A Crisp Definition of Money

The blog "The Epoch Times" had a post by Valentin Schmid "The Economic School You've Never Heard Of". I wrote the following comment:

I have not yet seen where "Austrian economics" recognizes how government spending violates the "trade-for-trade" (Note one) rule. To understand this concept, we must recognize that government never produces a product--government can only produce money to pay for a product.

Where does government get money to pay for a product? Taxation is one method but tax (in the form of money) is only collected if someone first produces products that can be traded for money. Government spending financed by taxation is following the "trade-for-trade" rule.

The second source for government spending may not follow the "trade-for-trade" rule. Government can borrow money for future spending.

Government has two sources of lenders; one follows the "trade-for-trade" rule, one does not. Government can borrow from private lenders who do follow the "trade-for-trade" rule. Government can also borrow from itself by borrowing from the central bank. THIS SECOND SOURCE OF BORROWED MONEY VIOLATES THE "TRADE-FOR-TRADE" RULE (because no-one ever worked to first earn the money marked for future government spending.

*Note one: "People come together to voluntarily engage in commerce with one another for their mutual benefit." I sum this phrase with the term "trade-for-trade". As an entity (not a productive individual) government has no ability to be creative. Government can only work in terms of monetary exchange. Hence, the source of money for government exchange becomes crucial.

In reply to my comment, Richard wrote:

 In order for your comment to have greater validity, wouldn't it help to define the concept "money", to include its purpose and source of creation? Of course everyone uses the term 'money' without giving it a moment of thought as to what it is and how it springs into existence. 

         I suggest a thorough reading of E.C.Riegel

In reply to Richard's comment, I wrote:

Yes, it would help to have a crisp definition of money.

I used a birthday gift certificate a few days ago. As I wandered the store (which issued the certificate), I realized that, so long as I was in the store, the certificate had equal value to the "money" i had in wallet or national credit card.

"Is money just a National Gift Certificate?" I wondered. That thought led me to think deeper into the idea of "merchant money", which is money issued by merchants and commonly known as "gift certificates". How does the merchant issuing certificates account for the certificates, print them, and redeem them? Can "merchant money" be traded or issued as payment for services rendered?

The answers to these questions (and more) seems to be parallel with our expectations from our everyday money. Our everyday money seems to be "merchant money" traded on an international scale.

To integrate this idea with my previous comment, think of the Central Bank acting as an arm of Government, issuing "National Merchant Money" or "National Gift Certificates". It all seems to fit together quite well.

These comments tie with my blog post  "The NGC Model, Banking and the Creation of Money".  The recent comments contain an new idea, which is to identify "gift certificates" as "merchant money". The term "merchant money" translates easily to the money we handle on a daily basis and seems to convey an accurate impression.

Maybe "mercantile money" would be a better term, more general than "merchant money"?

Richard is right. We (as economist) need a crisp conception of money, and how it is created and destroyed. A crisp analog seems to be available in "mercantile money" commonly known as "gift certificates". This "mercantile money" must be created by the merchant, be properly accounted for, be used in trade, and have the possibility of direct dissemination by the merchant in exchange for goods and services.

Our crisp definition for "money" is "Money is a National Gift Certificate". An analog of "money" is "mercantile money", commonly known as a "gift certificate".

I think the crisp definition  and analog work.

The Natural Monetary Chart

Here at the Mechanical Money blog site, the philosophy is to make the monetary system as mechanical as possible. This requires each monetary concept fit seamlessly into the next concept.

Our Questions

A question that frequently arises in basic monetary discussions is the initial pricing of the reference item. How do we decide if the initial price is 100 units or just 10 units?

The second question is a follow-up of the first. Knowing the first price, what is a second item worth?

Some Background

Now assume that we have no monetary system at all. How do we select the first price? Logical deduction supplies no answer. We must simply pick a beginning point.

Wait! Pick a point? Where in the mechanical world might that be?

Let's assume that our model society understands arithmetic. They would understand a measuring stick that was scaled between zero and some commonly used maximum measure. An example would be a 'yard stick' that is measured in inches, having a maximum scale of 36.

Our Monetary Scale

We can build a monetary scale that begins with zero and expands to infinity. The width of each unit is completely arbitrary. We will call this imaginary line "The Natural Monetary Scale".  It can drawn onto paper but we don't  yet have scaling units. Scaling will follow after we introduce another concept.

More Background

The reason we are considering the money concept is because we would like to theoretically move past the barter system. In barter trade, dissimilar objects change ownership group-by-group. For example, five arrowheads could trade for one elk antler. This is very inconvenient if the antler owner, wanting to not break his elk antler, wants only one arrowhead. Money is a standardized physical object (some claim an "abstract or non-existent" object), available in very small sizes that can easily be aggregated and stored. The use of money (if he had some) would simplify the antler owner's trade decision.

The Value Question

The problem faced by the antler owner is faced by every owner of every item. The value of the item is not the same as the item potentially purchased. Money does not solve this problem. Money is just another item (whether physical or abstract). Money has it's own valuation problem.

Further complicating the value question, the value of any item varies in the eyes of the trading persons. The person owning eight arrowheads will have a different unique value assigned compared to the person owning just one arrowhead. A red arrowhead will have a different value than a black arrowhead.

If we expect to value property, it will need to ranked and scaled just like money needs to be scaled. The money scale will have one advantage--it will be a scale with uniform steps.

The Chart

With this background in mind, we can draw Figure 1, the Natural Money Chart.

Figure 1. The Natural Monetary Chart. The uniformly increasing numbers on the x-axis constitute the Natural Monetary Scale.                                

We use the Natural Money Chart by entering the item-of-interest onto the vertical axis. In Figure 1, we see that several apples are worth about 3 units on the Natural Money Scale. Gold is more valuable but not yet evaluated. One apple is less valuable than several apples but (again) not evaluated.

The Natural Money Chart is a purely arbitrary chart. The Money Scale is arbitrary. The single factor that makes it  (the scale) physically real is the decision to relate several apples to a point on the scale. In Figure 1, several apples translate into 3 natural money units.

We will need to add more items into our Natural Money Chart. To do this, find agreement on the relative value of any other item. A single apple is an easy example. Assume that several apples are counted to be seven individual apples. We would calculate that when seven apples are valued at 3 units, one apple would be worth 3/7 money units. Draw the connecting lines to 0.42857 on the Natural Money Scale. One apple is worth 0.42857 units of money. [We already assumed that our society understood arithmetic.]

There is a second way to set the scale units on the Natural Money Scale.  Any two dissimilar items can be picked and assigned an arbitrary value [preferably an evenly scaled value such as when the more valuable has seven times the value of the less valuable]. To make the chart, place the physical items on the vertical line and the arbitrary values on the horizontal line. Following the scale lines, establish a reference line with the correct intersecting slope.

Conclusions

Once we have monetary units, we can begin bookkeeping.

The Natural Money Chart allows a seamless transition from physical property to money-as-a-physical-object. It is immaterial whether money is considered as abstract or physical; all that is important is that a seamless translation from socially acceptable value to a uniformly scaled number be made.

The NGC Model, Banking and the Creation of Money

Nick Rowe is a prolific and creative author to whom we all owe thanks. Today he gives us a model that we can use to create a new vision of the creation of money.

Nick writes

You decide to make a new monetary system from scratch. You give everyone a chequing account on your computer, with an initial balance of 0 units. If Andy buys bananas from Betty and pays her 100 units, Betty now has a positive balance and Andy now has a negative balance.

Nick may disagree but I think his model first presupposes a monetary system and then calls our attention to a nearly complete monetary event. The focus of this post will be on the events that had to occur before Nick's model begins. It is these background-events that are interesting and offer us additional insight into the creation of money.

Establish a Frame of Reference

These background events need a frame of reference to make them plausible, easily described, and comparable to actual macroeconomic events. The framework we will use is the National Gift Certificate Model (NGC) which treats money as an analog of the well known gift-certificate.

The possibility of a NGC model of money creation first appears in a comment to Nick's post:

Using the NGC example, the issuing store prepares to sell a gift certificate by printing the certificate. Then the store has a choice: recognize the increase in inventory and expense of production immediately OR wait until actual sale and then recognize the event. The first choice makes sense if the intended use of the gift-certificates is to pay for goods and services; the second choice makes sense if the intended use is to sell the gift-certificate for money in the future.
In either case, the actual creation of money or NGC is not visible to the usual measuring tools available to the public. The actual issuance of new money is more visible but identical to using old money; issuance is just another exchange of goods and services for money/NGC.

It is obvious that any store offering gift certificates can do some accounting behind the curtains as just described. We need to notice that the store is providing not only accounting services behind the curtains--it is providing banking services. With the issuance of a gift certificate, the store is providing a certificate with future value (like a check written on a bank). The store is also providing storage for future value that will be claimed when the gift certificate is presented for redemption (store products will be available in the future which is comparable to bank money that will be available when a check is written).

A Model of Money Creation

We have not yet created money. An analog with newly created money comes from the observation that a gift certificate can be issued by a store in payment of goods and services received. This event can be compared directly with a barter transaction in which goods are traded for goods. The only difference is that this is a partially delayed transaction: the services are delivered first; payment is made later when the gift certificate is redeemed. The creation of a money certificate is easily compared to the creation of this delayed-payment* gift-certificate.

To see the comparison, we look at the creation of money by a bank when a bank makes a loan. The bank creates a deposit in the borrowers name and will ask the borrower to sign a promise to repay the amount borrowed (and a small charge in repayment for the bank's services). This action creates an increase in the money supply and is widely recognized as a creation of money.

If you are like me, you don't immediately see these two events (the store's certificate and bank's new deposit) as being nearly identical. To see this clearly, we need to go behind the curtain. The bank can perform the identical steps just completed by a store preparing to offer gift-certificates as payment. Whether either store or bank actually does these steps in preparation or not, the important take-away is that observably identical results are obtained.

There are two behind-the-curtain tasks that both banks and gift-certificate issuing stores perform:

1.  Prepare a certificate that will be delivered to the customer. A store will prepare a gift-certificate. A bank will open an account with a positive balance in place. In both cases, before delivery to the customer, the name on the instrument will be the name of the issuing entity (or blank).

2. Make a record that the certificate/account has been backed by an asset. A store will reserve goods/value owned by the store.  A bank will create a bond signed by the bank and promising to repay the amount on deposit.  (Yes, this is a bank lending to itself but no problem, the actions are entirely within the bank, hidden behind a curtain.)

With the instruments in place and funded, a store or bank is ready to pay a bill or service a new customer.

When a bank borrower actually comes through the door, he is asked to sign a loan agreement. If he does, the account is signed over to the borrower. The bank's loan document is now secondly backed by the borrowers signed repayment commitment.

We can see that money has been created ad nihilum. Or has it? When the borrower reduces the deposit by spending money the deposit represents, other banks will receive money.  In the fiat monetary system, the bank transferring funds must transfer money that all banks will accept. There has to be a problem if all banks are lending money created by assigning accounts and backing them with bank guarantees.

The Dilution Problem

There is a problem. The observed money supply rapidly increases which effectively dilutes the base money supply that was first used to begin the repeated-lending-sequence. In the modern fiat monetary system, this expansion is controlled by the central bank.

The control process is simple. The central bank creates a block of money using the bank money creating process previously described. This would be considered as "base money". Base money is then distributed to private banks, usually through the sponsoring government when government pays for goods and services. Once received, private banks are allowed to re-loan the new deposits. Control of the loan process is maintained by the central bank with a requirement that a "tax" be collected on deposits in every private bank. This "tax" drains original funds at a rate proportionate to the "tax rate",  amount, and number of loan events. After several events, the entire original money issue will be returned to the central bank, allowing the central bank to know when the original base money supply has been completely loaned-to-limit. (This sequence is partially described in the Federal Reserve document "Reserve Maintenance Manual").

We have seen how the NGC model can be used to understand the creation of money.

Another Look at Nick's illustration--Motive

We now have the opportunity to examine Nick's illustration from a new perspective. We can see that behind the curtain, some entity must have prepared the green entry that Betty would receive in trade. Some entity would have prepared the red entry that Andy received. Further, Andy would have been given the red entry along with the green entry that he later traded to Betty. The entity behind the curtain can be assumed to have authorized all of this activity.

Why would any entity carry out all this activity? One logical possibility is that Andy thought that bananas were worth more than the 100 units and the added obligation-to-repay that he incurred. At the same time, the sponsoring entity could have thought that Andy's obligation to repay 100 units in the future (together with service charges)  was worth more than the 100 units that the entity would render temporarily unavailable. We can safely believe that Nick's illustration has described a three-way mutually advantageous trade.

Nick inconveniently omitted the events that occurred behind the curtain.

The Value of Money

It does not seem logical to extend the creation of money into the value of money. We can safely believe that Betty willingly traded 100 units for bananas but we don't know how many bananas she traded. We only safely observe that 100 units have been found.

Conclusion

The NGC model provides a powerful analogy to processes found in the broader monetary system. This descriptive path-of-creation for money is yet another example in the use of the model.

Thanks

Thanks to Nick Rowe, whose cryptic yet tantalizing posts on macroeconomics repeatedly inspire many amateurs and professionals.

*[11/10/2016 update] The combined words "delayed-payment" were inserted to call attention to the important fact that the comparison of money to a gift-certificate depends upon the store FIRST receiving goods or services THEN providing a gift-certificate in acknowledgement. The gift-certificate is evidence of an obligation for the store, only payable by trade within the store. We could think of the certificate as being Delayed Evidence of a Barter Transaction (DEBT).