Cartoon from 1864 poking fun at politicians and greenbacks (source and explanation)

During the greenback era, the Union government issued irredeemable paper money to help pay for its war against the Confederates. What many people don't realize is that there were actually two different strains of greenbacks—those printed before March 1862 and those printed after. Although these two strains had only slightly different properties, they were not fungible with each other and would go on to have drastically different values in the marketplace. Looking at the respective properties of each type gives some insights a thorny problem: why do colored bits of paper money have value?

One classic explanation for the value of fiat money is so-called 'tax-backing.' If the government stipulates that taxes must be paid using government-issued chits of paper, then that will be sufficient to give those chits a positive value. Back in 1910 economist Philip Wicksteed was one of the first economists to champion this explanation:

The Government, then, levying taxes upon the community, may say: "I shall take from you, in proportion to your resources, as a tribute to public expenses, the value of so much gold. You may pay it to me in actual metallic gold or you may pay it to me in anything which I choose to accept in lieu of the gold. If you do not give it me I shall take it from you, in gold or any other such articles as I can find, and which would serve my purpose, to the value of the gold. But if you can give me a piece of paper, of my own issue, to the face value of the gold that I am entitled to claim of you, I will accept that in payment." Now, as these demands of the Government are recurrent, there will always be a set of persons to whom the Government paper stamped with a unit weight of gold is actually equivalent to that weight of gold itself, because it will secure immunity from requisitions to the exact extent to which the gold would secure it. - The Common Sense of Political Economy, Book II Ch 7

The idea that a tax obligation can be the basis of money, or what Randall Wray has termed twintopt, is at the core of modern monetary theory, or MMT.

Let's see how the tax backing theory holds up during the greenback period. To set the context, South Carolina had seceded from the Union in December 1860, soon followed by ten other states. Hostilities between the Union and newly-formed Confederate states began in April 1861. To help fund the Union side of the war effort, an initial $50 million issue of greenbacks was authorized in July. This was to be the first government paper money emitted since the Second Bank of the United States had been wound up.

The act ruled that these notes were to be redeemable on demand in gold, a promise that was also inscribed on the face of each note (see below). They thus earned the nickname demand notes. This promise meant that, at the outset at least, their price could not deviate from par since any movement above or below their gold value would be arbitraged away. When redemption was rescinded a few months later on December 30, 1861, demand notes began to trade at a 1-2% discount to their face value in gold.

Greenbacks were introduced in 1861. Note the progression from the first issue—ie 'demand notes'—to the second in 1862—'legal tender notes'. pic.twitter.com/ELnSg3QRtB

— JP Koning (@jp_koning) October 10, 2017

The second vintage of greenbacks, known as legal tender notes, was authorized two months later by the Legal Tender Act of February 25, 1862. This act provided for an issue of $150 million, much larger than the first vintage. One novelty is that the second batch of notes was declared legal tender, which meant that a creditor could not refuse to receive them at par in discharge of a debt. The legal tender property was extended to demand notes in March 1862. The second vintage of notes was also irredeemable, putting them on the same basis as the demand notes, which became irredeemable at the end of 1861.

What distinguished legal tender notes from demand notes? As the tweet above shows, the two vintages had visible differences—unlike demand notes, legal tender note did not have the promise to redeem on demand printed on their face. Demand notes also had an extra promise inscribed on them: "receivable in payment of all public dues". What this meant in practice is that the government accepted demand notes in payment for all taxes, including customs dues, whereas legal tender notes were only receivable in a narrow range of internal revenue taxes—and not for customs dues—which at the time made up the majority of Union tax revenues.

Receivability for customs dues was an important point of departure between demand notes and legal tender notes. Duties were priced in gold and could also be discharged with gold coins. So if an importer was on the hook for $x in custom duties, they could certainly scrounge up $x in gold coin to get rid of the obligation, but $x in demand notes would be sufficient to "secure immunity" from the tax. Not so with legal tender notes.

A given importer might only need a small portion of the demand notes in his possession to pay customs duties. Anything above that amount would be worth less than their face value to him, since gold—not demand notes—was necessary to buy goods internationally. However, if that importer could find other importers who were themselves under obligation to pay customs duties, and who would therefore value his remaining stash of demand notes for their tax receivability, then he might sell them his remaining demand notes at a price quite close to the value of gold coins.

So all that was needed to have irredeemable demand notes trade near the value of gold was a permanent market of tax payers who demanded those notes, and a flow of new notes that did not exceed the rate of drainage provided by the tax outlet. After all, if the supply of notes overwhelmed the amount of tax that needed to be paid, then notes would accumulate in importers pockets with no one willing to bid for them. Once everyone's taxes had all been paid up, demand notes would trade at a discount to gold coins. 

Tax receivability was successful in keeping the value of demand notes close to their gold value. The chart below shows the price of both demand notes and legal tender notes relative to gold through 1862-63.  Demand notes never fell to more than a 10¢ discount relative to gold coin. Calomiris blames this discount on the risk that receivability for customs duties would be revoked by the government before notes had been paid in.


Legal tender notes, however, fell to an ever larger discount relative to both gold coin and demand notes, reaching a 40¢ discount by March 1863. While legal tender notes were receivable for domestic taxes, these taxes did not account for a very large share of government revenues. Nor were these taxes priced in gold. Which meant that, unlike demand notes, legal tender notes were not benchmarked to some real good or price index.

So what, if anything, determined the price of legal tender notes? Here I'll introduce another theory for the value of money; the metallist viewpoint. Rather than tax receivability driving a currency's value, a metallist looks to the currency's intrinsic value. When banknotes are fully redeemable, their intrinsic value is determined by the underlying gold on which the note is a claim, the value of which is set in the market for precious metals in technology and the arts.

In the case of legal tender notes, which were no longer redeemable, the realization of intrinsic value had only been delayed to some future point in time when gold convertibility would be re-adopted. This eventual re-mooring date was in turn a function of the Union government's ability to win the war, among other factors. According to this theory, the steady decline in the gold value of legal tender notes in the chart above can be blamed on the realization by the public that the war would last much longer than most originally thought, pushing the re-mooring date ever further into the future.

While the 1861 issue of demand notes had all been bought back and cancelled by the government by mid-1863, greenbacks remained outstanding even after the war had been won. Their discount to gold continued to widen till July 1864 at which point their price steadily rose. See the chart below. The steady return to par probably can't be explained by the tax-backing theory. Improved odds that the government's fiscal situation would allow it to resume gold convertibility—an event that finally occurred in 1879—is a better explanation. There have been a few interesting accounts written about the value of greenbacks over the full 1862-1879 period, including Wesley Clair Mitchell's A History of the Greenbacks in 1903, but also more recent contributions here (Calomiris), here (Smith & Smith) and here (Willard et al).


In sum, the U.S. government was issuing three non-fungible currencies by 1862. Coins and legal tender notes operated under the principles of a metallic money whereas the third, demand notes, seems to have been a purely tax-driven money as described by Wicksteed. So what about a modern dollar note? Is a Federal Reserve note like an 1861 demand note and mostly tax-driven, or like legal-tender notes and operating on a metallic basis?

I'm not entirely sure, but my guess is that it is a messy combination of both. When it comes to money, I'm not a believer in any one theory. Although the odds of a future return to the old 1972 gold redemption rule of 0.024 ounces per dollar is non-existent, the metallic explanation for the dollar's value continues to be relevant. Instead of redeeming currency with fixed amounts of metal as in days of yore, modern central banks repurchase notes with financial assets held in their vault in a manner that is consistent with hitting an inflation target. This is very much like 1800s-style metallism, except with an ever-shrinking CPI basket in the place of a fixed amount of gold.   


Sources:

Wesley Clair Mitchell, A History of the Greenbacks

PS: I recently started a discussion board here. Feel free to bring up topics not covered on my more recent blog posts, suggest posts, or discuss ideas that appear on my Twitter feed. I don't like Twitter for long-form discussion; I'd much rather divert them to the board.

PPS: Nathan Tankus responds here.

by Paul Conrad

When we talk about bitcoin, one thing we need to ask ourselves is this: can worthless things circulate and be accepted in trade? If so, how? And can this state of affairs continue indefinitely?

An intrinsically useless, unbacked, and costless fiat object might be accepted in trade, but only if it already has a positive price. A history of positive prices will generate sufficient expectations among potential acceptors that they will be able to trade that object on tomorrow. But how might our fiat object earn a positive price to begin with? If we reply that early adopters expected it to be widely accepted by others in trade, how did these early adopters ever form these expectations if that object didn't already have a positive price? We're dealing with a problem of circularity. There is no way to "break into" a dynamic that might generate a positive value for a fiat object. So logically, worthless things cannot trade in the market at a positive value.

However, fiat objects like dollars and yen do seem to have a positive value. Two types of economists, Austrians and MMTers, recognize the circularity dilemma that emerges when trying to explain the positive price of a useless fiat object. Both solve the circularity problem in different ways.

Austrians say that when early adopters first acquired the fiat object, it was not yet intrinsically useless, unbacked, or costless. Thanks to its original commodity nature, or perhaps its status as a backed financial asset, it already traded at a positive price. Even if that character is lost, the object suddenly becoming a fiat one, it may still be widely accepted in trade on the basis of people's memory of its pre-fiat price. Thus the circle can be broken into, and worthless bits of paper can legitimately have a positive value in trade. This is Ludwig von Mises's famous regression theorem.

MMTers solve the circularity problem by bringing in the tax authority. As long as some agency like the government imposes an obligation on people to pay taxes with these fiat objects, that will be enough to drive their positive value.

I should point out that I don't think we actually face a circularity problem with modern central banknotes since they aren't worthless bits of paper but rather exist as a liability of their issuer. But we do run into the problem with bitcoin. Here we have an unbacked, intrinsically useless, stateless fiat object trading at $950 or so, not to mention a legion of copycat coins trading at various positive prices. [1]

Austrians are all over the board on bitcoin. Because their solution to the circularity problem is to invoke the legacy commodity value of a fiat object, bitcoin poses some theoretical hurdles for them since it is by no means clear whether bitcoin ever had an original commodity value. Bob Murphy for one argues here that bitcoin may have earned its first foothold thanks to non-pecuniary ideological reasons. However, there seems to be no consensus among Austrians on that point. MMTers seem to genuinely dislike bitcoin since their preferred tax obligation story can't bear the load of explaining bitcoin's price. Here is L. Randall Wray who says that bitcoin is a test of the "infinite regress view of money", then gleefully points to its falling price as evidence that the taxed backed theory is the dominant theory (it later rebounded).

Let's move on from MMTers and Austrians. George Selgin recently came up with an interesting way to explain how bitcoin might have earned its all important original positive price:

Records show that a just a few persons took part in most early Bitcoin transfers, and especially in the larger-volume ones. My guess is that they all knew each other, and that those trades were more-or-less fictitious, with large values being traded and then traded back again, with the intent of enhancing the prominence of the positive-value equilibrium by drawing attention away from the much larger set of inactive Bitcoin markets. Bitcoin’s inventors, I’m now almost certain, were making conspicuous leaps onto their own bandwagon, so as to encourage others to do so, whether to express themselves or to profit by doing so. In short, a clever marketing strategy, including a little strategic sleight-of-hand, can substitute for history in putting a positive sign on the expected value of an otherwise useless potential exchange medium.

Here we have neat way to break into the circle. Have a group of insiders trade the fiat object amongst each other in order to generate an artificial history of positive prices, at which point outsiders will be willing to accept it in trade based on the expectation that others will repurchase it from them later.

Making "conspicuous leaps onto one's own bandwagon," as Selgin calls it, is a well worn tactic. In stock markets, the term wash trading refers to the illegal practice whereby an individual or group of schemers trade an illiquid, often worthless, stock back and forth among different accounts. The goal is to give the illusion of activity, thereby attracting innocent traders who would otherwise pass up the stock. A more colourful term for this is "painting the tape", which refers to the old ticker tape of yore.

Another way to paint the tape is to high close a stock. Using this technique, a trader or group of traders will buy a stock in the closing seconds of the day, pushing its price up. Since media outlets tend to focus on a stock's daily closing price, and stock charts depend on the daily close, high closing may be a cost effective strategy for traders to create and benefit from the positive price momentum that news of a high closing price engenders.

Auction markets, say in livestock or art, are sometimes populated with confederates—those who work in conjunction with a seller to provide fictitious bids so as to drive some object's price, say a dubious piece of abstract art, or a lame horse, far higher than it would otherwise be worth. Should the confederate's bid be the only bid, the worst that happens is that the schemers get their own painting or horse back, upon which they can try the same trick over again in the next auction. If their bidding excites someone else to add a bid, then they've succeeded in earning something for nothing.

In any case, all of these techniques can push a worthless object's price above zero, at which point that object may have generated enough of a history of positive prices that it will be valued by enough outsiders that it will join the mass of non-fiat objects in circulation. From nothing, our worthless item it has pulled itself up by its own bootstraps.

Which explains bitcoin's incredible volatility. A bootstrapped object can just as easily let go of its own straps and fall back to zero. Without some real use or backing, there's nothing to catch it on the way to $0. And at $0, there's no guarantee of re-bootstrapping bitcoin back to some positive price. As such, Bitcoin users justifiably expect incredible returns from bitcoin holdings in order to bear the risk of a zero-value equilibrium. Expected hyperdeflation is the carrot that must be proffered up for risky cryptocoins to be held. When those expectations of price appreciation aren't met, a large crash in the current price (relative to its future expected price) is necessary in order to tempt the next crop of speculators to hold it again. Thus bitcoin's pattern of incredible rises, or hyperdeflation, followed by 50% flash crashes, followed by the next round of hyperdeflation.

So if unbacked, useless, and costless objects can be imbued with a positive price via Selgin's painting-the-tape story, why isn't everyone doing it? But they are! Attracted by the potential for large gains, plenty of people are creating alt-coins, as I wrote here and here. In theory, their combined greediness should have the effect of swamping the market with fiat objects, driving their price towards the cost of production. The idea here is similar to the Somali shilling story, in which continual counterfeiting of old fiat shilling notes drove their price down to the cost of production, namely the costs of paper, printing, and shipment.

This hasn't happened yet with bitcoin, which is hovering at around $950. In my old post Milton Friedman and the mania in "copy-paste" cryptocoins, I hypothesized that the seeming inability of competitors to drive bitcoin prices down had something to do with the unassailable benefits that bitcoin enjoys as being the first mover, including superior security and liquidity. Tyler Cowen has some interesting thoughts on this. Bitcoin has a market cap of about $20 billion. As long as Bitcoin's entrenched advantages are so supreme that it would cost $20 billion to create a competitor, then there's no profit in tackling its niche. Cowen, however, thinks that the cost of mimicking bitcoin is far less than this. Rather than being in equilibrium, the cryptocurrency market is currently working itself via a process of "supply-side arbitrage" to a new equilibrium at which bitcoin will be worth far less.

On this same topic, Nick Rowe suggests that a BackedCoin might be one of the competitors capable of carrying of this feat. I agree with Cowen and Rowe —that's why I mostly sold out of bitcoin last year, and why I plan to eventually sell my litecoin. Of course, I'm the dummy who sold BTC back at $100, so my opinions should be taken with a grain of salt.

Where will the competition come from? Robert Sams makes a good argument for why bitcoin knock offs like litecoin, sexcoin, etc., though costless to produce, can't easily compete with bitcoin itself. The mining power that goes into maintaining the integrity of the various blockchains is in scarce supply. Merchants will always congregate to the blockchain with the most security, since that will be the coin that guarantees that the threat of double-spending is the smallest. While clones can be created with a few key strokes, good security can't be bought. Thus bitcoin's price can't be competed down to $0ish by alt-coins.

I think I buy Sams's point. However, he couches his argument within the existing universe of bitcoin and its clones. I'd make the argument that the crypto phenomena through which "supply-side arbitrage" will be carried out could be something entirely different than bitcoin, say Ripple or something we haven't yet seen. Ripple for one isn't constrained by the supply of existing mining power, or hashing, since the Ripple blockchain is maintained via consensus, not by hashing miners. Is this type of security cheaper? I'm no techie, so I won't speculate. But it is something different. And though it may take a while, at some point new and different will also be cheaper.

Another bonus of the Ripple system is that the crypto currency it creates are not bootstrapped assets, they are redeemable IOUs (let's not confuse Ripple IOUs and XRP!). In Rowe's UnbackedCoin vs BackedCoin world, Ripple IOUs are the equivalent of BackedCoin. It is their backing that should protect the exchange value of Ripple IOU from the threat of competition. This very same backing frees them from the hyperdeflation-crash-hyperdeflation patten that bootstrapped coins tend to display, stability being a desirable feature among  those who want to hold an inventory of media of exchange. As long as Ripple IOUs are just as transferable & secure as bitcoin and other alt-coins, this stability will be the edge that pushes them above the crypto competition.

So in sum, worthless assets can be kickstarted into circulation, say by a group of confederates who paint the tape in a way to attract outsiders. The riskiness of these bootstrapped assets requires that they yield incredibly high returns, or constant price appreciation. However, this state of affairs can't last forever since others will be eager to issue their own competing fiat objects, including superior non-volatile competitors. If I'm right, in the future bitcoin will be a smaller part of the cryptocoin world than it it now, whereas stable-value non-bootsrapped crypto assets, like Ripple IOUs, will be a larger part of that world.

---

[1] Bitcoin may not be entirely intrinsically worthless. I have floated the idea before that bitcoin has commodity value as a symbol of geek cred.

This post may get a bit rambling. It's an attempt to tie together a couple of different strands that I've been thinking and reading about.

Modern monetary theory (MMT) in a nutshell, at least as far as I see it, goes something like this. Back in the 1990s a couple of clever guys came up with the idea of a government-provided jobs guarantee. They realized that this program would be seen by the public as an expensive boondoggle requiring sky-high taxes and huge debts. Could they outflank these criticisms by finding another way to fund the jobs guarantee?

To find the funds the early MMTers worked backwards through the labyrinthine relationship between the Federal Reserve and the Treasury. What they claimed to have discovered at the end of their trek was certainly shocking. The US Treasury, they said, funds itself not by the conventional route of taxes and bonds, but by creating and directly spending fiat (i.e. inconvertible) money. Furthermore, it is not only the government's prerogative, but its obligation to spend this money into existence, since people need a stock of fiat money to pay their taxes. Bonds, contrary to what most of us think, are not a sign of government indebtedness—rather, they drain spending.

This bit of monetary jiu-jitsu is powerful because it has the ability to disarm people's instinctual aversion to expensive social programs. If all it takes to fund a jobs guarantee is that the government spend money, and debt and taxes are not the great evils we have been trained to think, then why resist it?

Most governments don't create fiat money—their central banks do. For a government to have this power, it needs to be able to force its central bank to add new money to the government account. One way to do this is for the government to print up a bond and give it to the central bank. The central bank then credits the government's account for the full amount of the bond, and now the government can spend, say on a jobs guarantee. Alternatively, the transaction can be completed without the transferral of the bond—just have the central bank automatically credit the government's account prior to spending. When the government can require its central bank to create money on its behalf, we say that they are effectively consolidated into one entity.

The earliest MMT tome, Wray's Understanding Modern Money, is very insistent on the consolidated nature of the Fed-Treasury:

"The important thing to notice is that the Treasury spends before and without regard to either previous receipt of taxes or prior bond sales."

"...permanent consolidated government deficits are the theoretical and practical norm in a modern economy... Further, government spending is always financed through creation of fiat money - rather than through tax revenues or bond sales."

"While it appears that the Treasury 'needs' the tax revenue so that it can spend, that is clearly a superficial view... The government certainly does not need to have its own IOU returned before it can spend; rather, the public needs the government's IOU before it can pay taxes."

Now as their critics were quick to point out (see Lavoie, for instance), the relationship between Fed and Treasury is such that the two are not consolidated. The Treasury cannot ask the Fed to credit its account, nor can the Treasury print up a bond and give it to the Fed in exchange for spending power. The only way the Treasury can spend is by moving previously acquired funds that are held in the private banking system into its Federal Reserve account—and the only way it can acquire these funds is through taxes and bond issues. Using the Fed to print money and fund a jobs guarantee program is impossible.

The MMT wish, it would seem, was the father to the thought—Wray's 1998 tome was too hasty in consolidating the Fed and Treasury. MMTers are left with an intriguing theory of how modern money works, yet their theory corresponds to no underlying reality. That doesn't mean that MMT is without some merits. MMTers are hackers. In their efforts to reverse engineer the Fed-Treasury nexus in order to fund their pet project, they've come across plenty of interesting minutiae about monetary operations. MMT papers and blogs go into these details and are worth reading if you want to hone your understanding of the monetary system [just take anything they say about consolidation with a grain of salt].

Has the lack of overlap between Wray 1998's theory and reality stopped MMTers? Not at all. When your theory doesn't describe reality, don't bother changing your theory—change reality so that it conforms to your theory. Enter the platinum coin.

The idea of issuing a trillion dollar platinum coin rose to prominence with the onset of yet another US debt ceiling crisis. The MMT blogs hummed about the coin, a huge coin crescendo grew on Twitter, and the issue went all the way to the White House, which demurred. My hunch is that beating the debt ceiling is only a tertiary motive for MMTer excitement over the platinum coin. Far more important to them is that the platinum coin, if implemented, will effectively consolidate the Fed and Treasury, finally redeeming Wray 1998. This opens to door to their beloved jobs guarantee.

I'm not sure how MMT will evolve, but one thing we'll probably see more of is platinum coin-style activism. Though the rest of world has moved on from the coin, the MMT blogs are still buzzing about it. I'm sure more clever ways to hack the Fed-Treasury nexus will be found, thereby giving the Treasury other routes by which to force Bernanke or whomever follows him to print dollars on demand. These hack-arounds will be publicized. Perhaps a political movement will form. This wouldn't be unique. All sorts parties have formed around monetary ideas—Greenbackism, Free Silver, and Social Credit.

I've always wondered why MMTers ignore Canada. Of all the major central banks, the Bank of Canada conforms most fully to the MMT ideal. Consider this—the Bank of Canada routinely buys bonds directly from the government. The Fed, ECB, and other central banks can only buy government debt on secondary markets. This degree of consolidation goes beyond the ability to participate in bond auctions. The BoC is permitted to lend directly to both the Federal and provincial governments without requiring any security whatsoever. Section 18(j) of the Bank of Canada Act says that the Bank may

make loans to the Government of Canada or the government of any province, but such loans outstanding at any one time shall not, in the case of the Government of Canada, exceed one-third of the estimated revenue of the Government of Canada for its fiscal year, and shall not, in the case of a provincial government, exceed one-fourth of that government’s estimated revenue for its fiscal year, and such loans shall be repaid before the end of the first quarter after the end of the fiscal year of the government that has contracted the loan. 

The US Treasury was once allowed to go into overdraft at the Fed, but this hasn't been permitted since 1981. And even when it could have its account credited, overdraft loans were quite limited in size and duration.


The Bank of Canada is engaged in a very MMT-like operation right now. As I wrote in an earlier post, the Federal government is currently implementing what it calls a prudential liquidity management plan. The BoC typically buys 15% or so of bonds auctioned off by the government. It does so on a non-competitive basis, meaning that it pays the average of all competitive bids submitted to the auction. The traditional 15% allocation is enough to ensure that maturing government debt held in the BoC's portfolio is replaced. In late 2011, the government asked the Bank to fund its prudential liquidity plan by raising its allocation at government bond auctions to 20%. Because this larger allocation is more than enough to make up for maturing debt, the BoC's balance sheet has been growing quite fast. At the same time, the government's account at the BoC, which usually hovers at around $2 billion, now clocks in at $11.5 billion, and by 2014 or so, should rise to $20 billion. Below is a chart of the Bank of Canada's balance sheet. Note the large jumps in government bond holdings (red) and deposits (bottom green).


MMTers might not agree with the prudential liquidity plan, but it surely represents the sort of consolidation they are so anxious to see in the US.

So what happens when the Federal government begins to spend down its prudential balances held at the BoC? Private banks will quickly realize that they have far too many clearing balances and will try to get rid of them. Canada's overnight lending rate will collapse below its target rate. In order to bring the rate back up to target, the BoC can do any number of things.

1) Sell assets from its existing portfolio, thereby withdrawing excess clearing balances.
2) Issue Bank of Canada sterilization bills, which banks will purchase directly from the BoC with excess clearing balances.

Alternatively, the BoC can work together with the government:

3) Ask the government to issue more bonds, depositing the proceeds at the Bank of Canada. Bonds here are fulfilling the money-draining purpose that MMTers like to emphasize.
4) Ask the government to increase taxes, depositing the proceed at the BoC. Just like bonds, taxes would be draining previously spent money.

Finally, the BoC can simply leave this spending unsterilized.

5) Rather than withdraw (i.e. sterilize) balances, let the excess supply drag the overnight rate to the deposit rate. All clearing balances now earn the deposit rate.

The BoC currently maintains a corridor system. During the day, private Canadian banks make and receive hundreds of thousands of payments. By lunch time on a normal day there will be a number of debtor and creditor banks. Debtors can settle with a creditor by borrowing clearing balances from the BoC on a collateralized basis and transferring these balances to their creditor. By the end of the day, the BoC will have typically swallowed up large amounts of collateral as it creates and lends whatever quantity of intraday clearing balances that deficit banks require.

Banks who have borrowed balances to fund a deficit are free to maintain these positions overnight, but are dissuaded from doing so because the rate which they must pay to the BoC, the bank rate, is 0.25% above the market overnight rate. Nor do surplus banks wish to keep the quantities of clearing balances they have received at the BoC overnight, since the deposit rate is 0.25% below the market rate. As a result, those banks holding clearing balances are incentivized to transfer them to those banks that are in debt to the BoC. This transfer allows the deficit banks to pay back their intraday debts to the BoC and get their collateral back. In short, BoC balances are not attractive to maintain so they reflux back to the Bank of Canada. A good visual aid is to think of the central bank as a blowfish: it blows up during the day and sucks itself back in at night when it isn't needed.

If it turns to this last solution, the Bank of Canada will be throwing away its corridor system and adopting a floor system. Steve Waldman generated plenty of discussion on his recent series of blog posts on floor systems. As the Federal government spends down its $20 billion prudential balance at the BoC, all private banks will end up holding excess clearing balances. There is no way for them to contract among each other to remove this excess. Only one option remains to the banks—hold these balances overnight and receive the deposit rate. The Bank of Canada would be a permanently inflated blowfish.

If it adopts a floor, the BoC wouldn't be the first. The Federal Reserve stumbled its way into a floor system in 2008 by injecting so many reserves that it was unable to sterilize them. But a floor system is by no means universally accidental. The Reserve Bank of New Zealand chose to adopt a floor in 2006. When it maintained a corridor, the RBNZ began to notice signs of stress in the banking system that it traced to insufficient liquidity. Evidence included delayed or 'just-in-time' payments, failed settlement, collateral hoarding, and increasing use of the bank's overnight lending facility.

Between July and October 2006, the RBNZ moved to a fully "cashed up" system by injecting $7 billion worth of settlement cash on which it paid interest. Banks had typically required $3-5 billion worth of intraday credit in order to meet their payment requirements. Now that there was a permanent $7 billion worth of balances, there was no longer any need for banks to get intraday loans from the RBNZ, nor scramble for collateral to qualify for these loans. Banks ceased waiting till the end of the day to make payments. The time of day when 50% of all payments were completed was moved up by two hours compared to when the corridor system was in place. (See the RBNZ's account of this here.) Flattening out settlement over a trading day can be desirable since settlement delays, especially if they spread from participant to participant, can be costly.

The Bank of Canada has toyed with an RBNZ-style cashed up system. In response to the credit crisis, in May 2009 the BoC injected $3 billion of excess settlement balances into the clearing system, pushing the overnight rate down to the Bank's deposit rate. This excess was removed in June 2010, a year later. We know from a presentation by former Deputy BoC Governor David Longworth that much like New Zealand, Canadian payments tended to be made earlier in the day during the period between May 2009 and June 2010.  If the Federal government's prudential balances at the BoC are spent down, a decision to use the occasion to move to a floor system rather than sterilizing this spending would not be without precedent or merit.

[If you're interested on this subject, this paper relates the US experience with excess reserves. Much like Canada and New Zealand, US payments after the onset of excess reserves were more evenly distributed throughout the day.]

Back to MMT, where this whole ramble started. Much a large corporate conglomerate, MMT might benefit from being dismantled. Beholden to the jobs guarantee division, the monetary division has made unrealistic claims about the nature of consolidation. Now it is turning to monetary activism. The monetary division would be less conflicted, and therefore be taken more seriously, if it was spun off from its parent. As separate corporations, the jobs guarantee folks could focus on lobbying governments like Canada to use their central banks to fund social programs, freeing the monetary folks to focus on how monetary systems actually work. Why not deconsolidate MMT?

Rai at the Bank of Canada - part of Canada's foreign reserves

As I pointed out in my previous post, all sorts of economists have incorporated the example of Yap stones into their monetary discourse. One of the more peculiar uses of these stones can be found in neo-chartalist L. Randall Wray's Understanding Modern Money (1998).

In Chapter 4 of his book, Wray claims that an economy becomes monetized by the introduction of state-issued tokens (what I call coupon instruments). To provide empirical support for his claim, Wray repeats the story about German administrators marking all Yap stones with paint (see previous post, #9). The Germans did so in order to motivate the Yapese to build roads. After all, in order to get the state to remove these markings from their valuable stones, the Yapese were required to provide their labour. The implications of Wray's chapter are that instead of requiring labour, the German government could just as easily have required payment in government-issued paper coupons. Thus Yap, which up till then had never been a monetary economy, would have suddenly become monetized.

Wray is in some difficulty here since Yap stones already circulated as media of exchange (see Goldberg in previous post). Thus the emergence of a monetized economy came prior to any German state-inspired monetization. This possibility is particularly harmful to Wray since he has adopted throughout his book an extreme, or "vulgar", version of chartalism in which the only way to monetize an economy is to introduce a state-issued coupon instrument. In a note, Wray tries to wriggle out of his predicament, claiming that:

Furness, almost certainly in error, called these 'stone currency' and imagined that they were used as some sort of primitive 'medium of exchange'; however, his description uncovers no evidence that there were any markets. (73)

Wray is contradicted by the anthropological evidence provided by Gillilland and Furness, who list all sorts of examples of rai acting as media of exchange. Rai were used to purchase fish, housing materials, yams, labour, women, coconuts, and many other valuable items. Yap stones original circulation as commodity media-of-exchange therefore prove Wray wrong  in his extreme view that an economy can only be monetized via state-issued coupons.

Federal Reserve Bank of Cleveland's Michael Bryan wrote a paper called Island Money (2004) in which he adopts the chartalist idea that "money" is a marker, or a credit/debit, in order to explain rai. Owning a stone meant that one possessed a credit on the rest of the Yapese or, put differently, that Yap was in debt to the stone's owner. In this way rai functioned as "memory", a means by which to tabulate who owes whom. This is an old idea going back centuries but most popularly reincarnated in Narayana Kocherlakota's Money as Memory.

Now it is certainly true that credit IOUs have and continue to serve as some of society's most liquid instruments. Bank deposits are a great example. But to assume that only credit can qualify as "money" is to commit the same sin of monetary extremism that Wray commits. Bryan maintains that

rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money... Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established. Lacking intrinsic worth, Yap stones may be an especially useful object of study for students wishing to understand the significance of U.S. dollars, which, after all, have no value other than as a monetary unit; they’re what economists call an “fiat” money.

But as Goldberg has pointed out, Yap stones did have significant intrinsic value. There is no need, therefore, to accept Bryan's fallback view that within the so-called vacuum of intrinsic worthlessness, money could only earn value from its status as an IOU, or as so-called "memory".

The other problem with the Bryan's rai-as-credit story is their sheer size. Why choose something so awkward as a three meter wide stone to record an IOU? Any small token can be used to represent either smaller or larger debts. Casinos issue chips of the same size and shape representing amounts from $1 to $1000 — no casino deems it necessary to issue human-sized intrinsically valuable (gold plated?) $1000 casino chips. Rather than using huge stones as IOUs, the Yapese could have easily used verbal promises to record debts (see #8, previous post), or coconut shells emblazoned with markings. The simpler explanation for rai's value is Goldberg's: rai were intrinsically valuable for religious and aesthetic purposes.

I'm not saying that chartalism is wrong. I've pointed out before that I think the idea of coupon "money" makes some sense—even McDonald's could create chartal coupon instruments. So while you can count me in as a soft chartalist (I'm also a soft metallist, a soft monetarist, a soft Keynesian, a soft Austrian, etc), I'm not persuaded by the extreme versions of chartalism. The contortions its advocates are forced to undertake in order to explain monetary phenomena like Yap stones lead them astray.