Nick begins his post:
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.
This setup is identical with a monetary system I've been studying intensively – that is, I often dream about it and wake up every morning with a deep sense of duty – for the last 12 months. Prior to that, I worked 20 months as intensively to arrive at the setup; this is what makes me envious of Nick's ability to come up with thought-experiments!
I have two suggestions which might help us make more sense out of Nick's new system:
- Let's explain what a 'unit' is (Nick doesn't). We have to know why Andy and Betty agreed that the price of the goods (bananas) should be 100 units, and not, say, 10 units. Notice that there are no units in existence, not even in the "accounting realm", when Andy and Betty agree on the price.
- Let's not use, uncritically, old language and concepts when describing a new monetary system.
Eugene Fama has touched on both of these points:
Suppose we have... an advanced society in which it is economic to carry out all transactions through the accounting system of exchange provided by banks. The system finds no need for currency or other physical mediums of exchange, and its numeraire has long been a real good, say steel ingots. The society is so advanced that terms like money, medium of exchange, means of payment, and temporary abode of purchasing power have long ago fallen from its vocabulary, and all written accounts of the ancient ‘monetary age’ were long ago recycled as part of an ecology movement.
Suppose now that, for whatever reason, the government of this society decides that it would be more aesthetic to replace steel ingots as numeraire with a pure nominal commodity which will be called a ‘unit’ but which has no physical representation. Although monetary theory has long since passed away, value theory has strengthened with time, and the government’s economists realize that the ‘unit’ cannot be established as numeraire by simple decree. It must be a well-defined economic good, that is, the ‘unit’ needs demand and supply functions which can determine its equilibrium value in terms of other goods.
As Nick's description currently stands, his 'unit' is just like the initial 'unit' Fama criticizes. I don't agree with Fama, though: the 'unit' doesn't need to be a numeraire (I'm not thinking in terms of an equilibrium, like Fama was). But we still have to be able to explain why the price Andy and Betty agreen upon was 100 units and not 10 units.
To start with, I'd like to replace Nick's "unit" with "skilo". It's more convenient to use a word which, for most of us, has no real meaning. But this 'skilo' used to refer to something concrete in the economy under study. A long story short:
Imagine a closed economy where the numeraire is a kilogram of salt; the price of a watermelon might be 1.50 salt-kilos – "s-kilos" in short. All goods are priced in s-kilos, which is the unit of account (notice the subtle difference between the numeraire and the unit of account). By definition, the price of the "numeraire good", a kilogram of salt, is 1 s-kilo. Goods are exchanged against other goods, and salt doesn't need to appear as one of the goods in a transaction (because of this, salt is not 'money' as Clower defined it). When we have established (sticky) market prices expressed in s-kilos for most of the traded goods, it becomes feasible to denominate bilateral debts in s-kilos; this arguably makes the prices even more sticky. In most cases these debts didn't arise because the debtor bought salt "on credit", neither do debts need to be paid in salt. The debtor can deliver to his creditor a sack of flour, for instance. (The parties can sue each other if they don't agree on the price, but usually they come to an agreement as trade is seen as mutually beneficial.)
The system works as long as the real cost of procuring salt remains more or less stable, so that prices of other goods don't need to be constantly changed or the nominal value of outstanding debts (usually short-term; < 1 year) adjusted. But let us now imagine that one day – well, abruptly anyway – the real cost of procuring salt, due to a technological shock, is reduced by 50 %. The community faces a choice: Should they adjust prices of all goods (except salt) and nominal values of all debts – a formidable task including menu costs and mental costs –, or should they only adjust the price of a kilogram of salt? The majority of our agents are flexible thinkers, so they choose the latter option: the new price of a kilogram of salt is 0.50 skilos. What is a 'skilo'? It's nothing you can touch, nothing you can point at. It's an abstract unit of account. It cannot be a numeraire, because there isn't any supply of, or demand for, it.
OK. We have a unit of account: skilo. A kilogram of salt has ceased to act as a numeraire. If we stretch the concept of a numeraire a bit, we could say that all goods with sticky prices act as numeraires of sorts. Our economy looks much like the economy Ralph Hawtrey had in his mind here:
Suppose then that society is civilised, and that money does not exist. Goods are brought to market and exchanged. But even though there is no medium of exchange, it does not follow that they must be bartered directly for one another. If a man sells a ton of coals to another, this will create a debt from the buyer to the seller. But the buyer will have been himself a seller to someone else, and the seller will have been himself also a buyer. The dealers in the market can meet together and set off their debts and credits. But for this purpose the debts and credits, which represent the purchase and sale of a variety of goods, must be reduced to some common measure. In fact a unit for the measurement of debts is indispensable. Where a commodity is used as money, it naturally supplies the unit for the measurement of debts. Where there is no money, the unit must be something wholly conventional and arbitrary. This is what is technically called a ''money of account"... This is an approximation to the state of affairs which we are assuming. But however conventional and arbitrary the unit may be, once it is established as the basis of the debts and prices and values of a market, it is bound to assume a certain continuity.
Each dealer in the market calculates his own command of wealth in the same unit; it affords the basis for his valuation both of what he wants to buy and of what he wants to sell, and he looks for only such divergence from the previous prices as variations of supply and demand will justify. The total effective demand for commodities in the market is limited to the number of units of the money of account that dealers are prepared to offer, and the number that they are prepared to offer over any period of time is limited according to the number that they hope to receive. Therefore, arbitrary as the unit is, capricious variations in its purchasing power will not occur.
Arthur Kitson has suggested something very similar to our concept. Cowen & Kroszner explain Kitson's idea like this:
An abstract medium of account can be defined by setting the value of any commodity on a given day equal to “one” and pricing all commodities in terms thereof. For all succeeding market periods, however, this link is severed and only the abstract medium remains. Market participants set prices (in terms of abstract media) by reference to the abstract medium-denominated prices of the preceding period. The abstract medium is derived from a sequential process which ultimately refers back to an original commodity value.
Kitson talks about our 'skilo', doesn't he?
Now we can finally start re-writing Nick's story. Andy buys bananas from Betty, after agreeing with her on a price of 100 skilos for the said bananas.
In the current blog post, we have dealt with this task:
- Let's explain what a 'unit' is. We have to know why Andy and Betty agreed that the price of the goods (bananas) should be 100 units, and not, say, 10 units.
In the next post (Part 2), I will start re-interpreting Nick's new monetary system. I will avoid words like "money", "money supply" and "payment". The accounting stays the same. The way we established skilo – the "origin myth" of our unit of account – will affect our interpretation of the system going forward. (It would be very interesting to hear how Nick establishes his 'unit'. It would probably make comparison of our ideas easier.)
Part 2: Records Schmecords
 Nick continues: "The Net money supply remains at 0 units, but the Gross money supply is now 200 units."
Having read him often, I should by now understand what he means with the last sentence. But I don't. I know Nick thinks there exists both positive money (which he sometimes calls "green money": for instance, here, here and here) and negative money ("red money"), and he seems to sum the amount of both types of money to arrive at the gross figure, 200 units. Nick is a clever guy, so I'm sure he has a good reason to think like he thinks, but like I said, I haven't fully figured out the reason yet.
 Fama, Eugene. 1980. “Banking in the theory of finance” (p. 55).
 Clower, R. W. 1967. “A Reconsideration of the Microfoundations of Monetary Theory”. Clower writes: "Money buys goods and goods buy money; but goods do not buy goods." (p. 5)
 Hawtrey, Ralph George. 1919. “Currency and Credit” (p. 2).
 Cowen & Kroszner. 1994. “Explorations in the New Monetary Economics” (p. 126). They refer to Kitson: "Mr Kitson's Defence", 1895.
 Andy could have bought 200 kg of salt from Steve for the same price, so in our economy bananas might be a luxury item, salt supply abundant or then we are talking about a lot of bananas... I'll go for the latter.