The Curious Union of Chess, Money, and Economic Production

 \(c(t)+g(t)=r(t)k_b(t)+f_w(t)n(t)+k_p(t)\)

\(c(t) + g(t) = f_w(t)n(t)(1+r(t)) + k_p(t)\)
\(c(t) + g(t) = k_b(t)(1+r(t)) + k_p(t)\)

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In the game of Chess, players own the moves they make. Each move advances the game in a continuum from start to finish.

A productive firm works the same way. When a fractional part of a complex product is made or purchased, the firm owns another fractional part of a continuum that evolves into a priced product.

In a curious way, I'm frustrated by Brian Romanchuk's article
"The Curious Profit Accounting of DSGE Models." I can't convince myself that his beginning equation 16.2.3 is correct.[1] [2] It certainly doesn't fit with the real-world economic framework that I observe!

Unable to make sense of the equation but agreeing that an equation linking three sectors of the productive economy is a worthy goal, I would like to remove the wrinkles. A task harder to do than I expected.

The Problem

While my initial criticism of the equation was the number of sectors represented, I eventually realized that the basic flaw stemmed from a misuse of the capital tool. Financial capital was conceptually used as means of production in the same manner as labor so that it became one of the final products. That made no sense to me. In the real world, financial capital is directly exchanged for fractional contributions thereby transferring ownership in both directions.

We can use the example of fractional labor as an illustration to make the point. Using monetary exchange, one current hour of labor is traded for an hour of labor-that-has-been-previously-completed. In other words, when a person works one hour, that effort is effectively traded monetarily for one past hour that another person has sweated through.

The Solution

We can symbolically show past laboring effort expended, then represented by financial capital, and then returned to labor by writing  \(n \mapsto k \mapsto n, \) where \( \mapsto \) is the maps-to symbol, \(k\) is the capital received from previously expended effort and \(n\) is hours expended either past or currently.

This symbolic description using money [5] does not relate hours directly to a rate of payment. It has the limited task of indicating that a block of labor has been traded for a block of money has been traded for a block of labor. The concept of trading blocks for blocks will be woven into this article.

Only by accident does perfect mapping occur in real world exchanges that occur over a time period. Instead, there is always a difference in values that we will describe symbolically by writing  \(n \mapsto k \mapsto (n+p), \) where \(p\) represents a value difference perceived by the owner of the second \(n.\) In words, we say that the second provider of labor must perceive a benefit (or Profit) that encourages a decision to proceed. The benefit may be visible in the form of money or invisible in the form of product preference.

Continue  Defining Sectors

Returning to the subject of sectors, my initial criticism of Brian's equation 16.2.3 was that four sectors were described, not three as he suggested. Now that I am in version 6 (or more!) of developing a 'better equation', I believe that FIVE sectors are required to fully describe the productive economic continuum.

How do I define 'sectors'? If an economic contributor can make a decision, there is a need to represent that ability by assignment to an economic sector. The ability to make a decision implies ownership of some part of the productive amalgam with entitlement to financial reward. The five sectors that I see are consumption, government, productive firm, labor, and financial capital.

The productive firm sector will be assigned a reward coming from profit (if any).

The need for a financial capital sector is not immediately obvious because each of the other sectors have within them members who own financial capital,  The need for a separate sector stems from the ownership impairment decision that must be made when property is rented away. 

Our capital sector will have a undefined stock of preexisting capital. This will be a necessary assumption when we later assume that productive firms borrow and repay all financial capital used to pay expenses during a time period. The capital sector will be assigned a reward in the form of interest payment.

Describe Model Conditions in a Nutshell

The task of a productive firm is to reorder the capabilities of our five sectors into a product exchange evolution. The assembly process will be measured and modeled as a capital expense using three sectors: 1) a stylized all-inclusive labor sector, 2) a sector describing the cost of rented capital, and 3) an unpredictable remainder (Profit?) assumed to be owned by the productive firm sector. The selling process (of the product for consumption by the household and government sectors) provides income. The entire process is assumed to start and complete in one year.

Capital (owned by the capital sector) is existent and adequate. Financial capital is traded fractionally for fractional product parts as the product is assembled and finally sold.

Now Write a Productive Continuum Equality

We will describe the productive process by completing an annual income statement in terms of our five economic sectors. The result is surprisingly satisfying.

Our income statement will be written directly from the description given.[4]  Label the sector terms as labor \(n,\)  borrowed capital \(k_b,\) profit \(k_p,\) household \(c,\) and government \(g.\) With income on the left side, we write the general concept mapped to the real-world as \[c+g \mapsto k_b+n+k_p.\] where profit is the incentive  term.

Before writing an equality, we need to adjust the data from each sector into a place on the monetary scale, noticing that only the labor sector is not already reported in monetary terms. We will adjust labor by using a translation factor \(f_w.\)  The cost of borrowed capital will be calculated using cost factor \(r.\)

To do all of this, we will use a function format[3] with a time notation to indicate that the equality is related to a unique time period. We will write our equality as

(1)       \(c(t)+g(t)=r(t)k_b(t)+f_w(t)n(t)+k_p(t).\)

Equation 1 bridges the continuum of the productive process using five sectors.

Readers may be interested in comparing equation 1 to Brian's equation 16.2.3. In 16.2.3,  terms \(k_b(t)\) and \(f_w(t)n(t)\) seem to have been equated which enables us to simplify the equation. This is allowable if capital is borrowed at the same time and amount that labor cost are paid (albeit an inefficient process). With stylized labor cost clearly paid with borrowed capital, we have  \(k_b(t) = f_w(t)n(t).\) Substitute into equation 1 using the labor term to get \[c(t) + g(t) = r(t) f_w(t)n(t) + f_w(t)n(t) + k_p(t).\] Simplify to read

(2)          \(c(t) + g(t) = f_w(t)n(t)(1+r(t)) + k_p(t). \)

We can also substitute using the borrowed capital term to get

(3)         \(c(t) + g(t) = k_b(t)(1+r(t)) + k_p(t).\)

The difference between expressions (2) and (3) is the emphasis on financial capital or labor. The two expressions should evaluate to the same monetary number.

Equations 1, 2 and 3 are all final versions of an equality that I think describes the productive continuum adjusted to the real-world using five sectors. Perhaps my readers will have a better definition of exactly what the equation describes.

Unfortunately, Brian's 16.2.3 looks like a distant cousin of the equations developed here. I still don't understand 16.2.3.

Making the Unknown Known

In the assumptions (in "model conditions"), we clearly stated that profit \(k_b(t)\) was unknown, yet, we also clearly assumed that the entire equation completed in one time period. If completed, we can learn the value of all terms by examining the accumulated data.

Equation 1 (and equivalent 2 and 3) describes a relationship between economic sectors. It would be correct to attach a historical number to each of the sectors. It would also be correct to predict future numbers for each sector based on changes envisioned.

DSGE models supposedly try to find points of optimization for the sector of interest. The equations developed here would suggest that optimum for one sector would not be optimum for a second sector.

Using the Equation

It is important to remember that the profit term \(k_p(t)\) is a balancing term that maps theory to the real-world. Hence, we should NEVER expect to find numerical values by beginning with a known profit result. Yes, the profit term is real in the real-world, but it represents motivation (or disincentive) for decision makers at the theoretical level.

This model of money and it's use in productive effort seems (to me) very robust. As a robust description, it can become a common reference for departure into other, hopefully improved, models. Three model excursions follow to illustrate this possibility:

1)  This productive continuum equation was built based on micro economic principals. It can be smoothly expanded to the macro economic scale by adding productive firms. When ALL of the productive firms are included, we can begin consideration of the catastrophic transfer problem [If productive firms are always profitable, eventually all of the money available in an economy will be in the ownership of firm management.]. This undesirable conclusion could materialize using this model if financial capital ownership was not widely distributed in the economy. Would government ownership of capital prevent the potential problem?

2)  We can easily model a government that uses two revenue sources, bonds \(g_b(t)\) and taxes \(g_t(t)\). We could write the equation as \(c(t) + g_b(t)b_k(t)+g_t(t) = f_w(t)n(t)(1+r(t)) + k_p(t) \) where the term \(b_k(t)\) converts the bonds to financial capital. This model would need an explanation for how that conversion mechanism worked in the real economy.

3) Still using the model of example 2, which government would be more interested in imposing tariffs and why?

Hmmm. How would we fit foreign sourced production into an equality like we have here? I don't have that question resolved.

Conclusion

A DSGE equation that seems to not fit smoothly with other frameworks caused enough irritation to initiate an effort to find a better fitting equation. The better fitting equality found requires a base framework of assumptions that clearly included a capital owning sector that had decision making authority.

The simplicity of the equation found makes it seem almost trivial. Yet, we needed to assume a robust continuum of sequential money transfers before we could logically connect fractional construction to finished priced product. We also needed to divide the economy into sectors, each with decision making capability and with the ability to contribute to the productive or consumptive processes. The simplicity of the equation hides the rigidity of the required assumptions.

The management role of decision makers has barely been considered here. The role of a lender supplying initial capital is particularly important. This productive continuum model is discontinuous at the starting point. If a lender fails to allow initial production, nothing happens! In a similar fashion, labor, whether organized or individually represented, has a decision making role. Labor is supplied hour by hour. A discontinuity is reached if labor decides to not perform. In the real economy, consumers can borrow money to buy goods. It is easy to see in this model that production would be stimulated by customer borrowing. Government borrowing may be sustained sequentially over time, potentially forming a mechanism for hyperinflation. Thanks to Brian Romanchuk for his efforts to present this series of articles. [Brian's final article in the series can be found here.] ============================================== [Note 1] One of the nice things about beginning a study of economics when you are older is that you have a lot of experience from which to draw. One of the frustrations is that you may have little or no economic schooling to guide you. This places you in the position of learning everything about economics from the position of being a well educated beginner. I resist accepting economic theories until each element can fit seamlessly with the mating theories, like in assembling a jigsaw puzzle. [Note 2] This article contains an expanded explanation of the equations first presented (by me) in a comment in Brian Romanchuk's article at http://www.bondeconomics.com/2018/03/the-curious-notation-of-dsge-models.html#comment-form. [Note 3] Function notation is a method of mapping inputs into a repeatable pattern. The time term \(t\) as in \(f(t)\) indicates that the data is accumulated over a time interval. [Note 4] Term \(n\) represents hours of labor. We will use hours of labor as a proxy for all cost of production whether purchased directly as labor or hidden in a bid price for a part or service. The actual expense of a widget is not of concern here. We are only interested in learning the interactions between borrowed money and other sectors. If we later are interested in other interactions, we may need to refine our definitions. Hours of stylized labor must be converted to a financial capital equivalent using term \(f_w\). [Note 5] The terms 'money', 'financial capital', and (occasionally) simply 'capital' are used somewhat interchangeably in this article. 'Capital' is never used as a reference to fixed capital such as buildings or bonds. (c) Roger Sparks 2018

Tariffs, Sales Tax, and a Stronger Dollar

President Trump has proposed placing a 25% tariff on foreign steel and a 10% tariff on foreign aluminum. How in the world are we supposed to analyze that action?!

Well, maybe it's not so hard. This would be the United States government imposing a tax on all steel and aluminum that moved across borders. The tax would be paid in American dollars, not in the currency of the country of origin. It would be paid by the customer buying steel or aluminum should the customer chose a foreign made source.

Hence, we see here that an American steel consumer would be asked to make a choice of supplier, knowing that choosing foreign would result in a higher price due to the tax imposed. Considering only the tax implications, what is the relationship between the domestic and foreign prices?

Tariffs are a sales tax

A customer may have a choice between two governmental taxation schemes. If a customer has the choice of paying a sales tax or not, it makes no difference to the customer which government imposes the tax. The only differentiation is the relative price for the product. With this in mind, a tariff can be considered the same as a sales tax, the only difference being which government imposed the tax. This realization allows us to consider the situation of a customer living very close to a border between states, one state charging a sales tax and one not charging a sales tax. (The states of Oregon and Washington come to mind.)

A steel customer in Oregon (no sales tax) buying steel made in Washington would pay a 8% (about) sales tax. How would this customer make a purchase decision?

The sales tax or tariff decision

We will ignore the cost of transportation and other distance and time considerations to focus only on the tax consequences.

Our customer would find the point of price indifference where the price of product from each source is the same. In mathematical terms, the point of indifference occurs when

Oregon Price = Washington Price + Washington Price X Tax Rate

                        = WP + (WP X TR)
                        = WP(1+TR)

Transposing, we see that the point of indifference occurs when

Washington Price = OP/(1+TR).

Still ignoring transportation cost and using the 8% sales tax rate,  we can calculate that the Washington Price must be 0.926 or about 7.4% less than Oregon price before the price advantage shifts to Washington's favor.

With this background, we can consider President Trump's proposal from the standpoint of a steel purchaser. If a American steel customer must choose between foreign steel which carries a 25% tax and tax free domestic made steel, the foreign steel must be priced at less than 1/ (1 + 0.25) = 0.80 of domestic price.

Of course, in the real economy, transportation cost and other factors would be considered additionally.

A new tariff impacts three groups

Everyone dislikes taxes so it is certainly understandable that proposal for a new tariff would bring protest from the impacted parties. We can broadly group impacted parties into three groups: tax payers, disfavored suppliers and favored suppliers.

Broadly speaking, the domestic taxpayer will be the customer who must pony-up the tax payment. With a new tariff, government is raising the cost of product to the consuming public. This invokes the cost related supply-demand factors that we commonly study in economics.

Disfavored suppliers can be expected to lose sales to favored suppliers. This will again set into motion the supply-demand factors that we commonly study in economics, with opposite-trending local effects on the two supply groups.

It is interesting to consider the longer term macro-economic interactions of these three groups. A tariff will quickly cause a reduction of foreign trade accompanied by a transferred increase in domestic demand for the tariff-taxed product. Moreover, because domestic taxes are increasing for the tariff imposing nation, the strength of the domestic currency will INCREASE. This makes it more difficult for the foreign nation to obtain currency so we would expect an immediate decline in purchases of all products. It follows that a tariff imposing nation should expect to see fewer sales to other national economies as well as slower domestic sales.

The economy shifting effects of tariffs

In the longer term, the macro-economies of the victimized economies can expect to see permanent economy shifting effects. In the case of steel, the local price of steel should fall (due to less demand) but that makes the cost of producing other products less expensive which would (in the longer term) improve sales (including foreign sales) of products made using steel.

The general effect of tax streams on governments

We need to further consider the effect of a tariff on the finances of the imposing country. The most important part of this consideration is that the tax will be paid in the currency of the imposing government.

The tariff imposing government will have a new income stream. This stream will come from tariff paying customers. Additionally, if the taxed product is a basic building material like steel, then we can certainly expect to see the cost of the tax flow into all new construction. To the extent that cost increases result in higher tax flows (such as results for Washington state sales tax) general governmental revenues increase.

In the case of the American federal government, the imposition of a tariff should rapidly increase income taxes coming from the steel industry as wages and profits rise in response to increased/transferred domestic demand.

The foreign taxation dilemma

The last tax effect that we will consider in this post will be the dilemma faced by governments as they tax to pay for government needs. How do you tax labor and production facilities that reside outside national boundaries?

Consider a government dependent upon the income tax to meet a large portion of government cost. Apply that dependency to build a contrast between domestic production and foreign production. It is safe to assume that domestic producers will be subject to the income tax while foreign producers will avoid this tax. How does this difference distort trade?

The effects are not immediately obvious. What is clear is that foreign workers would not contribute to the tax needs of domestic government. In that sense, foreign production arrives at the border tax free. On the other hand, these same foreign workers have better incomes earned from the economy supporting the tax deprived government. Presumable these foreign workers pay taxes to their own government, but the money paid comes from the tax deprived economy. [Post Note: Yet, foreign workers are paid in a second currency, not the currency of final sale. In the absence of balanced trade, some entity must absorb a trade of paper for product.]

The synergy described sets up conditions encouraging every government to support foreign sales, with a goal of increased government revenue due to more income tax paid. Of course imports have the opposite effect.

As if it were a surprise, we can conclude that taxation can have economy shifting effects.

Conclusion

It seems to me that a better sales effort needs to be made to sell a new tariff on steel and aluminum. This new tax would be easier to accept if the need to bring foreign production into a tax sharing mode is made clear (to the public). Domestic governments would like all producers to fairly help pay for government programs, (thus sharing the tax burden laid upon domestic producers). Of course, domestic customers prefer buying foreign if they can get a less expensive product, ignoring (or even relishing) the probability that avoidance of domestic taxes may be the reason for lower price.

To the extent that tariffs better-balance the tax burdens of government, tariffs seem reasonable.

An afterthought

Disfavored suppliers, victimized by a new tariff, will be understandably upset by what is perceived as being discrimination against them. They will take it personally.

Governments housing these same disfavored suppliers are likely to attempt to find new markets, keeping workers and factories in a production mode. New markets, if peaceful, can be good. However, these same (in the case of steel) production facilities can be used in markets producing ships, tanks and other weapons, which would not be good. Thus we see a danger in forcing rapid changes in economies by using blunt trade weapons such as tariffs.

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.

Conclusion


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