Posts Tagged 'inside money'

Nick Rowe Ignores, But Does Not Refute, the Law of Reflux

In yet another splendid post, Nick Rowe once again explains what makes money – the medium of exchange – so special. Money – the medium of exchange – is the only commodity that is traded in every market. Unlike every other commodity, each of which has a market of its very own, in which it – and only it – is traded (for money!), money has no market of its own, because money — the medium of exchange — is traded in every other market.

This distinction is valid and every important, and Nick is right to emphasize it, even obsess about it. Here’s how Nick described it his post:

1. If you want to increase the stock of land in your portfolio, there’s only one way to do it. You must increase the flow of land into your portfolio, by buying more land.

If you want to increase the stock of bonds in your portfolio, there’s only one way to do it. You must increase the flow of bonds into your portfolio, by buying more bonds.

If you want to increase the stock of equities in your portfolio, there’s only one way to do it. You must increase the flow of equities into your portfolio, by buying more equities.

But if you want to increase the stock of money in your portfolio, there are two ways to do it. You can increase the flow of money into your portfolio, by buying more money (selling more other things for money). Or you can decrease the flow of money out of your portfolio, by selling less money (buying less other things for money).

An individual who wants to increase his stock of money will still have a flow of money out of his portfolio. But he will plan to have a bigger flow in than flow out.

OK, let’s think about this for a second. Again, I totally agree with Nick that money is traded in every market. But is it really the case that there is no market in which only money is traded? If there is no market in which only money is traded, how do we explain the quantity of money in existence at any moment of time as the result of an economic process? Is it – I mean the quantity of money — just like an external fact of nature that is inexplicable in terms of economic theory?

Well, actually, the answer is: maybe it is, and maybe it’s not. Sometimes, we do just take the quantity of money to be an exogenous variable determined by some outside – noneconomic – force, aka the Monetary Authority, which, exercising its discretion, determines – judiciously or arbitrarily, take your pick – The Quantity of Money. But sometimes we acknowledge that the quantity of money is actually determined by economic forces, and is not a purely exogenous variable; we say that money is endogenous. And sometimes we do both; we distinguish between outside (exogenous) money and inside (endogenous) money.

But if we do acknowledge that there is – or that there might be – an economic process that determines what the quantity of money is, how can we not also acknowledge that there is – or might be — some market – a market dedicated to money, and nothing but money – in which the quantity of money is determined? Let’s now pick up where I left off in Nick’s post:

2. There is a market where land is exchanged for money; a market where bonds are exchanged for money; a market where equities are exchanged for money; and markets where all other goods and services are exchanged for money. “The money market” (singular) is an oxymoron. The money markets (plural) are all those markets. A monetary exchange economy is not an economy with one central Walrasian market where anything can be exchanged for anything else. Every market is a money market, in a monetary exchange economy.

An excess demand for land is observed in the land market. An excess demand for bonds is observed in the bond market. An excess demand for equities is observed in the equity market. An excess demand for money might be observed in any market.

Yes, an excess demand for money might be observed in any market, as people tried to shed, or to accumulate, money by altering their spending on other commodities. But is there no other way in which people wishing to hold more or less money than they now hold could obtain, or dispose of, money as desired?

Well, to answer that question, it helps to ask another question: what is the economic process that brings (inside) money – i.e., the money created by a presumably explicable process of economic activity — into existence? And the answer is that ordinary people exchange their liabilities with banks (or similar entities) and in return they receive the special liabilities of the banks. The difference between the liabilities of ordinary individuals and the special liabilities of banks is that the liabilities of ordinary individuals are not acceptable as payment for stuff, but the special liabilities of banks are acceptable as payment for stuff. In other words, special bank liabilities are a medium of exchange; they are (inside) money. So if I am holding less (more) money than I would like to hold, I can adjust the amount I am holding by altering my spending patterns in the ways that Nick lists in his post, or I can enter into a transaction with a bank to increase (decrease) the amount of money that I am holding. This is a perfectly well-defined market in which the public exchanges “money-backing” instruments (their IOUs) with which the banks create the monetary instruments that the banks give the public in return.

Whenever the total amount of (inside) money held by the non-bank public does not equal the total amount of (inside) money in existence, there are market forces operating by which the non-bank public and the banks can enter into transactions whereby the amount of (inside) money is adjusted to eliminate the excess demand for (supply of) (inside) money. This adjustment process does not operate instantaneously, and sometimes it may even operate dysfunctionally, but, whether it operates well or not so well, the process does operate, and we ignore it at our peril.

The rest of Nick’s post dwells on the problems caused by “price stickiness.” I may try to write another post soon about “price stickiness,” so I will just make a brief further comment about one further statement made by Nick:

Unable to increase the flow of money into their portfolios, each individual reduces the flow of money out of his portfolio.

And my comment is simply that Nick is begging the question here. He is assuming that there is no market mechanism by which individuals can increase the flow of money into their portfolios. But that is clearly not true, because most of the money in the hands of the public now was created by a process in which individuals increased the flow of money into their portfolios by exchanging their own “money-backing” IOUs with banks in return for the “monetary” IOUs created by banks.

The endogenous process by which the quantity of monetary IOUs created by the banking system corresponds to the amount of monetary IOUs that the public wants to hold at any moment of time is what is known as the Law of Reflux. Nick may believe — and may even be right — that the Law of Reflux is invalid, but if that is what Nick believes, he needs to make an argument, not assume a conclusion.

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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.

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