Friday, December 5, 2014

Unlearning Money: Part 2

Here's a funny thing about bank-created money:

A real estate investor sells one of her holdings, an apartment in Encinitas, California, to a young couple for $400,000. The couple finances 100 % of the purchase with a mortgage from a bank. The bank creates a $400,000 deposit out of thin air and the couple transfers the deposit to the investor. The investor feels, for a good reason, that she got paid for the apartment. One month after the transaction, the investor realizes she doesn't want to just sit on the money earning 1,0 % (from a Certificate of Deposit). She decides instead to invest it in a mortgage-backed security (MBS) which yields 3,0 %. A mortgage-originating bank has created this security by bundling loans it has made to homebuyers. In effect, the investor ends up funding homebuyers. She went, in the course of a month or so, from a rental-income-earning apartment owner to someone who has a claim on mortgage payments -- did she, or did she not, get paid for her apartment?


Of course you might argue that she got paid for the particular apartment and then invested her money elsewhere. But it's again the micro-view of money. I took this up because this is very relevant from the macroeconomic perspective. This explains how banks make loans and by doing so they simultaneously create the deposit that can later buy these loans if the bank decides to securitize those loans, i.e. sell them forward to investors in a bundle. And this is what is happening in financial markets every day. From a macroeconomic perspective, the society as a whole is not getting paid, yet. In a (very real) sense, when people buy something with money (an IOU), it's the buyer who gets paid (in assets, goods or services), not the seller. This multitude of available perspectives is what makes economics fascinating to me. At times it is also horribly confusing.

In our example above, the investor ended up holding an MBS because she preferred it to money (in this case a deposit). This is not so surprising, because money -- whether she thought of it or not -- is just another IOU. Whereas the MBS is linked to a bunch of mortgages, a deposit is (indirectly) linked to all loans on a bank's balance sheet. Here's an important point: Funding, seen from the perspective I have taken here, means "accepting IOUs from others". What it doesn't mean is "providing money". By accepting money as a payment, you accept an IOU -- you are funding someone (indirectly a bank borrower or directly a government). If you are later willing to lend the money out and accept another type of an IOU, you end up trading IOUs. Perhaps we could call it "redirecting your funding".

So when one thinks about "money flows", it's best to concentrate on who owes whom and how the positions are changing. It's best to forget the idea that there would be some "real" money flowing from A to B. There isn't.

I'll use QE as a stylized example: As part of its latest QE program, the Fed buys a Treasury Bond from Bank W. The Fed "pays" by creating reserves on Bank W's reserve account, indicating that it owes Bank W. What happened here is this: first the government owed Bank W (holder of the bond), but now the Fed owes Bank W and the government owes the Fed. If Bank W had previously bought the bond from Investor K and "paid" by creating a deposit for the investor, then the IOU chain is one link longer: The government used to owe Investor K, but now Bank W owes Investor K, the Fed owes Bank W and the government owes the Fed.

I'll elaborate all this in the coming posts.

I end the post with a riddle: Assuming that the shareholders of a bank have deposit accounts in the bank, does the bank pay dividends to its shareholders?

4 comments:

  1. Word!

    "In a (very real) sense, when people buy something with money (an IOU), it's the buyer who gets paid (in assets, goods or services), not the seller."

    Very true! There are two meanings to "settling a debt": one kind of settling happens, when the creditor no longer carries the credit risk of the earlier debtor (e.g. when the debt has been repaid with "money"). The other meaning is the moment when all credit relations disappear. And that only happens when the holder of money (or other credit) buys some real good or service with that money. This is e.g. where Ray Dalio is quite lost (: His split between money and credit is very ambiguous in many ways:
    https://www.youtube.com/watch?v=4C1cS8Jl9Wc#t=1148

    "Funding, seen from the perspective I have taken here, means "accepting IOUs from others". What it doesn't mean is "providing money"."

    This helped me clarify my own expression. E.g. in my book Fixing the Root Bug, I wrote that "finance" isn't about "giving money", but "carrying risks". Saying that "funding" is accepting the funding target's debt (or other liability) is an even better clarification. Except that in e.g. the case of public expenses and investments, funding simply means "paying for" something.

    "So when one thinks about "money flows", it's best to concentrate on who owes who[m] and how the positions are changing. It's best to forget the idea that there would be some "real" money flowing from A to B. There isn't."

    Exactly! The whole idea of money "circulating" and hence concepts like "circulation velocity" are quite misleading and kind of artificial. With today's system of electronic money, the circulation velocity could be millions, if holding liquid credit were more costly ;) "Money" does not need to exist but for the split-second duration of the transactions.

    Good stuff overall!

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    1. Thanks, Tworay!

      I agree with you about Dalio. Oh, that feeling when you find yourself disagreeing about money and credit with a macro investor you respect probably more than any other (he's up there with Druckenmiller and Soros)... :-)

      You write: "There are two meanings to "settling a debt": one kind of settling happens, when the creditor no longer carries the credit risk of the earlier debtor (e.g. when the debt has been repaid with "money"). The other meaning is the moment when all credit relations disappear."

      I see what you mean. A particular debt can be, in a way, settled with "money". But the creditor remains a creditor, only to someone else. And here comes the reason why we should remain purists and resist calling this a settlement: The debtor *might* or might not remain a debtor (macro perspective, always). The debtor has settled his debt *if* he didn't incur new debt to pay this existing debt, i.e. he sold goods or services in advance and thus acquired the credit (money) he then transferred to his creditor. So any settlement is directly linked to the debtor's earlier sales transaction. That is when he settles his debt to "society" (macro). The later "settlement" has real impact on the creditor, from micro perspective, but macro-wise it is more a question of accounting.

      Do you agree? "Clumsy statements", so you might need to give it some time :-)

      I had a look at your Root Bug stuff. Impressive! There is one thing I wonder, though:

      (What follows is based on your comment above and your Youtube video "Banking 101, Root-Debugged - Full" https://www.youtube.com/watch?v=KLqYnW1RmDE )

      It seems to me that you and I view money in very much the same way. There is much similarity between us and Mitchell-Innes -- and Knapp. Despite this, I do not really agree with Modern Monetary Theory (MMT) that is said to combine Innes and Knapp. Either my reading of Innes is different from MMT's, or then I disagree (in a rather mysterious way) with Innes. I did not read him before I had started on my theory. He did help me to clarify my theory enormously, though.

      Do you agree with MMT?

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  2. I would agree with the mathematical identities emphasized by MMT, such as the "three-balance identity": current accounts = public sector surpluses + private sector net monetary saving (i.e. excl. investments)

    But when it comes to the Post-Keynesian normative conclusions of functional finance and an ELR (employer of the last resort) policy, I strongly disagree.
    If the private sector wants to save too much, that means that the interest rate is too high. It makes very little sense to conclude that then the public sector would have to go into debt to facilitate that excess monetary saving :D

    Post-Keynesians seem to completely forget the questions of (1) why capital has a cost and (2) why we pay people wages in the first place. And though they understand that money in the current system is a credit relation, they haven't quite grasped the Credit Theory of Money. The value of money is based on the expectation of someone being willing to give something for it. You can't assume a stable or linearly changing circulation velocity. That is what you'd have to do if you expect to be able to counter inflation with fiscal policies (i.e. taxing the "excess" money out of circulation fast enough).

    If the private sector has lots of monetary savings that are only backed by public debt (hardly any private debt), then that money is only good for paying taxes. How stable is people's willingness to hold such money? If most of the money is backed by private debt, they can expect to get work from others for that money - if they trust the interest rate is kept right (:

    Did that answer your question?

    More on these in Fixing the Root Bug chapters:
    2.2.6 Post-Keynesian Solutions – Ignore HyperInflation Risks and Guarantee Jobs
    1.2.3 Money as Credit – Real Wealth vs. Virtual/Fiduciary Wealth
    4.2.1 Eliminating the Zero Lower Bound with a Higher Inflation Target, or by Eliminating Cash
    1.3.3 The Circular Flow of Income – Consumption, Saving and Investing
    1.3.2 In a Closed Economy, Net Monetary Wealth Is Zero – Total Real Wealth Depends on Future Consumption and Capital Intensity (and Monopolies)

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    1. Thanks for the clarification!

      I think I follow you :) Some comments:

      You wrote: "The value of money is based on the expectation of someone being willing to give something for it."

      Who is this "someone"? Is it a debtor, or anyone? And if it is anyone, then why is *he* willing to take the money in exchange for his goods or services?

      You wrote: "...then that money is only good for paying taxes. How stable is people's willingness to hold such money?"

      It depends on how much taxes people need to pay. Right? I don't see how the difference between public and private debt would necessarily affect people's willingness to hold "money". Not directly, at least.

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