Real and Nominal Layers

JP Koning has written a thought-provoking post on the monetary system ("Money as layers"). (Based on the dozen or so posts I've read from him earlier, JP strikes me as a thoughtful, balanced writer who comes up with interesting, and often out-of-the-ordinary, topics. I've learned a lot from him. Johan, thanks for notifying me of this latest post of JP's!)

JP uses the layered structure of dreams from the film Inception as a metaphor for our monetary system. He says:

Like Inception, our monetary system is a layer upon a layer upon a layer. Anyone who withdraws cash at an ATM is 'kicking' back into the underlying central bank layer from the banking layer; depositing cash is like sedating oneself back into the overlying banking layer. 

Monetary history a story of how these layers have evolved over time. The original bottom layer was comprised of gold and silver coins. On top this base, banks erected the banknote layer; bits of paper which could be redeemed with gold coin. The next layer to develop was the deposit layer; non-tangible book entries that could be transferred by order from one person to another. Bank customers could "kick" out of their deposits and back into banknotes, and then kick out of banknotes into coin. Conversely, they could sedate themselves from coin into notes and finally deposits. 

 (Note the terms 'sedate' and 'kick', as I'm going to use those when I build on JP's idea. 'Sedating' is moving further away from the bottom layer, while 'kicking' is moving towards the bottom layer.)

If we take reality to be the bottom layer in Inception, then it would make sense to have the bottom layer in our economy comprise of real goods and services. We can call it the real layer. JP only talks about the bottom, or foundation, layer of the monetary system – not the economy. To him that bottom layer used to be the precious metals (to me this is different from gold and/or silver coins, although JP seems to mix these together?) and is nowadays banknotes issued by the central bank.

I would place precious metals in bullion form on the real layer. Gold and silver coins, with a face value higher, or potentially higher, than the price of the metal itself (intrinsic value), used to form what I'd like to call a nominal layer ("credit layer" wouldn't probably be a bad name, either). Banknotes[1], deposits, etc, are all nominal layers.

So, we have the real layer and we have nominal layers. Just like dreams are connected to reality, so are the nominal layers connected to the real layer. As an anonymous reader said under JP's post: "People consider these subordinated assets to be claims on real commodity wealth". What provides this connection is the (nominal) price we set on goods and services when we trade them. It is the unit of account which forms a link between the real layer and any nominal layer (see my first post for how I view the unit of account).

Just like dreams can feel very real, so can nominal wealth feel very much like real wealth. And for a good reason: most of the time, an individual can convert nominal wealth into real wealth – that is, kick himself out of a nominal layer into the real layer. This can happen either directly, or indirectly via other nominal layers closer to the real layer than the starting layer.

Here the layer, or hierarchy, metaphor doesn't work that well: it is possible for an individual to kick out from many of the nominal layers directly into the real layer, without visiting any possible layers in-between. This, often but not always, means that the counterparty to the trade, the one who sells the good or the service, sedates from the real layer directly into that specific nominal layer, say, a commercial bank deposit. (An example of when this is not true: the credit entry on the seller's account brings the account balance to zero from a previous negative/debit balance (an overdraft). In that case it is hard for me to see how we could say that the seller ended up on that layer.)

Where JP isn't too clear is what is the quality, or qualities, that separates one layer from another. Does it have to do with the (perceived) riskiness of the layer, the institution behind the layer, or even with the chronological order in which the layers appeared, or seem to have appeared? As Johan Meriluoto points out (and JP confirms), this idea of layers is similar to Perry Mehrling's idea that "the system is hierarchical in character".

When it comes to what makes one layer different from another, Mehrling seems to focus on the institutions (although risk as a factor lurks always in the background). He gives an example of a simple hierarchy of a central bank, commercial banks and security dealers. Mehrling's hierarchy fluctuates: one hierarchical level, or layer, can look (qualitatively) much like another in good times, while under market stress the hierarchical character gets amplified. Thus, in what way and to what extent the layers (are perceived to) differ from each other varies with time.

It would be hard to argue that the layers are only about risk. A commercial bank deposit which is covered by a public deposit guarantee can arguably be viewed as being, at all times, on par with currency. And when JP suggests that a (private) deposit is somehow a subordinated layer compared to a (private) banknote, riskiness as a differentiating factor disappears entirely from the picture – after all, the risk of theft or misplacement makes a banknote less secure than a deposit.

When it comes to this question of priority between banknotes and what he calls "non-tangible book entries", I find myself at odds with JP. What he says makes some sense if we consider the recent history of banking as it applies to the general public (say, from the 18th century onward), but I'm not at all convinced it is true about the early history of monetary systems (which is, unfortunately, not known). What makes it untrue even if we only consider the recent history is that the book entries have existed, all of the time, side by side with banknotes. They were not the "next layer to develop" after banknotes.

That might very well be a minor detail for JP. What makes it somewhat important for me is that as I'm trying to build a monetary system from scratch (as it might have happened thousands of years ago, although I'm not trying to make a historical argument; this is a thought-experiment which I believe can help us understand the current system better), I find it makes sense to view/describe/understand banknotes in terms of the non-tangible book entries. The latter should be logically prior to the former. (You might get a better idea of what I mean by this if you read first Part 3 and Part 4, and then Part 7 of my series.)







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[1] Banknotes, like gold coins, might on some occasions have an intrinsic value higher than face value. When this is so, they kind of "kick" themselves back on the real layer.

A New Monetary System From Scratch, Part 8: Taking Credit Notes to the Bank

Andy makes his first round-trip to the village (see Part 7). He sells apples, buys copper and returns to town with some copper and two credit notes (each note in circulation, ten in total, has a face value of SK100).

After holding the two credit notes for a week and having misplaced them twice, Andy thinks it best to return them to the bank.

Meanwhile, a couple of villagers with credit notes, six notes in total, have come to the bank and expressed their willingness to open an account. They have got their new accounts credited for the notes. (Could we interpret this as the villagers depositing the credit notes?)

The central bank has hired a new employee who has been tasked with taking in credit notes and opening accounts. As Andy arrives at the counter with notes, the newly-employed teller mistakes him for a villager, asks for his ID (assume no difference between a town ID and a village ID) and in all silence, apart from humming to himself, opens a new account for him. The teller credits the new account and debits the account "Credit notes in circulation", both with SK200.

Here's an overview of the bank ledger after the latest entries:

	BANK OVERVIEW
	Deb(i)ts/Liabilities	Credits/Rights
Andy(1)	950	200	Credit notes in circulation
	xx	xx
	xx	200	Andy(2)
	xx	xx
	xx	xx
	xxx	xxx

Andy finds out about the mistake when the teller gives him a new ETRS gadget (see Part 4 for more on the ETRS system and the gadget). Andy explains the situation to the teller and asks him to net the two accounts against each other and then close the new account. Employee debits new account and credits old account, both with SK200. (Could we interpret these two entries as Andy repaying some of his debt to the bank?) Then he closes the new account.

An overview of the bank ledger after the correction:

	BANK OVERVIEW
	Deb(i)ts/Liabilities	Credits/Rights
Andy	750	200	Credit notes in circulation
	xx	xx
	xx	xx
	xx	xx
	xx	xx
	xxx	xxx

I have placed two questions within the text in parentheses. This is because I've come to see my posts more and more as conversation starters. Well, not really as starters, but as a continuation of the conversation taking place in the comments section of my posts. It is that (long, winding and, at times, frustrating) conversation which really matters to me. By writing these posts I want to feed that conversation and, I hope, take it forward, or at least on a somewhat new track when the old one starts to repeat itself too much (not that I personally wouldn't like repetition!).

Warm thanks go to Johan, Oliver and Roger for having kept up the conversation so far! When you put people with so different backgrounds – with a burning interest to all things monetary as the only common denominator – together, what you get is always going to be a surprise.

A New Monetary System From Scratch, Part 7: Decentralized Recordkeeping

Andy, the proud owner of the fastest mule in the universe, was planning to start fortnightly round-trips to the village (see Part 6), taking apples with him to sell to the villagers, while buying copper from them. He would sell the copper once he got back in town.

Andy had a problem to solve. His trade with the villagers was going to be a deficit trade: if things went as planned, on every trip he would sell apples worth (market price) SK400 and buy copper worth SK1,200. This would have posed no problem if the village had been on-the-grid, but as things stood, there was no connection to the ETRS (see Part 4) from anywhere near the village.

Andy had come up with a solution to his problem. He presented it to the central-banker whose co-operation was required.

Andy suggested that the central-banker could issue central bank credit notes with, say, SK100 face value. The bearer of the note would be entitled, upon handing the note over to the central-banker, to a credit entry on her account in the central bank ledger. This would allow a villager to sell copper to Andy and get her account credited for the sale once she was in town for business – usually once a month. If she wasn't going to attend the town market, she could buy goods from a fellow villager who was, and who could then present the note(s) to the central-banker.

The central-banker, interested in expanding the reach of his new institution, saw this as a great opportunity for the central bank to bring the village more fully under its influence. He approved Andy's request and told him to come back the following day, as it would take some time to print the credit notes.

The following day, before making any entries, the central-banker printed out an account overview:

	BANK OVERVIEW
	Deb(i)ts/Liabilities	Credits/Rights
	xx	xx
	xx	xx
	xx	xx
	xx	50	Andy
		xx
	xxx	xxx

Andy's positive balance of SK50 reflected the fact that Andy had previously received bananas worth SK100 from Betty, given apples worth SK100 to Carol and apples worth SK50 to Seven.

Next, the central-banker gave ten credit notes, with a face value of SK100 each, SK1,000 in total, to Andy. Then he debited Andy's account with SK1,000 and credited a new account called "Credit notes in circulation" with SK1,000. He printed out a new overview:

	BANK OVERVIEW
	Deb(i)ts/Liabilities	Credits/Rights
Andy	950	1,000	Credit notes in circulation
	xx	xx
	xx	xx
	xx	xx
	xx	xx
	xxx	xxx

The central-banker explained the situation to Andy:

As long as Andy remained in sight of the central-banker, it was as if Andy had had two accounts in the central bank ledger: one with a positive balance of SK1,000 and one with a negative balance of SK950. What really mattered was the net balance, which was so far unaffected. Andy had no liability to give goods to others; he had a right to take goods worth SK50 from others without incurring a liability.

Once Andy left the central bank premises, the central-banker became unaware of his net balance/position. Recordkeeping became decentralized. From that point onwards, the central-banker had to assume that Andy had a net liability worth SK950. If he was in possession of credit notes which reduced his liability recorded in the ledger (SK950), or even cancelled it altogether, it was up to him to prove this to the central-banker by presenting the notes to him. Once he did this, the central records could be updated to reflect Andy's actual position. (It was not a case of Andy paying a debt by handing over the notes.)

The central-banker wanted to make it very clear that this was not a loan of credit notes from the central bank to Andy. Andy was not obliged to return any credit notes. Having got rid of the credit notes by buying goods, and in this way having incurred an actual liability, he could sell goods to someone and thus get rid of his liability.

The effect of the issuance of credit notes was to introduce a lag between a trade and the reporting of the trade's effect on the trading partners' position[1] (their credits or liabilities); there was no real-time netting of credits (gifts given) and debits (gifts received) when credit notes were involved.

The logic behind the recordkeeping was unaffected by the issuance of credit notes. A net liability was still a liability to give goods to others. A gross liability recorded in the central bank ledger was assumed to be a net liability until the account-holder proved otherwise by presenting credit notes to the central-banker. A delayed netting of debits (personal account) and credits (credit notes) was no 'debt repayment', but a delayed update to the records.

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[1] What is reported is not the trade per se, but the amount by which the trading parties' purchases exceed their sales, and vice versa. Usually there is no barter element involved; that is, there is only one buyer and one seller in a transaction; goods flow only in one direction; there is only one trade, not an exchange of goods (two trades).

A New Monetary System From Scratch, Part 6: Credit Limits

Within an 8-hour journey (in a mountainous terrain) from our town community with a new monetary system, there's an off-the-grid village. There's been small-scale trade between the village and our town as long as anyone remembers.

The trade has mainly taken the form of a few village merchants and tradespeople descending into the town once a month to attend a monthly market. At the market, they barter their wares for goods they either need themselves or know are in demand back home. In addition to barter, some credit has been involved, in form of bilateral debts between certain villagers and townspeople who know and trust each other. The debts have often been skilo-denominated (see Part 1), but in the absence of a medium of exchange, all the debts have been eventually settled by delivery of goods ("in-kind"), usually at the following month's market.

With the advent of the new monetary system, the villagers trading with townspeople became disadvantaged. The townspeople, having gradually got used to the new monetary system, and the related electronic trade reporting system (ETRS; see Part 4), found bartering with the villagers inconvenient.

It didn't take long before the central-banker agreed to open an account for any villager at request, on one condition: no negative balances were allowed. (He didn't know the villagers and no creditworthy townsperson was yet willing to step in as a guarantor.)

An account with the central bank, and the "ETRS gadget" that accompanied it, gave the villagers a chance to participate in "gift exchange" at the local market, on the condition that they gave up (sold) goods before accepting (buying) goods.[1]

Two questions:

Did the central-banker impose a Clower-constraint (cash-in-advance constraint) on the villagers?

Does money, after all, exist in our economy?






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[1]  Of course, they could make a sale first while promising to deliver the goods later, assuming the buyer was willing to extend personal credit to them. From that, there was only a short step to no (physical) delivery of goods at all; the two parties could agree on a re-purchase of the sold goods, by the villager, later on. This would be like a "money loan", if money existed in our model economy.
 

A New Monetary System From Scratch, Part 5: Credit Loss

In Part 4, we had three people and two trades.

Fast forward.

After an unknown amount of trades the central-banker, or record-keeper, produces an overview of accounts with negative (LHS) and positive (RHS) balances (all skilo-denominated):

	OVERVIEW
	Deb(i)ts/Liabilities	Credits/Rights
Otto	400	200	Kermit
Gary	50	150	Betty
Carol	100	100	Megan
John	25	50	Andy
Seven	50	125	Taylor
	625	625

We could start guessing who's been trading with whom, but it doesn't matter because no one participating in the trading is interested in bilateral balances. What matters is the multilateral, overall balance of each participant.

We can tell from the overview that Otto has been on a gift-accepting, or buying, binge. 

Bad news: the following day Otto gets hit by a school bus and dies. He leaves behind no assets. A credit loss of SK400 must be recognized. Who should incur it?

Otto's account will be credited with SK400, and that entry will bring the account balance to zero. Otto's negative balance is thus settled, and the account can be deleted from the system.

Some other account, or accounts, must be debited with SK400. That's the loss part. In normal course of business, Otto would have sold goods to someone for SK400, and this someone would have got his or her account debited with SK400 without incurring any loss – the debit would have been balanced by the goods received.

Just to give you an example: If Kermit would be made to incur the loss, not only would he have previously given up goods worth SK200 without receiving anything in return, but he would need to give up further goods worth SK200 without ever receiving anything in return for any of these goods. It's like he had given a pure (but forced) gift worth SK400 to Otto.

So, which account(s) should the central record-keeper debit? Who should incur the credit loss?

I'm asking you.

There's no wrong answer, but some answers might be better than others. Things you might want to consider: fairness and participants' expectations and assumptions regarding the rules of conduct, especially given the connection to a multilateral gift economy.

I have some ideas myself, but I don't want to miss a chance for a good discussion by randomly picking just one way to do this. People together, after listening to each others' arguments, make this kind of decisions all of the time. That's how the first ever monetary system must have been built, too. (We will never know for sure.)

(Answer by leaving a comment below and risk winning a Book Prize, including a hand-written thank-you letter from me! The book is going to be a book I personally like, of course. In your answer, let me know if you'd like to enter the prize draw. Please take into account that in case you happen to win, I'll need your, or your mother-in-law's, or your neighbor's, mailing address in order to be able to deliver the prize.)

(If I don't get any answers within a couple of days, I'll enlist the help of my friend and we'll come up with fictional commenters to save my face.)

Nick Rowe Is Getting into Trouble

The title of this post is all too premature. But my "cunning plan" to reform Nick Rowe's thinking involves applying some pressure on him. After all, some of his ideas appear to me as lumps of coal on their way to become diamonds.

In the center of this debate is Nick's red money.[1] For Nick, a negative ("red") balance on a checking account – what is also known as an overdraft – is a medium of exchange. For Nick, a medium of exchange is 'money'. Hence, red, or negative, money.

Many might ask: How is a negative balance a medium of exchange? Nick's answer goes something like this:

Andy has a negative $100 balance on his checking account. (We could say he's in possession of 100 negative dollars.) Betty has a zero balance on her checking account, and she is allowed by her bank to "overdraw" her account.

Andy sells apples worth $100 to Betty. Betty instructs the bank to debit her account and credit Andy's account.

As her account balance is zero, Betty is in no position to transfer any "medium of exchange" to Andy. Further, Andy's account balance will be zero after the bank has made the entries. This means that Andy is not going to receive any "medium of exchange".

After the entries are made, Betty's account balance will be negative $100. Thus, it seems plausible to think that Andy transferred 100 negative dollars to Betty. Those negative, or red, dollars are media of exchange.

This is no doubt unconventional thinking (that's why I like it).

Many will protest, and have protested, by arguing that Betty transferred 100 positive dollars to Andy. But that is to adopt a purely arithmetical view on money. Yes, one can deduct 100 from zero. But one cannot pull a rabbit, or hundred rabbits, out of an empty hat (right?).

For Nick, a medium of exchange – that is, money – has to be, if not a commodity like it is for Clower, then some kind of item, a "thing". Otherwise it won't fit into the model, explicit or implicit, of a "monetary exchange economy" Nick is using. That's why Nick must reject the arithmetical view on money.

This puts Nick seemingly at odds with accounting. Accounting is, in this sense, arithmetics. Make a debit entry on an account with a zero balance and you get a debit (negative) balance. No problem. It's no wonder that many people think Nick rejects accounting. But some people think he is doing the opposite. I believe I'm mostly in the latter camp, although I see some truth in the former view as well.

We must keep in mind where Nick is coming from. It is because Nick takes into account the accounting that he has moved away from the "Clower world" or "Monetarist world" where money is a commodity – an asset to its holder but a liability to no one – by coming up with red money, which Nick says is a "liability to its holder but an asset to no one".

This is how an accountant might view this: The monetarists have been traditionally saying that money is a credit without a debit, but Nick is saying that there are also debits without credits which should be called 'money'. Nick is saying that there are not only credits but debits, too. That, to me, is a sign that Nick is actually embracing accounting. (Who knows if Nick, working for Deloitte, will be auditing the Bank of Canada in a few years' time?)

Conclusion: Nick cannot fully embrace accounting because that would require an arithmetic view on money. Nick is half-embracing accounting by trying to describe what happens in the accounting realm in the language of the physical realm.

And you know what? I think Nick has raised an important point, although he might not know it himself. If we can choose whether we want to see, in our minds, positive or negative money being transferred between accounts, then it sounds plausible to argue that in reality no money is transferred between accounts. That's what I've been arguing for long.[2] What makes this an important issue to me is that this "non-transfer" is an integral part of my interpretation of our monetary system. Within the framework I have established (see my posts: Part 1, Part 2, Part 3 and Part 4) it doesn't make sense to talk about something being transferred between checking accounts.

If something really was transferred between the accounts, then I wouldn't be describing the real monetary system.






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[1] See, for instance, Nick's posts here, here and here.

[2] Schumpeter has expressed similar thoughts (in posthumously published "Treatise on Money"):

“… in a pure account-settling system the concept of money supply would correspond to nothing at all.” (p. 244) “… in a pure account-settling system there is no analogue for the velocity of the circulation of money… Because in the account-settling system a deposit element disappears with each act of payment and a new item, just as large, is created, it makes no sense to speak of ‘the same’ deposit element just ‘changing hands’.” (p. 247)

There is also a whole branch of economics (related to the Post-Keynesian school?), called Quantum Economics, which seems to agree with the "non-transfer" view I have adopted.

A New Monetary System From Scratch, Part 4: Nick on a Trip

In my post "A New Monetary System From Scratch, Part 3" I concluded:

The central bank accountant follows two simple rules which he applies on a person-by-person basis: (1) if a person sells something, then credit her account, and (2) if a person buys something, then debit her account.

What is being recorded is how much each person has given or taken, without paying attention to who happened to be the counterparty in any particular trade. We know that Andy has taken goods worth SK100; from whom, it doesn't matter. We also know that Betty has given goods worth SK100; to whom, it doesn't matter. [1]

Before we delve further into the principles of this record-keeping system, let's assume that right after meeting Betty, Andy bumps into Carol and sells her apples priced at SK100. Following rule 1 (see quote above), the central bank credits Andy's account with SK100 and, following rule 2, debits Carol's account with SK100.

So, now we have two trades:

Trade 1: Betty gave bananas worth SK100 to Andy (without receiving anything in return)
Trade 2: Andy gave apples worth SK100 to Carol (without receiving anything in return)

 The central record-keeper was duly informed, through an electronic trade reporting system (ETRS), about both of these trades and made the following entries on people's accounts (I use "T-accounts" as visual aids):


 

(We could close the "circle" or "triangle" by having Carol sell carrots to Betty for SK100, but I don't want to do that. In reality, we always have some open balances.)

To remind you of the purpose of this record-keeping system, here's what I said in Part 2:

Our new monetary system is about keeping records of gifts given and gifts received by each person. Betty gives a gift and this (transaction) is recorded by making a credit/positive entry – the nominal value of which reflects the value of the gift expressed in terms of the abstract unit-of-account – on her account. Andy receives a gift and this (transaction) is recorded by making a debit/negative entry on his account. Nothing moves from Andy's account to Betty's account, or vice versa. There's only a real-world 'banana flow' from Betty to Andy.

When we look at the three accounts above, we can see that Andy's overall net trade is zero (he is "even"), Betty has a credit worth SK100 and Carol has a liability worth SK100. We also know that, in keeping with the "multilateral gift economy" concept, Carol doesn't owe Betty (in particular). Carol could sell carrots to anyone and in this way get rid of her liability.

Nick's world

Let us now compare our system to the monetary system Nick Rowe made from scratch here (see also my Part 1).

Let's assume Nick Rowe is "airlifted" into our imaginary economy. Not being able to speak the language, Nick has to rely on his deep understanding of both trade and accounting when he tries to make sense of the exchange system.

Nick arrives just in time to witness Andy selling apples to Carol. The first thing which catches Nick's attention is that goods flow only in one direction.

"The economy might be primitive, but at least they don't rely on barter", he mumbles.

Nick also notices that the buyer of the goods, Carol, uses some kind of electronic gadget. The seller, Andy, has a gadget, too. Right after Carol has typed something in her gadget, Andy's gadget beeps. Andy looks at the screen and gives a thumbs-up to Carol. After this, they separate.

"OK. The economy cannot be that primitive", says Nick to himself. He is quite sure they are using some kind of electronic money in this economy.

Nick is thirsty and he walks into the first building that comes his way. Unfortunately, it's not a bar. It's the central bank.

Nick seems harmless enough, so the central banker lets him have a look at the electronic ledger (an unrealistic assumption, but a fairly harmless one?). There are a lot of accounts, but only three of them have had any entries made on them, and only two have open balances (see T-accounts above).

Now Nick has seen all he needed to see in order to be able to explain how the exchange system in this economy works.

Nick explains:

First of all, we are talking about a monetary exchange economy, not unlike ours.

In Trade 1, Andy paid Betty 100 skilos for her bananas. 100 "green skilos" were transferred to Betty's account. Andy ended up having 100 "red skilos" on his account. After the trade, net money supply remained zero, while gross money supply reached 200 skilos.

In Trade 2, Andy sold apples to Carol. With the apples, Andy also delivered 100 red skilos (a medium of exchange) to Carol, thus getting rid of his liability. Now Carol is in possession of 100 red skilos.

Betty has 100 green skilos on her account and she can transfer those, as a payment, to the seller if she wants to buy some goods.

The medium of exchange, skilo, serves also as a unit of account.

[Nick continued about velocity of skilos, about IS-LM models, and so on. I left it out here because I wasn't able to follow his thought.]

Is Nick right?







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[1] Probably I should have said "...without paying undue attention to who happened to be the counterparty...". The two entries made by the central record-keeper (central bank) do reveal the counterparty, but the point I wanted to make was that the trade doesn't establish any on-going relationship between the two parties to it. For all we know, they could be strangers to each other.