Sunday, 8 June 2014

Bank Lending and the Value of Money



There is a theory of money that says that the value of private bank money derives from the need of debtors to obtain money in order to settle their debts.  Some people see this as being rather circular.  If the value arises from the existence of debts, how do those debts come about?  How can you borrow or lend something without knowing its value in the first place?

This is where it is useful to see that debts created through bank lending do something special, that other debts on their own do not.  A useful way to see this is by looking at the monetary circuit described by circuit theorists.  In this scheme, banks lend to firms to enable them to pay their workers.  The bank loans create the money, which the firms then hand over as wages.  At a later stage, workers spend their money, buying goods from the firms.  The firms use the money they receive as sale proceeds to repay their loans.

It is assumed here that firms need to pay their workers in advance.  Production takes time, so the firms cannot simply exchange goods for labour.  One possibility would be for firms to pay workers with contracts for delivery of goods at a future specified time.  So, for example, a worker might receive coupons entitling him to receive 100 widgets at the end of the month.  This is fine, but if the worker doesn't want widgets himself, he then has to find people to exchange his widgets (or widget coupons) with, in return for the goods he actually wants.

On the face of it, money does not help here.  For at least the widget coupons entitle the holder to a specified amount of something.  Money doesn't entitle the holder to anything.  If firms just printed up some coupons, with no specific entitlement attached to them, and tried to use these to pay their workers, the workers would quite reasonably reject them.  They would have no reason to believe that anyone would subsequently accept them in return for anything of value.

Involving banks means that the coupons can become tokens for the cancellation of debt.  Each firm can (in fact must) use coupons to repay their loans from the banks.  The coupons thus have value, without the need to be linked to a specific commodity.  Firms need to obtain coupons to meet their contractual obligations to banks.  Workers will accept coupons as wages, because they know firms will be prepared to accept them for goods at a later stage.

So creating value in the coupons specifically requires the involvement of the bank.  In the monetary circuit, the firms are the debtors, the workers the creditors and the banks are just intermediaries.  But although they only intermediate, the role of banks is critical to establishing a money denominated in an abstract unit.  Firms and workers can create contracts through bilateral agreements, but these can only ever be linked to specific commodities.  Credit money requires a tripartite arrangement.

Of course, there is still no guarantee for holders of coupons of what they will be worth in the future.  They know there will be a demand for coupons, but if there is a rush of new lending there may be an excess supply of coupons depressing the value.  People's belief in the intention of banks (specifically the central bank) to control the rate of credit creation is crucial to establishing the value of this money. 

18 comments:

  1. Or if you believe the Fiscal Theory of the Price Level, the intentions of the fiscal authority to tax back government debt and/or the monetary base. Bank money will thus be valued by the fact that it trades at par with base money.

    But once the price level is already anchored by existing contracts, the theoretical problem of valuing money seems to be a smaller issue. At which point, the determination of inflation is what matters, which is presumably under the control of the central bank. (Although the amount of control they have is debateable; I do not see that the central banks having the capacity to get inflation to 3% next year, for example.)

    ReplyDelete
    Replies
    1. Although I have focussed here (and in other posts) on how money's value might relate to private debts, I would agree the view that the need to pay taxes is a sufficient condition for money to have value. And I think the FTPL has some use in explaining what the price level is. But I'm not sure it is enough, because I do think that private sector credit creation can have an important impact.

      I also agree that the degree of control the CB can exert is limited. I guess all I'm concerned about here is the idea that the CB has enough control to give holders of money comfort that the value of money is not going to collapse. As long as they know that, they will be prepared to hold it and not worry too much about a few percentage points variation in the outcome inflation rate.

      Delete
  2. Nick,

    This is great, these are my thoughts exactly. I also agree with your comments about the FTPL. I actually think though, that the real problem central banks face is not keeping the value of the dollar UP but actually managing to dive it down in order to keep up with the expectations that they created (in order to induce past borrowing). So I would say that people do worry about a few percentage points variation in the inflation rate, it matters a lot for demand for loans and willingness to hold money (which, of course, then affects the price level) but it's not a mater of getting spooked by a little inflation and ditching the dollar.

    ReplyDelete
    Replies
    1. Yes, I didn't mean that people don't care about the inflation rate at all. I just meant that a little uncertainty about the actual rate wouldn't outweigh the benefits of using money.

      Not sure what you mean by "induce past borrowing".

      Delete
  3. You write “Involving banks means that the coupons can become tokens for the cancellation of debt. Each firm can (in fact must) use coupons to repay their loans from the banks. The coupons thus have value, without the need to be linked to a specific commodity.”

    It seems to me that this explanation is not complete. You have introduced money, but without giving it a certain “starting value”. And thus workers will not accept it as payment, because they do not know what they can buy with it.

    It seems to me that at first, before banks can be introduced, someone in a position of power has to:
    - create the money as a monopoly supplier;
    - force it into circulation by exchanging it for a certain amount of services and goods and thus giving it a certain value (the price level);
    - require it to be returned as a means of payment of taxes, such that the value of the tax payment equals the value of services and goods that were required as tax payment before its introduction.

    Anton

    ReplyDelete
    Replies
    1. Rather than asking what sets the starting value, we have to look a backwards valuation here. So the value today depends on what people will think it will be worth tomorrow, which will depend on what they think it will be worth the next day, and so on. The idea here is that this future value depends on the demand and supply of currency, and that the demand depends on the extent of debt.

      But you are right that this requires someone in a position of power, because in this case it needs someone to exert a controlling influence over nominal credit creation. We could see this as the state, but here I have chosen to treat the currency as the domain of the central bank. It's not that I necessarily prefer one approach to the other - I just think it's useful to look at it different ways.

      Delete
    2. You state “So the value today depends on what people will think it will be worth tomorrow”.

      Are you sure it works that way? It seems to me that the price level is set by firms who sell final products. And as far as I understand, these firms are more or less price takers in the sense that they set prices by calculating present production costs (wages, depreciation of capital, taxes, interest, etc.) and adding a mark-up which will depend on the competitive environment, and not, as far as I understand, on expected future costs.

      Anton

      Delete
  4. I'm not sure if I have any criticisms of the theory behind this post, but I don't think it holds up empirically. Like the coupons entitling their holder to 100 widgets, bank deposits have always entitled their holder to a specific commodity on demand, whether that be a gold coin, some amount of silver, or x central bank notes. In 1800s Scotland banks would from time to time temporarily suspend the "on demand" provision, but the deposit or note remained a liability of the bank during that period and in general the public expected a return to full convertibility. Do you have any examples private bank deposits that didn't carry a convertibility privilege and existed as pure tokens for the cancellation of debt?

    ReplyDelete
    Replies
    1. That's a good question. I don't have any examples, but I have to confess that my knowledge of economic history is very poor. I'm quite prepared to accept that it has never actually worked this way.

      I should say I am interested only in a very limited argument here, which is whether money can have a fundamental non-zero value in this situation rather than being just a bubble asset. In practice, I think there are various reasons why money can have a value, and possibly any one of them alone suffices. I generally accept that the need for dollars to pay taxes is a sufficient reason for dollars to be valuable, so in some respects, given that we know there are taxes we don't need to look for other reasons.

      I think the purpose of this sort of exercise though is that it is helpful to look at the role of money from different angles. And I think that applies to most approaches, including backing theories. I'm not sure however how well it works to build a theory of the price level off any of these ideas on their own. Certainly, I would be wary of trying to explain the price level in terms of this idea of bank debt alone.

      I largely see inflation as a cost driven process. The relevance of this sort of stuff is in thinking about how changes in the price level effect monetary equilibriums and how that might shape ongoing cost pressures, including through expectations. Part of my interest in this particular approach is that I think the massive network of private debt claims that characterises modern economies is an important element of this.

      Delete
    2. I am not sure this is a completely relevant example, but in Canada before Confederation (1867) a lot of commerce was undertaken with private sector tokens as money. Even the banks issued tokens. The tokens were denominated in the wacky British coins of the time (shillings, pence), I believe. But I do not think they were convertible. These were not bank deposits, but they did allow the expansion of private sector activity.

      Delete
    3. " I think there are various reasons why money can have a value, and possibly any one of them alone suffices. "

      Couldn't agree more. These are useful and entertaining thought exercises to run through and I appreciate your posts on the subject. I do think we eventually have to get back to the empirical side of things to double check our stories.

      The other thing I'm having difficulties imagining is how the price of money denominated in this abstract unit is set. If the first person to kick-start the money off borrows 50 units of bank money and walks into a store to buy something, how is the storekeeper supposed to price those units? He could let the borrower purchase one apple for those 50 units, or he could let him purchase 50 apples with one unit... but there is no rhyme or reason why he would choose one price over the other.

      Delete
  5. Anton and JP,

    First, I'll just say again that I'm a bit wary about turning this into a theory of the price level. I see it more as being about why money should have any non-zero value, rather than what that value actually is.

    That said, if I were to try and explain the price level this way, it would probably go something like this. We'd start by assuming that there is just a single monopoly bank which wants to create a stable currency. The bank then sets an inflation target (or future price level targets) with the intention of varying the nominal interest rate to meet that target. The bank then makes the initial loans to the firms. The nominal value of these initial loans is entirely arbitrary, but this is what pegs the price level.

    We can assume for convenience that all money is actually bank deposit and that the bank pays the same rate on deposits as it charges on loans. Based on the bank's interest rate policy, there is an expected real rate of return on money and equivalent real cost of borrowing money. Together with expected real returns on other assets and assumptions about household time preferences and production technology, this should give us enough information to tie down the expected price level from now into the future.

    So if our shopkeeper knows all this and can work out the model, then he will know how to price the apples. I don't want to give the impression though that I remotely think this is what happens in practice. As I said, I see inflation as being primarily a cost driven process (with an inevitably historical element), and that this sort of stuff is really about what kind of disequilibrium that might create in the money market.

    ReplyDelete
    Replies
    1. Initially, there isn't such a thing as a price level in terms of the newborn currency, because nobody is using it as a unit of account. To define the value, you have to refer to a commodity or basket of commodities or an existing currency. After the currency achieves acceptance, then you can change the definition to something like "a stable price index", with a value that freely floats in terms of all currencies and commodities.

      Delete
    2. Actually, I don't think there is anything in what I have said that requires this money to actually be the unit of account, or even the medium of exchange. All this really does is establish how there could be a viable market in debt reapyment tokens. However, once we have established that, then it would be convenient for everyone to use them as unit of account and medium of exchange.

      Delete
    3. "The nominal value of these initial loans is entirely arbitrary, but this is what pegs the price level."

      Wouldn't a bank be worried about making its first loan if it didn't know how much it was lending? If the nominal value of a deposit is set arbitrarily at the outset, that number could be so high that the bank might find that it has lent far more than it can support.

      The bank might want to protect themselves by requiring some sort of collateral in case the first borrower goes bust. But how can the bank know how much collateral to ask for if it doesn't know what the value of its deposits is to be once issued?

      Delete
    4. Remember I was talking about a monopoly bank here.

      What matters here is the real value of debt firms want to carry and the real value of deposits workers want to hold. Whatever nominal value the bank lends, the price level will adjust to ensure the real quantities are right. So this will only be a problem if a) the bank wants to set a price level target, and b) the bank doesn't know the model well enough to be able to fix the nominal value of the first loans at an amount that is consistent with that target.

      I don't think this is any difference to this issue you might have with backed money. Assume the first money is created by a bank being set up and obtaining a load of gold by issuing dollars in return. How many dollars does it issue for 100 oz of gold? $1? $100? Unless the bank has a seperate price level target, it makes no difference.

      Delete
  6. I have come to think of it this way:

    The value of money at the time of the loan is determined by the expected market value of the output it finances.

    The universal convertibility of money into goods and thus the stability of its value over time is determined by the uniformity and stability of lending standards by banks (which is further enhanced by the lender of last resort facility of the central bank).

    So, the value of my wage is determined by what I can buy for it, which should be equivalent to what others are prepared to pay for the output I produce. Both now and - give or take a few percentage points - in future.

    Taxes as well as the obligation to pay down principal are policy tools with which to manage the value of outstanding loans over time, but are not the essence of money's value per se.

    ReplyDelete
    Replies
    1. "The value of money at the time of the loan is determined by the expected market value of the output it finances."

      I'd cautiously agree to some extent, in that the value is determined by the ability of firms to buy back the money using produced goods as payment. However, the on-going position matters, because if firms don't need to buy back money if they can simply re-borrow.

      Delete