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.