Where Does the Buck Stop?

The Example of Nations in relation to Money would be a very uncertain Rule... opposite measures have been us'd in some Countries to what have been used in others, and contrary measures have been used in the same Countries to what was used immediately before, not because of any difference in their Circumstances, but from the Opinion, that since the Method used had not the effect design'd, a contrary would; And there are good Reasons to think that the Nature of Money is not yet rightly understood.

- Money and Trade Considered, With a Proposal for Supplying the Nation with Money, John Law, 1705

310 years have passed since John Law wrote the text above. Judging from the current, often heated, discussions on Twitter and in the blogosphere, fueled by the Bank of England among others, I'm tempted to conclude that there are good reasons to think that the nature of money is not yet rightly understood.

Some time ago I read Walter Bagehot's Lombard Street, published in 1873. Afterwards it has crossed my mind that had Bagehot been brought to us, in person, with the help of a time-machine, he would have been able to teach us a lot about the current monetary system. I imagine him being able to focus on the most relevant parts of it and pose the most relevant questions.

As John Law describes above, the monetary system has evolved, and still evolves, through trial and error. Although -- or perhaps exactly because -- his own trial in France ended up in a very famous error, we should be thankful to Law for the work he did to increase our understanding of money.

To us mere mortals, the problem with trial and error is that at any given point in time, the more consecutive trials and errors -- and, necessarily, time -- have passed, the less understandable the system is to us. Think about the human brain and the universe. One thing is that the complexity of the system increases. Another one is that we get accustomed to things being as they are. We start taking things for granted. We might think that it can only be this way, missing the fact that we are in the midst of a trial. We adopt one viewpoint out of many possible ones. We stop asking questions, from ourselves and others.

Einstein has said: "It's not that I'm so smart, it's just that I stay with problems longer.". If you want to find a problem to stay with for the rest of your life, trying to understand the nature of money seems like a good bet.

Today, there are perhaps a million people, old and young, around the world, staying with the "Money Problem". Never has there been as many as there are now (thanks to increased leisure), and never have they had as good an access to information as they have today. Monetary economics, and macroeconomics in general, is on the rise. For this we can thank the Great Financial Crisis. The emergence of Quantitative Easing and negative interest rates, regardless of their effect on the real economy, has had an huge impact on people's understanding of money, or more precisely on the feeling of lack of understanding which has led to willingess to study the subject. This is in no way confined to amateurs: many of the academic economists often seem as puzzled as the laymen when thinking about QE, especially if they haven't been too familiar with monetary economics -- and most of them haven't. There is also a great sense of urgency, even unease, behind all this, much like there was in the 1930s. Something is wrong, and it seems it has a lot to do with money and debt.

To the point of this post. Where does the buck stop?

When discussing money (a term which I have mostly abandoned) with people familiar with monetary economics, sooner or later someone mentions "high-powered money" (HPM). I would be happy if we could shed more light onto this in the comments section later on, but let me try to make the first try here.

I see that most of the lines from (people who turned out to be) MMT advocates in a Twitter discussion I participated in yesterday are to be found in a single blog post by Bill Mitchell ("Money multiplier and other myths"), so I'll quote him below to represent what I assume to be the "MMT case". I want to stress the point that I'm not here to attack MMT. I'm someone who thinks for himself, and I have learned a lot by reading people who seem to consider themselves MMTers. I question many things they say, like I question nearly everything I happen to come by, be it written by New Keynesians, neoclassicals, Austrians or Post-Keynesians. Most importantly, I believe I question my own thinking all the time, too.

Mitchell critizes the "money multiplier" concept and says:

The monetary base does not drive the money supply. In fact, the reverse is true. So the reserves at any point in time will be determined by the loans that the banks make independent of their reserve positions.

I believe he is correct. Later on, discussing HPM, he writes:

Modern monetary theorists consider the credit creation process to be the “leveraging of high powered money”. The only way you can understand why all this non-government “leveraging activity” (borrowing, repaying etc) can take place is to consider the role of the Government initially – that is, as the centrepiece of the macroeconomic theory. Banks clearly do expand the money supply endogenously – that is, without the ability of the central bank to control it. But all this activity is leveraging the high powered money (HPM) created by the interaction between the government and non-government sectors.

Let's keep in mind that monetary base is another name for HPM. Money supply consists mostly of commercial bank deposits, which are held by non-bank businesses and households. Based on this, I don't fully understand how Mitchell can hold these two positions simultaneously:

1. Private credit creation by commercial banks (which affects the money supply) drives the amount of HPM. (first quote above)

2. Private credit creation process is leveraging of HPM. (second quote above)

Have I misunderstood something? To me, "leveraging of HPM" sounds a bit like "money multiplier". I find it hard to believe that Mitchell would hold such opposite positions, so I point this out in order to get this clarified.

Mitchell continues:

HPM or the monetary base is the sum of the currency issued by the State (notes and coins) and bank reserves (which are liabilities of the central bank). HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them! All Government spending involves the same process – the reserve accounts that the commercial banks keep with the central bank are credited in HPM (an IOU is created). This is why the “printing money” claims are so ignorant. The reverse happens when taxes are paid – the reserves are debited in HPM and the assets are drained from the system (an IOU is destroyed). 

[...] 

So HPM enters the system through government spending and exits via taxation. When the government is running a budget deficit, net financial assets (HPM) are entering the banking system. Fiscal policy therefore directly influences the supply of HPM. The central bank also creates and drains HPM through its dealings with the commercial banks which are designed to ensure the reserve positions are commensurate with the interest rate target the central bank desires. They also create and destroy HPM in other ways including foreign exchange transactions and gold sales.

We can think of the accumulated sum of the vertical transactions as being reflected in an accounting sense in the store of wealth that the non-government sector has. When the government runs a deficit there is a build up of wealth (in $A) in the non-government sector and vice-versa.

He is obviously not saying that only the fiscal position affects the amount of HPM in the system. For instance, the amount of HPM in the US economy today has very little to do with the size of the fiscal deficit (say, five years prior and five years foward). So he must be saying that (a small) part of the HPM is "net financial assets" -- that is, until the deficit is covered by issuing government bonds which then take the role of "net financial assets" (until the central bank does QE...). Some MMT advocates seem to put a lot more importance on the fiscal deficit as a source of HPM, and this can be misleading.

My main problem with MMT described by Mitchell is this: Fiscal deficits do not create assets without corresponding liabilities. ("Only vertical transactions create/destroy assets that do not have corresponding liabilities.") The view is too narrow. Government acts on behalf of its citizens, and spends mainly on behalf of its taxpayers. Therefore the liabilities it acquires are acquired on behalf of the "non-government sector".

No IOU can ever present "net wealth" in the global economy.

Connected to this, we need to acquire a broader view where he writes that "HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them!". It is an IOU which has a nominal value of $A10, denominated in an abstract unit of account (in this case, Australian Dollar; the IOU itself is not "a dollar"). What is owed is not defined -- only the nominal value of it is. It is left to the creditors (holders of this IOU) and the debtors (taxpayers and other debtors) to decide what is owed. It will be decided on the market. I will clarify this in my coming posts.

So where does the buck stop? It doesn't stop at HPM. It doesn't stop at "the money which is a promise to pay money". It stops at the transactions (often of goods and services) between creditors and debtors. Money is an IOU, and that is why money can never be what is ultimately owed.

Paying by Promising to Pay

John Hicks writes in "A Suggestion for Simplifying the Theory of Money" (1935) about banks:

... the security of their promises to pay is accepted generally enough for it to be possible to make payments in those promises.

I find it hard to accept that payments can be made in promises to pay. It is illogical. Yet, this is how we view and talk about the economy. We consider payments made mainly in banks' promises to pay, although we do accept another way to make payments which we call barter.

Merriam-Webster defines barter (verb) as follows:

to exchange things (such as products or services) for other things instead of for money

In a barter system, payments are made in goods or services. Some people contrast bartering with the use of money as a medium of exchange and claim that a system where sellers acquire credits -- but not money -- which they can later use to buy goods or services is essentially a barter system. To me, this is too big a stretch from the classical definition of barter. For instance, Adam Smith, writing in Wealth of Nations (1776) of a situation where paper money would lose its value after the loss of the gold stock of a nation, says:

The usual instrument of commerce having lost its value, no exchanges could be made but either by barter or upon credit. (Book II, Chapter II) 

It is good to see that Smith, though often blamed for having suggested that money emerged from the difficulties (see Jevons' famous "double coincidence of wants") related to a barter system, does recognize credit as something which enables exchange, and which he separates from barter.

Here comes my main point. What we all must agree upon is that a seller who, in a transaction, extends credit doesn't receive a payment. From this it must follow that the buyer involved in the transaction doesn't make a payment.

If accepting a bank's, or anyone else's, promise to pay is not extending credit, then what is?

I, too, have grown up thinking that payments are made in money, that bank deposit transfers are money transfers, and so they constitute payments. But I'm ready to question all this if it helps me understand better how the economy works. Having now, for some time, entertained the thought that one cannot make payments in money *, I have come to believe strongly that it must be so. And not only that, but actually everything seems to make more sense when viewed through this "new lense". Although I have always considered myself a contrarian, I must admit that here I have exceeded myself.





* What I in the current post say about commercial bank deposits, I extend to central bank notes and deposits as they, too, are "promises to pay". See my earlier post for more information on this wider perspective.