing equilibrium conditions in the banking system. There is no disequilibirum in equilibirum. OK.

    As far as I know, people receiving payment by currency behave little different than those receiving checks. Most of them deposit the currency and checks into their checking accounts.

    Generally, people receiving money, even if they intend to place it in a checkable deposit, do not call up their bank to determine in the deposit interest rate has risen a bit so that they will be willing to permanently increase their money balances.

    Quite the contrary, they accept money payments even if they do not intend to hold them, but rather to spend them.

    And that is what the “hot potato” is all about.


  6. 6 Mike Sproul May 10, 2012 at 9:47 am


    One case where the backing theory gives a different answer from the hot potato theory is where the money-issuing bank loses assets. Let’s say all the bank’s assets are dumped in the ocean, but there is no change in the quantity of money issued by that bank. The backing theory implies the money would lose all value, while the quantity theory implies no change in value, since (on that view) the value of money was determined by money supply and money demand, not by the assets/liabilities of the issuing bank.

    It’s misleading to say that a currency-issuing government has no inter-temporal budget constraint. For example, a landlord has land worth 1000 oz., and he collects 50 oz./year in rents (market R=5%). The landlord might buy groceries by writing personal IOU’s (dollars) that he promises to accept for 1 oz of rent on his property. Assuming he spends his dollars on candy, which he eats, he could issue a maximum of 1000 of these IOU’s. That’s his budget constraint, but in a limited sense.

    The thing is, he could then issue another $2000 in IOU’s and this time, use them to buy another 2000 oz. worth of land. As long as he uses his newly-issued dollars to buy new land, his budget constraint now looks a lot bigger than before. Assuming he can buy land with 10% down, his original 1000 oz. of net worth could be leveraged to where he owns 10000 oz of land. That’s also, in a sense, his budget constraint. But he didn’t need to be able to issue money to do this. He could have done the same thing by issuing bonds. Conclusion: The ability to issue money does not affect the intertemporal budget constraint, whatever it is.

    “No other entity has that degree of freedom. ” In the 1800’s, banks suspended convertibility or devalued all the time. People weren’t happy about it, but it happened, usually as a result of losses on loans. Government-operated banks operate the same way, except that the policeman is less likely to throw the government banker in jail.


  7. 7 W. Peden May 10, 2012 at 11:00 am

    Bill Woosley said what I wanted to say (but in all probability, better). My eyebrows were raised as soon as you said-

    “Because in equilibrium, the marginal revenue to a bank generated by an incremental loan just equals the marginal cost of making the loan, so that banks can decide to decrease their lending just as easily as they can decide to increase their lending, it makes no sense to think that bank-created money is, like central-bank currency, a hot potato.”

    It is true that, if we assume that broad money is in equilibrium, then broad money will be in equilibrium and will not be a “hot potato”; when quantity supplied equals quantity demanded, then quantity supplied will be equal to quantity demanded. Quite how this is an argument against disequilibrium theorists like Yeagar is beyond me, but I don’t quite understand this debate yet.


  8. 8 Tas von Gleichen May 10, 2012 at 12:29 pm

    lol referring to currency as a hot potato. I could have not put it any better.


  9. 9 Becky Hargrove May 10, 2012 at 2:37 pm

    Forgive me for barging into this discussion about the hot potato effect, but I have so been wanting to talk about these ideas. Pehaps the effect would be noticed as money in deposits, but I think of it more as the time frame money moves between locations. Why that is so important: the money which is measured in such time frames is far more substantial than ‘new’ money coming to the system in that timeframe, such as loans or credit.

    For instance, think of income as a starting point. We might dedicate a large percentage of income to previous commitment, which represents a delayed velocity for that percentage of income. Other small purchases allow greater degrees of velocity in those timeframes.

    Perhaps the most important aspect of all this is the degree to which velocity is affected by specific zones, regulations etc. which set up perimeters that create very slow velocity. Because the velocity is so slow, more new money has to come into the system than otherwise would have been necessary for stability. Wow, this was fun. Thanks.


  10. 10 David Glasner May 10, 2012 at 7:59 pm

    Mike, I agree that there is a potential for reflux depending on what policy the central bank chooses to follow. The difference that I see is that private producers of competitive supplied money are subject to constraints (convertibility into a dominant outside money) that the monopoly issuer of a fiat money is not subject to. We have already discussed out disagreement on that point, and I am guessing that we will continue to do so for a while.

    Ritwik, I am puzzled by Nick’s position, but he has made it clear that he believes that bank money is as much a “hot potato” as is fiat money.

    Bill Woolsey and W. Peden, I think that you were both misled by the passage quoted by W. Peden. My reference to equilibrium was not to a macro-equilibrium, but to the equilibrium of an individual firm where marginal revenue equals marginal cost. Firms increase output when marginal revenue exceeds marginal cost and decrease output when marginal cost exceeds marginal revenue. That was the only use that I was making of the concept of equilibrium, and I don’t think that Tobin was working with a stronger concept of equilibrium than that, either.

    I didn’t suggest that people receiving currency behave differently from those receiving checks. The question is not what they receive, but what they choose to hold. The question is not whether depositors check the interest banks are paying on deposits before putting money into their bank accounts. If banks find it profitable to expand their balance sheets by making more loans, they will try to do so by offering to pay higher interest to depositors in order to attract more deposits either by inducing depositors to switch from other banks to themselves or inducing people to switch from currency to deposits or to shift from holding savings bonds to deposits. Equilibrium is not necessarily maintained continuously, but adjustments are constantly taking place in response to the desire of banks to attract more deposits and depositors to earn higher returns, and another twenty other relevant factors. If people are earning competitive interest on their deposits, what makes you think that if they accept payment (either in checks or currency) that when they put the money in the bank, they will want to spend that money. If they are earning competitive interest, they may just be content to leave the money in the bank and earn interest on it. Why is that a “hot potato.” Are all the reserves sitting in banks’ reserves balances at the Fed earning interest “hot potatoes?”

    Becky, Glad to be of service.


  11. 11 Mike Sproul May 10, 2012 at 8:54 pm

    We sure have a range of views here. Nick thinks both central bank money and private bank money do the hot potato. I think neither kind does, and David thinks central bank money does while private bank money doesn’t. In defense of my view I’d start by saying that central bank money that is convertible cannot do the hot potato. I think David would agree to this, but probably not Nick. I’d then go on to imagine suspending various kinds of convertibility (i.e., closing various channels of reflux). First, suspend gold convertibility, while still allowing bond convertibility. Then suspend both kinds of convertibility. First for days, then for months, then for decades. Finally, suspend all forms of convertibility forever. I’d say that as long as there is any available form of convertibility (i.e., any open channel of reflux), the money will not do the hot potato. Only when all reflux channels are closed forever do you have the possibility of a hot potato, but then the money would have also lost all of its value due to the complete inability of customers to get access to the assets backing the money.


  12. 12 Ritwik May 10, 2012 at 11:39 pm


    1) Of course the inter-temporal constraint holds. I’m just saying that your inflation = default view does not prove anything because that’s precisely what a monetarist/ New Keynesian will also say when a Post Keynesian says that the government has no inter-temporal constraint. So there’s no difference between the backing theory and the neoclassical view there. That’s the point I was trying to make.

    2) I find it very hard to think of what it means to ‘dump all assets in the ocean’ in the context of modern day monetary policy, where the assets on a CB’s balance sheet are govt bonds, forex and gold. Can you give a more realistic test case that we can actually work through? Perhaps you mean to say that fiscal profligacy leads to inflation even if this profligacy is not monetized in a quantitative sense? Then that’s the fiscal theory of the price level, not the backing theory per se.

    3) In the absence of any ‘convertibility’, the backing theory necessitates that you must have a theory of asset valuation that precedes the valuation of money itself. What is this theory of asset value? If it is that a well established central bank can, in most circumstances, by fiat decide the value of the assets on its own balance sheet, then the backing theory is not saying anything particularly meaningful.

    4) I didn’t really understand your point about central bankers and jails. Are you saying that ‘a free banking system leads to an indeterminate and localised price level’ ? Or are you saying that the government’s power to place people in jail (or equivalently, to tax) maintains the price level? In which case, I’d say, we’re back to the fiscal theory of the price level.


  13. 13 Ritwik May 11, 2012 at 12:15 am


    Let me try to put the point about asset valuation somewhat differently and couch it in the language of Perry Mehrling’s hierarchy of money.

    Click to access Mehrling_P_FESeminar_Sp12-02.pdf

    The ultimate money is the assets on the currency issuer’s balance sheet. At every level of medium of exchange creation, the liability side of the level just above you looks like money to you. So reserves and currrency are money for banks. Currency and deposit are money for individuals etc. The ultimate money is the medium of account. In the gold standard, gold is the ultimate ‘money’, which is to say that a theory of the price level is basically about the supply and demand of gold and convertibility.

    In this framework, Nick’s point with his post on the shift from the gold standard to CPI targeting was that so long as a central bank has enough credibility to change convertibility rules by fiat and get them accepted by fiat, even the gold standard was not really a ‘gold standard’, it was a ‘central bank standard’. If there is a sudden supply or demand shock to gold, and the govt/central bank can manage it just by changing convertibility rules, there is no effective gold standard. The gold standard becomes effective only when the central bank chooses to respect it or when the central bank loses credibility.

    Now let’s come back to today’s fiat money world. The ultimate money is still the assets on the currency issuer’s balance sheet. The big difference is that the central bank seems to be able to decide the valuation of its own assets (the majority of them) by fiat, by setting interest rates. This is like a gold standard world where the central bank has perfect freedom to choose its degree of convertibility. It’s a central bank standard. So the ultimate money, the medium of account, stops at the liability side of the central bank rather than going over to the asset side.

    What are the constraints on this central bank standard? Credibility, for one. But that’s a constraint in all states of the world. The other constraints are the assets on the CB’s balance sheet. Forex reserves. That’s the balance of payments constraint, that’s acknowledging that your own currency is not the ultimate money – there is the ‘world balance sheet’ with the dollar being the ultimate money, currently. And finally, there’s gold. That’s the ultimate money in case even the dollar is no longer accepted

    But these are crisis/ extreme crisis scenarios. In a simplified, normal operation of the world scenario, where the only asset on the CB’s balance sheet is assumed to be govt. bonds, the backing theory’s relevance simplifies to this question – does the central bank set the price of government bonds or do government bonds set the price of money. Which is to say, from a balance sheet/ backing theory perspective, the only challenge to the mainstream ‘the central bank sets the price level’ view is the fiscal theory of the price level.

    So do you endorse the FTPL? Because if you don’t, then I think you’re contradicting yourself. And if you do, then I shall throw Buiter at you. 🙂


  14. 14 Ritwik May 11, 2012 at 12:42 am

    I really like the Perry Mehrling hierarchy framework. Money at all lower levels of hierarchy is a medium of exchange. The ultimate medium of exchange is the medium of account. The price level is determined by 1) medium of account 2) the traction of the medium of account setter over the economy. There is always some medium of account setter. It need not be your own national government, it could be the US. in the doomsday scenario, it need not be the US, it could be the players in the gold market.

    If the medium of account is the government’s spending actions and its power to tax, we have the FTPL. If the medium of account is the central bank’s liabilities, or equivalently, its power to decide the value of its own assets, we have the nuanced QTM, or the ‘central bank standard’.

    The law of reflux is equivalent to saying that the medium of account dominates all media of exchange – it is the ‘ultimate money’. Therefore, the hot potato-ists are the medium of exchange nuts. Everyone else is a medium of account nut, including Monetarists, New Keynesians, Post Keynesians, Tobin, Glasner, Sumner etc. These all agree that the central bank sets the medium of account – within them, the difference of opinions on CB actions stems from different evaluations of the medium of account setter’s traction over the economy. Krugman thinks it loses traction when rates approach zero. Post Keynesians/ finance and banking types think it loses traction in a variety of different scenarios – peak elasticity as Mehrling would call it. Hyperinflations result from the CB losing all traction over the economy.

    It all makes sense now. 🙂


  15. 15 Becky Hargrove May 11, 2012 at 6:05 am

    David, the thought experiment I was able to carry out actually gives me a reasonable way to argue in the structural and cyclical arguments that are currently taking place, as I have been caught between them. I will continue to try to understand this most fascinating aspect of money.


  16. 16 JP Koning May 11, 2012 at 7:10 am

    Mike: “…and David thinks central bank money does while private bank money doesn’t.”

    I’m not so sure David thinks that. He said: “I agree that there is a potential for reflux depending on what policy the central bank chooses to follow.” Perhaps you two are not as far apart as you think.


  17. 17 Jon Finegold May 11, 2012 at 2:41 pm


    Unrelated question: if there is one thing by Hawtrey that you would suggest a young economist to read what would it be?


  18. 18 Mike Sproul May 11, 2012 at 5:07 pm


    Work commitments are bearing down on me, so I’m going to have to do a little condensing here.
    1) I’ll skip this.
    2) Yes; fiscal profligacy leads to loss of assets, and loss of assets can lead to inflation. The Fiscal Theory of the Price Level is a special case of the backing theory. I wrote a paper last year about this. Just google “fiscal theory of the price level sproul”
    3) No convertibility=no backing. But convertibility can take weird forms. For example, a bank might issue dollars today with the promise of gold convertibility in 100 years at $1=1 oz. Today, those dollars will trade for 1/(1+R)^100 oz./$. If the printing and handling cost of the dollars are C oz./year, then those dollars will trade for 1/(1+R-C)^100 oz./$, so if C=R, the dollars trade for 1 oz today, and stay at that value for 100 years. They appear to bear no interest, but in fact the interest is burned up by printing/handling costs.
    4) See my fiscal theory paper.
    5) Mehring’s heirarchy: I use the terms “base money” and “derivative money”, since it gives a good analogy to financial securities. A paper dollar is a claim to gold. A checking account dollar is a claim to a paper dollar, so gold is base money and paper and checks are derivative moneys. Likewise, a corporation owns a farm and has issued shares of stock. The stock is a claim to the farm. A Broker has issued derivative securities (calls, warrants, hypothecated shares, etc.) that are a claim to the stock. Everyone recognizes that the issuance of derivative shares does not affect the value of the base shares. That is, derivative shares do not do the hot potato. Everyone also recognizes that the issuance of new shares, matched by new assets (NOT like a stock split) does not reduce the value of the base shares. That is, base shares do not do the hot potato. By analogy, neither base money nor derivative money does the hot potato.

    6) “I shall throw Buiter at you.”
    Nooooooo! Anything but that!


  19. 19 Mike Sproul May 11, 2012 at 5:12 pm


    You’re right. David agrees that reflux works. He just doesn’t take it to the extremes that I do. Our differences seem to boil down to convertibility and monopoly.


  20. 21 JP Koning May 11, 2012 at 7:31 pm

    I think Bill W and David have different definitions of hot-potato. Bill defines hot-potato as a micro-behavior – people adopt a hot potato frame of mind when they agree to accept something it in order to pass it off. Presumably people are not using hot potato behavior when they accept something because they want to consume it.

    David applies the concept of hot-potato to assets – a hot-potato asset is one that can only be sold into the “secondary market”, or open market, whereas a non hot-potato asset can also be sold back to its issuer for cancellation, the result being a elastic supply.

    These seem to be quite different uses for the same word.


  21. 23 Bill Woolsey May 12, 2012 at 4:25 am


    The worst problem with your framing of this matter is exactly the error you made. Are all of those funds sitting in banks’ reserve accounts earning interest at the Fed “hot pototoes?”

    Only that part that is an excess supply is a hot pototo. Paying interest is irrelevant the the disquilibrium process. It is one factor among many that influences the demand to hold reserves. There is no market process that compels the Fed to adjust that rate so that banks are willing to hold the existing quantity. The Fed buys bonds, and the banks of those selling the bonds accept the reserve balances. They don’t refuse to accept the added deposit by their customer because they don’t think the Fed is paying sufficient interest on reserves.

    In a scenario of an increase in the demand for bank credit, banks that supply added credit find that they receive more deposits.

    More importantly, if the demand for checkable deposits falls, banks in general do not lose checkable deposits. Spending just on other goods justs rises.

    Now, if the demand for base money is positively related to spending, then the redemption clause will constrain the banks. But this has nothing to do with Tobin’s argument that the banks will directly respond to the decrease in demand for checkable deposits by paying higher interest on them.

    Tobin is assuming a Walrasian auctioneer. Tobin is assuming equilibirum always.

    Most money pays interest. Interest on money can possibly adjust so that the demand to hold money equals the existing quantity. But because money serves as medium of exchange, the interest rate on money doesn’t have to adjust so that people are willing to hold the existing equantity. People with excess money can just spend it, and those who receive it just take it planning to spend it.

    The notion that somehow when money pays interest it is no longer really money is false. It is just a factor that influences the demand to hold money. And so, given any quantity of money, if the interest rate paid on money is just right, the demand equals the supply.

    If there is no interest on money, say it is banned on checkable deposits or it is too expensive to pay on banknotes, then redemption into base money still constrains the issue of bank money. If interest is paid on money, there is nothing that forces the banks to pay interest on money such that people are willing to hold it.

    Tobin’s argument is a red herring. It diverts attention from the problem.

    Come to think about it, another problem with Tobin’s argument is the implication that bank issued hand-to-hand currency is a problem.


  22. 24 David Glasner May 13, 2012 at 7:08 am

    Mike, My view is that convertibility constrains the value of the liability within a very tight range enforced by arbitrage conditions implicit in the convertibility commitment. As the commitment is relaxed the arbitrage constraints are relaxed and the range of permissible variation is expanded. So I think that we may be in accord in principle, but are arguing about the relevant empirical magnitudes.

    Ritwik, Thanks for all your interesting and insightful comments synthesizing the various strands of the debate. It provides me with a lot of material to think about and perhaps to write about in the future.

    Becky, We obviously have a lot on our plate right now. I hope this will lead us to a higher level of understanding.

    JP, This discussion is helping me get a better handle on what exactly is the source of disagreement among the various different explanations trying to account for the value of money.

    Jon and JP, I don’t think that I have much to add to my response to JP from a few months back. There is also some interesting stuff that Hawtrey wrote on non-monetary issues. His book the Economic Problem published in 1925 is a kind of general intro to economics and he also wrote some works of a philosophical or religious character as well, but I haven’t read them and can’t comment on them. He was very prolific so there is a lot of material to be studied. And any young scholar looking for something to write about could probably find plenty of ideas for worthwhile topics to research and write about.

    JP, Interesting take on what hot potato means. The idea of a hot potato is something that can’t easily be held, something that you want to shift to someone else as soon as it comes into your hands. When money is interest-bearing, there is much less urgency in trying to pass it off to someone else.

    Bill, Sorry, but I don’t seem to be getting your point. The Fed is paying interest on reserves, so banks are more than happy to hold whatever amount of reserves the Fed chooses to create. The reserves are not a “hot potato” because banks are happy to hold any reserves the Fed creates. I am not saying that this results in an equilibrium, just that there is no hot potato effect.

    To figure out what happens “when the demand for checkable deposits falls,” one needs to specify what the corresponding increase in demand is. In other words, a reduced demand for checkable deposits could be associated with an increased demand to hold currency, or with an increased demand to purchase consumer goods or an increased demand to purchase income-producing assets. The adjustment process corresponding to each of those scenarios would be different from the others. There is no reference to Walras in Tobin’s paper, so I don’t see any basis for attributing a Walrasian auctioneer to him. Nowhere does he posit that adjustments to changes are instantaneous. He just says that there are ways by which the banking system can adjust to an excess supply of deposits other than via an increase in spending.

    Whether the payment of interest on money implies that it is not really money is just a verbal issue, not a substantive issue. Yeager seems to be caught up with “essential properties of a medium of exchange.” I think that Friedman and Schwartz do an excellent job in the chapter on the definition of money that I have cited previously of pointing out the problems that result from taking that approach. I don’t see why bank-issued hand-to-hand currency creates a problem because it can be converted instantly into an interest-bearing deposit.


  23. 25 JP Koning May 13, 2012 at 7:45 am

    Mike: “Our differences seem to boil down to convertibility and monopoly.”

    I think the main difference between you and David is on the question of what gives the modern US dollar value. You say that it is the valuable assets on the asset side of the government’s balance sheet which, via various channels of reflux, are sufficient to give fiat money its value. David has argued in the past (the Wickteed/Knapp/Lerner argument) that it is the obligation to pay for government services with $US that gives $US its value.

    I don’t think you would disagree with this because within your framework, this is but one channel of reflux. Government services are valuable products, and the ability to provide them on an ongoing basis is an asset of the government. People will hold dollars in order to buy the flows of services those assets throw off in the future. David seems unwilling to accept your other channels of reflux as an explanation for fiat’s value. For instance, I don’t believe he accepts your idea that, without convertibility upon demand or a tax obligation, the assets held by the Fed are sufficient to give dollars a positive value. In your way of thinking, any sort of Fed windup/bankruptcy would result in a reflux of assets back to dollar holders. So just as common stock is valuable due to its contingent claim on firm assets in windup, so are dollars valuable. At least that’s my impression from reading his blog and book as well as your papers.


  24. 26 JP Koning May 13, 2012 at 8:06 am

    David, regarding definition of hot potato, now I am confused.

    David: “The idea of a hot potato is something that can’t easily be held, something that you want to shift to someone else as soon as it comes into your hands.”

    JP: “a hot-potato asset is one that can only be sold into the “secondary market”, or open market, whereas a non hot-potato asset can also be sold back to its issuer for cancellation, the result being a elastic supply.”

    Tobin: “The community cannot get rid of its currency supply; the economy must adjust until it is willingly absorbed. The “hot potato” analogy truly applies. For bank-created money, however, there is an economic mechanism of extinction as well as creation, contraction as well as expansion.”

    Bill: “Quite the contrary, they accept money payments even if they do not intend to hold them, but rather to spend them. And that is what the “hot potato” is all about.”

    Tobin and me seem to be using the same definition. You and Bill are using an alternative definition. Yet ironically, David, you are taking Tobin’s side against Bill.


  25. 27 Mike Sproul May 13, 2012 at 3:38 pm


    “it is the obligation to pay for government services with $US that gives $US its value.”

    I think it’s better to say that it’s the government’s assets that give money its value, and one of those assets is “taxes receivable”, i.e., taxes people have to pay to the government. So even if taxes can be paid in something other than $US, the taxes receivable are still an asset, and still back the government’s money.


  26. 28 Mike Sproul May 13, 2012 at 3:43 pm


    In option theory, the value of an inconvertible call on a non-dividend paying stock is equal to the value of a convertible call. I think the same applies to money. But we have to be careful . Convertibility can’t work without backing, and backing can’t work without SOME form of convertibility. Think of a leaky pipe. Plugging one hole will have a negligible effect if there are lots of other holes. In the same way, restricting one channel of reflux will have a negligible effect as long as there are lots of other open channels of reflux.


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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