Friday, 7 March 2014

Samuelson's Consumption Loan Model with Inside Money



One of the big questions of any theory of money is why a people accept useless bits of paper in exchange for useful goods.  The MMT guys would point to the role of taxation.  The state's requirement for money in return for extinguishing tax liabilities creates sufficient demand to create a market for money.  I would be inclined to agree that use of a currency by the state is sufficient to make it valuable.

In Samuelson's consumption loan model, people want to hold money because it the only available store of value.  In this model, there is a continual flow of new people wanting to save, so people will accept payment in money, hoping that they will always be able to pass it on to someone who wants it as a store of value. 

However, I find it a slightly odd feature of this model that the money is a financial asset, but without any obvious party on the liability side.  There is no government in Samuelson to whom the money can be remitted.   Samuelson's money can never be extinguished or destroyed.  It must be passed round forever.

This means that the value of money in this model is purely based on the hope that it will have value in the future.  This has caused some people to think of it as a kind of bubble asset.

So I thought it would be interesting to look at how Samuelson might work with inside money, where the private sector is borrowing as well as saving.  To do this, we need a reason for people to borrow, so I'm also going to add in an extra asset - land.  So the economy would look something like the following:

Households live for two periods then die (I'm simplifying it to two periods from Samuelson's three).  They work in the first and save some of their earnings to spend in the second period, when they do not work at all.  A new cohort of households is born at the start of each period, replacing the households that die.

There is a bank.  The bank makes loans by crediting household deposit accounts.  The deposit accounts serve as money.  Loans are used to buy land.  Land is held for personal enjoyment rather than for producing goods, so both workers and retireds hold land.  Retireds also hold deposits, whereas workers have to fund their land holdings with debt.  The national balance sheet at the start of each period looks something like this:



Worker
Retired
Bank
Loans
- L

L
Deposits

D
- D
Land
pa . Aw
pa . Ar



This is expressed in monetary units, where pa is the price of land.

All transactions take place at the end of each period.  At this point, retireds are still alive and new households have just been born, so all three generations can transact.  Retireds then die, workers retire and newborns start work.  For simplicity, we are assuming the rate of interest on loans and deposits is zero and that there are no credit constraints.  The flow of funds between entities is shown in the schematic below (inserting a land market and a separate production, for ease of illustration):




At this point, newborns are borrowing to buy the land they will use as workers.  Retireds are selling their land and spending their deposits to pay for consumption.  Workers are doing lots of things.  They are repaying the loans they took out as newborns.  They are possibly adjusting their land holdings.  They are consuming and they are retaining the balance of their earnings as deposits.  A more formal flow of funds is set out below:
 


Newborn
Worker
Retired
Bank
Loans
L
- L t-1

L t-1 - L
Earnings

pc . C


Land
- pa . Aw
pa . ( Aw - Art-1 )
pa . Art-1

Deposits

- D
D t-1
D - D t-1
Consumption

- pc .Cw
- pc . Cr

Total
0
0
0
0



There are a few interesting things that this model brings out.

1. The demand for money now partly arises from the need of workers to repay their loans.  In Samuelson's version, people held money as savings in the hope and belief that future generations would also want to hold money as savings.  Now they can hold money in the knowledge that someone else will at some point need it to repay a debt.  Ultimately, the need to repay debts exactly matches the funds available to do so.  The supply of money creates its own demand.

2. The general price level, depends on the volume of lending.  We are assuming that the bank decides how much to lend and therefore the nominal value of deposits in the economy.  Yet the optimal real value of deposits is determined by household preferences - how much to save for retirement, how to split asset holdings between land and deposits.  If prices are perfectly flexible, an increase in lending will lead to a rise in prices[1].  But a change in preferences can also effect the price level.

3. This result does not depend on the fact that deposits are used as the medium of exchange.  The price level is driven by the demand and supply of deposits as a store of value.  We could imagine the consumption good being used as the medium of exchange (and as the unit of account) and we would still get the same result.

I prefer this model to Samuelson's as the money seems to be much closer to what we actually have in the real world (although I have not included state money).  For me, the most useful thing it illustrates is the way the value of the currency is determined by the long and short positions that people have on it.  Where most borrowing and a significant part of investment take place in instruments that are highly correlated with the currency, then saving and borrowing habits are key to determining its value.



[1] We can do an experiment with this model.  We assume that each generation aims to consume the same amount in retirement as when working, and to keep a constant ratio between consumption and land holding.  With zero growth, this means Cw = Cr and Aw = Ar = Art-1 in all periods.  If the bank then decides to increase lending by 20%, then constant production requires a rise of 20% in the price of land and of goods.  However, whereas the price of land adjusts immediately, the price of goods rises by 10% in the first period and the rest in the second.

45 comments:

  1. Could your model be extrapolated to have different countries competing for savings? So a neoliberal success could be modeled where the people in a "success" country borrowed money as workers to bid up the value of land and the funding for those loans came from savings from other countries being continuously exchanged into the currency of the "success" country -allowing the "success" country to perpetually obtain a flow of real goods and services in return for providing a secure store of value in the form of stable, private sector, land backed, debt?

    ReplyDelete
  2. Potentially, yes. I did it this way because it was a development on Samuelson (apart from using 2 period lives, rather than 3, which just makes it simpler). I think the OLG structure is useful though for looking at inside money, because it has heterogenous agents where there's also a kind of roll-over. You can have models with agents who are permanently different, e.g permanent savers and permanent borrowers, but you then need growth, or its unstable.

    Also, I'm not sure whether you had any currency issues in mind or were just thinking of different countries with a shared currency. Part of what I am looking at here is how the value of a dollar can be determined when it has no value in its own right. That still works in an international context, but you need to consider the open positions people have in each currency.

    ReplyDelete
    Replies
    1. How you described it is very clear and helpful (to me anyway).

      I did have currency issues in mind and I was in particular thinking of countries such as Australia and the UK where we have perpetual current account deficits and yet manage to maintain strong currencies because foreigners find our private sector debt an attractive store of value (Australia doesn't have much government debt). Basically just as you looked beyond the MMT idea of what gives currency its value within a country, I was wondering whether that same private debt repayment force could similarly confer the ability of a country to run current account deficits in a floating exchange rate regime.

      Delete
    2. Extending the model would not be straightforward. Even as simple as it is, there's an actual a lot of stuff going on. But I would say that this is the sort of framework that I have in the back of my mind when I think about currency issues.

      Delete
  3. Neat.

    So I’m trying to draw out the comparison with Chartalism.

    Chartalism basically says that money is accepted as a medium of exchange because it is required to pay taxes.

    I think you’re saying – as a simplified sufficiency condition in systems that include inside money - that money is accepted as a medium of exchange because an equivalent amount will be required at some point to repay the liability that created it (supply creates demand). The macro coherence of that requirement is reflected in double entry bookkeeping.

    The common element is that there is a liability pull on demand and acceptance in each case - a tax liability or a private sector loan liability.

    “This result does not depend on the fact that deposits are used as the medium of exchange. The price level is driven by the demand and supply of deposits as a store of value. We could imagine the consumption good being used as the medium of exchange (and as the unit of account) and we would still get the same result.”

    Interesting. But in your particular model, don’t newborns need deposits as the medium of exchange?

    P.S.

    Do you think that if Say’s Law is false with respect to real activity in a monetary economy, it might be true with respect to monetary activity in a monetary economy? Seems to be a symmetry begging there somewhere. Are you touching on that here? I seem to recall Godley and Lavoie expressing something like that in their own way.

    ReplyDelete
    Replies
    1. Yes, that's pretty much it. I would tend to agree with the Chartalist position that if the state is demanding the currency, that's good enough reason for anyone to take it. But I also think that inside money can create its own demand pull, provided there is a sufficient large network of claims, i.e. I think there has to be liquidity as well.

      I think I'm right on the medium of exchange point. Imagine one of the consumption goods is apples and that is used as the medium of exchange. So newborns would get a loan which would give them deposits. They'd then sell those deposits to workers for apples. Workers would buy the deposits because they need them to repay their loans and because apples are no good for saving, because they go off. Newborns would then use the apples to buy land from retireds, who would use the apples to buy other goods from workers. So even though they're not used as an exchange medium deposits are still bought as an investment and, crucially, to pay off debts.

      I started writing up the post that way, but I decided it was too complicated for a single blog post.

      I'll have to think about the last point. Say's Law seems to have some subtleties, that I've never thought worthwhile getting to grips with.

      Delete
    2. Interesting in this case that borrowing and lending is not done in the medium of exchange.

      Have you ever modelled a barter economy with borrowing and lending?

      Delete
    3. You can have borrowing and lending in something other than the medium of exchange, of course, because we have stock lending. But that's lending of something that is itself a loan of the MOE. Or you could have a loan of bananas, say. I give you 100 bananas now, you give me 110 bananas after 3 years. But what we have here is rather different because it's a loan of something that is not pre-existing - like real bank lending, but not actually the MOE. It sounds a bit weird, but I think it's right. (I got this through thinking about some points in one of Nick Rowe's posts.)

      I think what I said about how apples might be the medium of exchange would extend to barter. In other words, not all exchanges would need to be apples for something else; some could be bananas for oranges. So I think the same points would apply. I'm slightly less sure on that. Otherwise, I haven't really attempted to specifically model barter with lending.

      Delete
  4. I don't normally pursue semantic/conceptual issues, but:

    "But what we have here is rather different because it's a loan of something that is not pre-existing - like real bank lending, but not actually the MOE. It sounds a bit weird"

    In normal banking, we don't say that a bank lends deposits, do we? I certainly don't.

    (Although perhaps we would if there were nothing further up the money hierarchy.)

    How do you think of/phrase that here? What is it that is being loaned?

    ReplyDelete
    Replies
    1. No, I wouldn't tend to say that either. The thing is that a bank loan is different from a loan of a car say, in this sense. People sometimes come at it that way - they see that if I lend a car, I had to have had a car in the first place. Then then try to think of bank lending in the same way, but I think you can run into all sorts of problems with that. It leads people to conclude that banks lend reserves. If I had to say what it was they were lending, I'd probably go with reserves, but the better response I think is that it's the wrong question.

      I didn't mean here that real bank lending is a loan of the MOE - I just meant it is conducted within the MOE. Whereas, in my model, it need not be. The MOE can be something else completely. Again, I think this is right - but I'm open to being shown otherwise.

      Delete
    2. I think that's right also.

      What's interesting is that there's lending and borrowing of the stuff that is usually the medium of exchange - but not necessarily here when it is used instead to obtain the medium of exchange.

      So if neither of us tends "to say that" in the usual world, what is it precisely that is being loaned when "loans create deposits" in the usual world?

      (I see your point on "in the first place" as a separate issue actually, which is also interesting in this case and in the case of barter lending and borrowing versus monetary bank lending and borrowing)

      Delete
    3. sorry - overlooked you're "wrong question" point

      although not sure what is wrong with the question

      (this is a highly unusual train of questioning for me in total)

      Delete
    4. I suppose the reason I think it is the wrong question, is that anything you identify as the subject of the loan is not going to be like the car that you lend in a car loan. So trying to think about what it is that is being loaned is not going to help you understand it very much. Personally, I think of it as just a loan - not actually a loan of anything - but I can see how that wouldn't satisfy everybody. As I said, if I had to give an answer, I'd probably go with reserves, but we know the confusion that answer leads to.

      Delete
  5. I see your lending flow schematic as a very useful tool. You need to look carefully, but it illustrates the contrast between long term and short term borrowing. It does this in the following way:

    Long term lending, such as for land, is seen as a transfer of the land to the bank. This is because the seller has been made whole and no longer has an interest in the property, and, while title passes to the buyer, the security for the loan passes to the lender (bank). As a result, the bank with security interest in the land owns the land in case of default by the buyer. The bank's liability for deposits is now backed by a land ownership interest.

    Here is the subtle point. A one time transfer of funds fits right in with ideal low turnover of deposits which works well with bank lending policy (using deposits to provide cash for loans). We can then assume that the deposits from the land-seller will remain available for re-lending.

    With deposits available for re-lending, it is logical that the bank will make loans to consumers (not shown in your schematic). This pattern of additional lending should work reliably so long as all parties perform their contractual obligations.

    I have not yet thought this all the way through but I would expect that we can use your schematic to consider what happens when people try to "game" the system. Two paths to explore come immediately to mind: Customer refusal to pay and excessive consumer lending which would eventually drive up prices. I expect either would put the deposits of the land seller at risk, either by direct loss or by value dilution.

    Another thoughtful post; thanks!

    ReplyDelete
    Replies
    1. Although I haven't talked about security, you are right that the deposits here are in a sense ultimately backed by land because all of the loans are for land purchase. The value of loans, which depends on the ability of borrowers to repay or the underlying security is an importnat part of this.

      Talking about deposits being available for lending (or re-lending) doesn't really fit with this. I think the idea that bank lending involves lending deposits can be misleading - see my discussion with JKH above.

      Delete
  6. Nice interpretation. In terms of "money as an intergenerational bubble asset" it seems this model would more intuitively describe the asset/liability position of people as they save for retirement and then dissave, the transfer of wealth/consumption from old to young (and vice versa) and the liability (from the borrower POV) being collateralized by life income. This interpretation also implies the importance of housing (as the largest asset for most households) from a monetary policy framework. Maybe generally, the model implies that there is a greater link between money and private balance sheets than most economists recognize?

    ReplyDelete
    Replies
    1. Thank you. Yes, I think this is a much more realistic picture than Samuelson's and I actually think it picks up quite a lot of what actually goes on, given how simple it is. I think there is a more important role for private balance sheets in creating money value than is sometimes suggested. I don't want to play down the impact of the state in real economies - it's just that the state doesn't figure in Samuleson.

      Delete
  7. It is interesting to read the exchange between you and JKH. I just re-read it from a different viewpoint.

    The concept of not able to lend a car unless the car exists seems incontrovertible. I confess to assuming that in your schematic, there was SOMETHING to lend, without assuming what was being loaned. I also assumed that what ever was loaned, had a long duration, which in my mind, is like "capital".

    I did not see any reference to how much "capital" was needed, just that some was needed. I think Nick Rowe's recent post at http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/coordination-and-the-demand-for-money.html#more would apply here.

    I use the phrase "lending deposits" to refer to a bank lending pattern of lending much more than they have in legitimate money. We then must ask "what is legitimate money?". Well, it is NOT money from "loans create deposits".

    If "deposits from loans" is ruled out as legitimate money, what is left? In my mind, only government produced money or the backing for money be it gold, silver, or something else. In the fiat money economy, government produced money is the only legitimate money during normal times.

    So do banks REALLY lend deposits? I think I would say "yes" if the loan to deposit ratio was less than 1:2 meaning that the total sum of loans was more than equal to the sum of legitimate currency on deposit at the bank. (Total deposits = legitimate deposits plus loan deposits).

    ReplyDelete
    Replies
    1. There is no money that isn't created by lending. This is a model with purely inside money. So there is no currency or gold or anything like that. This is completely intentional, because I wanted to look at how inside money could be self-sustaining, rather than something that rests on some more "legitimate" money.

      Delete
    2. This is a good exercise , I think , because you can imagine an outcome that satisfies both the loanable funds types and the endogenous money types.

      The land value is a substitute for deposits to the loanable funders. With the loan on the land in hand , the borrower begins constructing a house , adding to the collateral value held by the bank , enabling further borrowing to complete and furnish the house. With enough people sharing similar "animal spirits" , a housing boom results , with rising asset values that justify more lending. Banks sell securitized debt to savings-flush overseas investors , preventing their balance sheets from getting unwieldy , and spreading the risk. The buliding and house price boom continues and then finally crashes when a butterfly in Hawaii flaps his wings once too often.

      The money was all created endogenously , but never was loanable funds violated in any obvious way. It was all win-win , until it was all lose-lose.

      Marko

      Delete
    3. Yes, I think that's right, but it may be partly because I haven't really said much about the bank's lending appetite. If we started to play around with that, allowing the bank to vary it's lending, then we would see that this did not depend at all on household savings decisions. So, loanable funds arguments might look more shaky. Of course, actual savings must always match actual borrowing, but that will be true in any model

      Delete
  8. Interesting article. I needed some time to understand it, and noticed that is much easier to onderstand, at least for me, if you add an "opening" balance sheet to the "closing" balance sheet for the period and use a somewhat different notation. The opening balance sheet then consists of the assets and liablities "inherited" from the previous generational phase (new symbol N: newborn): loans of workers = -LN(t-1), deposits retired = DW(t-1), land workers = pa*AN(t-1), land retired = pa*AW(t-1). The flows related to these assets and liabilities are then simply the opening balance sheet - closing balance sheet.

    Based on the above, the flow land/worker should be, I believe, pa*AN(t-1) - pa*AW

    Anton van de Haar

    ReplyDelete
    Replies
    1. Yes, I think that's right. Note that what appears in the FoF is the expenditure so if your land increases, that will show as a negative, because you had to pay for it. So that's the flow of land, but what would go in the FoF would the negative of the expression.

      The notation is a little confusing because the way the periods work here is slightly uncoventional. I need to have all flows taking place at period end, rather than during the period, so that I can have newborns transacting with retireds.

      Delete
  9. Sorry, forget to mention that you then have to add a column newborn to the balance sheet
    Anton

    ReplyDelete
    Replies
    1. Could do, but you shouldn't have a balance sheet with items appearing for both newborns and retired at the same time- it's either / or.

      Delete
  10. I will email you the tables to make it more clear
    Anton

    ReplyDelete
  11. Yes, this is much more realistic than Sameulsonian money, as is chartal money. I'd add backed money as a third plausible alternative--that the ability to put a piece of paper back to its issuer for redemption into some underlying medium is sufficient to drive its value.

    ReplyDelete
    Replies
    1. I was wondering when I wrote this how it sat with backing theory. There is clearly no backing to the deposits other than the loans, which are no more than claims on the deposits. In pure backing terms, it seems very circular. But maybe the real backing is the earning power of the borrowers and the underlying land? I'm not that fluent on backing theory, so I'm not sure.

      But yes, in reality I think that there are various possible reasons why money is accepted and they be more or less important in different circumstances.

      Delete
  12. "Maybe the real backing is the earning power of the borrowers and the underlying land?"

    Yes! I've been trying to argue this exact point.

    Is Fiat Money an IOU? http://realfreeradical.com/2014/02/27/is-fiat-money-an-iou/

    On the Convertibility of Fiat Money http://realfreeradical.com/2014/03/03/on-the-convertibility-of-fiat-money/

    The Value of a Dollar http://realfreeradical.com/2014/03/07/the-value-of-a-dollar/

    I think you have the right idea. Most people don't notice the connection between money and debt.

    ReplyDelete
    Replies
    1. Very interesting. It seems to be very much in line with what I'm saying here. I've had a brief read, but I will go back and look more carefully.

      Delete
    2. Looking at your last post there, I think it might be worth saying a bit about how anchoring works in the above model, because I skated over it.

      In my experiment in the footnote, I am assuming that the bank determines the nominal amount of loans - we can imagine that this is a figure fixed by the central bank. The real demand for long positions in deposits then has to tie in with this, which effectively pegs the price level. As discussed, there has to be an adjustment process - the price level doesn't immediately jump to the new long-term equilibrium.

      Once the price level has adjusted, the real value of loans is back where it started. So if we instead wanted to assume that the bank wished to fix the real value of loans, this wouldn't work. To achieve that, the real value of deposits has to change and to achieve that, there needs to be a change in the relative returns on assets. In the simple model I've set out here, the only way this can happen is by having some degree of inflation (or deflation) with matching price inflation in the price of land.

      So there is a solution with a rate of change in price, but as a static equilibrium, there is nothing to determine the value of a dollar. However, on a path dependent basis, there is. So if we start from the equilibrium position I have used with zero inflation and a fixed nominal value of loans and then have the bank reduce the real value of loans, there is a unique solution for the price level in each subsequent period.

      Delete
    3. Nick,

      You state "I am assuming that the bank determines the nominal amount of loans [... ] which effectively pegs the price level". Based on your model, this seems to be true for the price level of land (pa), but not for the price level of consumption goods (pc).

      In your model, in which it is assumed that all money lent is used for the purchase of land, pa is simply equal to Ln / A (with n: newborn). But it seems to me that pc = ( Ln(t-1) + Dw)/(c - cw) with c and cw assumed constant. And as it seems to met that, based on your model, Dw = pc*cr-Ln(t-1), any increase of Ln(t-1) wil be met with an equal decrease in Dw, and thus pc will remain constant.

      It seems to me that you could change this by assuming that newborns (you could also name them pre-workers) also consume, and that this consumption is paid with part of the loan.

      Anton van de Haar

      Delete
    4. If the nominal loan volume changes, the price of goods must change, although not necessarily one for one. If loans start to increase at a constant rate of say 2% per period, then in a steady state, the price of goods will need to increase at the same rate. The same applies to the price of land.

      For the purposes of this post, I only looked at analytical solutions, but I might do a post with an equation listing for some simulations.

      Delete
  13. This reminds me of the discussion I had with Paul Grignon over at the realworld economics blog, that you were pulled into at some point, too. I very much agree with your appraoch, also in relation to the Chartalists. In my view, the Chartalist hierarchy is a special case within your more general framework. I'm not even sure the distinction between inside and outside money is necessary, as the principles apply to both?

    And as for Say's Law, Cencini calls it the 'law of the logical identity of sales and purchases', whereby purchases include those of financial assets.

    ReplyDelete
    Replies
    1. Yes, I think I'd agree that you could see Chartalism as a special case of this. The inside / outside money thing is just because in Samuelson, the money looks like outside money, but without there being anybody apparently outside. An alternative approach would be to add a government to a Samuelson type model, with spending and taxation, as the source of the outside money.

      Delete
    2. "An alternative approach would be to add a government to a Samuelson type model, with spending and taxation, as the source of the outside money."

      This is the model I was using when (in my comment) I spoke of "legitimate money". Money coming from government would be "legitimate money".

      The link between value and money is elusive. In the past, I have suggested that the value is established from exchanges with government. The private sector has something to sell (labor or product). Government makes an offer of money; the private sector accepts or rejects. Rejection is denial of value, acceptance is agreement of value of money.

      Once money is in hand, it is up to the owner to receive value in exchange. Going into two different stores can result in two values for the identical product.

      Delete
    3. Just read through your post again, and must correct myself on some points (I was focussed on the comment thread with JKH at first).

      What determines the value of land in your model? Why is land a valuable commodity?

      You write:

      Households live for two periods then die (I'm simplifying it to two periods from Samuelson's three). They work in the first and save some of their earnings to spend in the second period, when they do not work at all. A new cohort of households is born at the start of each period, replacing the households that die.

      There is a bank. The bank makes loans by crediting household deposit accounts. The deposit accounts serve as money. Loans are used to buy land.


      Starting from tabula rasa, where does the money come from to pay wages and save?

      You continue:

      The general price level, depends on the volume of lending. We are assuming that the bank decides how much to lend and therefore the nominal value of deposits in the economy. Yet the optimal real value of deposits is determined by household preferences - how much to save for retirement, how to split asset holdings between land and deposits.

      Optimal, in this case, means optimally allocated over a lifetime? But it doesn't explain why a bank would make a loan to buy land in the first place.

      To me, logically, determining the real value of a loan means determining the estimated wages earned (things produced) by households that, as a second order effect, then give value to land. So, while the mortgage may be the point of entry for money into the economy, the value enters at a different point, no matter whether it is optimally allocated over a lifetime or not. Nomads and subsistence farmers don't have mortgages.

      So to me, it isn't the volume of bank lending per se that determines the price level, it is the estimate of the bank of the future earnings / productive value of the borrower that determines the initial price level at the time of the loan. The actual revenue generated over time then determines whether the initial estimate was correct or whether a correction of prices is due (prices were inflated).

      Of course, land being a scarce good, more lending against it will puswh up its price, but there should only be more lending if there is reason to believe that the productive economy will deliver the goods to ratifay that rise in prices.

      Does that make sense to you? Do you agree?

      Delete
    4. Roger,

      Sure. Although I don't see money that arises from claims on the state as being inherently more "legitimate" than that which arises from claims on private entities.

      Oliver,

      "What determines the value of land in your model? Why is land a valuable commodity?"

      I am assuming that people enjoy land for its own sake and that it is not used in production. I am also implicitly assuming that there is some disutility to holding land (the hassle of having to maintain it, perhaps), so there is some point at which people don't want to hold any more, even if the opportunity cost is zero. All this does is allow me to have a zero interest rate on deposits. Formally, if U(A) is the utility of holding land A, I am assuming U'(A) = 0 for a finite A.

      The price of land is then determined in a general equilibrium, driven by the amount people wish to save, relative returns and the nominal amount of loans, which I have treated as exogenous.

      "Starting from tabula rasa, where does the money come from to pay wages and save?"

      I'm going to duck that question, by saying that what I was doing here was modifying Samuelson and he also assumes a starting point where money exists. I think you could tell various stories about how things might have started and ended up in this position, but what I was interested in looking at here is whether it is sustainable once it already exists.

      By the real value of deposits or land, I simply mean their nominal value deflated by the price level of the consumption good. If we were to assume some utility functions for the agents in this model, this would allow us to calculate an optimal real level of deposits and of land holdings, given expected yields (which basically comes down to expected price changes). See my reply to Mike Freimuth above for more on this.

      Delete
  14. "Sure. Although I don't see money that arises from claims on the state as being inherently more "legitimate" than that which arises from claims on private entities."

    I certainly agree that money from the state is indistinguishable from money sourced from "loans create deposits".

    The huge difference that I notice is that the state issues money for reasons of state and the banks issue money for reasons of bank practice. The two reasons are very different and result in great differences of DURATION. Money issued by the state (in the United States) has been nearly permanent (if you agree that payment by government must be in money). On the other hand, money created by loan deposits is expected to be returned to the bank in a predetermined time period, which makes "bank money" temporary by design.

    So you can see that I see a huge difference between the two sources of money on a marco-economic scale.

    ReplyDelete
    Replies
    1. Well, I do think that the state having negative financial net wealth has different implications from the same for private sector entities. But I'm not sure about the permanency point. Relative to GDP the net indebtedness of either can go up or down, but I think its unlikely that either would go to zero.

      Delete
  15. Why does anyone feel compelled to pay back their loans? Why not default? The best reason why not would be that the bank would repossess your land. That answers the question of what the ultimate "backing" is. It's the loan collateral, land.

    An unanswered question is, how does the bank define its money? What's the "medium of account"? Perhaps land, but that's a little tricky since land isn't homogenous. But if the bank can solve that problem, then it would have a good business. Money would be "liquid land", a beneficial financial service.

    Assuming the bank somehow defines its money in terms of land, then the money price of land would be stable. The (non-land) price level would then be determined by the land market.

    ReplyDelete
    Replies
    1. Although any collateral might incentivise repayment, we shouldn't have to rely on it. Social pressures or legal requirements with penalties or earnings attachment may be enough. I haven't attempted to address that here.

      On the medium of account question, see my point 3 in the post. The bank doesn't have to define its money by reference to anything else. Think of the bank's money as "loan repayment tokens". A loan consists of the bank giving you X tokens now and requiring you to deliver back X + R tokens after one year. Provided there are enough tokens out there for there to be an active market in them, this is entirely self-sustaing with the value of tokens being dependent on how much people want to borrow and how much people want to save.

      Delete
    2. Thanks for replying!

      If the bank allows the value of its money to drift aimlessly, sooner or later the result will be hyperinflation. And knowing this, people will not want to hold a lot of its money (maybe none). So this is not a profit maximizing strategy for the bank.

      Aside from that, there's a bootstrapping problem. Land can't have a money price until the bank starts making loans. So unavoidably, the bank has to decide arbitrarily how much money land is worth. Why not promise to keep that value stable? That would improve the odds of the bank's money getting accepted.

      Delete
    3. The bank can exert a fair amount of influence over the value of its money by controlling its supply throught the volume of new lending (maybe indirectly by setting the interest rate). I would imagine that it would undertake to target a general price level or rate of inflation to maintain the attractiveness of the money. This is like what happens in reality where the central bank manipulates the interest rate to attempt to control the supply of new money through new lending, with a view to an ultimate inflation target.

      This is just a story about how the system is self-sustaining, but I haven't explained how it might get off the ground in the first place. You could come up with various stories, but we do find ourselves in such a system now and I'm only trying to look at why it might continue. Why do we continue to value money, rather than why did anyone except money in the first place.

      Delete
  16. I just realized this post is a year old. I thought I was only a week late to the party! I'll try to be more punctual.

    ReplyDelete