Wednesday, November 15, 2017

Money and a Heterodox Monetary Model

I think that every economist and every economic blogger would like to build a better monetary model.  Those with computer skills would like to build a better monetary  computer model. Unfortunately, modelers will find one problem thwarting predictions that cannot be overcome--shocks to the economy on a monetary level are driven by human decision.

Somewhat amazingly, economist and bloggers find little common ground when it comes to money and monetary matters. Instead, they divide into camps and choose sides. This results in discourses that are little on discussion and heavy on salesmanship, with repeated rehashing of the same boxed-reasoning and frozen perspectives.

This post will be different. Here you will find a mechanical framework that builds upon a fundamentally different initial conceptual base. The approach will be heterodox while still containing some recognizable elements found in the boxed and frozen discussion. After all, even boxed and frozen discussion must have at least some kernels of accepted truth to keep linkage to reality. We will try to find and preserve those kernels but will leave it up to the reader to identify where tradition folds into heterodoxy.

Following a non-economist understanding of money

Our first break into heterodoxy will be to conceptually follow a commonly held public-view of money. We will be thinking of 'fiat money' which is commonly understood to be money printed by the government that has no formal backing other than a guarantee to replace with equal kind. The public thinks of fiat money as a physical object that can be exchanged for value. That is the way we will think of it here.

As a physical object, the public thinks of money as being durable over time. We will honor that concept and add an economist twist: A physical object that has persistence through time periods must have a point of creation, a period of existence, and a method and point of de-creation. To the mainstream economist, we are already preaching in a heterodox fashion. Brace your self--we will find and discuss these three events with differing degrees of thoroughness.

We will be careful to keep descriptive contact with commonly experienced monetary phenomena. Being a heterodox presentation, there will be a need to conceptualize commonly experienced monetary phenomena from different perspectives (yes, plural!).

We may as well open our unorthodox monetary description by using an unsavory contrast. We will ask why counterfeiters want to create money? Our conventional answer will be that they want to create money rather than earn money by doing conventional things. And why do they want to create 'money'? Our heterodox answer will be that they really are trying to create a gift certificate similar to the gift certificate each of us may receive on birthdays or Christmas.

Frankly, I don't know which would be easier to counterfeit--money or a Lowe's gift certificate. If I had either one in hand, I could get something at Lowe's. Obviously, having money in hand would open the door to much more than only Lowe's, so money would be the more desirable counterfeit goal.

We will think of the gift certificate similarity to money later when we consider how money takes on value. Until then, the concept does little for us as we turn our attention to the creation of money. (Beware! The concept may mold our thinking into unexpected pathways.)

Physical money must be created some place, at some time

Consistent with a gift certificate model, we will locate a place of beginning for each certificate. Continuing the dangerous tact of using an illegal act as the initial reference point, we observe, much to everyone's dismay, that counterfeiters can create physical money. This is a fact of reality--an annoying fact. We could say that counterfeiters print their own gift certificates.

Obviously, governments can do anything that a counterfeiter can do.

Now we take the strikingly heterodox position that official government fiat money is nothing more than a product created by government. This money is not 'counterfeit' so long as it is 'official'. This money also has 'gift certificate' characteristics but hopefully government will carefully manage this product to retain value. Methods of value management will be discussed peripherally later in the post. For now, it is sufficient to say that the local counterfeiter prints currency (money) to benefit his personal desires; government prints money to benefit the political desires of a much larger consistency.

I think most readers will be uncomfortable with the idea that government simply prints money. While they may think that this occurred in countries like Germany in the Weimar Republic era, or Zimbabwe of a few years back, or maybe even Venezuela today, they cringe at the thought that ALL modern fiat currencies are printed money.

Brace yourself--governments print money! How else can it be when we see every measure of money increase as the years pass? We need to understand exactly how this printing is done and how government printing differs from counterfeiting.

Governmental creation of money--management and ownership

Fortunately, printing money does not need to be destructive (and something to cringe over) if it is done prudently. The trick is to print and retain value. This can be done if the rate of printing is carefully managed. The key to careful management is ownership. We will point to the printer as the obvious first owner of printed money.

Our counterfeiter, being the first owner of money he prints, can spend his money whenever he wants. If we postulate that he can print a perfect product, his product could be used in parallel with official government printed money, without any problem.

So why is counterfeiting not allowed? It is because the counterfeiter has reached around the trade-of-value-for-value assumption that underlays a viable economic system. The counterfeiter requires very little effort to create money when he creates a paper currency. Despite this recognized fact, this nearly cost-free product can be traded for a days work or other object of value. The future value of money depends upon a reliable translation between units of money and every other traded thing. Uncontrolled creation of money would threaten or preclude stable relationships that might be formed.

The initial dilemma of unequal value exchange does not disappear just because government makes itself the only legal producer of money. After all, the cost of production of the monetary product really is near zero. As the initial owner, government can trade this 'free' money for valuable goods and services. This value windfall is known as 'seigniorage'.

For the non-government sector of the economy, seigniorage is a negative value event. Valuable products and services are traded for pieces of paper-with-numbers. Our next goal is to understand how paper-with-numbers can be translated into a reliable storage-of-value product.

The link between 'ownership' and 'value'

Many introductory economic books will contain a history of money with links of direct conversion to a commodity. In these cases, direct conversion is offered by government in an effort to give creditable value to the monetary product. For example, for many years the U.S. Government offered to convert $35 to one ounce of gold. Convertibility ended in March, 1973 when the world effectively went off the gold standard and adopted the current system of floating exchange rates. The fact that currencies, which are now purely fiat-in-character, continue to retain value emerges as somewhat of a mystery.

 [As the reader continues, he may wonder how the Bitcoin phenomenon can be woven into this mystery.]

Modern Monetary Theory (MMT) (a currently emerging economic theory) points to taxation by government as the driving link to give fiat money value. In my thinking, taxation is a factor but the gift certificate concept offers a much more satisfying valuation method. Money conceptualized-as-a-gift-certificate offers access to the national equivalent of a private business with products to sell. Money is like a National Gift Certificate.

Without a doubt, this is a heterodox concept which may be a show-stopper for some readers with a mainstream economic foundation. But what-the-heck--if we are going to be unorthodox, we may as well let our analogies morph as well. The important thing is to keep links to the real world and gift certificates are definitely a real world phenomenon.

In the gift certificate world, newly printed certificates have a fixed face value but an unknown commodity value. The person receiving a gift certificate, if it is a gift, welcomes the freely given generosity.

As a separate case (but still in the gift certificate world), gift certificates may be accepted as payment for services or products. By accepting gift certificates as payment, we can safely assume that acceptance followed an evaluation of the prudence of completing the exchange. Anyone accepting fiat money with National Gift Certificate characteristics can be safe in assuming that it will have some future value. Finding that future value will be the responsibility of the money owner.

At this point in our heterodox presentation, we have physical fiat money acting like a National Gift Certificate that has been evaluated by the entity owning it. If money is to have a predictable FUTURE valuation, fiat money needs to be carefully managed to avoid the danger of unlimited gift certificates (which would destroy value). How can this be done?

The need for good accounting

It is still dangerous to refer to illegal activity as a reference point but it is done here again to make a point. Let's assume that our local unlawful counterfeiter kept a careful record of the currency he created. Let's also assume that the currency printed was identical to the currency printed by government. How long would it take before our criminal was caught?

I think he could continue for a lifetime if he was careful to not attract attention to himself. He would need to live no better than his surrounding neighbors so that they would not look carefully at his source of income. He would need some sort of fabricated but plausible income source should the question arise in casual conversation. Only a careful trace of the currency he used would reveal that he never went to a job nor a bank nor any other source outside his residence that might be the source of legal money.

While not locally noticeable, this unlawfully produced currency should be noticed by accountants who care for lawfully produced money. These accountants should know how much lawful currency has been issued but they face a daunting task of counting currency in every pocket. The existence of banks makes this task easier.

In the modern world, banks are places where the public keeps most of it's money. Of course, only some of the government issued money should be in banks with the rest residing in the pockets of the private sector of our economy. Our counterfeiter would use the pocket-to-pocket method of money issuance. With his money being identical to 'official' money, counterfeit money would blend seamlessly and inevitably flow into banks. Sooner or later, government accountants should notice that they have someone helping government in the money printing effort. It would take careful accounting to catch our counterfeiter.

Bank loans create money

The task of our government accountants is complicated by banking practice. Banks do more than just take deposits of government printed money. Banks also loan money both to the private sector and to government itself. Great confusion arises as to how this lending gets recorded into the basic deposit system described above. Exactly what does a bank loan to a borrower?

Government has given banks the ability to loan by deposit-entry. This ability allows banks to create a deposit for a borrowing customer, enabling the borrowing customer to spend money up to the amount on deposit. Once created, the borrowed deposit increases the total amount of money apparently on deposit at the lending bank even though government has not printed additional money.

This ability of banks to create money-as-a-deposit is the reason mainstream economist consider money to be ephemeral in nature. Notice that physical money has not been created--only deposits. But deposits are the same as money in the eyes of the money receiving private sector.

We have here a dilemma of definition. How can money be defined to the common satisfaction of both economist and public users?

This dilemma of definition is resolved by observing governmental regulation of banks. Banks are effectively allowed to loan money up to a named fraction of the amount of money controlled by the individual bank. This practice allows banks to expand the apparent money supply (measured by deposits found) to some multiple of the base amount of money previously printed by government.

The money definition dilemma itself is solved by recognizing two classes of money--'reserves' printed directly by government (important to economist and money managers) and common money as in 'money' or 'deposits' (which is important to everyone).

We could say that private banks multiply money, governments add money.

Summing up, we could say that bank lending capability has increased the amount of deposits recorded at banks. This capability adds one step to the task of government monitors seeking our counterfeiter--they need to subtract loans from the total bank deposits which will leave only government printed money on deposit. Now our auditors should be able to detect our counterfeiter.

Not a hard job, but accurate accounting is required.

WHOA! Our banking model has glossed over a vital detail!

Rather offhandedly, I mentioned that banks can lend to government, which increases deposits in banks. This opportunity acts to give government three sources of money needed for governmental purposes--private bank loans, direct printing, and loans from private non-bank entities. Both private bank loans and direct printing increase deposits in banks but only direct printing increases the base money supply  (reserves) without question.

Loans to government from private non-bank entities recycle previously created money and are useful to protect the value of the fiat currency.

It is important to recognize the difference between private banks and central banks when central banks are assumed to be owned by government. If government owns the central bank, loans from the central bank to government are loans to one's self. How does it work to lend to yourself? You issue a bond promising to repay the notes you just created! When the notes are 'green money', you have just printed money. Hence, we observe that government loans from the central bank act to 'print money' and clearly result in increased reserves.

On the other hand, loans from private banks to currency issuing governments should be counted as increasing deposits when we try to catch our counterfeiter. These loans do not increase reserves until the loan itself is sold to the central bank.

Skeptical readers may claim that in the United States, the central bank is forbidden to lend directly to government. This prohibition does not prevent the CB from buying government debt from private debt holders.  The prohibition is effectively bypassed with a three way sequential trade wherein government issues debt, government debt is bought by private traders, and then private debt owners sell to the CB who has created reserves (green notes) in the form of deposits-available-to-the-private-sellers-of-government-debt.

There may be readers who are still skeptical of a relationship between reserves and government debt. Figure 1 confirms the relationship from 1970 through about 2008. During or after 2008, the Federal Reserve (Fed) began buying mortgages. Of course, the Fed has no earning power of it's own and must return all profits to the government. The only reason the Fed can buy mortgages (or treasury notes, for that matter) is because the Fed can print money by increasing reserves. After 2008, the Fed decided that the rate of increase of the base money supply, limited by flowing through the government budget process, was too slow.  A faster way to increase reserves was needed so the Fed joined other central banks (such as the JCB and ECB) in buying equities of some nature from the private sector. These purchases resulted in reserves far larger than would exist if reserves represented only government loans as had been the case before 2008

Figure 1. The relationship between government debt and the St. Louis Adjusted Monetary Base. The period after 2007-8 is distorted by QE programs.

We have seen how government and banks can create money. The de-creation of money is accomplished by reversing the process. Any reduction of government debt or reduction of outstanding bank loans will de-create money. Any money removed from the economy will no-longer be available for cycling within the economy.

Building models that predict lending

It would certainly be nice if a model could be built that predicted bank lending. To some extent, it should be possible if the model is based on past history. That said, it would always be possible to increase or decrease the annual rate of lending at a whim. This 'whimish' nature of lending would render any monetary model vulnerable to human disruption. It would also render any forecast offered by a model to be nothing more than the extension of the parameters cast into the model.

Models would be projections of the builders thinking, not generators of economic foresight.


We have here a monetary model and economic framework that fits with the economic perceptions found widely spread among community members. Following an analogy between money and gift certificates, money is allowed to be physical in character with time persistence in the form of both currency and currency-as -deposits.

Money, being physical in character, must have an originating event. An originating event occurs when fiat money is first made available for spending and subsequent measurement. Money is spent to acquire value in comparison to whatever is purchased.

Consistent with the limitations placed upon physical objects, we theorized the counterfeit creation of fiat money and asked if accounting could detect such an operation.  This question was answered by developing a logical, mechanical, path of money creation (similar to the path found in MMT) and observing that careful accountants watching over 'official' money creation should be able to detect counterfeit operations if the created size became large enough.

Finally, we noticed that money is a human creation, subject to human vagaries which renders economic predictions vulnerable to human realignment. Hence, models that make economic predictions based on monetary performance are vulnerable to human disruption.

This heterodox formulation challenges theoretical claims that  fiat money is debt. In substitution, a claim is made that fiat money is a product requiring careful management to retain value.

(c) Roger Sparks 2017