Friday, March 16, 2012

Hayek Grasps Endogenous Money

There is an interesting passage from Hayek’s Prices and Production:
“There can be no doubt that besides the regular types of the circulating medium, such as coin, bank notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money. Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, ceteris paribus, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.

In particular, it is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense of the word would be required. The criterion by which we may distinguish these circulating credits from other forms of credit which do not act as substitutes for money is that they give to somebody the means of purchasing goods without at the same time diminishing the money spending power of somebody else. This is most obviously the case when the creditor receives a bill of exchange which he may pass on in payment for other goods. It applies also to a number of other forms of commercial credit, as, for example, when book credit is simultaneously introduced in a number of successive stages of production in the place of cash payments, and so on. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.” (Hayek 2008: 289–290).
That is an insightful passage: it describes the endogenous money supply that capitalist systems have had for centuries.

A major aspect of the elastic, endogenous money supply historically was, and still is to some extent, the negotiable debt instruments we call (1) promissory notes and (2) bills of exchange.

Both are freely and voluntarily created by private agents – there is no fraud involved. Free agents on the market create money at will by both these debt instruments. If modern Western capitalism has any “natural” or normal characteristics, it is the endogenous money supply.

The Rothbardian, anti-fractional reserve banking Austrians are guilty of two-fold intellectual incompetence, as follows:
(1) fractional reserve banking (FRB) is not fraudulent. FRB is an exchange of present for future goods, and is a mutuum contract, not a bailment. FRB does not involve two parties owning the same property because fractional reserve accounts (which we normally call demand deposits, checking accounts, transactions accounts, etc.) are nothing but debt instruments (just like promissory notes and bills of exchange): you transferred legal ownership of the money when you signed the contract and your FR account is actually just a record of the debt owed to you by the bank, re-payable on demand.

(2) even if FRB was banned, capitalism would still have an elastic, endogenous money supply via promissory notes and bills of exchanges. In order to stop the elasticity of money production by negotiable debt instruments, Rothbardian Austrians would have to violate private freedom and ban promissory notes and bills of exchanges. By its own self-proclaimed standards, the Rothbardian system is nothing but a tyrannical ideology violating liberty and free contract.

BIBLIOGRAPHY

Hayek, F. A. 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.

15 comments:

  1. Okay, Lord Keynes, lets not get carried away here. We have had this discussion on Bills of Exchange and FRB banking and Rothbardian money supply definitions before.

    A Bill of exchange or a promissory note is only included in the money supply if the public perceives it to always be redeemable for the base money (for dollars) or if they "perceive" it to be base money; at a fixed rate (the par value of money).

    Bills of exchange, bonds, etc were not widespread accepted and each seller had to independently verify their soundness. The only type of bonds that could be considered apart of the money supply right now would be U.S Saving bonds because the public can always exchange them back to the government at a fixed rate.

    And whether or not you are intentionally trying to "troll" the Austrian community by calling banning of FRB tyrannical etc (I don't agree with this contract theory), whether or not later followers can sound "oppressive", or whatever, as I've said before, Rothbard wanted to ban FRB because since demand deposits were socially and economically PERCEIVED as bailments (using the definition of the money supply, and ask anyone on the street whether they believe they have secure access to "their" funds), then that must de jure make them bailments. Not saying I agree, but I don't think his ideas were as crackpot as you lead people to believe they were.

    Furthermore, in a Rothbardian world the money supply can be endogenous (gold inflows?)

    ReplyDelete
  2. (1) "The only type of bonds that could be considered apart of the money supply right now would be U.S Saving bonds"

    Where did I declare above that bonds function as money?? No where.

    (2) "Rothbard wanted to ban FRB because since demand deposits were socially and economically PERCEIVED as bailments (using the definition of the money supply, and ask anyone on the street whether they believe they have secure access to "their" funds), then that must de jure make them bailments"

    There is a large degree of public ignorance, yes. I am well aware of it.

    The belief that this must make FR accounts de jure "bailments" is specious nonsense. It's like saying that stealing pens or stationary from the office is widely perceived by people as moral and legal, so therefore stealing pens must be de jure legal, even though it's clearly not.

    Spare me this tortuous Rothbardian special pleading.

    Furthermore, this is actually the public attitude to FRB in, for example, the UK. It doesn't support your case:

    "One survey that is available from the UK ... (... June 2010) finds that 74% of people surveyed (in August 2009) thought that they were the legal owner of the money in their FR current account (p. 6). A further 16% thought that both the bank and the depositor were joint owners of the money (p. 6). Only 8% knew that the bank was the legal owner (p. 6).

    Now 74% is indeed a high percentage, but what is very interesting to me is that, despite this number, 61% of people surveyed also said that they did not mind the bank lending out some of the money in their current account as loans (p. 8)! Only 15% said that they keep money in a FR current account for safekeeping (p. 5).
    Furthermore, only 33% thought that the bank lending out some of the money from their current account was wrong because they did not give permission (p. 8). This strongly suggests to me that in fact if people were properly informed of the legal nature of FR banking (with the proviso that their debt/deposit is insured), they would not object to the actual practice of FR lending or its legal status. People want banking services with a return on their money. A majority do not mind that the bank lends their money, even though a majority most also think that they remain the legal owner of the money."


    http://socialdemocracy21stcentury.blogspot.com.au/2011/12/are-public-ignorant-of-nature-of.html

    The public view of FRB is clear: 61% of people surveyed said that they "did not mind the bank lending out some of the money in their current account as loans".

    (3) "Furthermore, in a Rothbardian world the money supply can be endogenous (gold inflows?)"

    That wouldn't really make it endogenous in the proper sense, but merely variable owing to international capital account movements.

    And you've not addressed how Rothbardians would stamp out promissory notes and bills of exchanges, if they wish to stop people creating (or "counterfeiting," in their ridiculous vocabulary) money.

    ReplyDelete
  3. And another thing on point (1), I've already made it perfectly clear here that I don't regard government bonds as money (= medium of exchange or means of payment) in the conventional sense:

    http://socialdemocracy21stcentury.blogspot.com.au/2012/03/epic-fail-from-william-l-anderson.html

    Only rarely do they function as such.

    ReplyDelete
  4. "Where did I declare above that bonds function as money?? No where.

    And another thing on point (1), I've already made it perfectly clear here that I don't regard government bonds as money (= medium of exchange or means of payment) in the conventional sense:

    http://socialdemocracy21stcentury.blogspot.com.au/2012/03/epic-fail-from-william-l-anderson.html

    Only rarely do they function as such."

    Yes, in this thread. I general I was talking about debt instruments. And remember, you did write this:

    "You have a descending list of things that are or could be used as money in the sense of a means of payments/medium or exchange or store of value. By the time you get to the bottom of the list it is rare for the thing in question to be used as money (especially if it not negotiable). E.g., in a commodity money world,

    gold
    silver
    so-called money certificates
    demand deposits/FR current accounts
    savings accounts
    shares/deposits in S&Ls
    Promissory notes (private bank notes, other notes payable)
    Bills of exchange (sometimes includes the cheque)
    cheques (particularly negotiable cheques)
    some time/term CDs (e.g., Negotiable CDs)
    securities (stocks, shares, bonds)"

    http://socialdemocracy21stcentury.blogspot.com.au/2011/12/are-public-ignorant-of-nature-of.html

    Granted, it is at the bottom, and my goal here is not to frame you, or to say that you think bonds are money. The topic at hand was negotiable instruments and claims to future money. But many people, especially when talking about what functions as money, can consider "bonds" or other promises to future money to function as money or quasi money.

    "The belief that this must make FR accounts de jure "bailments" is specious nonsense. It's like saying that stealing pens or stationary from the office is widely perceived by people as moral and legal, so therefore stealing pens must be de jure legal, even though it's clearly not.

    Spare me this tortuous Rothbardian special pleading."

    Not exactly correct, but I don't agree with his legal theory, so I'm not going to argue this.

    "Furthermore, this is actually the public attitude to FRB in, for example, the UK. It doesn't support your case:"

    Where exactly did you find that link to the Cobden center? I believe it was me. I know what it said.

    Besides, its completely beside the point. People can sign a contract and say "Yeah, yeah, sure, loan out my money, fine", but then they use their bank notes and deposits as if they have access to the money, and everyone who accepts them also perceives that they have access to the money, then you go back to the Rothbardian definition of the money supply. Money is something that people either perceive as base money (gold, etc) or always redeemable for base money (money substitute).

    ReplyDelete
  5. Lord Keynes, That Hayek passage is quoted at the start of this Credit Suisse paper:

    http://faculty.unlv.edu/msullivan/Sweeney%20-%20Money%20supply%20and%20inflation.pdf

    I agree that the Austrian carry on about FRB being fraudulent is nonsense. But I still object to FRB and on two grounds.

    First, commercial bank created money is pro-cyclical. Expanding the money supply in a boom and cutting it in a recession is exactly what we don’t need.

    Second, FRB results in artificially low interest rates. Reason is that under FRB, banks can produce “savings” from nowhere, and lend them out. In contrast, genuine savers need to sacrifice consumption in order to produce savings. Thus banks can undercut genuine savers.

    Re your point No.2, I agree that “even if FRB was banned, capitalism would still have an elastic, endogenous money supply via promissory notes and bills of exchanges.” However money is defined as anything that is WIDELY ACCEPTED in payment for goods a services. And those bills of exchange are not widely accepted, so I’ve got doubts as to how inflationary an expansion of bills of exchange is.

    Re your point that banning bills of exchange would “violate private freedom”, I have no objections to violating private freedom if the freedom is harmful. We place sever limits on the freedom to set up distilleries and trade in firearms. Quite right.

    Re your point that “61% of people surveyed said that they "did not mind the bank lending out some of the money in their current account as loans": my response is “of course they don’t”. Reason is that having your bank lend out your money means you get more interest than you otherwise would, while the taxpayer takes the risk. That is, if the bank goes under, you get rescued.

    This whole process of reaping the advantages of commercial activity while taking none of the risks should be banned. Banks should have two types of account: safe accounts and investment accounts where if the bank goes under, depositors lose their money. The latter system was advocated in this submission to the Vickers commission. See:

    http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf

    ReplyDelete
  6. Patch@Mar 16, 2012 12:00 PM

    "Besides, its completely beside the point. People can sign a contract and say "Yeah, yeah, sure, loan out my money, fine", but then they use their bank notes and deposits as if they have access to the money, and everyone who accepts them also perceives that they have access to the money, then you go back to the Rothbardian definition of the money supply."

    They do have access to money via a debt instrument that allows repayment of the debt owed to them on demand.

    It is irrelevant that some people might perceive that they have a bailment rather than a mutuum here. The perception that something is so-and-so falsely doesn't make it true: this remains specious.

    On legal and moral grounds:

    (1) FRB accounts are a debt instrument; the loan is a mutuum

    (2) it is an exchange of present for future goods

    (3) FRB does not involve two parties owning the same property

    (4) you transferred legal ownership of the money to the bank when you signed the contract.

    ReplyDelete
  7. Ralph Musgrave@Mar 16, 2012 01:08 PM

    I am really not show why you have this animus against FRB.

    "First, commercial bank created money is pro-cyclical. Expanding the money supply in a boom and cutting it in a recession is exactly what we don’t need."

    Saying it is pro-cyclical doesn't necessarily mean it is always a bad thing: FRB has allowed much higher levels of investment than earlier centuries, which translates into greater real output, more wealth, more employment.

    Besides, the negative aspects of FRB can be virtually abolished with central banks and rigorous financial regulation.

    "Second, FRB results in artificially low interest rates. Reason is that under FRB, banks can produce “savings” from nowhere, and lend them out."

    This relies on the mistaken time preference theory of interest rates. Interest rates are a monetary phenomenon. You concede too much to the Austrians by saying this.

    Also, it relies on the mistaken assumption that capitalist economies don't have idle resources, unused capacity and are not open to international trade.

    It almost verges on acceptable of equilibrium theory. General equilibrium is a fiction. It doesn't exist in the real world.

    "This whole process of reaping the advantages of commercial activity while taking none of the risks should be banned.

    Why? Do you think that, say, we must have high-risk agricultural sectors by cutting all commodity stabilization programs and subsidies? That is say, making farmers reap the advantages of commercial activity while taking few risks.

    Doing the latter is a recipe for disaster: it would mean large parts of the agricultural sector would collapse owing to wild swings in commodity prices.

    Do you think large numbers of farmers should just be allowed to go bankrupt by subjecting them to markets? Only the most naive pro-markets apologists think that there must never be any socialization of risk.

    There are plenty of cases where socialization of risk is a good thing: without it there are severe consequences for the community at large.

    Banks should have two types of account: safe accounts and investment accounts where if the bank goes under, depositors lose their money. "

    No one has intervened to stop people from setting up 100% reserve banks (that is banks offering either bailments or only time/term deposits), yet such banks are non-existent as far as I can see.

    Capitalism results in FRB. The moral arguments against FRB are nonsense.

    Even the consequentialist case you make is not convincing.

    All serious problems with FRB can be abolished with central banks and financial regulation.

    ReplyDelete
    Replies
    1. I agree that FRB brought benefits during the industrial revolution, i.e. it was doubtless an improvement on monetary systems that existed in previous centuries. However, there were booms and recessions during the industrial revolution – somewhat worse than those we have nowadays. Thus FRB leaves room for improvement.

      I also agree that ASSUMING one has “rigorous financial regulation” and a competent central bank then there is not much wrong with FRB. However, the West’s central banks completely failed to spot the property bubble that lead to the credit crunch, so they just aren’t competent. In contrast, given full reserve, a rise in demand for loans to fund property purchase would lead to a rise in interest rates which would tend to choke off the bubble.

      Re artificially low interest rates, I don’t understand your points here, except for your point about “idle resources”. I think you are saying here that the thin air money produced by private banks enables idle resources to be employed. My answer to that is that private banks will boost economic activity with thin air money even when an economy is at capacity. That is inflationary, which forces government to reduce demand. I.e. FRB does not bring an aggregate increase in economic activity: it just displaces other forms of economic activity, e.g. activity funded by genuine savers.

      Next: socialisation of risks, etc. This argument is actually incidental to the full versus fractional reserve argument: that is, one can have taxpayer backing for banks (or not) under fractional or full reserve.

      Anyway, this World Bank paper is not too impressed by the benefits of agricultural stabilisation:

      http://siteresources.worldbank.org/BRAZILINPOREXTN/Resources/3817166-1185895645304/4044168-1185895685298/016pub_br12.pdf

      Second, there is widespread horror at the size of the taxpayer cost of bailing out banks during the current recession. I share that horror.

      Third, it is doubtless a good idea for a government to prevent a collapse of its entire bank industry. But that is separate from the question as to whether taxpayers should recompense depositors who have knowingly taken commercial risks. I say taxpayers have no such obligation.

      If you invest or lend to a firm via the stock exchange, and it goes bust you get no compensation. But if you invest or lend to a selection of firms via a bank and it all goes belly up, the taxpayer rescues you. That is inconsistent.

      Re the fact that 100% reserve banks are few and far between, that’s no big surprise. Why put your money into a safe 100% reserve bank if you can get a better rate of interest by putting your money into a riskier fractional reserve bank where taxpayers foots the bill when it goes wrong?

      Having said all that, I accept that the full versus fractional reserve argument is complicated, and I’m certainly not 100% sure I’m right.

      Delete
    2. "I.e. FRB does not bring an aggregate increase in economic activity: it just displaces other forms of economic activity, e.g. activity funded by genuine savers."

      Yes, it does, and Steve Keen shows how the net new annual credit flows into an economy can be modelled as part of aggregate demand. It's precisely because credit flows today have fallen and stagnated and we have deleverging, and debt deflation that Western economies are so sick.

      The same thing happened to Japan in the 1990s.

      "Second, there is widespread horror at the size of the taxpayer cost of bailing out banks during the current recession. I share that horror."

      You are correct to despise the crony capitalist bailout. The type of bailout that was needed is described here by James Galbraith:

      http://www.youtube.com/watch?v=qHc5NaaZvrc

      Also, regarding commodity stabilization programs: this is an absolutely indispensable part of nay sane economic system. It is also the way to prevent cost-push inflation.

      Delete
  8. "It is irrelevant that some people might perceive that they have a bailment rather than a mutuum here. The perception that something is so-and-so falsely doesn't make it true: this remains specious.

    On legal and moral grounds:

    (1) FRB accounts are a debt instrument; the loan is a mutuum

    (2) it is an exchange of present for future goods

    (3) FRB does not involve two parties owning the same property

    (4) you transferred legal ownership of the money to the bank when you signed the contract."

    I never said FRB should be illegal. They should, in fact, be legal, and I will fight tooth and nail for that. All I'm saying is that demand deposits are legally debt instruments, economically and socially they act as bailments. There is nothing controversial here. Bank deposits are like callable loans. The public just thinks that these callable loans will be available all of the time.

    Finally, as to your earlier comment about gold mining not being endogenous, what about mined gold (inside the nation)?

    ReplyDelete
  9. "All serious problems with FRB can be abolished with central banks and financial regulation."

    Think about the 'licence to print money' that banks have, how about a fixed cap on the quantity of loans they can have outstanding as well as a capital ratio.

    That seems to allow the regulators to set private debt as a percentage of GDPs - as well as limiting the size of banks.

    (In conjunction with separation of the retail arm from the investment arms. I struggle to see why investment banks shouldn't be restricted to matched maturity funding for their operations).

    ReplyDelete
  10. What's wrong with FRB is the high levels of leverage it permits banks to have, with liabilities exceeding their share capital by many multiples. Depositors get the advantages (interest and liquid deposits) without bearing the risk should the banks become insolvent.

    The recent financial crisis would not have occurred if banks has been funded mainly by preference shares rather than deposits. Their losses would have been passed to investors through a modest reduction in the dividend and runs on banks would be impossible, as their investors would hold securities rather than deposits.

    Banks that offer savers interest-bearing deposits should be required to match those deposits fully with short-term government debt instruments (treasury bills). That would ensure the banking system was 100% secure at all times, rather than having a system which depends on unpredictable government and central bank interventions in times of crisis.

    ReplyDelete
  11. Interest rates are a monetary phenomenon in the sense that the central back can determine the rate of interest through its control of the money supply. But the central bank is also required to keep inflation low, which means choosing a rate of interest consistent with this objective. This low-inflation rate of interest does depend on the time preferences of savers and borrowers.

    ReplyDelete
  12. Also, it relies on the mistaken assumption that capitalist economies don't have idle resources, unused capacity and are not open to international trade.

    Hayek described Keynesian economics as "the economics of abundance", claiming it would only be beneficial when there were unused factors of production of all kinds. He argued that such excess capacity was an unusual situation and hence Keynes was wrong to call his book "The General Theory...".

    ReplyDelete
  13. Excess capacity is not "an unusual situation" at all: it is a normal situation in modern capitalism.

    Manufacturers and other businesses often carry unused capacity, to exploit unexpected surges in demand, without the need for additional capital goods investment. Kalecki pointed his out a long time ago.

    ReplyDelete