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.

Green Stones Don't Reside on Accounts

Ostroy and Starr[1] tell a story of "a pair of Robinson Crusoes":

Two elderly, largely self-sufficient gentlemen live on an island. Having only the most anemic impulses to truck and barter, their sole contact is the irregular exchange of dinners. Since both agree that meal preparation is onerous, they take turns. However, because dinners are exchanged so infrequently and because their memories are not what they used to be, these Robinson Crusoes cannot always agree on who gave the last dinner. On several occasions both have claimed to have provided the last meal. Each gentleman recognizes that this is a self-serving claim since this is what each would like to remember, but neither is sufficiently confident of his recollection to be sure of the truth. These disagreements have produced so much tension and ill-will that dinners are now exchanged even less frequently.

To attenuate this problem, the one who is coming to dinner next picks up a stone and paints it an artificially colored green to distinguish it from other stones and brings it to his host. At the next planning session for a dinner, the most recent host will be reminded by the presence of the green stone that it is his turn to be invited, and he will be expected to bring the stone with him when he arrives. Indeed, without receiving the stone the host may feel justified in turning away his guest as not having the required evidence of an invitation.

This quite rudimentary story reveals an essential feature of monetary exchange. Money is a commonly acknowledged record-keeping device. Here the only information about the past which has to be recorded is who gave the last dinner. Each gentleman "pays" for his dinner by transferring the record of this fact to the other.

That's a nice story which reveals something fundamental about money. The story is so good that I want to write a sequel to it.

Let us assume that in addition to these two gentlemen there is a fully self-sufficient accountant (an oxymoron?), called Monday, on the island. She has a lot of spare time and wants to help the gentlemen. Being elderly, the gentlemen seem to misplace the green stone once in a while, and this has led to a time-consuming search operation on more than one occasion.

Monday suggests that instead of using the green stone as a "counter", the gentlemen could rely on bookkeeping as a record-keeping device. Monday would take care of the bookkeeping. All the gentlemen have to do is to remember to inform Monday about any trades of dinners that take place between them.

Monday finds out that Nick Sr, one of the gentlemen, holds the green stone. She takes this to mean that Abraham, another gentleman, owes a dinner to Nick Sr. Both gentlemen agree on this interpretation, although they are not sure about the total number of meals prepared by each of them over time (what is one dinner between gentlemen!).

Nick Sr gives the stone to Monday, who buries it deep in ground now that it has become redundant as a record-keeping device.

The gentlemen don't know much about accounting. This is how they imagine Monday's ledger looks like:

Abe: 0 stone(s)
Nick Sr: 1 stone

This is how the actual accounts in Monday's ledger look like (being a CPA, she couldn't help using double-entry!):

Abe: -1 dinner
Nick Sr: +1 dinner


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End of extended story.
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What can we learn from my extension to the original story of Ostroy and Starr?

First, that green stones don't reside on accounts.

Second, that there is no transfer of a green stone, or anything for that matter, from Nick Sr to Abe the next time the latter prepares a meal for the former.

Instead, there is a "transfer" of a meal from Abe to Nick Sr. Monday will record this meal trade in her ledger by debiting Nick Sr's account with 1 dinner and crediting Abe's account with 1 dinner. This will bring balances of both of the accounts to zero. How do the gentlemen then know who is to be invited for a dinner next time? They ask Monday, and by looking at the entries she has made she will find out that it was Abe who prepared the meal last time and is to be invited next time.

Is there a need for Abe and Nick Sr to understand how the accounting works? Does it matter if they continue to think that Monday is transferring stones between the two accounts? I don't think it matters, at least not when the economy is so simple. The only tradable good is a dinner which is assumed to not vary in terms of utility derived from it – if Abe is not as good at cooking as Nick Sr, I'm sure he makes up for it by being an otherwise entertaining host.

We cannot yet talk about a monetary exchange economy in this case. (We need another sequel for that, which in one way or another is forthcoming.) But as Ostroy and Starr write, one could say that the gentlemen "pay" for the dinner by transferring the green stone to the host. So at least in some ways the green stone is comparable to money, or currency more specifically.

With this post I wanted to draw attention to the fact that bookkeeping in a double-entry format might look quite different from record-keeping where "counters" like the green stone are used, even when the object of recording – dinners given and received – is the same.







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[1] Ostroy, Joseph M. & Starr, Ross M. 1990. "The transactions role of money," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 1, pages 3-62 Elsevier. ("A pair of Robinson Crusoes", p. 8-9) – There is a working paper version freely available here.

A Bank "Loan" Is An Overdraft; It Is Not a Loan

Nice title, huh? I'll try to explain.

Many people have argued that a "bank loan" is not really a loan, because the bank is not lending any existing money; it creates the money it "lends" on the "borrower's" account and the money is destroyed when the loan is repaid. Still, from the bank customer's perspective, it looks like a loan: he receives money on his account ("from the bank"), spends the money and has to get the (same sum of) money back on his account to be able to return it ("to the bank") when the loan becomes due.

Not so in the case of an overdraft.

By agreeing[1] with his bank on an overdraft facility (a "credit line") connected to his checking account, the customer can spend money he doesn't have[2]. The customer incurs debt by using the overdraft – in the textbook case – to purchase goods[3] and repays that debt by selling goods.

I cannot stop people imagining that there was money first borrowed and later returned in the case of an overdraft, too. One can describe an overdraft in terms of what I call a "traditional bank loan".

What I want to argue here is that this works the other way, too; that one can describe a traditional bank loan in terms of an overdraft. Furthermore, I argue that we can consider an overdraft – I'm talking about the accounting treatment – as the "base case" and view the accounting treatment of a traditional bank loan as an unnecessary complication. (If this sounds unnecessarily provocative, take it as an argument against any kind of primacy, other than chronological/historical, given to the traditional bank loan. An overdraft doesn't involve "netting" something more than a traditional bank loan involves "grossing" something.)

Imagine that the accounting treatment of all kinds of debt had always been like it is in a case of an overdraft. (Perhaps it's just a historical accident that it hasn't been?) The credit contract – which should be viewed separately from the accounting treatment – could state that the overdraft limit is to be reduced monthly by a certain sum and that the limit will reach zero in, say, 10 years (for a 10-year "loan"). The contract would also state when interest is paid (through a debit entry on the checking account, as usual).

To help you imagine that kind of world, I have created a document where I map the corresponding figures in the two alternative accounting treatments. The color of the circle tells which figures correspond. (Please note that where I write "Unused overdraft" it should actually say "Unused ovedraft + initial checking account balance". In that way it would also cover the most common scenarios where the initial balance is not zero but positive.)

Had the accounting treatment always been that of an overdraft, not of a traditional loan, the words and concepts we use might differ from what they are today.

For instance, we would repay debt when we sell goods (item #3 in my document), not when the overdraft/credit limit is reduced (item #4). The latter is how we see repayment when we think of a traditional loan. If the accounting treatments are identical in their outcome, then why this discrepancy?

As far as I know, this discrepancy is one of the main reasons why Nick Rowe thinks an overdraft is "negative money" while a traditional bank loan isn't. Another reason perhaps has to do with the maturity of the credit limit, but that is something which is specified in the credit contract, regardless of the accounting treatment. There are bank loans without any clear, pre-agreed maturity, just like there are overdrafts with a pre-agreed maturity. And even if the maturity is specified in the contract, there is nearly always a lot of flexibility involved – after all, it is quite often in the bank's interest that a customer repays his debt more slowly.

If we had never seen a "traditional bank loan", would we talk about the bank lending us money, or would we only talk about the bank extending credit to us? Would we still think that there is money on our account, and that we need that money to pay for things? Or would we just talk about "the number" on our account?

The world of overdrafts looks quite different from the world of traditional bank loans – at least to me and, so I've understood, Nick Rowe. If you don't see the difference, it might be because you try, quite successfully, to interpret overdrafts in terms of traditional bank loans. (Or then you're JKH, who is probably comfortable in both worlds.)






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[1] I'm talking about a pre-authorized overdraft, which is in practice more common in Europe than in the US. One can also "overdraw" one's checking account without any prior agreement with the bank, but in that case there will usually be penalty charges.

[2] Alternatively, we could say that the unused overdraft is money he has, although it doesn't reside on his account – and never will.

Keynes (“A Treatise on Money”, Bk 1, Ch 3, 8ii(i.) “Deposits and Overdrafts”) was of the opinion that unused overdrafts should, logically, be included in monetary aggregates:

... it is the total of the cash-deposits and the unused overdraft facilities outstanding which together make up the total of Cash Facilities. Properly speaking, unused overdraft facilities – since they represent a liability of the bank – ought, in the same way as acceptances, to appear on both sides of the account. But at present this is not so, with the result that there exists in unused overdraft facilities a form of Bank-Money of growing importance, of which we have no statistical record whatever, whether as regards the absolute aggregate amount of it or as regards the fluctuations in this amount from time to time.

Thus the Cash Facilities, which are truly cash for the purposes of the Theory of the Value of Money, by no means correspond to the Bank Deposits which are published.

I see that we have two options if we want to be logical: either unused overdrafts are money, too, or then "cash-deposits" are not money, either. I opt for the latter, not least because there is only a fine line between a pre-agreed unused overdraft and an overdraft – or a "traditional bank loan" for that matter – that the bank would be willing to provide if only the customer wanted it. Trying to find out the size of Keynes' "Cash Facilities" is much like trying to find out the total amount of purchasing power in the economy – a hopeless task, if you ask me.

[3] He could be buying and selling financial assets, but it's best to leave that alternative out of scope for now. The interpretation of that case is somewhat more complicated within the broader framework/theory I'm promoting in my posts. One day I'll get back to that.

 

In the Land of the Color Blind, Neither a Borrower Nor a Lender Be: Part 2

In my previous post I first assumed that someone might borrow red money because he was credit-constrained (and thus couldn't buy goods without selling goods first). Then I proceeded to prove my assumption wrong, without even initially realizing what I had done (I woke up 6am this morning, and still lying in bed I realized my mistake).

By borrowing red money you receive red money, and buy buying goods you receive red money. If you borrow red money from a non-bank, and if red money can exist only as a debit balance on a checking account (which, I argue, must be the case), then the bank cannot differentiate between you buying goods or borrowing red money; the accounting entries are identical. (The same is true for selling goods and borrowing green money from a non-bank.)

I just wrote a short story about the need for collateral in the absence of trust, even when one only wants to sell goods. You find it here (Nick's blog).

So, let's forget the credit-constraint reason. The reason (for borrowing red money) I initially had in my mind when I started to write the previous post was the second one. It's this:

X wants to make a financial investment.

Financial investments in red-only world

In a green-only world, X would first sell goods and then make a loan of $1,000 to someone. In red-only world, the only way he can make a similar investment is for him to first take out a loan of $1,000 and then sell goods.

If X would take a loan of $1,000 but only sell goods for, say, $100, his investment would be 90 % debt-financed ("liability-financed" for Nick?), 10 % equity-financed. After first taking the loan, he can build his equity share by selling goods, which will be mirrored in his red money stock (a liability for him).

In red-only world, one builds a financial fortune by getting rid of borrowed red money -- while remaining a (big) borrower all along. Financial assets are red money loan contracts seen from the borrower's perspective, and holding this kind of asset is closest one can get to holding green money in red-only world.[1]

In green-only world, when the loan expires, the lender first receives money from the borrower, and then he can buy goods with the money. In red-only world, the borrower, having earlier "spent" the borrowed money by selling goods, must first buy goods to get red money (back), and when the loan expires he delivers the red money to the lender.

Is red money borrowing equivalent to green money lending, as JKH says?

In a way it is, but in another way it isn't. What happens when a loan is made?

A green money borrower acquires both an asset (the money) and a liability (the loan).

A red money borrower acquires both an asset (the loan) and a liability (the money).

A green money lender gives up an asset (the money) and acquires another asset (the loan).

A red money lender gives up a liability (the money) and acquires another liability (the loan).

Initially, I find no symmetry between the positions of a red money borrower and a green money lender. (Instead, there is clear symmetry between the positions of borrowers and between the positions of lenders.)

The position of a red money borrower is comparable to the position of a green money lender only after the former has sold goods and got rid of the liability (red money) he acquired. That's probably the equivalence JKH talks about.

We see that one can neither sell nor make a financial investment in the red-only world without first incurring a liability. And to be able to incur that liability, one has to have a checking account and either be considered creditworthy by the bank, or be able to post collateral.[2] For someone coming from the real world, this doesn't make any sense.

But I believe this is a feature, not a bug, in Nick's system. When he talks about red-only world, "Red Nick" is equivalent to "Green Clower". The requirement that one can only sell goods if one has red money is a "cash-in-advance constraint". Clower's requirement that one has to possess green money if one is to buy goods is silly, too. It doesn't make sense.

When we put the silly red-only and the silly green-only world together, we get the (slightly less silly) real world. When describing that world, we have two options:

1. We can suggest that both green money and red money are media of exchange.
2. We can suggest that green money is not a medium of exchange; that there is no medium of exchange, other than the record-keeping system as a whole.

Nick has chosen option 1. I have chosen option 2.







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[1] Assuming "shadow banks" are forbidden. If not, then I would establish a money market fund which would buy (investment grade) red money loans from borrowers by issuing deposit-like shares to them. These shares would probably become the green medium of exchange.

[2] My "creditworthy" is more or less the same as trustworthy. Having eligible collateral probably makes one creditworthy, in another sense of the word.

In the Land of the Color Blind, Neither a Borrower Nor a Lender Be: Part 1

(Yet another comment that became a full blog post. Actually two. Or three. Perhaps a book? This is a reply to Nick Rowe and JKH.)

JKH and Nick are creating a real challenge to anyone who wants to question the theoretical plausibility of Nick's red money construction, especially when it comes to symmetry between red and green money. Two beautiful minds put together create a real monster?

In what follows, I'll take out my two red pennies' worth.

Here JKH repeats one of Nick's key assumptions in red-only world, namely that you cannot sell if you don't possess red money:

He wants to sell something for $ 1,000 so he requires a red money balance to sell it.

So customer X borrows $ 1,000 in red money.

But why doesn't X just buy something for $1,000, receive $1,000 in red money from the seller, and then sell himself? Why would he want to borrow red money?

I see two options (if first is true, then the second kind of follows; but the second can exist independently of the first). To keep this post from becoming way too long, I'll leave the second option for another post. Here's the first one:

1. X is credit-constrained, which means that he cannot buy first and thus acquire a liability (red money).

 

Credit constraints

If you are totally unworthy of credit, you cannot incur financial liabilities. This is true both in green-only and red-only world. For you to incur a financial liability, there has to exist someone who considers you creditworthy and this someone has to be in a position where he can make it possible for you to complete the transaction – usually a purchase of goods/assets – as part of which you acquire the financial liability.

Red money, unlike green money, cannot be a (broadly defined) bearer instrument. A record has to be kept of the owner of the underlying liability, and the transactions involving transfer of liability. If I remember correctly, Nick has tried to justify "red paper money" (cash) by a garbage metaphor, where red cash is like garbage. But it seems hard to come up with a system which could help enforce the rule that you cannot dispose of the red cash other than by selling goods.

I see no reason why we shouldn't avoid this control/enforcement problem by assuming that there is no (physical) red paper money in existence; all we have is a more or less centralized record-keeping system run by a bank or banks. That system is the easiest way to establish the control required.

If red money is a record of a liability, then what is its holder liable to do and how did the first piece of red money come to exist? Remember that we are still in red-only world.

Red money is a liability to sell goods. (Green money gives a right to buy goods.) One acquires red money – once there is some in existence – by buying goods.

For the "origin myth", it seems we need to turn to Nick's garbage metaphor. As Nick says, garbage is a bad, not a good. The first red money must have come into existence through a sale of a bad. Perhaps like this:

There's a public disposal facility for radioactive waste (DFRW). The private producers of radioactive waste are under government surveillance, and they must deliver the waste they produce to the DFRW. How are the private waste producers made to pay for this public service? Remember that there is no money in existence. One option would be to make them pay in kind, by delivering goods to the government (for public use). But that's not convenient.

Let's assume that a standardized sack of wheat (WS) functions as a numeraire and a unit of account (see my first post for an explanation) in the economy under study. To avoid the inconvenience of payments in kind, the DFRW, our proto-central-bank, comes up with an ingenious record-keeping system:

It creates a ledger which includes "checking accounts" for all the radioactive waste producers – all these are trusted corporate citizens. The DFRW sets a fixed price, expressed in WS, on radioactive waste. When a waste producer delivers (ie. sells) waste, the DFRW makes, say, WS10,000 debit entry on the customer's checking account. Following the principle of double-entry bookkeeping, the DFRW makes a WS10,000 credit entry on its own account called "Waste stock". In conventional accounting language, the waste stock is a liability of DFRW (we find it on the RHS of balance sheet). Likewise, the customer's debit balance – only debit or zero balance is allowed – on a checking account is said to be an asset of the DFRW (LHS of balance sheet).

Before the customer leaves the premises, the DFRW and the customer together set a payment schedule. This schedule defines when the debit balance on the checking account is going to be reduced, and finally closed, by the customer. How can the customer, the waste producer, reduce its debit balance? By selling goods ("earning credits").

We have just witnessed the birth of red money.

But how does it become a medium of exchange? I see at least two ways to make it such (and these can be combined):

1. The State Theory of (Red) Money

The government establishes a special negative tax, in the form of lottery (positive taxes are already paid in kind, so I will call the recipient of this negative tax a taxpayee; it could be understood as "payer of red money"). To be eligible to receive this tax, a taxpayee has to be creditworthy enough so that the DFRW agrees to open a checking account in his name. Having opened an account with the DFRW, the taxpayee can buy goods from the waste producers by accepting "red money": his account is debited, the waste producer's account is credited. His purchases are limited by the "max debit" limit (conventional language: overdraft limit) connected to the account. Just like the waste producers, he has to agree on a payment schedule with the DFRW. Just like the waste producers, he reduces his debit balance by selling goods (incl. services, incl. labor).

It's time for the negative tax lottery. The government will select at random, say, 1000 checking accounts which it will credit with a random sum between WS10 and WS1000 – but only if the account has a debit balance that covers the credit entry.

OK. You probably get the idea. (If you don't, we can continue in the comments. This post is too long already.)


2. The Debt Binge Theory of (Red) Money

Who wouldn't want to buy stuff first, pay only later? Now it's made easy – for all creditworthy agents. Just open a checking account at DFRW and start accumulating debits. Perhaps you're a large scale user of electricity? Now you can buy it from your local nuclear plant by accepting red money from it. And you can rest assured that your customers are happy to buy goods from you in the same way, by accepting your red money.

Read my lips: This red money thing is going to snowball into a widely accepted medium of exchange!


OK. In this post we have dealt with some fundamentals of a red-only economy. In the next post we will get to look at the interesting stuff Nick and JKH are discussing, like the red money loans which I already mentioned.


UPDATE:

As you might have already realized, if X in JKH's example is severely credit-constrained (totally unworthy of credit in the eyes of the DFRW) he can neither buy first nor take out a loan of red money (from a non-bank). The latter would involve a debit balance on his checking account, and the DFRW wouldn't approve of it. From this it follows that collateral must play a decisive role in a red-only world. Logically, one must be able to sell first even if one's promises are valued at zero.

More on this in the next post!

Double-Entry and "Quadruple-Entry" Bookkeeping

(This post is not part of the series "New Monetary System From Scratch". This post is my attempt to establish a common understanding of bank accounting among all the discussion participants in Nick Rowe's blog comments here. I present here my own understanding and ask people to let me know if they agree with it or not.)

I have created a somewhat busy spreadsheet to illustrate some basics of bank accounting as I understand them. I suggest you have a look at it before you read the rest of the post. Going forward, I assume, for clarity's sake, that all transactions are recorded in the general ledger. That might not be the case in reality (see explanation here).

My spreadsheet example is adapted to an example Jamie, one of the participants to the discussion, has given in his laudable, easy-to-follow slide set here.

"Quadruple-entry bookkeeping", as I understand it, refers to two different real-life ledgers, or "books". Jamie gave an example in one of his comments:

Forget about creating money for a moment. Imagine the simplest possible economy where only one economic transaction takes place anywhere in the entire economy during an accounting period.

Imagine that the transaction is that my business sells you a bicycle for €100. Let’s look at this from both our perspectives.

Jamie’s perspective: I lose a bicycle and gain €100.
Antii’s perspective: You gain a bicycle and lose €100.

Macro-economic perspective: No gain or loss of either bicycles or money as the changes in Jamie’s position and Antii’s position cancel out. The macro-economy doesn’t care who has the bicycle and who has the money.

Note that there are FOUR position changes in the macro-economy that we must account for even in this simplest possible economy with only one transaction (two changes in bicycle inventories, two changes in money inventories).

If both Jamie and I kept records of our transactions (in a double-entry bookkeeping format), there would clearly be two different ledgers: Jamie's ledger and my ledger.

In reality, Jamie would probably make four entries on accounts in his ledger (see example here). Two of the entries would be related to his income: credit (CR) "Sales" and debit (DR) "Cost of goods sold"). The other two would be related to his assets: CR "Inventory" and DR "Cash"; "cash" includes checking account, if we are in the electronic age. (Notice that these are not the "credit-debit pairs"; those are "CR Sales, DR Cash" and "CR Inventory, DR Cost of goods sold"; see the example I linked to above.)

To simplify things, we can assume that Jamie sells the bicycle "at cost", so that his inventory is diminished by €100. It seems the purpose of Jamie's example is to highlight the asset positions, so we can overlook the income side (zero effect if goods are sold "at cost"). So, two entries: CR 100 Inventory, DR 100 Cash.

In the example, I, Antti, am not a business. That most likely means that I keep records only of my assets – not of my income. Two entries: CR 100 Cash, DR 100 Inventory (of assets/of bicycles).

Jamie's two entries and my two entries together are the four entries needed in "macroeconomic accounting", following the principle of "quadruple-entry bookkeeping", as suggested by Jamie. Looking at the entries, we could conclude that one person's credit is another person's debit, and vice versa.

What seems to remain unclear in the discussion is what happens in bank accounting. What kind of entries does a bank make in its ledger in different situations?

Here are two scenarios:

1. Let's take Jamie's example above and assume that we are talking about checking accounts, not physical cash. As far as I know, the bank would make only two entries in its ledger in this case: CR 100 on "Jamie's checking account" and DR 100 on "Antti's checking account". (Would taking a macro-perspective lead to sextuple-entry bookkeeping in this case?)

2. Nick's dad agrees on a $1,000 loan with his bank (see, again, my spreadsheet example). Outside of the bank ledger, a loan contract and possibly other documents are created and filed. In the bank ledger, two entries are made: DR 1000 on "Nick's dad's loan account" and CR 1000 on "Nick's dad's checking account".

In Nick's blog's comments, Jamie says:

Loans are assets for a bank. Assets are usually recorded in asset registers. I can’t say if banks have a specific name of their register of loans but I am pretty confident that this is correct.

I might interpret him wrong, but this sounds like he's suggesting that there are two different entries made in the bank's ledger to record (1) an asset of the bank ("green loan"), and (2) Nick's dad's loan/debt/liability ("red loan")? This is obviously not the case, as it is clear that the debit balance on Nick's dad's loan account is at the same time (considered as) an asset of the bank and a liability of Nick's dad (two perspectives).

The framework Jamie presents in his slide set doesn't seem compatible with the framework Nick has established by differentiating between green money and red money. In Nick's world, there are no loan accounts. There are only checking accounts that can be "overdrawn", and to Nick a positive (credit) balance is "green money" while a negative (debit) balance is "red money" – both primarily seen from the account-holder's (customer's) perspective. Nick also makes clear that he doesn't consider – in clear contrast to conventional accounting language – "green money" a liability of the bank (Jamie's "red money") nor "red money" an asset of the bank (Jamie's "green loan"). (I think the subject of overdraft and what I call a traditional loan – two alternative accounting techniques – deserve a "deep-dive" blog post. Let me know if you agree.)

I understand that we all use different implicit models when we try to make sense of the world. That's fine. But we all need to be able to tell the model from phenomena (reality). I think Nick does well in this regard, because it wouldn't cross anyone's mind that Nick thinks that the bank really uses red and green bits of paper, moving those between customers' boxes. But when I look at Jamie's slide 8, I cannot tell if Step 1 is supposed to be something that takes place in reality or not. As far as I know, it doesn't. And even if it did, I can't see any purpose in it. This is because the bank doesn't need to "create" or "manufacture" money (or medium of exchange) or loans. This has been understood since the overdraft was invented in Scotland in the 18th century. It was invented when a banker, with the help of a customer, realized that an account doesn't have to have "money" in/on it and still a payment can be made "from" it.

Quite a mess we've got ourselves in?

A New Monetary System From Scratch, Part 3: Give and Take

In my previous post I concluded:

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.

One assumption I left unspoken here is that the banana gift doesn't establish an on-going relationship between Andy and Betty. Andy is not expected to give a counter-gift to Betty. The system I have in mind was made explicit in the quotes from Ostroy & Starr (1990) and Kocherlakota (1996) in the previous post. Kocherlakota talks about an "interlocking network of gifts", which could perhaps be called a "multilateral gift economy". A very, very simplified version of this could look like this:

Six friends each agree to buy an item worth $20 (~market price/nominal value; going forward, when the word 'worth' is followed by a sum, it will always carry this meaning), to be given to someone else as a Christmas present. Later they put all six gift-wrapped items in a pot and each person, taking turns, draws randomly one item from the pot. The drawer has to keep the item she drew, unless it's the item she had bought, in which case she must put it back into the pot and draw a new one.

I'm not implying that trade in our economy is based on the box-of-chocolates idea emanated by Forrest Gump's mother. The principles I wanted to highlight with this example are:

1. Each individual gives an item worth $20 and receives an item worth $20 ("overall net trade with zero market value", in words of Ostroy & Starr – see quote in my previous post)
2. The gift Eric bought can go to Wendy, while the gift Wendy bought can go to Stan (bilateral balance not required)

These are clearly impure gifts, because all participants know that they will receive a gift of more or less the same nominal value as the gift they give. What they do not know is from whom they will receive this gift. Take Betty in our original example. She gave bananas worth SK100 (skilos) to Andy. Next, she might bump into Carol and get carrots worth SK100 from her, without giving anything in return. The trade will be recorded in the record-keeper's central ledger by crediting Carol's account and debiting Betty's account, both with SK100. At this point, we consider Betty's account settled – her account balance in the central ledger has returned to zero. She received, in form of carrots from Carol, a counter-gift to her earlier banana gift to Andy.

In a gift economy, the recipient of the gift doesn't usually have a passive role. More likely, in a gift economy without explicit record-keeping, Andy might have met Betty with a cart full of bananas and told her that he was actually looking for bananas, to which Betty might have replied: "I have plenty of bananas, please take some! How many were you looking for?". Andy, knowing that Betty trusts he will return the gift, if not to her then to someone else – if he hadn't already done so – would accept Betty's gift of bananas without hesitation.

This kind of setup relies, of course, on multilateral trust. Full (utopistic) multilateral trust would mean that there would be no talk about previous gifts given or taken; instead, everyone could trust that everyone else balances his or her budget over time. More likely, there would be some kind of "budget balance enforcement" system at least partly based on rumors. "Free riders" would risk being exposed.

But our economy is a gift economy with explicit record-keeping. There, budget balance enforcement doesn't need to rely on rumors and the risk of reputation loss (leading to diminished trading opportunities, perhaps even to autarky, on the part of the individual).

In his paper "Informational Efficiency of Monetary Exchange" from 1973 – a paper which Kocherlakota builds on in his afore-mentioned paper – Joseph Ostroy writes (p. 607-608; italics in original):

How to enforce BUB [budget balance] without imposing BB [bilateral balance]?

[...]

As a monetary version of the model of a trading economy, introduce a central receiving station called a monetary authority. Its function is to collect and collate the bits of information individuals have about each others' trading histories. Each will require his trading partner to write a signed statement, a check, indicating the amount by which the partner's purchases exceed his sales. This record is forwarded to the monetary authority who revises individual accounts on the basis of this new information. Sellers, by requiring payment in money, are guaranteeing a steady flow of information such that the monetary authority, and it alone, is able to monitor trading behavior. Of course, there is every incentive to require and deposit this information with the monetary authority; otherwise, one would not receive credit for sales and so have to cut back on purchases.

[...]

If the monetary authority is to be able to make trades between different individuals commensurable... we require a common unit of account. While this convention is essential to the operation of the recordkeeping system, it is not identical to it. Money is not simply a unit of account.

As I mentioned earlier, I'm not going to use terminology like "payments in money"; I don't even use the word 'money'. The word 'payment' implies a quid pro quo: the seller received something in return for her goods (this, in turn, sounds much like bilateral balance). Using the word 'payment', in Ostroy's sense, in the economy under study would lead to a paradox:

Betty received a payment (for her bananas) in the form of a record which states that she has given bananas worth SK100 without receiving anything in return.

The record tells us that there was no quid pro quo. Remember that Betty hasn't even heard about money. Her vocabulary most likely includes the word 'payment', but only in the sense "payment in kind" (that is, in the form of goods).

If we overlook what Ostroy says about payments and money, he could as well be describing our economy and its new monetary system. Ostroy's 'monetary authority' is our record-keeper, who we could call the central bank (like Nick does; it's so far the only bank in the economy). Andy and Betty inform the central bank about their trade where Andy's gifts received (SK100) exceeded his gifts given[1] (none) by SK100, and vice versa for Betty. The central bank, like Ostroy's monetary authority, revises individual accounts on the basis of this information. Had Betty not required that the central bank be informed about the trade, she would not have received credit for her banana gift to Andy and would have to cut back on receiving gifts from others (assuming an overall budget balance).

The decisive thing when it comes to the completion of a transaction is the credit entry on the giver's (seller's) account. The giver doesn't know the account balance of the taker (buyer[2]), neither does she care about it. Of course, the taker has to make sure that his account (or at least some account) can be debited, regardless of its balance, because credits must equal debits. But to suggest that the buyer transfers something to the seller would make no sense[3]. In our minds we can build an impenetrable wall between the two accounts. 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. If we could trust that all transactions are legitimate, we could severe the link between a particular credit (entry) and a particular debit (entry), as long as the total credits equaled total debits on a given day (assuming records were updated only once, in the end of the day).

I hope that in this post I have managed to shed some further light on our new monetary system. (I have certainly managed to create some confusion as well. I believe it is unavoidable, although I could always do better in minimizing the amount of confusion.) In my next post I'm going to look into the central bank ledger and present you some T-accounts and the balance sheet. That's what you have been eagerly waiting for, right?




Part 4: Nick on a Trip




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[1] We could simplify our terminology by substituting 'purchases' for 'gifts received' and 'sales' for 'gifts given', as long as we manage to keep in mind that there is no money involved. Thus, Andy bought and Betty sold bananas. The seller never gets anything in return (and this fact is recorded), unless she is at the same time a buyer (as is the case in a basic barter transaction).

[2] 'to buy', Latin 'emere' ; “Emere is to take, to accept something from someone” (Marcel Mauss: ”The Gift”, p. 68)

[3] The reason why it seems to make sense to us – it used to make sense to me as well – is probably because we have learned, starting when we were very young, to think primarily in terms of transactions involving currency (to us, money often is currency, a thing). This means that we mentally project an image of a currency transfer "onto the ledger page". We fail to notice that currency is only a physical "counter", and when we use a ledger we do not need "counters". To me, accounting is primary and currency is secondary; currency can be interpreted in terms of accounting, but not vice versa – although Nick tries hard to achieve the impossible by introducing "red money". For a more detailed argument about "counters", see this and this comment of mine on Nick's blog.

A New Monetary System From Scratch, Part 2: Records Schmecords

I'll begin this post by paraphrasing Nick Rowe (see my first 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 skilos. If Andy buys bananas from Betty and pays her 100 skilos, Betty now has a positive balance and Andy now has a negative balance.

Accounting is record-keeping. In Nick's example, what are we keeping records of? That's the question. For the answer we must, logically, look outside the records.

In the economy I described in my first post, there was no money, other than in a unit-of-account sense. Money didn't buy goods and goods didn't buy money, but goods did buy goods. If we now told Betty that she will receive money, 100 skilos, for her bananas, she wouldn't have any idea of what we are talking about. If she nevertheless played along with us, she might ask: receive what, and from whom? What: a credit balance of 100 skilos on her account in a ledger residing on an electronic device. From whom: Not from Andy, because he doesn't have any money, or a credit balance, on his account.

We are obviously not keeping records of people's money holdings.

I notice that Nick doesn't agree:

The central bank creates a box for each person, puts their money in that box, and transfers money between those boxes when it gets their consent to make those transfers.

In both worlds, a rumour spreads that the central bank has actually destroyed all the money, and is simply keeping a record on a ledger about how much money is supposed to be in each person's box. But economists say that rumour has no empirical content; it doesn't matter if it is true or false.

Nick imagines that there exists money holdings – bits of paper in boxes – outside the accounting (ledger). He says it doesn't matter if those money holdings really exist or not. Even if it didn't matter, we must be able to find a simpler, more realistic way than an imaginary box system with green and red bits of paper to explain the records on the ledger. One can easily argue – and Nick fully knows this – that those bits of paper are themselves just a record-keeping device ("counters"), and thus Nick is talking about records of records (which sounds, to quote Depeche Mode, very unnecessary). The question remains: What are we recording? (Besides, Nick's explanation would still make no sense to Betty, because there is no green or red money in existence when Betty and Andy meet; all account balances are zero.)

Nick isn't building a new system from scratch. Instead, he carries a lot of baggage with him from the old system.[1] As I explained in my first post, this is what I want to avoid. On Nick's part this seems to be intentional, though. In the end of the post I quoted from, we can hear him say to New Keynesians: "Don't you try to escape from the old ideas!" (By the way: I'm not a NK economist, nor do I agree with their theory in general. I'm an accountant.)

But let us stay outside the accounting, in the "real world", for now. Betty gave bananas to Andy, but Andy didn't give anything to Betty. For all we know, Andy might have arrived at their meeting empty-handed. Was there an exchange between Andy and Betty? Cambridge Dictionary defines 'exchange': "the act of giving something to someone and them giving you something else". There was no exchange – no quid pro quo – between Andy and Betty. Perhaps we could call it a transaction. Betty transferred, or gave, goods to Andy.

This actually sounds a lot like the world (an "Arrow-Debreu world" with trading?) Ostroy & Starr[2] describe:

Even though each person aims to execute an overall net trade with zero market value, the most efficient way to accomplish this in a sequence of pairwise trades is not to constrain the value of each bilateral commodity transfer to be zero. […] An individual who takes more than he gives at some pairwise meeting is simply executing a part of the overall plan to which the members of the economy have submitted themselves. It is as though the participants are agents in a firm carrying out their assigned tasks in front of each other. The lesson we draw is that in a world of complete information the requirements for enforcing overall budget balance are met, so quid pro quo is an avoidable constraint on the transactions process.

If Betty gave bananas to Andy without receiving anything in return (remember: we are still in the "real world" outside accounting), then we can conclude, following Ostroy's and Starr's wording above, that Andy took more than he gave at this particular pairwise meeting.

This makes it sound like a gift from Betty to Andy. Marcel Mauss has taught us – well, at least those of you who are anthropologists – that there exists no such thing as a pure gift[3]. Keeping that in mind, it would be very unfortunate if no one (but Betty) remembered Betty's gift of bananas the following day; say, Andy suffered from anterograde amnesia[4] – just like the main character in the movie Memento. In the movie, the main character uses Polaroid photos and tattoos to track information he cannot remember. Those photos and tattoos are his record-keeping devices.

Let us for now suppose that Betty gives a gift of bananas to Andy.

Is it a large or a small gift? Betty and Andy agree that the price (nominal value) of those bananas is 100 skilos, so we know something about how they both value the gift.

Now we have a hypothesis: 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.

We have found something that takes place outside the accounting, of which it makes sense to keep records. Much remains to be explained, but I will leave it for the coming posts (and the comments section of this post, if you have any questions/critique).

I will end this post by quoting Narayana Kocherlakota[5]. He by no means fully captures the logic of our system, but there is much which resonates with what I've said above (not only the bananas!). He writes (italics in original):

The main result of the paper is that in all of these environments, the set of incentive-feasible allocations generated by adding memory contains the set of incentive-feasible allocations generated by adding money. In this sense, in all of these environments, money is merely a primitive form of memory.  

There is a simple reasoning behind the main proposition. John and Mary meet. John has apples and wants bananas. Mary wants apples but doesn't have bananas. In monetary economies, this problem is solved by Mary's giving John money in exchange for apples. John then uses the money to buy bananas from Paul; if John doesn't give the apples to Mary, John doesn't get the money and can't buy the bananas from Paul. 

But of course the money itself is intrinsically useless. In terms of the reallocation of intrinsically valuable resources, we can think about the situation as being one in which John is considering making Mary a gift of apples. If he makes the gift, Paul will give him bananas in the future; if he doesn't make the gift, Paul won't give him the bananas. The money that John receives from Mary is merely a way of letting Paul know that John has fulfilled his societal obligations and given Mary her apples. 

Thus, if we account for the fact that money itself is useless, monetary allocations are merely large interlocking networks of gifts. The point of this paper is to show that these same reallocations of resources are feasible if agents knew the past history of all actions: Paul could react to different histories of gifts on John's part in the same way that he reacts to John's having different amounts of money. It follows that any function performed by money can be provided by an ability to access the pasts of one's trading partners, their trading partners, and so on.

Part 3: Give and Take



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[1] Keynes touched this problem in the last paragraph of the Preface to his General Theory: "The composition of this book has been for the author a long struggle of escape, and so must the reading of it be for most readers if the author's assault upon them is to be successful,—a struggle of escape from habitual modes of thought and expression. The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds." 

[2] Ostroy, Joseph M. & Starr, Ross M. 1990. "The transactions role of money," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 1, pages 3-62 Elsevier. (p. 10-11) – There is a working paper version freely available here. Another good overview of "mainstream" monetary economics is this paper by Meir Kohn. It is noteworthy that Kohn later gave up the attempt to make sense of money ("theory of exchange") within the general equilibrium framework ("theory of value", or "value paradigm").

[3] This explains the title of my blog.

[4] Many of us might be suffering from a mild form of this disease, in the sense that we are unable to let go of our past beliefs about money. Faced with new evidence that contradicts those beliefs, we tend to quickly forget the new evidence. Compare this with what Wikipedia says about anterograde amnesia: "...a partial or complete inability to recall the recent past, while long-term memories from before the event remain intact".

[5] Kocherlakota, Narayana. 1996/1998. "Money Is Memory". Working paper version (p. 2).

A New Monetary System From Scratch, Part 1: Unit-of-Account and Numeraire

Nick Rowe at Worthwhile Canadian Initiative comes up with new thought-experiments at an enviable pace. His subjects often touch my research interests, but with his recent post Synchronisation and the Gross Money Supply he managed to really hit a nerve in me. That blog post is the proximate cause for me starting to blog about research I've been doing the last three years.

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.[1]

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:

1. 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.
2.   Let's not use, uncritically, old language and concepts when describing a new monetary system.

Eugene Fama[2] 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[3] 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[4] 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[5] 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.[6]

In the current blog post, we have dealt with this task:

1. 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.)

Stay tuned.


Part 2: Records Schmecords



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[1] 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.

[2] Fama, Eugene. 1980. “Banking in the theory of finance” (p. 55). 

[3] 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)

[4] Hawtrey, Ralph George. 1919. “Currency and Credit” (p. 2).

[5] Cowen & Kroszner. 1994. “Explorations in the New Monetary Economics” (p. 126). They refer to Kitson: "Mr Kitson's Defence", 1895.

[6] 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.