Quantity Theory vs. Backing Theory: Round one

From The Economist:

USE of a paper currency is normally taken to be an expression of faith in the government that issues it. Once the solvency of the issuer is in doubt, anyone holding its notes will quickly try to trade them in for dollars, jewellery or, failing that, some commodity with enduring value (when the rouble collapsed in 1998 some factory workers in Russia were paid in pickles). The Somali shilling, now entering its second decade with no real government or monetary authority to speak of, is a splendid exception to this rule.

Somalia’s long civil war has ripped apart what institutions it once had. In 2011 the country acquired a notional central bank under the remit of the Transitional Federal Government. But the government’s authority does not extend far beyond the capital, Mogadishu. The presence of the Shabab, a murderous fundamentalist militia, in the south and centre of the country, makes it unlikely that Somalia will become whole anytime soon. Meanwhile, 2.3m people are in need of edible aid. Why, then, are Somali shillings, issued in the name of a government that ceased to exist long ago and backed by no reserves of any kind, still in use?

One reason may be that the supply of shillings has remained fairly fixed.

Over to you, Mike.

Update: Lars Christensen pointed out that I completely forgot to mention George Selgin’s recent paper, which discussed a similar situation in Iraq.

Update #2: Josh Hendrickson did a very good post a few weeks back that is loosely related.  He calls fiat money a “rational bubble.”


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58 Responses to “Quantity Theory vs. Backing Theory: Round one”

  1. Gravatar of Nick Rowe Nick Rowe
    5. April 2012 at 15:27

    Yep. You could also have titled this post: “Quantity Theory vs Chartalism”.

  2. Gravatar of Becky Hargrove Becky Hargrove
    5. April 2012 at 15:34

    One wonders how many chartalists actually had to live in small towns (or inner city slums), where practically the only available money was from government transfers or black market activity.

  3. Gravatar of dwb dwb
    5. April 2012 at 15:58

    cue 45,678 posts from MMTers, 12,765 posts from Austrians and 374 posts from M_F

  4. Gravatar of Jim Glass Jim Glass
    5. April 2012 at 16:18

    cue 45,678 posts from MMTers, 12,765 posts from Austrians and 374 posts from M_F

    They’re coming, I’m sure. When they get here, and while they’re going at it, ask them what the great stones of Yap were backed by, and what government issued them and forced the islanders to use them to pay taxes.

  5. Gravatar of Bill Woolsey Bill Woolsey
    5. April 2012 at 16:45

    Larry White gave a paper on this.

    The value of a $1,000 shilling note is approximately equal to the cost of printing them. They are traded in bricks of notes.

    Oddly enough, new ones are printed. Local businessmen pay to have them printed and import them. And they do this until their purchasing power is the cost of printing them.

    Imagining that the quantity that existed with the last government ended still remains appears to be false. They were pretty worthless then. But they wear out, and so are being replaced by newly printed notes.

    Apparently, there is no market for $10,000 or $100,000, or higher notes. The $1,000 shilling note is it and worth its quite low printing cost. Maybe something like 10 cents.

  6. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. April 2012 at 17:09

    The chartalist theory makes sense to me as a way that coins (and, much later, later paper notes) could get kick-started: if the biggest transactor accepts them, that is a great starting point. But as for explaining their swap values, it’s a non starter. Nor does it explain the ambit (the range of transactions) a particular money is useable for.

    As buying a Siberian rabbit fur hat with US$ in Red Square, for example, demonstrates.

    The state-as-biggest-transactor is, however, a reason to be somewhat sceptical about free banking theory. The state can have such a big say in which notes are acceptable, there is an argument for internalising to the government the costs of such decisions. (Somalia has no such dominant transactor.) In fact, given money is a form of network good with significant externalities, a lot of the arguments about infrastructure translate across to money (as I argue here). Which may leave us without a determinative answer about who should issue money, so it’s a case of weight your concerns and pick your choice.

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2012 at 17:09

    Scott,
    You said the magic word “Somalia.”
    We might as well get this out of the way early:

    http://www.youtube.com/watch?v=7QDv4sYwjO0&feature=player_embedded

    Now, on to some reasoned arguments.

  8. Gravatar of marcus nunes marcus nunes
    5. April 2012 at 17:10

    And Greenspan managed to keep reserves pretty much constant between 1987 and 2006! The closest we got to Friedman´s “Freeze th base”.

  9. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. April 2012 at 17:17

    Mark: Libertarian burblings about Somalia is one reason I don’t like describing myself as a libertarian.

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2012 at 17:21

    Lorenzo,
    Deep in my heart I’ll always be Libertarian. But I think it’s safe to say I’m somewhat nuanced (a la John Kerry).

  11. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. April 2012 at 17:27

    Mark: Me too 🙂 That is why I defined libertarians as classical liberals with the complexity button turned off.

  12. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2012 at 17:33

    Lorenzo,
    I read your post. Most Republicans these days classify Nazis as left wing (huh?). I recently went to great pains on Mark Thoma’s site explaining why that was all wrong, mentioning explicitly the French Revolution. I’m glad we’re on the same page.

  13. Gravatar of David Pearson David Pearson
    5. April 2012 at 17:37

    Woolsey,

    Sounds like dollarized Latin countries, where dollar banknotes circulate alongside locally-minted coins. If the local mints could churn the coins out at zero cost, they would be worth exactly that.

  14. Gravatar of AFG AFG
    5. April 2012 at 17:39

    “Paper currencies always need tacit consent from their users that they will exchange bills for actual stuff. But in Somalia this pact is rather stronger: an individual who flouts the system risks jeopardising trust in both himself and his clan.”

    It doesn’t have to be a nation-state for backing theory to be true…

  15. Gravatar of Tommy Dorsett Tommy Dorsett
    5. April 2012 at 17:40

    “Over to you, Mike”

    As in “monetary policy without money in the model” Woodford?

  16. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. April 2012 at 17:45

    Tommy,
    “Money” is the ghost in the machine.

  17. Gravatar of Kevin Donoghue Kevin Donoghue
    6. April 2012 at 02:37

    So I go to my new macro textbook to see what the score is. Mentions of ‘quantity theory’ and ‘backing theory’ in the index? It’s a draw: 0-0.

  18. Gravatar of Lorenzo from Oz Lorenzo from Oz
    6. April 2012 at 04:42

    Mark S: That “Fascism as leftwing” nonsense comes most recently from Jonah Goldberg; an analysis that I take issue with here.

  19. Gravatar of Lars Christensen Lars Christensen
    6. April 2012 at 05:15

    Scott, George Selgin recently wrote a paper on Quasi-Commodity money in which he talks about the Iraqi Swiss Dinar. The story is basically the same thing: http://marketmonetarist.com/2012/02/07/selgin-on-quasi-commodity-money-part-1/

  20. Gravatar of ssumner ssumner
    6. April 2012 at 05:20

    Nick, I have to admit I’m not very familiar with Chartalism.

    dwb, More ad revenue!

    Jim Glass. I’d add gold to that list. If you suddenly removed all memories of the gold standard from human beings, the price of gold would plunge. It’s valuable partly because we think it’s valuable.

    Bill, Interesting. I wonder why of all the expensive technically high quality images to print on paper, they choose to print currency images. Why not pictures of Lady Gaga? Wouldn’t those provide more utility?

    Lorenzo, I share your views on money–there’s more than one way to get there.

    Mark, There are many forms of libertarianism, just as there are many forms of statism.

    Marcus, Yes, but the overall base kept rising fairly steadily.

    AFG, I thought the backing theory rejected the view that money could be accepted by social convention, with no backing.

    Tommy, No, Mike Sproul–the backing expert who sometimes comments here.

    Kevin, What idiot wrote a macro textbook with no mention of the quantity theory? A student who left school never having heard of the QTM would seem like an idiot if he started conversing with other economists. By analogy, even non-Keynesians need to know Keynes, if they don’t want to seem ignorant.

  21. Gravatar of ssumner ssumner
    6. April 2012 at 05:24

    Thanks Lars, I added an update.

  22. Gravatar of Kevin Donoghue Kevin Donoghue
    6. April 2012 at 06:03

    “What idiot wrote a macro textbook with no mention of the quantity theory?”

    This is the topmost back-cover blurb:

    In this new text, designed for first year graduate students, Jean-Pascal Benassy conducts a review of every important development in macroeconomic theory since the 1950s. Each topic is viewed through explicit models, designed to reveal its central issues as simply and directly as possible, but without giving up either rigor or substance. There are 590 references, from Abel to Zabel. An encyclopedic achievement!”–Robert E. Lucas, Jr., University of Chicago and 1995 Nobel Laureate in Economics.

    “Encyclopedic” but nary a mention of the Quantity Theory. Lest you think it sneaks in under some other name, there’s no mention of the Velocity of Circulation either.

    But I agree with Lucas; it’s a very fine book indeed, certainly not the work of an idiot.

  23. Gravatar of ssumner ssumner
    6. April 2012 at 06:44

    Kevin, So Milton Friedman’s work was not an “important development?”

    What’s his theory of inflation in the long run?

  24. Gravatar of dwb dwb
    6. April 2012 at 07:04

    “Encyclopedic” but nary a mention of the Quantity Theory. Lest you think it sneaks in under some other name, there’s no mention of the Velocity of Circulation either.

    ok to be fair i looked up some notes on this book cause I was really puzzled, and i would have to say that although it does not say “the quantity theory of money” per se, my 30,000 foot view of the notes is that there are a whole bunch of mathematical models in here where where essentially the demand for money falls out as a consequence of various assumptions (or example sticky wages). There are *derivations* of the LM curve (or money demand curve), and the degree of neutrality of money is a function of various assumptions in the model to make the point of how optimal policy changes when prices/wages are flexible, vs when they are sticky, and so on (and interest rates ala time preferences).

    So although I would say its not in there per se, its in there.

  25. Gravatar of Mike Sproul Mike Sproul
    6. April 2012 at 07:12

    I know of 5 moneys that fit this pattern:
    1. The Iraqi Swiss Dinar: Easily explained since it was eventually redeemed in a new currency. The expectation of backing gave it value.
    2. Stones on the island of Yap: To the islanders, the stones were a rare good, just like gold is to us. Nothing to explain
    3. Monopoly money (the board game) that circulated on South Pacific island for some time after WWII: The natives thought they were real dollars. If the GM factory blew up 5 hours ago, and some people didn’t know it, GM stock would still have value. Same thing.
    4. Bitcoin. Dunno. I haven’t followed it.
    5. Somali shillings: Some combination of the same explanations for the Dinar and the Monopoly money.

    What is the common thread to all these moneys? They are insignificant in their scope, circulation, and value. The information we have on them is scanty and unreliable. No banks ever issued checking account based on them. (Oh, and we all know that things like rare postage stamps and baseball cards also fit this pattern.)

    On the other hand, what about real moneys, issued by real banks and really used by real people? They are all issued by banks, central or private, that hold enough assets to buy back all the money they have issued at par. They are backed by the bank’s assets, but usually not convertible into gold. People observe that a money is not convertible into gold and conclude that it is unbacked. The most remarkable thing about this simple non-sequitur is that it has survived virtually unquestioned for centuries.

    Chartalism is not the same thing as the backing theory. Chartalism holds that taxes create a demand for money. The backing theory holds that taxes back money in the same sense that a firm’s profits back its shares of stock.

    What idiot wrote a macro textbook with no mention of the backing theory? (Answer: Every one of them. And usually no mention of the real bills doctrine either.)

  26. Gravatar of dwb dwb
    6. April 2012 at 07:18

    … so for example, on the “Poole Model” derivations the link I found notes:

    IS: y_t = bi_t + e_t IS
    LM: m_t – p_t – y_t = -c i_t – v_t

    AS: y_t = h (p_t – w_t)

    … and then goes on to ask about full information optimal policy assuming the govt stabilizes output variance etc etc.

    while i am not defending how grad macro is taught (this seems pretty consistent to me) or defending the models, i would have to say most of this IMO is just going one or two levels deeper into the QTM to ask what what drives short/long run neutrality.

  27. Gravatar of marcus nunes marcus nunes
    6. April 2012 at 07:46

    Scott
    What rose steadily during 1987-07 was the currency component of the base, and that went mostly to satisfy foreign demand for dollars – mobs, corrupt governments, d dealers, etc

  28. Gravatar of W. Peden W. Peden
    6. April 2012 at 08:57

    Scott Sumner,

    “Bill, Interesting. I wonder why of all the expensive technically high quality images to print on paper, they choose to print currency images. Why not pictures of Lady Gaga? Wouldn’t those provide more utility?”

    In an Islamic conservative society? I’d be surprised if such pictures provided much positive utility. The last thing you want is for much of the population in a country to regard the face of currency as sinful.

  29. Gravatar of Jason Jason
    6. April 2012 at 09:17

    People continued to denominate transactions using roman money in Europe for hundreds of years after the fall of Rome — even without any physical currency.

  30. Gravatar of 123 123
    6. April 2012 at 09:19

    Both theories are right. Note that intangible assets do exist.

    In the Somalian case, the contingent liability to distribute gains from seignorage was destroyed by the collapse of the govt.

  31. Gravatar of Jay Mani Jay Mani
    6. April 2012 at 09:31

    If referencing the Somalian Economy is the best you can do…then MMT’s can rest easy at night…

  32. Gravatar of Kevin Donoghue Kevin Donoghue
    6. April 2012 at 09:55

    Scott,
    Milton Friedman is given his due, with coverage of the PIH; also some of his work on monetary policy, the i=0 “Friedman Rule” for example. But you don’t need the QT to show why that’s optimal.

    “What’s his theory of inflation in the long run?”

    It’s a textbook, so he’s not advancing any one theory. Actually one of its strengths is that he doesn’t seem to be rooting for any particular school.

    dwb,
    You’re right in a sense, but we can study these models without relating them to the QT. Similarly, microeconomics uses concepts that go back a long way, yet few teachers feel the need to explore whether a particular model is consistent with the Labour Theory of Value.

  33. Gravatar of Wonks Anonymous Wonks Anonymous
    6. April 2012 at 10:54

    Mike Sproul, my understanding is that in Somalia you can have an account based on Somali dollars.

  34. Gravatar of ssumner ssumner
    6. April 2012 at 11:02

    dwb, Thanks, If he’s got the neutrality of money he’s obviously got the QTM.

    Mike, I don’t see this as being at all like postage stamps and baseball cards, but I suppose anything is possible.

    Marcus, Maybe, but we lack good data on US holdings of currency, so it’s hard to know for sure.

    W. Peden. OK, but why currency images? Why not something innovative?

    Jason, Very interesting example.

    123, I’m not sure how both theories can be right. One says OMPs are inflationary and one says they are not.

    Jay, This post has nothing to do with MMT. And I no longer waste time dealing with the MMT model. Life’s too short (or perhaps I’m too stupid to understand it.)

    Kevin, OK he doesn’t deal with just one model. Then please tell me ANY OF THE EXPLANATIONS HE PROVIDES FOR THE LONG RUN TREND RATE OF INFLATION. Just one. Commenter “dwb” says he discusses money neutrality. That would be an explanation, wouldn’t it?

  35. Gravatar of 123 123
    6. April 2012 at 11:17

    Scott,.
    After OMPs, the contingent liability related to future distribution of profits grows, so the backing declines. Or something else happens. Backing theory is a very useful tautology.

  36. Gravatar of dwb dwb
    6. April 2012 at 11:23

    @ kevin
    I hope not, but let me rephrase my comment. my experience in grad school was that there is a certain body of knowledge you were expectedto already know or if you didn’t know pick up independently ( anything in undergrad econ). getting a find a teaching a piston in undergrad money and banking is a good way to refresh a lot of that information.

    these models kind of presume you already know QT, in my opinion, and already know whats in Mishkins money and banking text. now, I went to grad school back when massachusetts authorized wampum as money, so maybe things have changed. I am but it was sad me think you could get out of grad school without QT which is one of the few macro empirical regularities over the last 4000 years

  37. Gravatar of dwb dwb
    6. April 2012 at 11:54

    @kevin
    sorry if this end up a double post, android voice is not as good as it thinks it is.

    I hope not, but let me rephrase my comment. my experience in grad school was that there is a certain body of knowledge you were expected to already know or if you didn’t know pick up independently (anything in undergrad econ). getting a teaching assistant posting in undergrad money and banking is a good way to refresh a lot of that information, for example.

    these models kind of presume you already know QT, in my opinion, and already know whats in Mishkins money and banking text. They build on it to ask the deeper questions when there are sticky prices, rational expecations… so i dont see just 1 QTM, I see many models with the QTM implicit in some fashion.

    now, I went to grad school back when massachusetts authorized wampum as money, so maybe things have changed. I am but it would sadden me think you could get out of grad school without the basic intuition of QTM and long run money neutrality, which is one of the few macro empirical regularities over the last 4000 years.

  38. Gravatar of George Selgin George Selgin
    6. April 2012 at 12:04

    Mike Sproul’s explanation of why the Iraqi Swiss Dinar commanded value is a rare instance of what one might call the ante hoc ergo propter hoc fallacy.

    But at least it’s better than his suggestion that the real bills doctrine merits as much attention as the QT in a survey of pst-1950 monetary economics.

  39. Gravatar of Kevin Donoghue Kevin Donoghue
    6. April 2012 at 12:13

    Scott,
    Of course Benassy discusses models with money neutrality: the Sargent and Wallace mid-70s models for example, where {m(t)} is an exogenous stochastic process which drives {p(t)}.

    dwb,
    Actually I think a lot of the problems with modern macro come from the fact that some people come to it with first degrees in other subjects (often maths) so they don’t have the background which advanced courses assume. But they are fearsome econometricians so they do just fine, until they go out and cause trouble in the real world. This is one of the things that Scott and I might actually agree on.

  40. Gravatar of AFG AFG
    6. April 2012 at 14:46

    Scott,

    Backing theory doesn’t require a sovereign nation-state in the Western tradition (although that probably makes it more stable/effective), but simple sufficient assets to cover any currency. The article list two things:

    1. It interview Somali banks who verify and accept the currency. These banks presumably have assets to back them up. Them accepting the currency as a form of wealth and providing a service (security of wealth in a country in which there is not much) creates demand for the currency. Don’t forget that the original fiat monies were created by private banks…they were just susceptible to bank runs.

    2. My original point, the clans function as a quasi-sovereign power. By using the coercive apparatus to force people to accept the shilling in exchange for goods, as the article states, they are like a government that declares something as the “official currency.” I would bet that these clans also levy taxes or tributes partially in the currency.

    Under these theory, “Social convention” is why a particular thing is accepted as currency, not from where that thing derives it’s value.

    I also don’t think that Quantity theory and backing theory are as irreconcilable as you state. The pure theories certainly are, but when you begin to examine them in reality, the lines become more murky.

    Backing theory says that the issuance of currency is not inflationary since it increases the assets of the issuing institution. Whoever accepts the cash now has an IOU to the issuing institution, which exactly offsets any outflow of cash. If they keep issuing cash for IOUs, this is the equivalent of a bank leveraging up its balance sheet. Eventually, people doubt that, for political and/or economic reasons, the government will be able to collect those IOUs. They do the equivalent of a “bank run”, but instead of running to get their cash they run to GET RID of their cash for goods, gold or other currencies.

    This is why MMTers say that moderate inflation and hyperinflation are different phenomena, because this explanation only works for the quick crisis (bank run) hyperinflation. I think this is silly. Banks can have slow motion runs (http://www.npr.org/blogs/money/2011/09/16/140464797/a-slow-motion-bank-run-in-europe), so why can’t governments? As the supply of currency increases, SOME people think there is SOME probability of the big government bank run, so they begin to reduce their demand for the currency.

    Central banks have learned to control this process. They continually supplement the desire to hold less currency with more, reducing the price gradually to accommodate the less demand. With expectations, good institutions, and a proper financial transmission system, people come to expect the slow motion constant bank run as the norm as we get something like constant 2% inflation.

  41. Gravatar of Mike Sproul Mike Sproul
    6. April 2012 at 16:45

    Wonks:
    I’d be interested in hearing more about Somali checking accounts based on Somali shillings, since the QT implies that the spread of checking accounts would reduce demand for the base shillings and thereby reduce their value, with no stable solution short of zero value.

    Scott:
    It’s just like stamps and baseball cards. They have value because they are (1) limited in supply and (2) in demand. The usual explanation of why fiat money has value is that it is (1) limited in supply and (2) in demand (as a medium of exchange)

    George:
    Your “ante hoc…” claim implies a rejection of most of the theory of finance. We expect GM to have future profits, so its stock has value today.

    The real bills doctrine, as (usually) understood by its historical advocates (Clement, Law, Bosanquet, Tooke, Fullarton), says that money will hold its value as long as its issuer receives assets of adequate value as the money is issued. This assures that the issuer will have enough assets to buy back all its money at par. It has a long history of weathering misguided attacks. Illegitimi non carborundum.

  42. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. April 2012 at 20:41

    Lorenzo,
    “Both because there is on the Right far more diversity in animating values than there is on the Left””a central reason why it makes rather more sense to talk of “the Left” than it does of “the Right” “”and because it is central to my analysis of fascism that it partakes of both Left and Right features. Fascism’s own characterisation of itself as the “third way” was not empty.”

    Great blogpost. I think in gets to the essence of how fascism percieves itself and why there is confusion as to how to classify it.

  43. Gravatar of Lorenzo from Oz Lorenzo from Oz
    6. April 2012 at 23:12

    Mark S: Thanks 🙂

  44. Gravatar of ssumner ssumner
    7. April 2012 at 11:38

    123, I don’t see why, it can’t explain the historical correlation between money and prices, and it assumes cash and bonds are close substitutes at positive interest rates, which they most certainly are not.

    Kevin, Then why do you say he ignores the QTM? The QTM is the theory that M drives P.

    AFG, You may be right about Somalia, but I have no patience for theories that money issuance is not inflationary when interest rates are positive as long as money is backed. We know it is inflationary, the only thing we should be focusing on is to explain why.

    Mike, You said;

    “It’s just like stamps and baseball cards. They have value because they are (1) limited in supply and (2) in demand. The usual explanation of why fiat money has value is that it is (1) limited in supply and (2) in demand (as a medium of exchange)”

    Then we agree. I’ve always argued cash had value because it was useful as a medium of exchange, not because it was backed. Obviously people don’t collect cash for nostalgia reasons like they do with baseball cards, so we presume it has value because it’s useful as a medium of exchange.

    Mark’s right Lorenzo, that was well put.

  45. Gravatar of Mike Sproul Mike Sproul
    7. April 2012 at 12:38

    Scott:

    The thing we agree on is that you believe the baseball card explanation of fiat money. We also agree that when money is backed and convertible into gold (<1933) then the backing theory works. We part company on convertibility. I say there are many channels through which a central bank redeems its money, and as long as at least one of those channels remains open, the closing of the gold channel is irrelevant. We also disagree on inflation. You say it happens when the Fed issues more money, while I say it happens when the Fed's issuance of money outruns the assets held by the Fed as backing for that money.

  46. Gravatar of 123 123
    7. April 2012 at 12:56

    ” I don’t see why, it can’t explain the historical correlation between money and prices, and it assumes cash and bonds are close substitutes at positive interest rates, which they most certainly are not.”
    99% of supporters of the backing theory are applying it wrong. They use inappropriate accounting conventions and ignore intangible assets and contingent liabilities. This is the reason they get wrong results.
    It is like with IS/LM, a model whose supporters draw one of the curves the wrong way, as Nick Rowe has pointed out.

  47. Gravatar of AFG AFG
    7. April 2012 at 15:48

    Mike Sproul,

    “You say it happens when the Fed issues more money, while I say it happens when the Fed’s issuance of money outruns the assets held by the Fed as backing for that money.”

    As I understand it, this argument is that the money supply/inflation curve has kinks. You can increase the money supply with no inflation up to a certain point, then inflation will increase quickly.

    But does you’re model not allow room for expectations? It seems to me that, even if we haven’t outstripped the assets yet, increasing the money supply still increases the *risk* that we will cross it in the future, all else held equal. Therefore, the economy’s net demand for money lowers as people shift their portfolios to assets with a higher risk/return payoff.

    You don’t need full Ricardian equivalence for this to work, but any expectations will have the same effect if the Central Bank credibly promises to increase the money supply by an infinite amount if necessary to reach its target.

    It’s seems to me that your explanations (I’ve briefly read a few of your papers elsewhere) better explain countries with weak central bank institutions. Their policy changes have less credibility with the public, so an increase in the money supply gives less information about the future path. This is why inflation there tends to be less stable.

  48. Gravatar of Mike Sproul Mike Sproul
    7. April 2012 at 18:45

    AFG:

    Yes; the expectation of backing also affects the value of money, in the same way that the expectation of future profit affects today’s stock price. And just as countries can be strong or weak, so can corporations, and the effects on money’s value will be analogous to the effects on stock prices.

  49. Gravatar of Kevin Donoghue Kevin Donoghue
    8. April 2012 at 00:33

    “Then why do you say he ignores the QTM? The QTM is the theory that M drives P.”

    If I asked a student what the QTM is, back in the days when Milton Friedman was broadcasting Free To Choose, I’d be surprised to get that answer. At a minimum I’d expect to see MV=PT and/or MV=PY, with some discussion of why we might expect V to be a stable function of few variables.

    You’re not just moving the goalposts, you’re creating such a wide gap between them that any random shot at that end of the pitch is a goal.

  50. Gravatar of ssumner ssumner
    8. April 2012 at 14:26

    Mike, You said;

    “The thing we agree on is that you believe the baseball card explanation of fiat money.”

    I’m not sure what you mean. I believe it has value because it’s a medium of exchange. I don’t believe baseball cards are a medium of exchange.

    The reason I believe OMOs affect the price level is that I see lots of evidence that they do. So unless someone can convince me this evidence is wrong, I’ll keep assuming that a reduction in the quantity of money affects the value of money.

    Wallets don’t have value because they are backed, they have value because they are useful in making transactions. Ditto for dollars.

    123. If one of the curves is drawn the wrong way, that pretty much invalidates IS-LM. It obviously can be DRAWN to reflect any set of assumptions. But it’s only useful if we know the slope of the IS curve. By analogy, MV=PY is consistent will ALL macro theories, even MMT.

    Kevin, You said;

    “At a minimum I’d expect to see MV=PT”

    I can’t help it if most people don’t seem to know the difference between a theory and a definition. MV=PY is simply a definition of V, nothing more. It has no relationship to the QTM. Just as C+I+G=Y is unrelated to Keynesian theory.

  51. Gravatar of Mike Sproul Mike Sproul
    8. April 2012 at 20:59

    Scott:

    By “baseball card explanation…” I mean that you think that paper dollars have value because they are in demand (as a medium of exchange) and limited in supply. Just like baseball cards are in demand (for whatever reason) and limited in supply.

    About “the evidence”: A quantity theorist sees rising M correlated with rising P and claims support for the quantity theory, while a backing theorist looks at the same evidence, sees that M is rising relative to the issuer’s assets, and concludes that the backing theory explains the evidence. I don’t personally know of any evidence that is consistent with the quantity theory but inconsistent with the backing theory.

    As for wallets/dollars: It is clearly POSSIBLE that dollars are backed but inconvertible, and it is POSSIBLE that they are valuable because they are useful for making transactions. You haven’t given a reason to prefer the one theory over the other. I prefer the backing theory because it says that money has value for the same reason as any other liability, because all central banks do in fact hold assets against their money (which wouldn’t be necessary if supply and demand determined money’s value), because the BT doesn’t imply that the issuance of money generates a free lunch, because the BT is not subject to the Last Period Problem, because the BT doesn’t make circular claims like “Money has value because people hold it, and people hold it because it has value”, and maybe 5-10 other reasons.

  52. Gravatar of 123 123
    9. April 2012 at 02:23

    “If one of the curves is drawn the wrong way, that pretty much invalidates IS-LM. It obviously can be DRAWN to reflect any set of assumptions. But it’s only useful if we know the slope of the IS curve. By analogy, MV=PY is consistent will ALL macro theories, even MMT.”

    Imagine if 5% of the users of IS-LM used it the way Nick Rowe did. And suppose these users derived some additional insight in a convenient manner.

    Well this is the exact case with the backing theory, or balance sheet view if you like.
    Here is the ECB (Bindseil) quoting IMF (Stella):
    “Stella argues that capital when defined in the traditional accounting sense that is used for commercial banks is meaningless when applied to central banks. Instead, the central banks net worth defined as the price a fully informed risk-neutral investor would pay to purchase the bank under normal market conditions is a much more useful indicator of a central bank’s potential profitability and financial independence. First, net worth takes into account the central bank’s franchise value, the value of its special legal status of being able to print money and impose reserve requirements on commercial banks. At the same time, it also takes into account the central bank’s offbalance sheet rights and obligations such as the obligation to bail out the banking sector in a crisis or defend a fixed exchange rate peg which would tend to reduce net worth.”

    Source:
    http://www.ecb.int/pub/pdf/scpwps/ecbwp392.pdf

  53. Gravatar of ssumner ssumner
    10. April 2012 at 11:57

    Mike, Wait, I thought the backing theory claimed OMOs don’t influence the price level, but the QTM does think they do it affect P. If so, then there’s obviously empirical evidence.

    If tomorrow the Fed simply gave 80% of its assets to the Treasury, what would happen to the price level?

    123, I’d have to see cases where it can outperform the QTM.

  54. Gravatar of Mike Sproul Mike Sproul
    10. April 2012 at 20:32

    Scott:

    OMO’s don’t affect the price level if they are NEUTRAL, meaning that the Fed gets $100 of new bonds in exchange for 100 new dollars issued. The fed’s net worth is unaffected by this kind of OMO. But if the fed gets a bond worth only $99, then the fed’s net worth falls by $1. Assuming this pushes the fed’s net worth down to -$1, and assuming nobody will bail out the fed, it will cause inflation.

    That 80% transfer won’t affect anything, since we all expect the Treasury to back up the Fed. But if I had a note-issuing bank that had issued 100 Mike dollars, backed by my assets worth 100 oz. of silver, then giving away 80% of my assets would cause the Mike dollars to lose 80% of their value (in the simple case).

  55. Gravatar of 123 123
    11. April 2012 at 08:13

    Scott, what is QTM telling you about the optimal size of central bank equity?

  56. Gravatar of ssumner ssumner
    12. April 2012 at 11:55

    Mike, That’s where we disagree. I think OMOs have a huge impact on the price level, even if they involve the exchange of assets of equal market value.

    If the 80% transfer doesn’t matter, why even talk about the Fed’s balance sheet? Why not focus on government assets, not Fed assets?

  57. Gravatar of ssumner ssumner
    12. April 2012 at 11:56

    123, Nothing?

  58. Gravatar of 123 123
    12. April 2012 at 12:41

    Scott, if you take the version of backing theory that is consistent with QTM, you can discuss the optimal size of central bank equity.

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