Banks and drug dealers

[A response to comments after the previous post.]

By definition, the price level is the nominal currency stock divided by the real demand for currency.  The central bank should determine the nominal currency stock.  In that case, any other factor that impacts the price level would work through changes in the real demand for currency.  For instance, a rise in illegal drug dealing would increase the real demand for currency and thus, ceteris paribus, have a deflationary impact.   But of course we’d expect the central bank to accommodate that extra currency demand, and hence we naturally don’t think of the drug dealing industry as playing a significant role in our monetary policy regime.

A banking crisis might also lead to an increase in the real demand for currency, and thus, ceteris paribus, have a deflationary impact.  But of course we should expect the central bank to accommodate that extra demand, and hence we should not think of the banking industry as playing a significant role in our monetary policy regime.

The price level (and hence NGDP) are determined by the interaction of currency (or base money) supply and demand.  That’s monetary policy, and nothing else really matters.

BTW, some commenters insist you can’t do monetary policy without banks.  Governments have been doing monetary policy for 1000s of years, whereas banking has only been around for a few hundred years.  Read the Fama article.


Tags:

 
 
 

34 Responses to “Banks and drug dealers”

  1. Gravatar of johnleemk johnleemk
    15. October 2012 at 10:32

    To me, saying that monetary policy requires banks and therefore monetary policy and banking policy are synonymous is like saying that defence policy requires factories, and therefore defence policy and industrial policy are synonymous. Are they related and intertwined? No doubt. Does that mean we should think about them as synonymous and identical? Absolutely not.

  2. Gravatar of Sir Thomas Gresham Sir Thomas Gresham
    15. October 2012 at 10:40

    There is a simple way to separate a “Monetary Authority” from a “Central Bank”. Just separate the system of domestic and international payments from all financial intermediation. Payments are debits from accounts that are in turn credited by the payee (today there are many ways to debit an account, mainly electronically). The consolidated balance of all accounts is determined by the Authority (say the Treasury) so the accounts are backed by the power to tax. Cash is not different: your pocket’s Authority-printed bills are in your personal account that you manage yourself and when you pay the payee “credits” the cash into his/her own pocket account.

    You can run a system of payments totally separated from all financial intermediation, in particular that involving borrowing and lending which include many types of credit, including credit cards to borrow from pre-approved lending. Today there are many financial companies that are not banks and the only reason to separate banks from other financial companies is because of their involvement in the payments system. A “Central Bank” would be part of the financial intermediation system, mainly as part of whatever mechanism is established to deal with insolvency and liquidation of banks and other financial companies.

    Indeed, you may go to the store and “pay” with your credit card, but analytically this amounts to two separate transactions -one in which your lender has pre-approved you a loan (remember that the lender charges you a fee for committing funds), and the other one the lender’s payment to the store on your behalf. If you had paid with your debit card (or cash) there was just one transaction.

    That separation is not what you have in mind but it’s one that clears some important points. First, for policy purposes, the focus must be on seignorage (define as the Authority’s revenue from running the system of payments) as a source of funding government expenditures. Second, the expansion and contraction of the consolidated balance of all payment accounts is determined only by the net flow of payments to and from the Treasury. Third, the government is the only one responsible for fine-tuning that consolidated balance to achieve whatever it believes the power of seignorage can achieve (I hope all governments understand that the power of seignorage is good only in extraordinary times –when their expenditures must be increased sharply or when the expenditures suddenly decrease).

  3. Gravatar of Mike Sproul Mike Sproul
    15. October 2012 at 10:49

    If more drug dealers held GM stock, or if GM shares were held increasingly by foreigners, nobody would claim that that would affect the value of GM stock, and yet people commonly think that the value of the dollar is affected by those things. If we recognized that the dollar is valued because of its backing, just like GM stock (and GM bonds) then we can avoid quite a lot of mental gymnastics.

  4. Gravatar of Bill Woolsey Bill Woolsey
    15. October 2012 at 11:10

    I agree that monetary policy could be done even if there were no banks.

    But I think that in the world we live in, monetary policy is going to be closely tied to banks.

    That is because most of the actual spending is by check or electronic payment.

    The primary impact of an excess supply of currency isn’t greater currency expenditures, it is a deposit of currency into banks, and then increased expenditure by bank deposit.

    The primary impact of an excess demand for currency isn’t reduced currency expenditures. It is withdrawals of currency form and then reduced expenditures by deposit accounts.

    Consideration of the process by which changes in the quantity of currency or the demand to hold it impact the economy shows that banking is closely related. Only by an excessive focus on equilibrium states is there an impression that the quantity of currency and the demand to hold it determine spending on output and the price level independent of the banking system.

    Now, personally, if I have “too much” currency, I never deposited it and instead spend it. On the other hand, I never worry about keeping my currency balance greater than zero. I’ll spend it all to the last penny. Then I get some more from my bank, or really, I choose “yes” when the POS terminal at Piggly Wiggly asks about cash back.

    So, I do spend excess currency rather than deposit it, but I am quite sure that those who receive my currency deposit any “excess” with the rest of their daily receipts. I have worked for a variety of businesses which did sell items for currency. Not once did they start paying salaries in currency, or paying suppliers with currency, because they had lots of currency about.

    Now, banks have existed for more than 1,000 years, but it is only recently that most payments are by bank liabilities. So I will grant that gold imports from the New World impacted the European price level without banks playing an essential role. Heck, that happened during the period when governments were suppressing banks.

    Of course, the mints weren’t issuing coins by purchasing government bonds either.

    The way I see it, for a small open economy on a gold standard, the nominal anchor depends on the world supply and demand for gold. The local government and its pet bank have little to do with it. Central banking was mostly about getting the government most of the benefit of borrowing at a zero nominal interest rate by having its pet bank monopolize hand to hand currency. For this to work, other banks, households and firms have to have a great deal of confidence in the central bank. Loss of confidence in the central bank, and it is ruined. But if the government depends on a significant portion of its debt to be funded at low interest by this method, and especially if it is already borrowing as much as it can, then the gold run will ruin the government too. It has to borrow money to replace what it can no longer borrow directly from the central bank and so indirectly from its citizens holding the currency. If it finds no lenders, it is in big trouble. (The central bank sells off its government bonds. When they come due, shortly, the government must find a bunch of new lenders.)

    Anyway, when there is high confidence in the central bank, the rest of the banks find they can use central bank liabilities to meet most of their redemption demands. Maybe they are legally required to pay gold, but most of their customers prefer central bank paper money. And it saves on the cost of safes to keep part of the reserves as balances at the central bank.

    When the banks need currency, they can withdraw from those accounts, but they can also borrow from the central bank. And why shouldn’t the central bank lend to them? If the commerical bank’s customers want to hold more of the central bank’s currency, that is an increase in the demand for its liabilities. The public wants to “lend” more to the central bank. And while the central bank could make any sort of loans, the banks that need the currency are a ready source of borrowers.

    But are these banks sound? And so, now the central bank is worried about the soundness of banks. Should the banks hold reserves balances with the central bank, or just borrow as needed? Well, having thee banks hold reserve balances is good for the central bank–espcially if it pays no interest. But, of course, the regular banks have to make money too.

    And what if the central bank makes loans to them and they fail! Can’t have that, so to be safe, it is important to make sure they don’t lend into speculative bubbles.

    Of course, when we start considering net capital inflows into our small open economy, and how that raises nominal and real income, then that’s great. But what if the inflow was aimed at an illusionary profit, and when that it discovered by the foreign investors, there is a massive reversal–a massive capital outflow? Could that go so far as to ruin the reputation of the central bank and result in government default?

    Clearly, it is the role of the central bank to make sure that the banking system is lending for sound investment projects and not speculative projects that will turn out to be an illusion. Right?

    Again, the “monetary authority” role is taken up by the world supply and demand for gold. But the central bank in our small open economy ends up trying to make sure that the banks are making sound loans. Really, what else is there for it to do?

  5. Gravatar of ssumner ssumner
    15. October 2012 at 11:27

    Mike, And if drug dealers demand gold, its value rises. And if we recognize that currency is like paper gold, we can better explain actual movements in the historical price level, such as the deflation that follows bank panics, which are associated with a weakening of the government’s balance sheet. Or take the example of the hoarding of Swiss francs, which is also deflationary. Or the Volcker disinflation, which was associated with a worsening balance sheet of the government. Or the Argentine deflation of 1998-2001, which was assocated with a worsening balance sheet.

    Bill, Banking only matters to the extent it impacts the demand for currency (or the base). If it doesn’t (and normally bank demand for currency is fairly low and stable) then it’s just not very important. It makes no difference how much spending is done by check–it’s still an identity that the equilibrium price level is the nominal currency stock divided by real currency demand. Banks matter, if they matter at all, by affecting real currency demand.

  6. Gravatar of Merijn Knibbe Merijn Knibbe
    15. October 2012 at 11:45

    1. Value added is defined as the value of turnover minus the value of purchased input, which leaves the amount of money available for factor incomes (wages, profit and the like). That’s smart. Money, however, is used to settle final demand transactions as well as purchased inputs-transactions. Which means that comparing the stock of money with value added is fuzzy, as value added is only part of total turnover in the economy.

    2. To aggravate this: money is also used (and created) to finance transactions ins econd hand stuff, like existing houses, stocks and the like. As these are already produced they are not counted as value added (the fee of the notary is, however, and the seigniorage profit of the bank who created the money and collects the interest is. Obviously, the housing market and other second hand markets (art..) should be part of you equations.

    3. The flow-of-funds clearly state that it’s not the fed which creates money. Banks do, together with borrowers. Neo-classical economists have problems with this – but is basic monetary statistics and basic accounting. I.e. – the central bank just does not control the amount of money. Real currency demand influences the nominal currency stock. According to these stats.

  7. Gravatar of Bill Woolsey Bill Woolsey
    15. October 2012 at 12:05

    What would the bank demand for currency be like if banks could not deposit and withdraw currency from their deposits at the central bank when they want?

    Anyway, I am not so sure that currency demand is low. Compared to what? Bank reserve deposit balances have traditionally been very low. Most reserves have taken the form of currency. My understanding of that has been vault cash counts to meet reserve requirements and many banks need vault cash to handle day to day business–deposits and withdrawals by retailers.

    Suppose we have reserve requirements, but they are very loose. That is, reserve requirements are calculated based upon average deposits, and you have a lag, so there is a two day period to catch up. Further, suppose reserve requirements are binding. Banks would like to keep much less reserves than required. It is all set up so banks can stay right at the minimum. Shortfalls result in less than the required reserves, but you can fix them by more than the required reserves later.

    And then we look at monthly data, and reserve balances look so, so stable.

    What does that tell us about a world where banks hold reserves to meet currency withdrawals and keep the amount they think is best?

    Suppose people expect that nominal GDP will rise 10% and start spending and earning 10% more.

    Currency continues to grow 5%.

    What is the exact market process that reverses the 10% increase in nominal GDP?

    Did the demand for currency fall? Did the supply of currency rise?

    No, people just expected 10% more nominal GDP. Why isn’t this an equilibrium?

    An identity? That can’t be right.

    P.S. I think that control over the quantity of currency can be used to control nominal GDP. What is important, however, is that bank deposits are redeemable in terms of currency.

  8. Gravatar of Max Max
    15. October 2012 at 12:18

    Currency is the “barbarous relic” of our time.

    Monetary policy works unambiguously better without central bank issued currency (no zero bound).

  9. Gravatar of Major_Freedom Major_Freedom
    15. October 2012 at 12:31

    ssumner:

    By definition, the price level is the nominal currency stock divided by the real demand for currency.

    Price level definitions should explicitly include real goods and services in some way. The classicals defined demand as the quantity of dollars offered by buyers, and supply as the quantity of goods and services offered by sellers. The price level would here be defined as the weighted average of all prices for all goods and services.

    What if I like to pay for groceries in cash? I first have to demand currency, but according to your definition and your explanation of drugs below, the fact that I am desiring currency is allegedly deflationary.

    The central bank should determine the nominal currency stock.

    Why not the market process instead? What you’re really saying is “I don’t want to advocate for a free market in money. I have no rational basis for why that is, so I will defer to status quo biases and appeals to authority or whatever else will serve as an excuse in the present, but I will call this “pragmatism”, as a marketing gimmick, and call those who disagree with my ideology of state control an “ideologue”.”

    In that case, any other factor that impacts the price level would work through changes in the real demand for currency. For instance, a rise in illegal drug dealing would increase the real demand for currency and thus, ceteris paribus, have a deflationary impact.

    If the nominal demand for drugs increases at the expense of a fall in nominal demand for other goods, then it cannot be said that there is deflation. Drugs must be integrated into that which has a nominal demand. Otherwise, we would have to say that should the nominal demand for anything rise, then ceteris paribus, the nominal demand for everything else must fall (e.g. if one spends more on trips to China, then ceteris paribus, they must spend less on everything else, such as economics textbooks), and we would have to say deflation took place.

    But deflation is usually meant as a decline in the quantity of money and volume of spending (it would do market monetarism good to consider the implications of declines in the aggregate quantity of money, why it takes place, and what the ramifications are)

    But of course we’d expect the central bank to accommodate that extra currency demand, and hence we naturally don’t think of the drug dealing industry as playing a significant role in our monetary policy regime.

    What about the $40 billion in cash the NY Fed secretly (at the time) sent to Iraq 2003-2008?

    Shouldn’t we include central bank war financing as “playing a significant role in our monetary policy regime”?

    A banking crisis might also lead to an increase in the real demand for currency, and thus, ceteris paribus, have a deflationary impact. But of course we should expect the central bank to accommodate that extra demand, and hence we should not think of the banking industry as playing a significant role in our monetary policy regime.

    Not when they are targeting consumer prices, which is their official policy.

    The price level (and hence NGDP) are determined by the interaction of currency (or base money) supply and demand. That’s monetary policy, and nothing else really matters.

    You forgot about goods and services.

    BTW, some commenters insist you can’t do monetary policy without banks. Governments have been doing monetary policy for 1000s of years, whereas banking has only been around for a few hundred years. Read the Fama article.

    Banking has been around for thousands of years. See history. Especially ancient Greece and Rome. Lots of banking examples.

  10. Gravatar of Major_Freedom Major_Freedom
    15. October 2012 at 12:51

    Max:

    Currency is the “barbarous relic” of our time.

    Monetary policy works unambiguously better without central bank issued currency (no zero bound).

    I agree. Physical things are barbarous relics of our time.

    Milleniallist communism for example preaches the salvation of the human spirit…by humans becoming actual spirits and finally escaping the material world.

    All ideas have identifiable origins…

    Central bankers and others who do not want to be limited by the property rights and choices of the people, attack gold vehemently and call it a barbarous relic, because when gold is money, central bankers cannot print gold out of thin air. They must WORK for it by producing goods and services for the benefit of gold owners. That is something statists find intolerable. They don’t want to sink down to the low level of engaging in free market behavior. They want to rise above that and just print the money. That way, they don’t have to offer goods and services to others like everyone else

    With a printing press, the people’s catallactic choices are overridden, and they will be punished if they dare acquire a strict behavior when it comes to transferring the property rights of their money to others. They must “spend” even if they don’t consider any prospective seller’s goods to be worth it.

    The harder a currency is, the harder people have to work to acquire money. With a free market money, all the parasites who have lived the good life without offering anything valuable to others, only coercion and threats or benefiting from others using coercion and threats, all these people will find themselves having to find actual productive careers.

    This is why they hire academic morons to brainwash the next generation of people. Without the new age priests carrying the cross of nationalist central bankism, the parasites would have no way to prolong their exploitation any longer.

  11. Gravatar of Mike Sproul Mike Sproul
    15. October 2012 at 13:24

    Scott:
    In 1997, when there was a run on the Thai central bank, the baht lost value, but when there was a run on private US banks in the 1930’s, federal reserve notes gained value. On the other hand, when Jimmy Stewart’s bank faced a run, people sold their accounts to Mr. Potter for 50 cents on the dollar. Runs happen when the public thinks that the bank is unable to buy back the money that it has issued, so the result of a run is that the money issued BY THAT BANK loses value. There was no run on the federal reserve in the 1930’s, (at least after suspension in 1934) so federal reserve notes didn’t lose value. But at the same time there were runs on private banks, so their checking account dollars lost value.

    There are examples and counterexamples to support or refute both of our positions, so we’re stuck trying to use logic.

  12. Gravatar of K K
    15. October 2012 at 13:57

    Bill,

    “The primary impact of an excess supply of currency isn’t greater currency expenditures, it is a deposit of currency into banks,”

    Exactly

    “and then increased expenditure by bank deposit.”

    Maybe later. What happens first is that the banks try to get rid of the excess currency in the interbank market. That depresses the interbank lending rate to the point where liquidity demand clears the quantity of currency. All of that happens *instantly*. Increased spending takes many, many orders of magnitude longer, and is the result of lower rates encouraging increased investment and advancement of consumption.

  13. Gravatar of K K
    15. October 2012 at 13:58

    Max,

    “Monetary policy works unambiguously better without central bank issued currency (no zero bound).”

    That, of course, is the elephant in the room.

  14. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    15. October 2012 at 14:02

    As Bill Woolsey said;

    ‘The primary impact of an excess supply of currency isn’t greater currency expenditures, it is a deposit of currency into banks, and then increased expenditure by bank deposit.’

    Except that you need to add that those deposits will be lent, and (except in a 100% reserve banking system) will blossom. And, the process would also act in reverse.

    So, I’m having a hard time seeing any advantage to Fama and Scott’s idea. But, not having access to the JME article from 1983, maybe I’m missing something.

  15. Gravatar of bill woolsey bill woolsey
    15. October 2012 at 15:10

    The advantage to Scott’s idea is that the Fed will focus on the nominal anchor, ideally the nominal GDP target. Hopefully, the central bank will stop focusing on the well-being of the banking system and neglecting the nominal target.

  16. Gravatar of Becky Hargrove Becky Hargrove
    15. October 2012 at 15:16

    Here is Part 2 of The Numbers Game – The Economic Recovery video by Russ Roberts and John Taylor:
    http://www.youtube.com/watch?v=ooUbohNneCQ

  17. Gravatar of JoeMac JoeMac
    15. October 2012 at 16:31

    Scott,

    What about the famous by Kydland and Prescott paper where they showed that changes in the broad M come before changes in base money?

    http://unlearningeconomics.wordpress.com/2012/09/22/endogenous-versus-exogenous-money-one-more-time/

  18. Gravatar of Gabe Gabe
    15. October 2012 at 16:33

    “Hopefully, the central bank will stop focusing on the well-being of the banking system and neglecting the nominal target.”

    and hopefully politicians will keep their promises to cut out wasteful spending soon.

    woolsey…how old were you when you figured out that Santa Claus was not real?

  19. Gravatar of Major_Freedom Major_Freedom
    15. October 2012 at 17:33

    Gabe:

    “Hopefully, the central bank will stop focusing on the well-being of the banking system and neglecting the nominal target.”

    and hopefully politicians will keep their promises to cut out wasteful spending soon.

    woolsey…how old were you when you figured out that Santa Claus was not real?

    There has to be a Santa Clause at central planning headquarters, because if only naked aggression was there, Woolsey and other “mommy and daddy government” folks wouldn’t be able to sleep at night.

  20. Gravatar of ssumner ssumner
    15. October 2012 at 17:45

    Bill, If an “excess supply” of currency gets deposited into banks, with no price level increase, then ipso facto there is no excess supply. The banks have chosen to hold larger dollar balances. But banks typically don’t want to hold large dollar balances (except when rates are zero) so that’s not a plausible equilibrium (except when rates are zero.) It’s still a hot potato.

    You asked:

    “What would the bank demand for currency be like if banks could not deposit and withdraw currency from their deposits at the central bank when they want?”

    No need to speculate, the answer is in Friedman and Schwartz. In the 1920s it seems like vault cash demand fell about 30% compared to non-crises period demand in the prewar era. So yes, banks would want to hold modestly larger levels of vault cash if they had no access to deposits at the Fed, and of course the Fed could easily accommodate that demand so that NGDP wasn’t shocked during the changeover.

    Mike, There was a run on the Fed in the early 1930s, and the dollar gained value. That’s why I like the supply and demand for currency approach more than the backing theory.

    JoeMac, That finding has no implications for my claim here. I’m not claiming that currency supply predicts NGDP

  21. Gravatar of Daniel Daniel
    15. October 2012 at 17:52

    On a seperate note, you talk about how a fed committing to low interest rates until far into the future is nothing more than a presaging of low growth. Good news, Bullard gets it.

    http://www.bloomberg.com/news/2012-10-15/fed-s-bullard-says-3-5-2013-growth-will-cut-unemployment.html

  22. Gravatar of Mike Sproul Mike Sproul
    15. October 2012 at 21:08

    Scott:

    When there are runs on private banks and the supply of privately-produced money is dropping, there will be a surge in demand for federal reserve notes, which allows the Fed to lend new notes at a high interest rate, thus increasing the Fed’s assets and raising the value of federal reserve notes, even if the Fed is also suffering losses from gold drains. The trouble with empirical tests is that there’s too much going on. We might observe GM taking a beating in one sector, and expect that GM stock would lose value. But some other sector might be successful enough that GM stock rises in spite of losses in other areas. Conflicting observations like this would not induce people to abandon the backing theory of GM stock, because the logic of the backing theory is too compelling.

  23. Gravatar of Shining Raven Shining Raven
    15. October 2012 at 23:38

    Scott:

    “some commenters insist you can’t do monetary policy without banks.”

    Well, that is not what I am saying. You could of course abolish banks, and everybody banks at the Fed, which is then the only bank. Then you do not need to think about banks for doing monetary policy.

    But: “Banks are around. They do stuff.” So in the world we have, you need to deal with this. Among the stuff that banks do is creating money. So obviously, if you do monetary policy in the world we live in, you need to take into account what banks do.

    Since practically nobody except for banks deals directly with the Fed, everything that the Fed does filters through the banking system into the real economy. Banks isolate the real economy from Fed policy. The Fed can increase reserves in the system all it wants, as long as the banks do not transmit this increase in the monetary base to the real economy (by increased lending), it has not effect.

    Whatever you propose, you have to specify how the Fed/monetary authority in the new system is going to interact with the banking system. Or you need to specify that you are going to abolish the banking system.

  24. Gravatar of Shining Raven Shining Raven
    15. October 2012 at 23:48

    And of course I agree completely with Merijn Knibbe:

    “The flow-of-funds clearly state that it’s not the fed which creates money. Banks do, together with borrowers. Neo-classical economists have problems with this – but is basic monetary statistics and basic accounting. I.e. – the central bank just does not control the amount of money. Real currency demand influences the nominal currency stock.”

    I am a bit surprised that there is so much hostility against banks, and that bill woolsey and Scott are very much ready to impose a system that would break the banking system that we have.

    I am myself extremely critical of the financial sector and the banking system, but nonetheless you have to acknowledge that it does increase productivity by providing the services that it provides for the real economy. I would be very reluctant to replace this with a system that at least seems to significantly increase the risk of bank failures of non-insolvent banks.

  25. Gravatar of Bill Woolsey Bill Woolsey
    16. October 2012 at 02:59

    “I am a bit surprised that there is so much hostility against banks, and that bill woolsey and Scott are very much ready to impose a system that would break the banking system that we have. ”

    What system do I favor imposing that would break the banking system that we have?

  26. Gravatar of ssumner ssumner
    16. October 2012 at 06:14

    Mike, What’s the backing theory prediction regarding the demand for currency? Standard theory suggests that if the backing of currency is unchanged, in aggregate, and yet interest rates fall, then the demand for currency will rise causing deflation. Or alternatively the Fed might accommodate that rise in demand leaving prices unchanged, but the backing of each currency note reduced.

    So I’m trying to get your take on the demand for money issue. I have trouble seeing how backing theory meshes with a downward sloping demand curve for currency, as a function of the opportunity cost of holding currency (nominal rates.) Or am I assuming a crude caricature of the actual backing theory?

    Shining Raven, Banks don’t create the medium of account, they create debt. the price level is determiend by changes in the supply and demand for the medium of account.

  27. Gravatar of Mike Sproul Mike Sproul
    16. October 2012 at 07:00

    Scott:

    Think of bonds. Some bond promises $105 in 1 year. At a market rate of 5% it will be worth $100 today. We sometimes talk about the demand and supply of bonds, but we have to be careful because the price of bonds is not set by supply and demand in the way that the price of apples is set. If demand is high they will sell a lot of bonds and if demand is low they will sell few bonds, but as long as R=5%, the bond remains at $100. It’s as if both S and D are horizontal at $100.

    So to answer your question about falling interest rates: It will cause money to gain value just like it will cause bonds to gain value.

    Most of the confusing questions about the backing theory can be answered by assuming that the money is strictly convertible into 1 oz of silver. Once you work out the answer for that case, the answer will hardly change if you switch to the case of inconvertible money.

  28. Gravatar of Shining Raven Shining Raven
    16. October 2012 at 07:12

    bill woolsey:

    “Hopefully, the central bank will stop focusing on the well-being of the banking system and neglecting the nominal target.”

    I got the impression that a smoothly working banking system is not a high priority for you. Sorry if I am overstating this a bit, but on the other thread you dismissed possible concerns of banks quite summarily. I actually agree with part of your critique, that much of the speculation in the banking system is not very useful, and that it would be sensible to reign this in. I disagree that Scott’s proposal would be a sensible way of doing this.

    I believe that the idea of the separate clearing house, a requirement to use currency to settle interbank payments, an inability of the clearinghouse to issue currency, and a restrictive policy of the monetary authority that issues currency (it would have to follow a different policy from the current one, because otherwise, what is the point?) together would lead to frequent liquidity crises in the banking system and make it at least terribly inefficient. You don’t seem to see this as a problem, or do not believe that this would happen. I disagree, but I guess I won’t be able to convince you.

    Scott, banks also create money. They really do. They extend credit, and I can use credit to buy stuff. I can even convert the money that the bank created into currency, so it is “real money”. But I don’t need to do this, I can simply pay electronically at the store from my account balance from the credit that the bank created. How is this not creating “money”? I do not need currency to do this.

  29. Gravatar of 123 123
    16. October 2012 at 08:18

    Scott, separating the central bank from the monetary authority is a bad idea. You assume that we only care about the pegging of NGDPLT. But we should also care about the volatility of NGDP along the target path. Letting the central bank to ingnore NGDP in order to focus on other objectives would mean that we would get suboptimally large fluctuations of NGDP.
    The same argument applies to the fiscal cliff. Fiscall cliff does not determine the AD, but it increases my estimate of the volatility of NGDP quite significantly.

  30. Gravatar of Doug M Doug M
    16. October 2012 at 08:42

    The central bank doesn’t create money — okay the centeral bank prints a fratction of what is counted as M1 or M2 — But for the most part banks create money. Money is created out of nothing when a bank writes a new loan.

    The central bank can manipulate the reserves of commercial banks, and they can manipulate market interst rates, and they can set a rate at which they will lend to member banks. But the bulk of actual money creation is done by the banks.

  31. Gravatar of ssumner ssumner
    17. October 2012 at 05:01

    Mike, So if interest rates change, and the quantity of base money doesn’t change, and the amount of backing doesn’t change, you are claiming the backing theory predicts the price level will change?

    That’s news to me, I must not have understood the backing theory. I thought the value of a currency note was the amount of backing per currency note.

    123, I can’t imagine why it would affect NGDP volatility. Are you assuming the central bank doesn’t try to stabilize the financial system?

  32. Gravatar of 123 123
    17. October 2012 at 08:32

    Scott, suppose the central bank measures financial risks according to the growth of credit aggregates. Or it may use Tobin’s Q. So the central bank might engineer a greater volatility of NGDP in order to reduce the volatility of credit aggregates or of asset prices.

  33. Gravatar of Mike Sproul Mike Sproul
    17. October 2012 at 09:05

    Scott:

    The problem is similar to determining spot/forward prices when there are handling costs and convenience yields to consider. For example, suppose we expect the fed to be liquidated in 200 years, and at that time each dollar will be redeemed for 1 oz of silver. If R=5%, so the fed’s silver can be lent at 5%, and the cost of printing and handling paper dollars, etc. also added up to 5%/year, then the spot price of a dollar is 1/(1+.05-.05)^200=1 oz.
    (The paper dollar would falsely appear to bear no interest, when in fact the interest is burned up by printing and handling cost.)

    Now, if R (the 200-year rate) rose to 6%, the above becomes
    1/(1.01)^200, which is less than 1 oz.

  34. Gravatar of Tom Brown Tom Brown
    17. October 2012 at 17:59

    These two articles have created a lot of comments and two posts over at Cullen Roche’s pragcap.com.

Leave a Reply