[This is a guest post by Mike Sproul. Mike has posted a few times before to the Moneyess blog.]

Here is a summary of the Federal Reserve’s Principles for the Conduct of Monetary Policy, which aims at “walking the tightrope” between inflation and unemployment:

…the central bank should provide monetary policy stimulus when economic activity is below the level associated with full resource utilization and inflation is below its stated goal. Conversely, the central bank should implement restrictive monetary policy when the economy is overheated and inflation is above its stated goal.

In contrast, here is the real bills doctrine:

Money should be issued in exchange for short-term real bills of adequate value.

The real bills doctrine was developed by practicing bankers over centuries of experience, and was written into the Fed’s original charter. The real bills doctrine survived for centuries because banks that obeyed it survived. They tended to stay solvent, and they provided an elastic currency that grew and shrank with the needs of business. At the same time, the real bills doctrine helped banks to avoid inflation, recession, liquidity crises, and bank panics.

In this essay, I hope to make the point that as long as the Fed obeys the real bills doctrine, it cannot go wrong in issuing as much money as the public will absorb. In other words, monetary policy is not like walking a normal tightrope. It is perfectly safe to lean in the direction of “too much money”, but dangerous and pointless to lean in the direction of “too little money”.

A few points to notice:

1. As long as new money is issued in exchange for adequate backing, the Fed’s assets will move in step with its issue of money, and there will be no inflation. This explains (among other things) why the Fed was able to issue enormous amounts of money after 2008, without causing inflation.

2. If unemployment is a threat, then the Fed should not hesitate to issue new money (adequately backed). Unemployment is often caused by a tight money condition and accompanying liquidity crises. Issuing new money in this situation will relieve the liquidity crisis, thus reducing unemployment. Meanwhile, adequate backing assures that the new money will not cause inflation.

3. If inflation is a threat, then a restrictive monetary policy will only succeed in creating a tight money condition, without addressing the real problem, which is too little backing per unit of money. The right solution to inflation would be to correct whatever problem is causing the Fed’s assets to fall relative to its issue of money, and then, so long as backing is adequate, issue as much money as the public will receive. The only drawback is that the public might be faced with unwanted cash piling up in vaults and mattresses, but the storage cost of too much cash would be insignificant in comparison to the recessionary effects of too little cash. Besides, unwanted cash can only pile up so much before it simply refluxes to its issuer.

The recessionary effects of tight money, as well as the stimulative effects of issuing new money, have been noted by nearly all observers of monetary history.

The remedy was forthcoming in a scheme prepared at a meeting which had been held a week earlier (April, 1793) at Pitt’s private house. It provided for the creation of additional liquid assets in the shape of Exchequer bills, to be lent to temporarily embarrassed firms. By this means the channels of trade were successfully thawed, and, as it proved, without loss to the Treasury. Clearly, therefore, the panic was due to a temporary need for greater liquidity, which the Bank could not this time meet by contracting advances to the government, since these were needed to prosecute the war. (Ashton and Sayers, p. 10, 1953).

The real bills view is that the Fed should not only provide liquidity in times of crisis, but should provide abundant liquidity at all times, in order to assure that crises never get started in the first place. So the real bills doctrine tells us not to worry that the Fed’s balance sheet has been exploding over the last few months. An exploding balance sheet may be exactly what the economy needs. But the “tightrope” mindset makes the Fed wary of issuing too much money, for fear of causing inflation. This fear is unjustified. On real-bills principles, the Fed need only take the simple precaution of only issuing cash in exchange for assets of adequate value, and inflation will cease to be a threat. We have nothing to fear from too much money, and everything to fear from too little. Rather than unwinding the Fed’s balance sheet, the Fed should unwind its “tightrope” approach to monetary policy.

[This is a guest post by Mike Sproul. Mike has posted a few times before to the Moneyess blog.]


“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well tried principles of Laissez Faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

-J.M. Keynes, The General Theory.


Keynes’ ruminations about bank notes and coal mines are a good place to draw a dividing line between classical economists and Keynesians.  In contrast to Keynesian optimism about the coal mine scheme, classical economists tell us that the newly dug-up bank notes will only succeed in causing inflation, while wasting the labor of those who dig up the notes.

Surprisingly, there is some middle ground about burying bank notes. Economists of both stripes generally agree that money shortages cause recessions. If there is not enough money for people to conduct business conveniently, then people are forced to revert to barter or other less efficient means of trade. Trade slows, and productivity suffers.  Some economists will call it a “money shortage”. Others will say “liquidity crisis”, “credit crunch”, “tight money”, “failure of aggregate demand”, and so on. Whatever the terminology, economists have been saying for centuries that money shortages cause recessions.

In the year 1722-3, the Governor and Assembly…thought themselves obliged to take into their serious consideration the distressed circumstances and sufferings of the people, through the extreme want of some kind of currency…These bills being emitted, their effect very sensibly appeared, in giving new life to business, and raising the country in some measure, from its languishing state. (Pennsylvania Assembly to the Board of Trade, 1726. Cited in Brock, 1941, p. 76)

Now we begin to see the middle ground. Both Keynesians and Classicals agree that the coal mine scheme could potentially provide badly needed liquidity and thus end a recession. Once this is agreed, the rest is just dickering over the size of various forces. A Keynesian might think that the misallocation of labor spent digging up bank notes might drag down national production by 5%, but that the notes dug up might lubricate trade enough to boost production by 20%.  A Classical might put the figures at 10% drag and 15% boost.

The backing theory of money gives us a way to clear up some confusion between these two views, and provides a liquidity-based theory of recessions that both Keynesians and Classicals can live with.

The backing theory is summed up in figure 1:


In line (1), the bank (which may be a central bank or a private bank) receives 100 ounces of silver on deposit, and issues $100 of bank notes in exchange. Each dollar note is worth 1 ounce of silver.

In line (2) the bank issues another $200 in exchange for 200 ounces worth (or dollars’ worth) of bonds. The backing theory view is that even though the bank tripled the money supply, the bank also tripled the assets backing that money, so it remains true that $1=1 ounce.

Now suppose that the $300 in circulation is 10% less than the “ideal” quantity of money, and that the economy is therefore in recession. A well-functioning bank would respond to the money shortage by issuing another $30 of bank notes, while getting 30 ounces (or $30) of bonds or other assets in exchange. This open-market purchase of bonds would relieve the money shortage, end the recession, and leave the value of the dollar at $1=1 ounce. The open-market purchase method gives excellent results. Keynesians would not be surprised at this, but Classicals might be surprised that the money injection caused no inflation.

Next, let’s try the bottles-in-coal-mines method. The bank prints $30 of bank notes, places them in bottles, and buries them in coal mines. Workers will waste (at most) $30 worth of labor digging up the notes. The bank gets no new assets as it issues the $30 of bank notes, so the value of the dollar falls by about 10% relative to silver. While there are 10% more dollars in circulation, each dollar is worth 10% less silver. The real value of the aggregate circulating cash is thus unchanged. There is no relief of the money shortage, and so the recession continues. The bottles-in-coal-mines method gives terrible results, just as Classicals would expect. Keynesians might be surprised to see that even in a recession, the money injection still causes inflation and fails to stimulate production.

We can improve on the bottles-in-coal-mines method by following Keynes’ suggestion and issuing bank notes in exchange for houses and such. The bank prints $30 of bank notes and spends them acquiring 30 ounces (or $30) worth of houses. The bank’s assets (including houses) rise in step with its money-issue, so the value of the dollar remains at $1=1 ounce. This method relieves the money shortage, ends the recession, and causes no inflation. Excellent results, and not especially surprising to either Keynesians or Classicals. The problem is that it is not always easy for the bank’s assets to keep up with its money-issue. If the bank had spent its $30 of new notes on houses that were only worth 29 ounces, then money-issue would outrun the bank’s assets, and inflation would result. Overall, it’s safer for the bank to spend its $30 buying bonds than buying houses.

There are many more methods of issuing banknotes, but I’ll mention just one: Print $30 of bank notes and give them away to passers-by outside the bank. Then have the government give $30 of bonds to the bank. The bank’s assets will rise in step with its note issue, so there is no inflation. At the same time, the real money supply rises by 10%, so the money shortage is relieved and the recession ends. Excellent results once again. The only problem is that the government will eventually run out of wealth, and will be unable to help the money-issuing bank’s assets keep up with its money issue.

Conclusions:
1) Money shortages cause recessions, and the solution is to issue more money.
2) Issuing new money won’t cause inflation, as long as the new money is adequately backed.
3) It is best to issue new money via conventional open-market purchases of bonds. Failing that, it’s ok to issue new money for houses, or even to give it away, provided the government can cover the give-away. But whatever you do, don’t bury the money in coal mines.

Jacob Little, legendary short seller. The Great Bear of Wall Street 1794 - 186

This is a guest post by Mike Sproul




To understand short-selling, start with three words: “Borrow and sell.” The short-seller in figure 1 borrows a share of GM stock from a stockholder and then sells that share of stock to a buyer for $60 cash. If GM subsequently drops to $50, then the short-seller can buy a share of GM on the open market for $50, repay that share to the stock-lender, and profit $10. But if GM instead rises to $70, then the short-seller loses $10, since he must pay $70 to buy the stock before repaying it to the stock-lender.                                                      




As the short-seller borrows one share of GM, he hands his IOU to the stock-lender. This IOU promises to deliver a share of GM stock. (It would also promise to compensate the stock lender for any dividends missed as a result of lending the stock.) Since the IOU can be redeemed for a genuine share, the IOU will be worth the same as a genuine share. This means that the stock lender does not have much reason to care whether he holds the genuine stock or the IOU (unless he cares about losing his voting rights in the corporation).


Figure 2 shows a simpler way to sell short. The short-seller simply writes up an IOU and sells it directly to a buyer. This kind of short sale gives the same payoff as the “borrow and sell” short sale of figure 1. If GM falls to $50, the short-seller gets a $10 profit, while if GM rises to $70, the short-seller loses $10. This method of short selling is so simple that it can happen by accident. Suppose you're a stockbroker, and a client calls asking you to buy one share of GM for him. You answer, “OK, you got it”, and hang up, planning to deliver the actual stock later in the day. You have just gone short, and you stand to gain $1 for every dollar the stock falls, while losing $1 for every dollar it rises.


A still simpler way to go short is to make a bet with someone, as shown in figure 3. The terms of the bet are that for every dollar GM falls, the buyer pays the short seller $1, while for every dollar GM rises, the short seller pays the buyer $1. The payoffs from this bet are the same as the other two methods of short selling. The bet shown in figure 3 is like a futures trade: There is no actual delivery of GM stock, and gains and losses are settled periodically, including adjustments for dividends. In contrast, the trade in figure 2 is like a forward trade: There is a promise to deliver GM stock, and gains and losses accumulate until the position is closed out.

Some common misunderstandings about short selling:

1. Are these IOUs counterfeit shares? Do they dilute the underlying stock and reduce its value?

No, no, and no. And never mind what Overstock.com CEO Patrick Byrne says. The short seller who issues the IOU puts his name on that IOU, recognizes the IOU as his liability, and stands ready to deliver a genuine share to the holder of the IOU. These are not the actions of a counterfeiter. But suppose there are 1 million genuine shares of GM stock in existence, and that short sellers have collectively issued 2 million IOUs. In a sense, the quantity of GM shares has tripled, and you might expect the share price to fall to 1/3 of its former level. But don't forget that GM did not issue the IOUs, and they are not GM’s liability. They are the liabilities of the short sellers. The issuance of IOUs through short sales does not affect the number of genuine GM shares, nor does it affect GM’s assets, so it can't affect share price. If short selling somehow did put share price out of line with the firm's actual value, then arbitragers would pounce. There will occasionally be liquidity crises when markets break down, stocks are hard to borrow or hard to buy, and arbitrage can't play its usual role; but in normal conditions, arbitrage assures that short selling does not affect share prices. Besides, short selling itself helps to keep markets liquid, and makes these liquidity crises less likely to occur in the first place.

2. What is a naked short?

In figure 1, a naked short would occur if the short seller failed to deliver the genuine share to the buyer within 3 business days. If this happens, the “borrow and sell” short of figure 1 reverts to the “forward style” short of figure 2. The buyer ends up holding the short seller's IOU, rather than the genuine share. If the short seller fails to deliver the genuine share even after an extended period, then the two traders could still settle up with each other in cash or other securities. The “forward style” short of figure 2 would thus revert to the “futures style” short of figure 3. If worse comes to worst and the short seller defaults, then either the stock exchange will make good the loss, or the traders will get a costly lesson in placing too much trust in their fellow man. Sometimes the SEC will step in, and traders will get an even costlier lesson in placing too much trust in the government.

Note that in all three methods of short selling, the dollar payoffs to both traders are identical. This highlights the futility of the numerous restrictions that governments place on short selling in general, and on naked short selling in particular. In the first place, any legal restriction on one type of short selling will only cause traders to switch to a different kind that is not so easily restricted. In the second place, studies show that when governments do succeed in suppressing short sales, markets become less efficient.

3. Short selling and money

When you buy a house, you borrow dollars and then sell those dollars for a house. This makes you short in dollars, just like borrowing and selling GM makes you short in GM (figure 1). Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank's IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money. This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money.

It's reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued. For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$. But if the money supply and money demand curves intersect at a value of 1 oz/$, then the dollar will supposedly trade at a premium of 0.70 oz/$ over and above its backing value of 0.30 oz/$.

This is where short sellers pounce. They could borrow 10 dollars and sell them for 10 oz. of silver, as in figure 4. As they borrow dollars, the short sellers issue dollar-denominated IOUs that promise to repay $10 worth of assets (ignoring interest). These IOUs can either be used as money directly, or they can be traded for a bank's IOU, which could then be used as money. The proliferation of these IOUs will, on textbook principles, reduce the demand for the Fed’s paper currency, causing it to fall in value, let's say to 0.9 oz/$. Now the short sellers can repay their $10 loan with only 9 oz. of their silver, earning an arbitrage profit of 1 oz. (Note that they don't repay their loan with currency, since buying currency with silver would drive the dollar back up.). The short sellers profited from the inflation that they caused. As the short selling continues, the dollar will continue to fall until it reaches its backing value of 0.3 oz/$, at which point short selling is no longer profitable. (Reality check: Currency traders don't usually deal in silver. A more realistic scenario would have traders borrowing dollars and selling them for British bonds (denominated in pounds). This would reduce the monetary demand for dollars and the dollar would lose value, at which point the traders would swap their British bonds for depreciated US bonds, which they would use to repay their dollar loans.)


So here’s the problem with textbook monetary theory: If you think that money's value is determined by money supply and money demand, and that money trades at a premium over its backing value, then you'd have a hard time explaining how money holds its value in the face of speculative attacks by short sellers. You’d also have to wonder why central banks bother to hold any assets at all. But if you think that asset backing determines money's value, there's nothing to explain. Money's value is governed by its backing, just like stocks, bonds, and every other financial security, and short selling will not affect its value.

If you want to understand the law of reflux (and you should), then think of silver spoons. The silversmith shown in figure 1 can stamp 1 oz. of silver into a spoon. If the world needs more spoons, then silversmiths will find it profitable to stamp silver into spoons. If the world has too many spoons, then people will find it profitable to melt silver spoons. Unwanted spoons will “reflux” back to bullion. In this way, the law of reflux assures that the world always has the right amount of silver spoons. We could hardly ask for a simpler illustration of the Invisible Hand at work. But it costs something to stamp silver and to melt it, so the price of spoons will range within a certain band. It might happen, for example, that silversmiths only find it profitable to produce spoons once their price rises above 1.03 oz., while people only find it profitable to melt spoons once their price falls below 0.98 oz. If the costs of minting and melting were zero, then a spoon would always be worth 1 oz.

This is a point worth emphasizing: The value of a spoon is equal to its silver content. An increase in the demand for spoons would not raise the price of spoons much above 1 oz, since new spoons would be produced as soon as the price rose above 1 oz. A drop in the demand for spoons would not push the price much below 1 oz, since spoons would be melted when the price fell below 1 oz. Likewise, if the quantity of spoons supplied became too large or too small, market forces would restore the quantity of spoons to the right level, while keeping the price at or near 1 oz.


In figure 2, the silversmith starts being called a mint, and instead of stamping silver into spoons, the mint stamps silver into 1 oz. coins. The law of reflux works the same for coins as for spoons, always assuring that the world has the right amount of coins, and that the value of each coin always stays at 1 oz., or at least within a narrow band around 1 oz.

The usual thought experiments of monetary theory don't work in this situation. For example, economists often imagine that if the money supply were to increase by 10%, then the value of money would fall by about 10%. But the law of reflux won't allow this to happen. Mints would only issue 10% more coins if the public wanted coins badly enough to part with an equal amount of their silver bullion. And even if mints went against their nature and issued more coins than the public wanted, those coins would be melted or stored, and the value of a coin would not deviate very far from its silver content of 1 oz.


In figure 3, the mint re-invents itself again, this time as a bank. Rather than stamping customers' silver into coins, the bank stores the silver in a vault, and issues a paper receipt called a bank note. (Checkable deposits would also work.) This system has several advantages over coins. (1) It saves the cost of minting and melting. (2) It avoids wear of the coins. (3) Bank notes are harder to counterfeit, easier to carry, and easier to recognize than coins.

The law of reflux still works the same for bank notes as it did for coins. If the economy is booming and people need more bank notes, then people will deposit silver into their banks and the banks will issue new bank notes. If the economy slows and people need fewer bank notes, then people will return their unwanted notes to the banks and withdraw their silver.

Once again the thought experiment of imagining a 10% increase in the quantity of bank notes is pointless. Banks would only issue 10% more notes if the public wanted those notes badly enough to bring in 10% more silver. And even if we imagine that the banks took the initiative, printing 10% more notes and using those notes to buy 10% more silver, every bank note is still backed by 1 oz. and redeemable into 1 oz of silver at the bank, so every bank note remains worth 1 oz.

In figure 4, the bank makes one more important change. Rather than requiring customers to bring in 1 oz of actual silver to get a bank note, the bank also accepts an equal or greater value of bonds, bills, real estate deeds, or anything else that can fit in the vault. This system has several advantages: (1) Handling bonds, etc. is easier and safer than handling silver. (2) The silver formerly deposited can be put to productive use. (3) The quantity of bank notes is no longer constrained by the amount of silver available. (4) The bank earns interest on its bonds, bills, etc.

The law of reflux still operates as before, except that when people want more notes, they can bring in either silver or bonds, and when people have excess notes, the notes can be returned to the bank for either silver or bonds. As before, it makes no sense to ask questions like “What if the bank issues 10% more bank notes?” And as before, so long as every bank note is backed by, and convertible into, 1 oz. worth of assets, every bank note will be worth 1 oz. Just as reflux assures that the value of a spoon is equal to its silver content, reflux also assures that the value of a bank note is equal to the value of the assets backing it.

The Channels of Reflux

Here is a list of some of the many channels through which bank notes might reflux to the issuing bank:
1. The silver channel: Unwanted notes are returned to the bank for 1 oz. of silver. Alternatively, the bank sells its silver for its own notes, which are retired.
2. The bond channel: The bank sells its bonds in exchange for its notes, which are retired.
3. The loan channel: The bank's borrowers repay loans with the bank's own notes.
4. The real estate channel: The bank sells its real estate holdings for its own notes.
5. The rental channel: The bank owns rental properties, and tenants pay their rent in the bank's notes.
6. The furniture channel: The bank sells its used furniture for its own notes.

As long as enough reflux channels are open, it does not matter if a few channels are closed. Customers would not care if the furniture channel was closed, as long as major channels, like the bond channel, stayed open. The bank could take a more drastic step and close the silver channel, or could delay silver payments by 20 years, and as long as enough other channels stayed open, the law of reflux could operate as always, except that notes might be redeemed for 1 oz. worth of bonds, rather than 1 oz. of actual silver. The bank could even un-peg its notes from silver. Rather than redeeming a refluxing dollar note for 1 oz. worth of bonds, it could redeem dollar notes for 1 dollar's worth of bonds. As long as the bank's assets are worth so many oz., it doesn't matter if those assets are denominated in oz. or in dollars.

Once metallic convertibility is suspended, it would be an understandable mistake if people forgot all about the other channels of reflux, and started to think that bank notes were no longer backed by, or convertible into, anything at all. Unfortunately, this mistake has made it into the textbooks:

You cannot convert a Federal Reserve Note into gold, silver, or anything else. The truth is that a Federal Reserve Note has no inherent value other than its value as money, as a medium of exchange. (Tresch, 1994, p. 996.)

There you have it. The closing of just one channel of reflux (the metallic channel), has fooled economists into wrongly rejecting the idea that modern bank notes like the US paper dollar are backed and convertible. Once economists reject this simple and obvious explanation for why modern paper money has value, they are forced to resort to the more exotic explanations offered by textbook monetary theories, which are anything but simple and obvious.

References
Blaug, Mark, Economic Theory In Retrospect, 3/e. Cambridge: Cambridge University Press, 1978
Fullarton, John, Regulation of Currencies of the Bank of England (second edition), 1845. Reprinted by Augustus M. Kelley, New York: 1969.
Tresch, Richard, Principles of Economics, St. Paul, Minnesota: West, 1994

This is a guest post by Mike Sproul. Mike's last guest post is here.

Scott Sumner and I have argued about the backing theory of money (aka the real bills doctrine) quite a bit over the years, starting in 2009 and continuing to the present. (link 1, link 2, link 3, link 4, …) Scott rejects the backing theory, while I favor it. I think that printing more money is not inflationary as long as the money is adequately backed, while Scott thinks that printing more money causes inflation even if it is adequately backed. Our discussions in the comments section of his Money Illusion blog extend well over 50 pages, so I’m going to try to condense those 50+ pages into two key points that cover the main arguments that Scott and I have had over the backing theory. (That’s John Law on the right. He was an early proponent of the real bills doctrine, oversaw a 60% increase in French industry in the space of two years, and was the architect of the western world’s first major hyperinflation and stock market crash.)

The key points:
1. Scott thinks that the liabilities of governments and central banks are not really liabilities.

For example:

“In what sense is cash a liability of the Fed? I thought once we left the gold standard the Fed was no longer required to redeem dollars?” (July, 2009)

“Dollar bills are not debt. The government is not required to redeem them for anything but themselves. That's not debt.” (August, 2009).

It would be cheating if I were to point out that the Federal Reserve’s own balance sheet identifies Federal Reserve notes (FRN’s) as the Fed’s liability, and that a large chunk of the Fed’s assets are classified as “Collateral Held Against Federal Reserve Notes”. Scott already knows that. It’s just that he thinks that the accountants are wrong, and that FRN’s are not a true liability of the Fed or of the government.

Scott’s argument is based on gold convertibility. On June 5, 1933, the Fed stopped redeeming FRN’s for a fixed quantity of gold. On that day, FRN’s supposedly stopped being the Fed’s liability. But there are at least three other ways that FRN’s can still be redeemed: (i) for the Fed’s bonds, (ii) for loans made by the Fed, (iii) for taxes owed to the federal government. The Fed closed one channel of redemption (the gold channel), while the other redemption channels (loan, tax, and bond) were left open. For example, suppose that 10% of FRN’s in circulation were originally issued in exchange for gold, 20% of FRN’s were originally issued on loan, another 30% were given to the federal government, which spent them on office buildings, and the remaining 40% of FRN’s were issued in exchange for bonds. That would mean that 90% (=20+30+40) of circulating FRN’s could be redeemed through the loan, tax, and bond channels alone. Only after those channels were used up and closed would it matter whether the Fed re-opened the gold channel. Assuming that the Fed still cared about maintaining the value of the dollar, the Fed would finally have to start using its gold to buy back the remaining 10% of FRN’s in circulation. But as long as the loan, bond, and tax channels remain open, the mere suspension of gold convertibility does not make FRN’s cease to be the liability of the Fed or of the government.

So Federal Reserve Notes are a true liability, whether or not they are gold-convertible. And like any liability, they are valued according to the assets backing them, just like the backing theory says. In the case of a gold-convertible currency, this is not disputed by Scott or anyone else. For example, as long as the Fed maintained gold convertibility of the dollar at $1=1 oz, it would not matter if the Fed held assets worth 100 oz as backing for $100 in FRN's, or 300 oz worth of assets as backing for $300 in FRN's. The quantity of convertible FRN's can be increased by any amount without affecting their value, as long as they are fully backed. Once we understand that both convertible and inconvertible FRN's are a true liability of the Fed, it is easy to see that the quantity of inconvertible FRN's could also be increased by any amount, and as long as the Fed's assets rose in step, there would be no effect on the value of the dollar. (There is a comparable result in Finance theory: that the value of a convertible call option is equal to the value of an inconvertible call option.)

2. Scott thinks that if the central bank issues more money, then the money will lose value even if the money is fully backed.

For example:
“ That’s where we disagree. I think open market operations have a huge impact on the price level, even if they involve the exchange of assets of equal market value.” (April 2012)

“ I understand what the backing theory says, I just don’t think it has much predictive power. Nor do I think it matches common sense. If you increase the monetary base 10-fold, prices will usually rise, even if the money is fully backed.” (July, 2009)

The problem with supposing a 10-fold increase in the monetary base is that we must ask how and why the money supply increased. If the new money was not adequately backed, then I agree that it would cause inflation. So if every dollar bill magically turned into ten dollar bills, or if helicopters showered us with newly-printed dollar bills, or if the Fed issued billions of new dollar bills in exchange for worthless bonds or worthless IOU’s, then Scott and I would both expect inflation. It’s just that I would expect inflation because the quantity of Federal Reserve Notes was outrunning the Fed’s assets, while Scott would expect inflation because the quantity of FRN’s was outrunning the quantity of goods being bought with those FRN’s.

But if the Fed issued billions of new dollars in exchange for assets of equal value, then I’d say there would be no inflation as long as the new dollars were fully backed by the Fed’s newly acquired assets. I’d also add a few words about how those dollars would only be issued if people wanted them badly enough to hand over bonds or other assets equal in value to the FRN’s that they received from the Fed.

This is where things get sticky, because Scott would once again agree that under these conditions, there would be no inflation. Except that Scott would say that the billions of new dollars would only be issued in response to a corresponding increase in money demand. So while I’d say that there was no inflation because the new money was backed by the Fed’s new assets, Scott would say that there was no inflation because the new money was matched by an increase in money demand. It seems that for every empirical observation, he has his explanation and I have mine. We are stuck with an observational equivalence problem, with neither of us able to point to an empirical observation that the other guy's theory can't explain.

But what if the Fed lost some or all of its assets while the quantity of FRN’s stayed constant? The backing theory would predict inflation because the Fed would have less backing per dollar, and the quantity theory would predict no inflation, since the same number of dollars would still be chasing the same amount of goods. It looks like we finally have a testable difference in the two theories. But here again, it’s easy for both Scott and me to get weaselly. If inflation happened in spite of Scott’s prediction, he could answer that money demand must have fallen. If my expected inflation failed to materialize, I could answer that the government stands behind the Fed, so any loss of assets by the Fed would be compensated by a government bailout. Empirical testing, it turns out, is hard to do. But at least I can claim one small victory: Scott is clearly wrong when he says that the backing theory doesn't have much predictive power. It obviously has just as much predictive power as Scott's theory, since every episode that can be explained by Scott's theory can also be explained by my theory.

Scott is also wrong to claim that the backing theory doesn't match common sense. Clearly, it makes perfect sense. Everyone agrees that the value of stocks and bonds is determined by the value of the assets backing them, and the backing theory says, very sensibly, that the same is true of money. Actually, it's when we start to use our common sense that the backing theory gains the advantage over the quantity theory. There are many aspects of the quantity theory that defy common sense, but I'll focus on four of them:

(i) The rival money problem. When the Mexican central bank issues a paper peso, it will get 1 peso’s worth of assets in return. The quantity theory implies that those assets are a free lunch to the Mexican central bank, and that they could actually be thrown away without affecting the value of the peso. This free lunch would attract rival moneys. For example, if US dollars started being used in Mexican border towns, then the Mexicans would lose some of their free lunch to the Americans. As the dollar invaded Mexico, the demand for pesos would fall, and the value of the peso would fall with it. More and more of the free lunch would be transferred from Mexico to the US, until the peso lost all value. If the quantity theory were right, one wonders how currencies like the peso have kept any value at all.

(ii) The counterfeiter problem. If the Fed increased the quantity of FRN’s by 10% through open-market operations, the quantity theory predicts about 10% inflation. If the same 10% increase in the money supply were caused by counterfeiters, the quantity theory predicts the same 10% inflation. In this topsy-turvy quantity theory world, the Fed is supposedly no better than a counterfeiter, even though the Fed puts its name on its FRN’s, recognizes those FRN’s as its liability, holds assets against those FRN’s, and stands ready to use its assets to buy back the FRN’s that it issued.

(iii) The currency buy-back problem. Quantity theorists often claim that central banks don’t need assets, since the value of the currency is supposedly maintained merely by the interaction of money supply and money demand. But suppose the demand for money falls by 20%. If the central bank does not buy back 20% of the money in circulation, then the quantity theory says that the money will fall in value. But then it becomes clear that the central bank does need assets, to buy back any refluxing currency. And since the demand for money could fall to zero, the central bank must hold enough assets to buy back 100% of the money it has issued. In other words, even the quantity theory implies that the central bank must back its money.

(iv) The last period problem. I’ll leave this one to David Glasner:

“For a pure medium of exchange, a fiat money, to have value, there must be an expectation that it will be accepted in exchange by someone else. Without that expectation, a fiat money could not, by definition, have value. But at some point, before the world comes to its end, it will be clear that there will be no one who will accept the money because there will be no one left with whom to exchange it. But if it is clear that at some time in the future, no one will accept fiat money and it will then lose its value, a logical process of backward induction implies that it must lose its value now.”

Taken together, I think these four problems are fatal to the quantity theory. Scott is welcome to bring up any problems that he thinks might be similarly fatal to the backing theory, but it will be a tough job. It’s easy to make the quantity theory fit the data. It’s harder to reconcile it with common sense.

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Addendum: Scott Sumner responds.And Mike Freimuth comments. Over at Scott's blog, Mike Sproul writes a rejoinder to Scott. And now David Glasner has chimed in.

This is a guest post by Mike Sproul. Many of you may know Mike from his comments on this blog and other economics blogs. I first encountered Mike at the Mises.com website back in 2007 where he would eagerly debate ten or twenty angry Austrians at the same time. Mike was the first to make me wonder why central banks had assets at all. Here is Mike's website. 

On October 26, 2008, Porsche announced that it had raised its ownership stake in Volkswagen to 43%, at the same time that it had acquired options that could increase its stake by a further 31%, to a total ownership stake of 74%. The state of Lower Saxony already owned another 20% stake in VW, so Porsche's announcement meant that only 6% of VW's shares were in “free float”, that is, held by investors who might be interested in selling.

Porsche's buying had inflated the price of VW stock, and investors had been selling VW short, expecting that once Porsche's buying spree ended, VW shares would fall back to realistic levels. Short sellers had borrowed and sold 12.8% of VW’s outstanding stock, but with free float now down to 6%, short sellers owed more shares than were publicly available. If the lenders of those shares all at once demanded repayment of their shares, then there would be 12.8 buy orders for every 6 shares available. In what was called “the mother of all short squeezes” share price rose until the short sellers went broke.

A short squeeze is bad news for financial markets, largely because the fear of short squeezes deters short selling, and thus inhibits the normal arbitrage processes that keep securities correctly priced. If I may make a suggestion to the owners of the world's stock exchanges, there is a simple way to prevent short squeezes from happening on your exchange: Allow cash settlement of all short positions, just like in futures trading. If the most recent selling price of VW was 250 euros, and if short sellers suddenly find no shares available, then allow those short sellers to pay 250 euros in cash (plus some small penalty) to the lenders of the shares, rather than having to return an actual share of VW. This would prevent the stampede to buy VW, and would assure that VW’s price would not skyrocket to crazy levels. (As a measure of short-squeeze mis-pricing, it is worth noting that VW briefly became the world's most valuable company at the height of the short squeeze.)

Short squeezes on stock exchanges are mercifully rare. Unfortunately they are not quite as rare in the banking world, where they go by the name of bank runs. Just as a short squeeze pushes short sellers to hand over more shares of VW than can be obtained on the market, a bank run pushes banks to hand over more currency than can be obtained on the market. And just as short squeezes can be mitigated by allowing cash settlement, so can bank runs be mitigated by allowing banks to settle their obligations in forms other than currency. Clearinghouses and other banking associations can issue loan certificates or scrip for use in clearing checks, or even for public use as currency. Some creativity might be required in the issuance of money substitutes, but in return banks are spared from having to sell their assets at distress prices, while the community is spared from the effects of a bank panic.

What I find most interesting about short squeezes and bank runs is that they are a clear case of market failure, where financial instruments are obviously trading above the value of the assets backing them. During a short squeeze, value is no longer determined by backing, but by the forces of supply and demand. I don't think that economists pay enough attention to this point. The price of financial securities is normally determined by the underlying assets, while the price of commodities is determined by supply and demand. When economics textbooks explain supply and demand, they speak of the supply and demand for apples and oranges or other commodities. They rarely if ever speak of the supply and demand for stocks and bonds, because stocks and bonds are not objects of consumption, and they are not produced using scarce resources. There is no production function and no consumption function, hence there are no supply or demand curves. When we examine a bond that promises to pay $105 in 1 year, we find the price of that bond by dividing 105/(1+R). If R=5% and we tried to sketch supply and demand curves for that bond, we would draw a pair of meaningless curves that were both horizontal at $100. This is what makes short squeezes so strange. The price of VW stock is supposed to be determined by backing, and not by the supply and demand for VW shares. But during a squeeze, supply and demand take over, and stocks trade at a premium relative to their backing. The same might be true of money during a bank run.

This is a problem that JP and I have batted around a bit. I usually argue that arbitrage prevents money from trading at a premium relative to its backing, while JP usually argues that money can trade at a small premium. I can never pin him down on the size of the premium, but he doesn't argue much when I throw around a figure of 5%. Well, here we have VW stock trading at a premium of 500%. Might such a premium be possible for money?

Apparently not. We never see comparably large premiums on currency during bank runs. Gerald Dwyer and Alton Gilbert (Bank Runs and Private Remedies, May/June, 1989) examined American banking panics that occurred between 1857 and 1933, and found that the largest paper currency premium (relative to certified checks) ever observed during bank panics was 5%. The average paper currency premium during bank panics was much lower, only about 1%. Other measures of a currency premium, such as a rise in the value of money relative to goods in general (i.e., deflation), are also in the modest range of 1-5%. Why the enormous gap, from a 1% premium on currency to a 500% premium on VW stock? My best explanation is that banks can get creative in devising alternate forms of payment, while the traders in VW stock simply did not have the time or the legal means to devise alternate forms of payment. Thus the market in VW stock failed catastrophically, while banks facing a run are able to muddle through.

The result of the banks' muddling with money substitutes is that even during stressful events like bank runs, the value of money is, at most, only 5% higher than its fundamental backing value. This makes sense, because any premium over backing value gives an arbitrage opportunity to investors. If the fundamental backing value of each dollar is 1 oz. of silver, and if the dollar somehow trades at 1.05 oz., then the issuer of that dollar earned a free lunch of .05 oz. This free lunch would attract issuers of rival moneys, and rival moneys would keep being created until each dollar traded at its fundamental value of 1 oz.

The idea that money is worth no more than the assets backing it is consistent with finance theory, and with the backing theory of money, but it contradicts the quantity theory of money. The quantity theory asserts that modern fiat money has no backing, that it is not the liability of its issuer, and that its entire value is therefore a monetary premium. Which of the two theories gives a better fit to real-life moneys? When we look around for moneys that fit the quantity theory, that have no backing and are not anyone's liability, we find very little. Just bitcoin and a few orphaned currencies like the Iraqi Swiss Dinar. When we look around for moneys that fit the backing theory, that are the recognized liability of their issuer, and are backed by their issuer's assets, we find every other kind of paper and credit money that has ever existed. I conclude that the backing theory beats the quantity theory.

Kurt Schuler was kind enough to host a Mike Sproul blog post, which I suggest everyone read.

I think Mike's backing theory makes a lot of sense. Financial analysis is about kicking the tires of a issuer's assets in order to arrive at a suitable price for the issuer. If we can price stocks and bonds by analyzing the underlying cash flows thrown off by the issuer's assets, then surely we can do the same with bank notes and bills. After all, notes and bills, like stocks and bonds, are basically claims on a share of firm profits. They are all liabilities. Understand the assets and you've understood the liability (subject to the fine print, of course), how much that liability should be worth in the market, and how its price should change.

Mike presents his backing theory in opposition to the quantity theory of money. But I don't think the two are mutually exclusive. Rather, they work together to explain how prices are determined. By quantity theory, I mean that all things staying the same, an increase in the quantity of a money-like asset leads to a fall in its price.

We can think of a security's market price as being made up of two components. The first is the bit that Mike emphasizes: the value that the marginal investor places on the security's backing. "Backing" here refers to the future cash flows on which the security is a claim. The second component is what I sometimes refer to as moneyness—the additional value that the marginal investor may place on the security's liquidity, where liquidity can be conceived as a good or service that provides ongoing benefits to its holder. This additional value amounts to a liquidity premium.

Changes in backing—the expected flow of future cash flows—result in a rise or fall in a security's overall price. Mike's point is that if changes in backing drive changes in stock and bond prices, then surely they also drive changes in the price of other claims like bank notes and central bank reserves. Which makes a lot of sense.

But I don't think that's the entire story. We still need to deal with the second component, the security's moneyness. Investors may from time to time adjust the marginal value that they attribute to the expected flow of monetary services provided by a security. So even though a money-like security's backing may stay constant, its price can still wobble around thanks to changes in the liquidity premium. Something other than the backing theory is operating behind the scenes to help create prices.

The quantity theory could be our culprit. If a firm issues a few more securities for cash, its backing will stay constant. However, the increased quantity now in circulation will satisfy the marginal buyer's demand for liquidity services. By issuing a few more securities, the firm meets the next marginal buyer's demand, and so on and so on. Each issuance removes marginal buyers of liquidity from the market, reducing the market-clearing liquidity premium that the next investor must pay to enjoy that particular security's liquidity. In a highly competitive world, firms will adjust the quantity of securities they've issued until the marginal value placed on that security's liquidity has been reduced/increased to the cost of maintaining its liquidity, resulting in a rise or fall in the price of the security.

This explains how the quantity theory works in conjunction with the backing theory to spit out a final price. In essence, the quantity theory of money operates by increasing or decreasing the liquidity premium, Mike's backing theory takes care of the rest.

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P.S. Kurt Schuler's response to Mike.

I'm running into a lot of central bank doubt lately. Mike Sax and Unlearning Economics, for instance, both question the ability of the Federal Reserve to create inflation and therefore set NGDP. The title of my post borrows from Archimedes. Give any central banker full reign and they'll be able to increase NGDP by whatever amount they desire. But if rules prevent a central banker from building a sufficiently long lever, or choosing the right spot to place the fulcrum, then their ability to go about the task of pushing up NGDP will be difficult. It is laws, not nature, that impinge on a central bankers ability to hit higher NGDP targets.

Sax and Unlearning give market monetarists like Scott Sumner, king of NGDP targeting, a hard time for not explaining the "hot potato" transmission mechanism by which an increase in the money supply causes higher NGDP. I'm sympathetic to their criticisms. I've never entirely understood the precise market monetarist process for getting from A to B to C. Nick Rowe would probably call me out as one of the people of the concrete steppes, and no doubt I'd be guilty as charged. But I've always enjoyed looking under the hood of central banking in an effort to figure out how all the gears interact.

Nevertheless, I agree completely with the market monetarists that, at the end of the day, a central bank can always advance NGDP to whatever level it desires, as long as the central banker is unrestrained and willing. As Scott Sumner says, "I don't care if currency is only 1% of all financial assets. Give me control of the stock of currency, and I can drive the nominal economy and also impact the business cycle."*

Given the opacity of the market monetarist mechanism, here's my own explanation for how central banks can jack up the price level to whatever height they desire.

The central bank's Archimedean lever is their ability to degrade, or lower the return, on the dollar liabilities it issues. Any degradation in central bank liabilities must ignite a "musical chairs" effect as the banks holding these now inferior liabilities madly seek to sell them. Their value will fall to a lower level (ie the price level will rise) until the market is once again satisfied with the expected return from holding them… at least until the central bank starts to degrade their return again. Because an uninhibited central bank can perpetually hurt the quality of its issued liabilities, it can perpetually create higher inflation and NGDP. It only hits a limit when it has degraded the quality of its liabilities to the point of worthlessness. When that happens the price level ceases to exist.

Let's get more specific on how a central bank degrades the return on its liabilities.

Any central bank that pays interest on deposits can degrade their return by pushing interest rates down. From an original position in which all asset returns are equal, a decline in rates suddenly makes central bank deposits worse off than all other competing assets. Profit-seeking banks will simultaneously try to offload their deposits in order to restore the expected return on their portfolios. But not every bank can sell at the same time, so the price of deposits must drop. Put differently, inflation occurs. Once deposits have fallen low enough, or alternatively, once the price level has inflated high enough, the expected return on deposits will once again be competitive with the return on other assets. Voilà, NGDP is at a new and higher plateau.

Many central banks don't pay interest on deposits. Rather, they keep the supply of deposits artificially tight and force banks to use these deposits as interbank settlement media. The difficulty of obtaining these scarce deposits, combined with their usefulness in settlement, means that deposits yield a large non-pecuniary return. A non-pecuniary return is any benefit that doesn't consist of flows of money (ie dividends or interest). A banker enjoys the steams of relief and comfort thrown off by a central bank deposit, just as a consumer enjoys the shelter of a house or the beauty of gold jewelery.**

Just as a central bank can degrade the pecuniary interest return on deposits, it can degrade their non-pecuniary return. It does so by injecting ever more deposits into the system. With each injection , the marginal deposit provides a steadily deteriorating non-pecuniary benefit to its holder. The bigger the glut of deposits, the worse their return relative to all other assets in the economy. Banks, anxious to earn a competitive return, will race to sell their deposit holdings. The price of deposits will drop to a sufficiently low enough level to coax the market to once again hold them. This is inflation.

But what if a central bank needs to degrade its assets even more than this in order to get NGDP to rise? Can it inject more deposits? This will achieve little because once deposits are plentiful, their non-pecuniary benefit hits zero. When there is no non-pecuniary return left for a central bank to reduce, successive injections will be irrelevant with regards to the price level. More on this later.

Can it reduce interest rates below zero? We know this will pose a problem because if the central bank embarks into negative territory, it risks having all of its negative yielding deposits being converted into 0% yielding cash. And when this happens the central banks loses its interest rate lever altogether. This is the so-called zero-lower bound.

But all is not lost. In order to forestall a mass conversion of negative-interest central bank deposits into 0% yielding cash, Miles Kimball has proposed that a central bank need only cease par conversion between deposits and dollar notes. The introduction of a floating rate would allow a central bank to set a penalty on cash conversion such that when rates fall below zero, cash yields the same negative return as deposits. This removes the incentive for people to “simply hold cash”. With this mechanism is in place, interest rates can easily be moved into negative territory, thereby pushing up prices and NGDP.***

But let's say Miles's option is off the table. A second approach is the New Keynesian one. Even if a central bank can't make their depositors worse off today -- they already pay the minimum 0%, after all, and can't go lower -- a central banker can promise to make depositors worse off tomorrow by maintaining rates at 0% for longer than they otherwise should. To avoid being hurt tomorrow, depositors will simultaneously try to offload the central bank's liabilities today until their price reaches a level low enough to compensate the market. Thus a promise to degrade in the future creates present inflation and higher NGDP.

QE is another oft-mentioned approach for increasing NGPD, but it won't be very effective. If deposits on the margin have already ceased providing non-pecuniary returns, introducing more of them makes little difference. As I noted in these two posts, large purchase will only have an effect if they were carried out at the wrong prices. Here, the Fed would be effectively "printing" new liabilities and purchasing an insufficient amount of earnings-generating assets to support those liabilities. As long as the market doesn't expect the government to bail out the irresponsible central bank by immediately topping it up with new assets, central bank liabilities will be forthwith flagged as being more risky. This means that relative to other assets, the return on deposits is now insufficiently low. Only a fall in their price, or inflation and higher NGDP, will coax investors to hold deposits again.

The above is a very Sproulian way of hitting higher NGDP targets.

Because modern-day QE has been carried out at market rates in big, liquid markets, and not at the wrong prices, central banks doing QE have amassed a sufficient amount of earnings-generating assets to support their liabilities, and therefore fail to compromise their underlying quality. QE is a poor lever for increasing inflation and hitting higher NGDP.

Here is the last Archimedean lever for degrading central bank liabilities and pushing up NGDP. As I've already pointed out, the New Keynesians want to reduce the present interest return on deposits by attacking future returns. We can appropriate this forward-looking strategy and use it to attack the future non-pecuniary returns provided by deposits.

Say that a central bank promises to put off making deposits scarce again in the future. Put differently, it says that it won't mop up excess deposits with open market sales till well-after the expected date. This means that the future reversion of deposits to their special status as 'rare settlement asset' will have been pushed down the road. As long as this commitment is credible, then the market's assessment of the future marginal non-pecuniary return thrown off by a deposit -- a function of their rarity -- will be reduced. Today's deposit holders, conscious of not just present but future returns, will now be holding a worse asset than they were before the announcement. They will simultaneously try to sell deposits until their price has fallen to a low enough level to bribe the market into once again owning deposits . Once again, we've created inflation and higher NGDP.

This last lever seems to me to be a decent market monetarist transmission mechanism. You'll notice that it is similar to the New Keynesian lever in that it endeavors to reduce the present return on deposits by promising to attack their future return. Maybe that's why I've had so many difficulties dehomogenizing Krugman and Sumner -- they both want to attack future returns. Where the argument between them gets heated concerns the specific return each group wants to attack: New Keynesians want to push down future interest rates, whereas Market Monetarists absolutely despise talking in terms of interest rates.

From a concrete steppes person to any market monetarists who may be reading this: what do you have to say about the above transmission mechanism? In emphasizing the importance of the quantity of money and expectations, aren't market monetarists really just proposing to attack the future non-pecuniary return on deposits? Aren't they guaranteeing to put off sucking out excess deposits till well after they responsibly should?

Recapping, here are the various sure-fire Archimedean levers for pushing NGDP up, even when interest rate are at 0% and deposits plentiful:

1. Miles Kimball's floating conversion rate and negative returns
2. Sproulian purchases at wrong prices****
3. Krugman's New Keynesian credible commitment to keep future interest rates too low
4. Market monetarist's credible commitment to keep future non pecuniary returns too low

Now some of these techniques are legal and some aren't. The most direct ones are not, namely Miles's negative interest rates and open market operations at silly prices. I call these the most direct strategies because their success doesn't depend on long range commitments to attack future returns. The problem with commitments to reduce future returns, i.e. numbers 3 and 4, or the "Krugmnerian" position, is that they require future central bankers (and their political masters) to uphold their end of the bargain. If the market has little confidence in the wherewithal of future central bankers to carry through on their predecessor's promises, then a central bank will not be able to reduce present returns by attacking future returns. Positions 1 and 2, on the other hand, directly reduce today's returns on deposits and therefore are less dependent on the future actions of others.

So to sum up, to doubt that a central bank can drive up NGDP is to doubt that the central bank can manipulate their omnipotent Archimidean lever, namely their ability to degrade its own liabilities. Certain laws might prevent degradation. So do frictions put up by the politically-linked nature of central bank policy. But as long as these impediments are removed, then nothing can prevent a central bank from pushing up NGDP.

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Notes:
You can accept all of these points and still believe in so-called "endogenous money". It doesn't change anything.  

* For now I'm agnostic about the last bit of Scott's phrase, namely "impact the business cycle". In this post I've worked purely with the price side of things. The careful reader may notice that Scott's quote is a working-over of an old Rothschild quote: "Give me control of a nations money supply, and I care not who makes it’s laws." 
** Another word for non-pecuniary return is convenience yield. When writing in a purely monetary context, I've referred to the specific non-pecuniary return provided by exchange media is their monetary optionality, or their moneyness.
*** One other lever for degrading is a policy of randomly freezing deposits. I've written about this here. Say that deposits are plentiful such that the marginal deposit no longer yields a non-pecuniary return. It's still possible to decrease this return even further. Say banks face the possibility that the central bank might randomly block their access to deposits for a period of time. Central bank liabilities, once excellent settlement media, are no longer as effective due to potential embargoes preventing them from serving that purpose. Their non-pecuniary return now less than before, banks will hastily try to sell deposit holdings in order to maintain the expected return of their portfolios. Prices rise, as does NGDP. Like negative interest rates, at some onerous rate of embargoing deposits, depositors will flee into non-embargoed 0% cash. So some scheme like Miles Kimball's floating exchange rate between cash and deposits is necessary to prevent mass conversion into paper.
****I'm not saying Mike Sproul necessarily advocates this policy, but if he did need to jack up inflation, I think it might be one of his go-to options since it is entirely consistent with his "backing" theory.

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Changes
21.08.2103 -  I'd be guilty [as charged]

In the comments section of my post on Adam Smith and the Ayr Bank, frequent commenter John S. brought up the real bills doctrine. The phrase real bills doctrine gets thrown around a lot on the internet. To muddy the waters, there are several versions of the doctrine. In this post I hope to dehomogenize the various versions in order to add some clarity.

1. Lloyd Mints's version

We may as well start with Lloyd Mints's version, since he coined the phrase real bills doctrine back in 1945 on his way to denouncing the doctrine. Mints taught at the University of Chicago and mentored Milton Friedman. [1] Here is Mints:

The real-bills doctrine runs to the effect that restriction of bank earning assets to real bills of exchange will automatically limit, in the most desirable manner, the quantity of bank liabilities; it will cause them to vary in quantity in accordance with the "needs of business"; and it will mean that the bank's assets will be of such a nature that they can be turned into cash on a short notice and thus place the bank in the position to meet unlooked-for calls for cash. - A History of Banking Theory

Mints's RBD states that so long as only real-bills (short term liquid debt instruments created by merchants to finance inventory) are discounted by the banking system, an excess amount of notes can never be issued. When businesses require cash, they'll simply discount bills at a bank, and when that cash is no longer required, they'll pay back their borrowing. Even in a world *without* note convertibility into specie (a "fiat standard")  the real bills stipulation alone is sufficient to keep the price level anchored.

Mints rightly declared that this version of the RBD was "completely wrong". After all, a central bank not constrained by convertibility might discount only real bills, yet by discounting at an unreal price, it would alter the purchasing power of the notes it issues and create either runaway inflation or deflation). The price level was indeterminate in Mints's RBD-world.

Mints singled out Adam Smith for being "the first thoroughgoing exponent of the real-bills doctrine". For the next forty years, Smith's reputation as a monetary theorist would be tarnished. [2]

2. Adam Smith's version

Though tarred and vilified, poor Adam Smith never actually conformed to the real bills doctrine as described by Mints. This has been pointed out by David Laidler in his 1981 paper Adam Smith as a Monetary Economist, one of the first efforts to rehabilitate Smith's reputation as a monetary theorist.

Smith lived in an era in which paper money was fully convertible into a fixed amount of gold. Mints's description of the RBD, on the other hand, applies to a fiat world. For Smith, the gold convertibility clause was sufficient to ensure that the economy needn't endure an excess amount of notes. After all, should banks as a whole issue more than was desired, the public would return the notes en masse for specie. This is the so-called reflux process.

That being said, Smith did mention real bills several times in the Wealth of Nations. He famously advises banks that they should only discount "real bills of exchange drawn by a real creditor upon a real debtor." (I go into some detail in my last post on the personal and historical reasons that may have motivated Smith to advocate this position).

Why limit discounts to real bills? When the banking system issues excess paper currency, gold convertibility ensures that this excess will soon reflux back to issuer. A bank that holds long term loans and bonds issued by speculators will be insufficiently prepared to meet the demands of reflux since liquidating such debts might take time. A bank that holds short term bills issued by credit-worthy merchants will be better equipped to meet redemption demands, and less likely to meet the same demise as that experienced by the Ayr Bank, a bank run that Smith personally witnessed.

Thus Smith's admonishment to only discount real bills wasn't a mechanism for anchoring the economy's price level—gold convertibility served this purpose. Smith's real bills stipulation was just good advice for individual banks: stay liquid and don't take on too much credit and term risk. This distinction has been aptly described by David Glasner in his paper the Real Bills Doctrine in the Light of the Law of Reflux, and for his part Laidler notes that "as advice to an individual bank, it's probably pretty sound, as a principle of
monetary policy under commodity convertibility it is relatively harmless..." [link]

3. The Bank Directors' version

Why did Mint's cast Adam Smith as his first thorough-going exponent of the RBD?

In 1797, some seven years after Smith had died, Britain went off the gold standard. (See this post for details). The pound soon began to trade at a discount to its pre-1797 gold value. In other words, the pound was capable of purchasing less gold. The Directors of the Bank of England found themselves accused of creating inflation, notably by the members of the 1810 Bullion Committee. One of the apologizers for the Directors, Charles Bosanquet, a pamphleteer, wrote a famous rebuttal in 1810 that insisted that by limiting discounts to "solid paper for real transactions," the Bank could not have contributed to a deprecation of the pound. According to Bosanquet, several factors outside of the Bank's control had caused the deprecation.

To help buttress his point, Bosanquet invoked the name of Adam Smith. Wrote Bosanquet: "The axiom, or rule of conduct, on which the Committee has been pleased to heap contempt and ridicule, respecting which they have declared that the doctrine is fallacious, and leads to dangerous results, was promulgated by, and is founded on, the authority of Dr. Adam Smith."

Bosanquet's appropriation of Smith's name was inappropriate since Smith implicitly assumed gold convertibility. But the damage had been done. From then on, economic historians like Mints would automatically associate Smith's name with the arguments of the Directors.

The Directors' RBD is very much a manifestation of Lloyd Mints's RBD, which we already know was a poor guide for monetary policy. Years later, Walter Bagehot would write that when the Directors were examined by the Bullion Committee in 1810, "they gave answers that have become almost classical by their nonsense". If anyone deserved to be castigated as the first thoroughgoing exponents of Mints's real bills doctrine, it was the Directors and not Smith.

4. Antal Fekete's version

If you've spent some time wading through the online monetary economics community, you'll have run into Antal Fekete's real bills doctrine. This is an attempt to apply a warmed over version of Adam Smith's RBD mixed in with some Austrian free market economics.

The use of bills of exchange began to diminish in the late 1800s and today they are a relatively unimportant financial instrument, having been replaced in bank portfolios by commercial paper, bonds, mortgages, and other types of debt. Fekete tries to draw a number of broad based conclusions from this trend. The crowding out of real bills by non-real bills (longer term finance bills and government issued treasury bills), for instance, is seen by Fekete as the reason for the Great Depression and the creation of the modern Welfare state:

When real bills were replaced by non-self-liquidating finance bills, payment of wages has become haphazard. Employment was made touch-and go, hiring, ‘hand-to-mouth’. This threatened with unemployment on a massive scale, unless governments were willing to assume responsibility for paying wages. [Link]

Conversely, rehabilitating the real-bills system would end chronic unemployment and reduce the size of government. I only have a passing knowledge of Fekete's thinking — it really doesn't do much for me —so hopefully someone in the comments section can pick up the slack.

5. Mike Sproul's version

Of the modern reincarnations of the RBD, I'm far more familiar with Mike Sproul's version.

Mike's version is an application of modern finance to monetary economics. The price of a financial asset is determined by the discounted value of the expected flows of cash thrown off by underlying capital. Alcoa's stock price, for instance, will equal the sum of discounted earnings that Alcoa's machinery and employees are expected to generate. Transferring this idea to the monetary landscape, Mike says that value of modern central bank liabilities should be determined by the earnings power of the assets held by that central bank.

Like the other versions of the RBD, Mike's version shares a preoccupation with the asset side of a bank's balance sheet. But that ends their similarity. For instance, Mike doesn't have a fetish for actual real bills. I doubt he'd agree with the Directors that so long as they only discounted short-term mercantile bills of exchange, they'd never cause a decline in the value of the pound.

That's why I prefer to call Mike's RBD the backing theory. It's a very different beast from the RBDs of Mints, Smith, Fekete, and the Bank Directors, and to share the same name only adds to the confusion.

So there you have it. If you're going to have an argument over the RBD, make sure you know which one you're arguing about!

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1. Fischer Black received this letter from Milton Friedman on August 6, 1971: "With respect to your so-called passive monetary policy, here you are simply falling into a fallacy that has persisted for hundreds of years. I recommend to you Lloyd Mints' book on The History of Banking Theories for an analysis of the real bills doctrine which is the ancient form of the fallacy you express. Do let me urge you to reconsider your analysis and not let yourself get misled by a slick argument, even if it is your own. " Ouch. Play nicely, Milt. I get this via Perry Mehrling's book on Fischer Black.
2. Here's a video of Lloyd Mints in 1988 upon his 100th birthday.

Real t-bill and bond yields have been falling for decades and are incredibly low right now, even negative (see chart below). With an eye to historical real returns of 2%, folks like Martin Feldstein think that bonds are currently mis-priced and warn that a bond bubble is ready to burst.

Investors need to be careful about comparing real interest rates over different time periods. Today's bond is a sleek electronic entry that trades at lightning speed. Your grandfather's bond was a clunky piece of paper transferred by foot. It's very possible that a modern bond doesn't need to provide investors with the same 2% real coupon that it provided in times past because it provides a compensating return in the form of a higher liquidity yield.

[By now, faithful readers of this blog will know that I'm just repeating the same argument I made about equity yields.]

Here's a way to think about a bond's liquidity yield. Bonds are not merely impassive stores-of-value, they also yield a stream of useful services that investors can "consume" over time. In finance, these consumption streams are referred to as an asset's convenience yield. (HT Mike Sproul)

For instance, the convenience yield of a house is made up of the shelter that the house owner can expect to consume. A Porsche's convenience yield amounts to travel services. What about a bond's convenience yield? I'd argue that a large part of a bond's convenience yield is comprised of the liquidity services that investors can expect to consume over the life time of the bond. Let's call this a monetary convenience yield.

In an uncertain world, it pays to hold a portfolio of goods and financial assets that can be reliably mobilized come some unforeseen event. A fire alarm, a cache of canned beans, and a bible all come to mind. Liquid financial instruments, say cash or marketable bonds, are also useful since they can be sold off quickly in order to procure more appropriate items. This ability to easily liquidate bonds and cash is a meaure of their monetary convenience.

Even if the unforeseen event for which someone has stockpiled canned beans or bonds never materializes, their holder nevertheless will enjoy the convenience of knowing that in all scenarios they will be secure. The stream of uncertainty-shielding services provided by both a bond and a can of beans are "consumed" by their holder as they pass through time.

This monetary convenience yield is an important part of pricing bonds. Prior to purchasing a bond, investors will appraise not only the real return the bond provides (the nominal interest rate minus expected inflation) but will also tally up the stream of future consumption claims that they expect the bond to provide, discounting these claims into the present. The more liquid a bond, the greater the stream of consumption claims it will yield, and the higher its monetary convenience yield. The greater the stream of consumption claims, the smaller the real-return the bond need provide to tempt an investor into buying. (HT once again to Mike Sproul on consumption claims)


Which brings us back to the initial hypothesis. If the liquidity of government debt has increased since the early 1980s, then we need to consider the possibility that bonds are providing an ever larger proportion of their return in the form of a monetary convenience yield, or streams of future consumption claims. If so, the observed fall in real rates isn't a bond bubble. Rather, negative real rates on treasuries may reflect technological advances in market microstructure and improvements in bond market governance that together facilitate the increased moneyness of bonds. Put differently, investors aren't buying bonds at negative real interest rates because they're stupid. It's possible that investors are willing to accept negative real interest rates because they are being sufficiently compensated by improving monetary convenience yields on bonds.

I find this story interesting because we usually think that in the long term, real interest rates are determined primarily by nonmonetary factors, including the expected return to capital investments and the time preferences of consumers. The story here is a bit different. In the long term, real interest rates on bonds are determined (in part) by monetary forces. The higher a bond's monetary convenience yield, the lower its real interest rate. Oddly, bonds may be bought not by consumers who are willing to delay gratification, but by impatient consumers who want to immediately begin consuming a bond's convenience yield (ie. using up future consumption claims). The line between consumption and saving is blurred and fuzzy.

In my previous post on equities, I gave some numbers as evidence for the increased liquidity of stocks. Bonds aren't my shtick, so I won't try to prove my hypothesis. All I'll say is that the rise of repo markets would have contributed dramatically to bond market liquidity since repo increases the ability to use immobilized bonds as transactions media. Give Scott Skyrm a read, for instance.

There is a case of missing markets here. If we could properly prices a bond's monetary convenience yield, then we could get a better understanding of the various components driving bond market prices over time.

Imagine a market that allowed bond investors to auction off their bond's monetary convenience yield while keeping the real interest component. Thus a bond investor could buy a bond in the market, sell (or lease) the entire chain of consumption claims related to a bond's liquidity, invest the proceeds, and be left holding an illiquid bond whose sole function is to pay real interest. By stripping out and pricing whatever portion of a bond's value is related to its monetary nature, investors might now precisely appraise the real price of a bond relative to its real interest payments. Excessively high real prices relative to real interest would indicate overvaluation and a bubble, the opposite would indicate undervaluation and a buying opportunity.

But until we have these sorts of markets, we simply can't say if bond prices are in a bubble. Sure, real rates could be unjustly low because bonds prices have been irrationally bid up. But they could also be justly low if bonds are simply providing alternative returns in the form of monetary convenience. Without a moneyness market, or a convenience yield market, we simply lack the requisite information to be sure.