Wednesday, December 4, 2019

Two Intuitive Conflicting Models of Money

Money is quite a puzzle to economist. They can't quite figure it out. For sure, it's not exactly the 'stable' medium of exchange that people think of when they consider their 'cash'. Stability is fleeting at best.

'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.

Conclusion

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

11 comments:

  1. "We will intuitively assume that value is proportional to the amount of money available."

    Only to an academic could this be intuitive. Businesses set prices according to demand with cost as a floor & within a range allowed by competition, (And conscience - a business wishing to stay in business had better put striving to raise quality & lower price at the top of their agenda.) The quantity of money that exists is the last thing on their mind. (Yes, it can have an effect at the extremes. If the money available to their customer set drops enough, the drop in sales of their product(s)/service(s) may make servicing that customer set no longer worth their while. And if that money increases dramatically, they'll first look for additional goods/services they can sell that set, then look at functionality they can add to justify higher pricing & then raise prices only if they have no competition (& most businesspeople won't even then).

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    1. That's not the concept that I was trying to convey. I was trying to intuitively understand why (for instance) Japan uses so many more money units than the USA to place a monetary price on things. Japan uses about 108 yen for every dollar's worth. Why is that?

      My intuitive reason is that relative value is basically an entirely arbitrary relationship. Accepted prices (such as you describe) are developed over time as a currency gains acceptance through usage.

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    2. Sorry for my erroneous interpretation. I added your blog to my reading list because of your August post & have not yet read your earlier posts to get a better handle on where you're coming from. Going back & rereading this post, you gave me clear warning in your 5th paragraph - I'm one of that clear minority that doesn't see money as physical. I'll keep your view in mind in reading past & future posts & try to take that into account in my interpretations of what you write.

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    3. Well! Thanks for placing this blog on your reading list. The mechanic in me wants to fit all the econ pieces together seamlessly. Money, because it endures in time, seems to need a physical presence.

      There is an ephemeral element to my 'physical' money. It comes from nothing (via the CB) and vanishes when debts are paid down (CB held debt). However, while money is in existence, it has an owner who carefully watches both deposit and wallet levels (which allows us to trace a chain of ownership).

      Borrowing from privately held banks is just a little different but still money is created from nothing, will exist for a period, and then back to nothing when the private bank debt is repaid. If my physical money reality is to be honored, private banks lend CB money. Problem is that no one knows if they are lending CB dollars or private bank dollars (They look the same.). The look-a-like feature prompts the CB to use ratios in measuring money supply. The CB knows how much money it has out--always less than the amount of deposits in private banks.

      Thanks for your comment. I apologize for the long diversion.

      Do the three SFC models make sense to you?

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    4. Roger; Re your last question, I understand your 3 models but truthfully, I don't buy into them - & in fact, have reservations about the basic SFC/sector-balance approach. In hopes of convincing you that I'm not a complete idiot, I need to follow that up with a long explanation, that I have no emotional expectation that you read or respond to.

      First, as a retired engineer, I have (I believe healthy) reservations about most opinions that are not backed by accurate definitions & measurements. When I became interested in macroeconomics a couple of years ago & started reading economists papers, I was astounded by the seeming narrowness of vision & ineptness of methods - basic math errors, logical fallacies, unrecognized assumptions. I started feeling that here was a whole body of intellectual endeavor that amounted to no more than trying to determine "how many angels fit on the head of pin".

      I finally found an anchor in the NIPA accounts - here was an attempt at reproducible measurements & a realistic understanding of double-entry accounting - which led to the nutshell understanding of an economy that I could believe in:

      "GDP is the measure of our productive economy. GDP is the sum of household, business and government spending (and likewise the income of those sectors equals that spending because all spending is someone else's income). Our economy depends on household spending (2/3 of GDP). That spending is limited by household income (which comes only from those three sectors). Business provides that income to the extent demand (business opportunity) exists, and government provides the rest (by way of bookkeeping entries to household bank accounts). All that's important to the economy is maintaining this flow, and with a fiat currency (whose value, by definition, depends only on currency-users perception), there are no limits other than that perception."

      I purposefully omitted the "rest-of-world" sector from this descriptor as it seemed to add nothing consequential to the basic understanding (but am aware the "import" measurement is embedded in the other sector expense measurements).

      This descriptor doesn't answer the many "whys" that economists seek answers to, but it's the clearest & most reliable predictor of economic events that I've found. To me, the NIPA GDP/GDI accounts is the (productive) economy's earnings statement (comparable to that of any business). It establishes the economy's expected income & expenses - & when deviations from those expectations occur, one can drill down into the subsidiary accounts to find the causes of the deviations & assess the options for correcting them.

      If you got this far, you have some understanding of where I'm coming from. Now to my reservations of the SFC/sector balance approach. I'll use the Sector Balance description from Wikipedia here (but it's the approach most economists use.)

      From the NIPA expenditure side: Y=C+I+G+(X-M)
      From the NIPA income side: Y=C+I+G+(X-M)
      "You then bring the two perspectives together (because they are both just “views” of Y) to write C+S+T = Y = C+S+T=Y=C+I+G+(X-M)".
      And then the fatal flaw: "You can then drop the C (common on both sides) and you get: S+T=I+G+(X-M)."

      But no, you cannot drop C. Recognize that C from the expenditure side (call it Ce) is the measure of "Personal compensation expenditures" & C from the income side (call it Ci) is the measure of "Compensation of employees paid" & Ce does not equal Ci & therefore mathematically cannot be dropped from the equation. I found it hard to believe that a relationship with such a basic math error could have such common usage, so have searched for a another interpretation without success. Saying that all people spend everything they're paid makes no sense. Hence, my reservations.

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    5. In rereading my last post, I realized I miswrote "From the NIPA income side: Y=C+I+G+(X-M)".
      It obviously should have been, From the NIPA income side: Y=C+S+T".

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    7. I am also an engineer but only by degree. I spent my working career farming. I continued my science interest in many ways, but especially in ham radio. I also run an amateur seismic station where quakes are recorded but no actual science.

      I share many of the economic reservations that you express. My econ effort began with an attempt to reverse engineer the economy, extracting from what I had learned from over 50 years of activity. One year of college econ 101 helped with 50 years back perspectives.

      Returning to money, the NIPA Y=C+S+T has fascinated me because the S term is so devious (in my opinion). The three SFC models deal with the S component.

      I'll confess that I also think the three SFC models are less than perfect. I spent considerable thought-time today on the two bank borrowing situations, thinking that they do not flow smoothly one-to-the-other. Still not completely satisfied.

      The two principals that I am trying to adhere to are "continuity of chain of ownership" and "physically relocatable in a sector". (Of course I am thinking of money, especially when created by the Fed buying something.)

      Now I think of money (once created) as physical and durable, you have another idea. Why do you think otherwise?

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  2. Roger: I believe that money isn't "real" simply because it's fiat, ie, there's nothing "real" backing it up, only people's faith (belief) that it's real. You can see from this Trump-era how easy it is to manipulate people's beliefs. How difficult would it be for the monied power structure to invest heavily in the Chinese yuan & then launch a massive publicity campaign aimed at convincing the American public that the dollar's in real trouble, that American industry is on its last legs, that we're headed for hyperinflation & that their only hope is to convert their dollars to yuan now!.

    The trailing line in my nutshell description of the economy says it all - "All that's important to the economy is maintaining this flow, and with a fiat currency (whose value, by definition, depends only on currency-users perception), there are no limits other than that perception. It's the flow of these tokens we call "dollars" that keeps our economy productive. There's a whole "non-productive" part of our economy, not a part of GDP, that includes banks, stock brokers, money advisors, insurance agents, etc, that I see as one big casino - nothing more than money game-playing.

    There's a reason their operations aren't included in GDP. There's a reason the economy's Earnings Statement (GDP/GDI) shows no "earnings" (ie, GDP=GDI). It's the flow that's important to maintaining a healthy economy. The accumulated flow (ie, wealth) is, in reality, nothing more than illusion.

    Just as a side note, from my current viewpoint, it looks like your biggest obstacle was that Econ101 course. As MMT is showing us, everything in those textbooks is wrong. All those theories were derived from an economy of gold-backed money, which haven't been applicable in 50 years. Looking back I'm so thankful I plowed into economics by just reading economists' papers & blogs. If I had gone through the process of being "taught" how the economy works, I'm not at all sure I could have broken through those blinders.

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    1. Ed: A great answer--thanks.

      You have probably read more econ theory than I. For me, the books are on the shelves--great for studying a passage or theory--but who can we believe? My recourse is to figure things out--mechanically--from what I see and can gather from resources available.

      My goal is better econ theory. What I have so far is mostly MMT without recommendations. The not-MMT part is mostly due to my insistence on a "chain of accountability" which requires durability.

      I am just starting a small project on SFC modeling. May even create a beginners post (with emphasis on "beginner) based on a mechanical perspective. Don't hold your breath.

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  3. Sounds good. I'[ll be looking forward to it if you go ahead.

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