'Value stability' is the issue we will consider. We are not going to worry about the size of money or whether it is backed by gold. We will be thinking about paper money as commonly used. (An economist would call it fiat money.) We're going to think about how this money gets value and holds it.
Now, I am not a trained economist. What you will be reading is meant to be intuitive and logical, not quotes from a text book or academic article. The goal is to meld everyday observations about money into a coherent framework.
So what is money? In this post, we are going to look at money from two perspectives, one stable and one unstable. Paradoxically, they both must be true. Coherent logic convinces us the we must have two models of money. The real macro economy must operate with effects from both models contributing to the maelstrom. Our task is to match components with models.
Before we get into discussing models, I want to warn some readers away. The readers I want to warn away are those who are convinced that money is not a real physical reality (thereby arguing with maybe 99% of the public). As in all the articles you will find in the Mechanical Money blog, money is assumed to be physical, whether green or on electronic deposit. This physical reality demands that there be present a way that humans can both create and uncreate money. Goodbye ephemeral money advocates!
Stable Money Model
Stable money is by far the easiest to understand. We who live in an industrial economy have daily contact with stable money. It's in our wallets and in our bank accounts. We earn it or maybe receive it as a gift or pension distribution. It has pretty much the same value each month, and becomes a dependable source of funds for spending of all kinds. Usually, the only problem is that there isn't enough money to do everything we would like to do.
This is the stable money model. Economist build equations and flow charts in an attempt to explain how the macro economy works to keep real production in balance with resources. These models can work quite well so long as money operates within the bounds of the stable money model.
Bounds of the Stable Money Model
What might be the bounds of the stable money model? One bound would be that money needs to have a nearly constant value in relation to real production and resources. Not that the value needs to be identical across entire national regions-- we certainly can allow for regional resource access differences. Constant value needs to be found over time periods so that $100 will buy about the same quality and quantity of food this year and next year. The model stability we are looking for is value durability over the passage of time.
When we have value durability over time periods, an economy can build complicated supply chains, using complicated tools, that take long time periods to build. Value can be predicted which allows contribution to the bigger effort to be parceled out with the result that early contributors can have an already earned share in the final result.
There is really no other bound. Stability is a boundary, a condition-- by definition. The word "stability" says it all. Economist looking for additional boundaries can only find conditions for instability.
The Unstable Model
Our searching economist looking for stability boundaries must, at some point, ask how money is created in the first place. Money is a human creation and someone must create it. Creation out of nothing is instability on steroids. Somehow, we must incorporate instability into our models for fiat money.
Mainstream economist commonly describe bank loans (from both private banks and central banks) as the source of modern fiat money. We will agree and proceed to parse between stable loan sources and unstable sources.
Before parsing, we need to make another intuitive assumption. We will intuitively assume that value is proportional to the amount of money available. In other words, the total amount of money available can be divided by the total second-value (valued a second way) of objects available. Described a third way, 100 items in a small store could each be worth $1 or 100 yen, the choice being made by the creator of money. Hence, more money entering an economy would be expected to reduce the value of each money unit.
Now we can parse bank loans into stable and unstable sources.
Loans from individual entities (not banks) would be stable. There is no increase in amount of money available to the macro economy. Individual entities would have first earned the money they are about to lend. (Individual entities cannot create money.) Bank lending that moved money directly tied to depositors (with a bank acting as agent for depositors) would be stable for the same 'first earned' reason.
Loans from banks that did not tie loan risk to a specific supplier of money would result in the appearance of an increase in the amount of money on deposit at banks. This would be an unstable increase of money, and would therefore follow the unstable model parameters. The lending bank would become at-risk of bank runs when depositors became aware of deposit claims in excess of money actually available for distribution.
Loans from the central bank are inherently unstable. Central banks have no money of their own to lend because they are restricted to being caretakers of money owned by others. Despite having no money of their own, central banks can create new money in exchange for a promise to repay. Usually, only governments get money via this path but we also have modern examples of central banks buying securities from private owners. Central banks are immune from bank runs because they can always create more money.
Additional sources of instability can be found. Physical destruction from fire, record loss, and government monetary recall come to mind. More common than any of these three, a broad recall of risk-unassigned loans by banks would result in a rapid money supply reduction.
Parsing complete, we can see that lending does not need to be a source of instability. Stable lending depends upon tying risk of repayment to lending entities. Without repayment risk assignment, there need be no rational expectation of loan limits or possible future money supply reduction.
That completes the description of the unstable money model. Instability comes from a change in the amount of total money available to the macro economy.
Stability and Instability in SFC Models
Stock-flow consistency (SFC) models can be used to show stocks and flows under stable and unstable monetary conditions. We begin with a very simple model found in Wikipedia, Figure 1. This model assumes government borrowing from the household sector and is therefore, a model of an economy with a stable money supply. We know the economy is monetarily stable because the flow balances (found at the bottom and right sides) are all zero. This would be true despite the household money supply (∆Hh) and government money supply (∆Hg) being labeled differently. Here ∆Hh equals ∆Hg.
|Figure 1. Stock-flow consistent model from Wikipedia|
In Figure 1, money borrowed from the household sector flows from household bank accounts to government and then back into private ownership. Money supply therefore remains constant in the banking system. (We are assuming household money is stored in the banking system.) This represents a stable money supply situation with loans causing changes in the liquidity conditions of sectors.
Figure 2. Three SFC models showing three methods of introducing stability or instability into a monetary model as a result of bank lending.
In Figure 2, we have changed the labels to show money being owned by either banks or households. This is done to allow an illustration of bank loans made with and without risk assignment. (While the lending bank may be at risk, deposit insurance (for the most part) protects the depositor from risk.) Having no perceived risk, the household sector is the beneficiary of bank loans and will perceive an increase in wealth realized through the income stream (identified as wages paid by firms).
Assigning Value to Newly Created Money
Early in this article, we recognized an intuitive relationship between the amount of money available and value of any physical item. We went on to say that any subsequent increase in money supply would intuitively decrease the value of each monetary unit. With all that said, how might small, measured increases in money supply be valued?
Still thinking intuitively, small increases should enter the payment stream valued as if they were an undifferentiated member of the existing, stable money supply. New money should have the same value as previously issued money. Applied to a practical example, a plumber, asked to repair a plugged drain, should charge the same hourly rate to both a customer with saved money and a customer with borrowed money.
We can extract an intuitive lesson from the plumber example. The creation of money by itself does not create economic disturbance. Economic disturbance occurs when both saved money and borrowed money want to buy at the same time. The degree of economic disturbance can be predicted as ranging from near zero to hyper inflationary (as when two customers get into a bidding war). We won't examine all the economic disturbance possibilities here.
Taming the Unstable Model
This article has placed a lot of emphasis on the unstable model of money. That said, the money we are familiar with using is relatively stable. Why do we see stability?
Still working from intuition but adding logic to extract probable supports for stability, we can think of several reasons of why a human creation becomes stable:
1. Human creators fundamentally want stability.
2. Instability is principally caused by creation and destruction of money. Since creation and destruction are controlled by banks, control of stability is a reachable goal.
3. Controlled instability can be used to improve the well being of the controller. While stability may be necessary for money to function, the controlled positive effects of monetary creation can be utilized/captured by controllers.
We won't discuss these three stability-tending reasons here. Our monetary system fundamentally works and we will leave it at that.
I have to wonder if this whole article is somewhat trivial in nature. What is being pointed out that we don't already know? My response is that an intuitive investigation cannot really be expected to reveal anything not already known. On the other hand, emphasizing the unstable aspects of our perceived-as-stable monetary system can help us better understand paths to manipulation. Monetary manipulation can be good or bad---it's all in the eye of the beholder.
(c) Roger Sparks 2019