Does it make a difference if Tether lends out new USDt?

I recently tweeted something about the world's largest stablecoin, Tether. It gives me an opportunity to ask a broader question about money in general:

Tether's terms of service explicitly prevents it from creating new USDT stablecoin units for bitcoin: "only money will be accepted upon issuance." So why is Tether lending USDT to Celsius in return for bitcoin/ethereum collateral?https://t.co/tka3LxMVxc via @kadhim pic.twitter.com/CwIVAbXwhS

— John Paul Koning (@jp_koning) October 19, 2021

Tether issues USDt, which are U.S. dollar-denominated IOUs redeemable for actual dollars at $1. Unlike a PayPal IOU, a Tether IOU exists on a blockchain.

What the tweet (and linked-to article) is saying, in short, is that Tether has misadvertised itself. Tether says in its terms of service that it only creates new stablecoin tokens, USDt, in acceptance for money. That is, to get $1 worth of USDt from Tether, you need to send it $1 in actual U.S. dollars. But in reality, Tether does not seem to be waiting for deposits to roll in before issuing new USDt. As the FT's Kadhim Shubber reports, it is directly lending new USDt out, much like how a bank puts new dollar IOUs into circulation by lending them out.

I want to use Tether to ask a more general question about the economics of money creation. Granted, Tether is not issuing stablecoins according to its terms of service. But does it really make an economic difference whether Tether lends out new USDt stablecoins or if it only creates them when someone deposits U.S. dollars?

We could also ask the same about PayPal. PayPal only creates new PayPal dollars when someone transfers U.S. dollars to PayPal. But what if PayPal were to start creating new PayPal dollars by lending them into existence? Would the monetary economics of the PayPal change?

I'd argue that it doesn't. But I'd be interested in hearing the other side of the debate. I'll show why the method of issuing Tethers or PayPals doesn't really matter using two quick examples.

Let me quickly outline one assumption I'll be using. The market has a certain demand to hold USDt, and if that demand is exceeded by new issuance of USDt, the excess USDt will be quickly sent back to Tether for redemption at $1. That is, given the existence of a $1 peg, a stablecoin issuer can never exceed the market's demand for a stablecoin.

Say that Tether has $100 in USDt outstanding and also has $100 sitting in a bank account as backing. 

Under the first scenario, one that is consistent with Tether's terms of service, John arrives and deposits $10 with Tether and gets $10 USDt. Now there is $110 USDt outstanding. There is also $110 sitting in Tether's bank account. Next, Tether lends $10 of the $110 in its bank account to Sally at 6% per year. It asks for collateral to protect itself. That is, Tether requires Sally to pledge $15 worth of bitcoin as security.

Now for the second scenario, the one described in Kadhim Shubber's FT article. Tether prints $10 worth of new USDt out of nothing and lends it directly to Sally at 6%. Tether asks Sally to pledge $15 worth of bitcoin as collateral. There are now $110 USDt in circulation. If Tether were to overissue by lending more USDt than the market wants to hold, that amount would quickly reflux back to Tether for redemption at $1. (So if Tether lends Sally $15 USDt but the market only wants $10 USDt, then $5 USDt would quickly be brought back to Tether for redemption. Tether adjusts by reducing its exposure to Sally by $5.)

Under both methods of issuance, we end up at the exact same spot. There are $110 USDt in circulation. Backing that amount, Tether has $100 in cash in a bank account and $10 worth of a 6% loan secured by bitcoin.

So economically speaking, it doesn't matter whether Tether lends out new USDt or if it creates new USDt upon reception of actual dollars. Either way, $10 worth of new USDt will go into circulation. And either way, that issuance will be backed by a 6% loan to Sally collateralized by $15 worth of bitcoin.

The interesting thing is that even though there is no difference between the two scenarios, our language and law distinguishes between Tether 1 and Tether 2. In the first scenario, Tether is considered a fintech, a money services business, or a payments company, and thus subject to a certain set of laws. In the second scenario it is a bank, or a depository, and thus subject to an entirely different set of laws.

But if the two Tethers have the same economic function, why don't we the use the same language and set of laws & regulations for each?

Was Bretton Woods a real gold standard?

John Maynard Keynes and Harry Dexter White, who contributed to the design of the Bretton Woods system

David Glasner's piece on the gold standard got me thinking about the Bretton Woods system, the monetary system that prevailed after WWII up until the early 1970s.

There are many differences between Bretton Woods and the classical gold standard of the 1800s. My claim is that despite these differences, for a short period of time the Bretton Woods system did everything that the classical gold standard did. I'm using David's definition of a gold standard whereby the monetary unit, the dollar, is tied to a set amount of gold. This linkage ensures that there can never be an excess quantity of monetary liabilities in circulation—unwanted notes will simply reflux back to the issuer in return for gold. When most people criticize Bretton Woods, they say that it lacked such a linkage.

A narrowing redemption mechanism

For a gold standard to be in effect, a central bank's notes and deposits have typically been tied down to gold via some sort of redemption mechanism. In the days of the classical gold standard, central banks didn't discriminate; the right to redeem was universal. Whether black or white, big or small, male or female, you could bring your notes or deposits to a central bank teller and have them be converted into an equivalent quantity of gold coin. Any unwanted notes and deposits quickly found their way back to the issuer.

After 1925, the world adopted a narrower redemption mechanism; a gold bullion standard. Economist and trader David Ricardo had recommended this system a century before as a way to reduce the resource costs of running a gold standard. Gold coins were withdrawn from circulation, and rather than offering to redeem notes and deposits in coin, the monetary authorities would only offer bulky gold bars. This excluded most of the population from redemption since only a tiny minority would ever be wealthy enough to own a bar's worth of notes.

It might seem that this narrowing of the redemption mechanism compromised the gold standard. After all, if too many dollars were created by a central bank, and these fell into the hands of those too poor to redeem for bullion bars, than the excess might remain outstanding rather than refluxing back to the issuer.

But consider what happens if a free secondary market in gold is allowed to operate. Unable to send excess notes to the central bank, less wealthy gold owners can sell them in the free market. This would drive notes to a discount relative to their official price, at which point large dealers will buy them and bring them back to the central bank for redemption in bars, earning arbitrage profits. The free market price is thus kept in line with the central bank's redemption price. So as long as the wealthy and not-so wealthy are joined by a market in which they can exchange together, then a narrower redemption mechanism needn't impinge on the proper functioning of a gold standard.

Anyone who has toyed around with ETFs will know what I'm talking about. Despite the fact that a gold ETF limits direct redemption to a tiny population of investors (so called authorized participants), the price of the ETF will stay locked in line with the market price of gold. Authorized participants earn profits by arbitraging differences between the ETF and the underlying, thus maintaining the peg on behalf of all ETF owners. You don't need many of them; just a few well-heeled ones.

When authorized participants don't do their job

The U.S. narrowed the gold redemption mechanism even further when, in 1934, Roosevelt limited redemption to foreign governments. As long as foreign governments and the public were joined by a market, then excess notes could be sold to these governments and returned to the U.S. for gold at the official price. The free market price and the U.S.'s official price would converge and a gold standard would still be in effect.

Things didn't work that way. After it entered WWII, the U.S. continued to buy and sell gold to governments at $35, but gold traded far above that level in so-called free gold or premium markets in Zurich (see chart below), Paris, Beirut, Macau, Tangiers, Hong Kong, and elsewhere. The existence of premium markets continued through the 1940s and well into the 1950s.

While private dealers have incentives to engage in arbitrage, national governments are driven by political motives. Governments no doubt could have earned large profits by buying gold from the U.S. at $35, shipping it home, and selling it in their domestic free gold markets at $45 or $50, but they chose not to, most likely to avoid raising the ire of American officials.

The monetary system in the 1940s and 1950s was a malfunctioning ETF. For various reason the authorized participants (ie. foreign governments) were not arbitraging differences between the price of the ETF and the underlying, and the ETF was therefore wandering from its appropriate price.

With the redemption mechanism compromised, the supply of U.S. monetary liabilities in circulation could exceed the demand, the result being that the market price of dollars sagged to a discount to their official price. Bretton Woods, with its multiple prices for gold, was not a gold standard, at least not yet.

The London gold market

It was only in 1954 that the so-called "free gold" price in Zurich and elsewhere finally converged with the official price of $35. This happened more by accident than purposeful arbitrage conducted via the redemption mechanism. On the supply side, the Soviets were bringing large supplies of "red gold"  to sell on free markets while the South Africans were diverting more gold away from official buyers in order to earn wider margins. At the same time, the end of the Korean War was reducing safe haven demand.

Source: The Economist

Once parity between free gold prices and the U.S. official price was established, the London gold market reopened for business. London had always been the largest gold market in the world, far eclipsing Paris, Zurich, and the rest. Its re-opening had probably been delayed for face-saving reasons. Given that the Brits and the Americans effectively ran the world's monetary system, they could safely ignore premium markets in Zurich and Paris. But the existence of a British gold price in excess of the official price would have been embarrassing. Upon the market's reopening, British authorities limited the ability of locals to buy on the market (they could freely sell) but put no restrictions on the ability of foreigners to participate in the London gold market.

From the time it opened in 1954 to 1960 the London price was well-behaved, staying locked in line with the official price. In October 1960, however, speculators took over control of the London gold market and sent the price of gold to an intraday high of $40, well above its official price of $35. Rather than arbitraging the market by buying from the U.S. Treasury at $35 and selling in London at $40, foreign central banks stepped aside.

The London gold pool

The authorities' response to the 1960 gold crisis is what finally turned Bretton Woods into a real gold standard, at least in my opinion. While the U.S. had ignored premium markets in the 1940s and early 50s, they couldn't ignore a premium market in their own backyard. At the behest of the U.S., the London gold pool was formed. Under the management of the Bank of England, the pool assembled a gold war chest with contributions from the U.S., U.K., Germany, Holland, France, Italy, Belgium, and Switzerland. Whenever gold rose above $35.20, the pool sold gold on the London market in order to keep the price steady. When it fell to $34.80, it bought in order to support the price. The existence of the pool was never officially declared, but everyone knew it was in operation and had the task of setting the London gold price.

This effectively created a functioning gold standard. Before, the only mechanism connecting the public's excess dollars with the U.S.'s gold was the somewhat unpredictable predilection of foreign governments to buy that excess and exercise the right to return it for redemption. Now the public could deal directly with the U.S. government by selling on the London gold exchange to the U.S.-led London gold pool, which guaranteed a price of at least $35.20.

And as the chart below shows, the pool worked pretty well for the next few years, keeping the price of gold in a narrow range. However, the devaluation of the British pound in 1967 and the departure of the French from the gold pool shook confidence in the $35 peg. The system imploded in March 1968 when a steady jog into gold accelerated into an all out run. Rather than continue to bleed gold to speculators, the London gold pool disbanded and the price of gold in London shot up to over $40, well above the official price of $35.20.

But from 1961 to 1968, the world pretty much had a gold standard. Or, put differently, thanks to the opening of the London gold market and the arming of the London gold pool, the world's monetary system between 1961 and 1968 did pretty much everything that the  gold standard of the 1800s did. After 1968, the U.S. dollar slid back into its earlier Bretton Woods pattern of having more than one price in terms of gold; the $35 official price and the "free" London price. This was no gold standard. When Nixon famously dismantled the already-narrow redemption mechanism in 1971, most of the damage had already been done.

The law of reflux

One of the coining press rooms in the Tower of London, c.1809 [link]

[This is a guest post by Mike Sproul.]

The law of reflux thus assures the impossibility of inflation produced by overexpansion of bank credit. (Blaug, 1978, p. 202.).

It is the reflux that is the great regulating principle of the internal currency; and it was by the preservation of the reflux, throughout all the perils and temptations of the period of the restriction, that the monetary system of these kingdoms was saved from the utter wreck and degradation which overwhelmed every paper-issuing state on the Continent… (Fullarton, 1845, p. 68.)

If you want to understand the law of reflux (and you should), then think of silver spoons. The silversmith shown in figure 1 can stamp 1 oz. of silver into a spoon. If the world needs more spoons, then silversmiths will find it profitable to stamp silver into spoons. If the world has too many spoons, then people will find it profitable to melt silver spoons. Unwanted spoons will “reflux” back to bullion. In this way, the law of reflux assures that the world always has the right amount of silver spoons. We could hardly ask for a simpler illustration of the Invisible Hand at work. But it costs something to stamp silver and to melt it, so the price of spoons will range within a certain band. It might happen, for example, that silversmiths only find it profitable to produce spoons once their price rises above 1.03 oz., while people only find it profitable to melt spoons once their price falls below 0.98 oz. If the costs of minting and melting were zero, then a spoon would always be worth 1 oz.

This is a point worth emphasizing: The value of a spoon is equal to its silver content. An increase in the demand for spoons would not raise the price of spoons much above 1 oz, since new spoons would be produced as soon as the price rose above 1 oz. A drop in the demand for spoons would not push the price much below 1 oz, since spoons would be melted when the price fell below 1 oz. Likewise, if the quantity of spoons supplied became too large or too small, market forces would restore the quantity of spoons to the right level, while keeping the price at or near 1 oz.

In figure 2, the silversmith starts being called a mint, and instead of stamping silver into spoons, the mint stamps silver into 1 oz. coins. The law of reflux works the same for coins as for spoons, always assuring that the world has the right amount of coins, and that the value of each coin always stays at 1 oz., or at least within a narrow band around 1 oz.

The usual thought experiments of monetary theory don't work in this situation. For example, economists often imagine that if the money supply were to increase by 10%, then the value of money would fall by about 10%. But the law of reflux won't allow this to happen. Mints would only issue 10% more coins if the public wanted coins badly enough to part with an equal amount of their silver bullion. And even if mints went against their nature and issued more coins than the public wanted, those coins would be melted or stored, and the value of a coin would not deviate very far from its silver content of 1 oz.

In figure 3, the mint re-invents itself again, this time as a bank. Rather than stamping customers' silver into coins, the bank stores the silver in a vault, and issues a paper receipt called a bank note. (Checkable deposits would also work.) This system has several advantages over coins. (1) It saves the cost of minting and melting. (2) It avoids wear of the coins. (3) Bank notes are harder to counterfeit, easier to carry, and easier to recognize than coins.

The law of reflux still works the same for bank notes as it did for coins. If the economy is booming and people need more bank notes, then people will deposit silver into their banks and the banks will issue new bank notes. If the economy slows and people need fewer bank notes, then people will return their unwanted notes to the banks and withdraw their silver.

Once again the thought experiment of imagining a 10% increase in the quantity of bank notes is pointless. Banks would only issue 10% more notes if the public wanted those notes badly enough to bring in 10% more silver. And even if we imagine that the banks took the initiative, printing 10% more notes and using those notes to buy 10% more silver, every bank note is still backed by 1 oz. and redeemable into 1 oz of silver at the bank, so every bank note remains worth 1 oz.

In figure 4, the bank makes one more important change. Rather than requiring customers to bring in 1 oz of actual silver to get a bank note, the bank also accepts an equal or greater value of bonds, bills, real estate deeds, or anything else that can fit in the vault. This system has several advantages: (1) Handling bonds, etc. is easier and safer than handling silver. (2) The silver formerly deposited can be put to productive use. (3) The quantity of bank notes is no longer constrained by the amount of silver available. (4) The bank earns interest on its bonds, bills, etc.

The law of reflux still operates as before, except that when people want more notes, they can bring in either silver or bonds, and when people have excess notes, the notes can be returned to the bank for either silver or bonds. As before, it makes no sense to ask questions like “What if the bank issues 10% more bank notes?” And as before, so long as every bank note is backed by, and convertible into, 1 oz. worth of assets, every bank note will be worth 1 oz. Just as reflux assures that the value of a spoon is equal to its silver content, reflux also assures that the value of a bank note is equal to the value of the assets backing it.

The Channels of Reflux

Here is a list of some of the many channels through which bank notes might reflux to the issuing bank:
1. The silver channel: Unwanted notes are returned to the bank for 1 oz. of silver. Alternatively, the bank sells its silver for its own notes, which are retired.
2. The bond channel: The bank sells its bonds in exchange for its notes, which are retired.
3. The loan channel: The bank's borrowers repay loans with the bank's own notes.
4. The real estate channel: The bank sells its real estate holdings for its own notes.
5. The rental channel: The bank owns rental properties, and tenants pay their rent in the bank's notes.
6. The furniture channel: The bank sells its used furniture for its own notes.

As long as enough reflux channels are open, it does not matter if a few channels are closed. Customers would not care if the furniture channel was closed, as long as major channels, like the bond channel, stayed open. The bank could take a more drastic step and close the silver channel, or could delay silver payments by 20 years, and as long as enough other channels stayed open, the law of reflux could operate as always, except that notes might be redeemed for 1 oz. worth of bonds, rather than 1 oz. of actual silver. The bank could even un-peg its notes from silver. Rather than redeeming a refluxing dollar note for 1 oz. worth of bonds, it could redeem dollar notes for 1 dollar's worth of bonds. As long as the bank's assets are worth so many oz., it doesn't matter if those assets are denominated in oz. or in dollars.

Once metallic convertibility is suspended, it would be an understandable mistake if people forgot all about the other channels of reflux, and started to think that bank notes were no longer backed by, or convertible into, anything at all. Unfortunately, this mistake has made it into the textbooks:

You cannot convert a Federal Reserve Note into gold, silver, or anything else. The truth is that a Federal Reserve Note has no inherent value other than its value as money, as a medium of exchange. (Tresch, 1994, p. 996.)

There you have it. The closing of just one channel of reflux (the metallic channel), has fooled economists into wrongly rejecting the idea that modern bank notes like the US paper dollar are backed and convertible. Once economists reject this simple and obvious explanation for why modern paper money has value, they are forced to resort to the more exotic explanations offered by textbook monetary theories, which are anything but simple and obvious.

References
Blaug, Mark, Economic Theory In Retrospect, 3/e. Cambridge: Cambridge University Press, 1978
Fullarton, John, Regulation of Currencies of the Bank of England (second edition), 1845. Reprinted by Augustus M. Kelley, New York: 1969.
Tresch, Richard, Principles of Economics, St. Paul, Minnesota: West, 1994

Rowe v Glasner... round 33!

It's the Roe v Wade of the blogosphere, a battle that never quite gets resolved. Nick Rowe and David Glasner have been having one of their bi-annual debates over the ability of private bankers to create excess deposits. See here, here, and here.

The nub of their conflict seems to resolve revolve around the following points: if we assume that 1) bank deposits and cash are imperfect substitutes for each other, and that 2) bankers simultaneously raise the rate on deposits and increase the quantity of deposits, then 3) an excess supply of deposits and cash will emerge. Nick argues for the last point while David argues against it.

At the risk of only adding noise to what is always an interesting debate, I'm going to chime in. I'm going to focus on the step-by-step process by which events play themselves out, the bricks & mortar if you will. Given the complexity of this process there will no doubt be errors in this post, hopefully readers will flag them.

The thought experiment that Nick and David have been debating involves a simultaneous increase in deposit rates and the quantity of deposits via loans. But I'm going to focus on just an increase in deposit rates first, then bring in the quantity adjustment later.

Let's start out with a full spectrum of assets, including central bank liabilities (cash and reserves), bank deposits, durable assets (i.e. gold, houses, stocks, and bonds) and perishable assets (apples, soap, jeans). All provide varying expected pecuniary returns (i.e. dividends, interest, and capital appreciation) as well as expected non-pecuniary returns (consumption and liquidity), the sum of which adds up to an asset's total return. In equilibrium, every asset offers the same total expected return.

What do we mean when we say that cash and deposits are imperfect substitutes for each other? Like cash, deposits are useful in a wide range of transactions. However, unlike 0% banknotes, deposits yield interest. Given that deposits provide both interest income and broad marketability, people will prefer to only hold the bare minimum of cash that they deem necessary.

What dictates this bare minimum? The marginal unit of cash that an individual holds in their wallet has been specifically accumulated to deal with a unique set of transactions in which deposits simply cannot participate. This unique set of transactions occurs in markets where digital payments are not allowed, say laundromats, farmers' markets, or cash-only diners; or where fees are levied on card payments, like gas stations; or in places where payments must be anonymous, like in the back alley behind city hall.

On the margin, people try to anticipate the chances of engaging in these sorts of cash-only transactions and accumulate what they deem to be an appropriately sized cash inventory. So while an individual's inventory of 0% cash does not provide a pecuniary return, it does provide a non-pecuniary liquidity return arising from its ability to be used in both a broad set of transactions in which it competes with deposits, and a narrower set of transactions in which only it is useful.

Now say that banks have figured out a way to cut costs. Their profits grow, but this only lasts a short time as competition forces them to increase the interest rate they offer on deposits. Given stationary pecuniary yields and non-pecuniary yields on cash, durables, and perishable assets, deposits now offer the best return. An excess demand for superior-yielding deposits and an excess supply of inferior-yielding durable assets, perishable assets, and cash emerges.

A number of adjustments need to occur in order to restore equilibrium. Along the margin of deposits-to- durables and perishables, an effort to simultaneously sell these assets for deposits will result in a fall in the their relative price. Their prices will fall until they stabilize at a low enough level that they are now expected to appreciate at a rate sufficient to equal the return provided by deposits. This resolves the excess demand for deposits along both the deposit-to-durable asset margin and the deposit-to-perishable asset margin.

Things are a little trickier along the deposit-to-cash margin. Given the superior return on deposits, people will now want to hold more deposits. An excess supply of cash develops. Unlike the durable and perishable asset markets, the cash-to-deposit market is inflexible; the price of cash cannot fall relative to deposits in order to restore equilibrium.

What happens instead is a quantity adjustment; people begin to sell cash for deposits at a fixed rate of one-to-one. The market where they go to do this is at a bank. They don't "sell" cash. Rather, they deposit cash at the bank in return for higher-yielding deposits. They continue to deposit cash until the benefits of adding one more unit of deposits to their portfolio, namely the marginal enjoyment provided by their higher pecuniary return, no longer exceeds the foregone benefit of one less unit of cash, namely their ability to participate in prospective cash-only transactions.

Once people have reduced their cash balances to a point at which they are once again indifferent between cash and deposits, equilibrium has once again been restored along the cash-to-deposit margin.

So in short, an increase in deposit rates causes a temporary excess demand for deposits in the deposit-to-cash market as well as the deposit-to-durable and perishable asset markets. These excesses are quickly removed by a fall in the prices of durable and perishable assets, and a quantity substitution of cash for deposits.

I'll bring this back to Rowe v Glasner in a moment, but as an aside it's worth noting that the process doesn't halt here. Having sold deposits for cash, the banks now have more cash than they desire. Their excess balances are trucked over to the central bank where they are converted into reserves, or clearing balances. But banks don't really want these either. Instead, they will all try to spend away their reserves simultaneously on durable assets, or try to lend them in vain to other banks in the interbank market. This pushes prices of durable and perishable assets higher and the interbank rate lower. At this point the central bank, noticing that its target for the interbank interest rate has deviated from its target, steps in and mops up all the excess reserves by conducting open market sales. This pushes the interbank rate back up to target. Voilà, the excess quantity of cash (and reserves) has been removed, first by depositors forcing cash back on banks, and then banks forcing the cash back on the central bank.

Let's circle back to Nick and David's argument. They were considering not just an increase in deposit rates, but a simultaneous increase in deposit rates and the issuance of new deposits. I'd argue that the same process that I've just described applies to this second scenario.

The rise in deposit rates causes durable and perishable asset prices to fall. At the same time, the new deposits are spent into the economy by borrowers. Individuals now hold more deposits than before, but they still own the same quantity of cash, an undesirable situation for them since cash is providing an inferior return relative to deposits. How can they rid themselves of this unwanted cash? If one person sells their horde, the next person will only try to sell it to someone else, and someone else. The cash never leaves the economy.

But here's an out. At some point an individual who is in debt to a bank will come into possession of that cash and will use it to reduce the amount owing. That cash will take the same route back to the central bank described earlier, ultimately meeting its demise in the blades of a paper shredder.

So given an increase in deposit rates and the emission of more deposits, the final resting point is a fall in durable and perishable asset prices, and an increase in the amount of deposits at the expense of the quantity of cash. That leaves us in the same spot as an increase in deposit rates alone.

Where does that place me relative to Nick and David? If it takes a while for unwanted cash to find a debtor who will reflux that cash back to the banks, then we can see the sort of effects that Nick describes. But on the whole, I think I'm more on David's side here. But that's hardly surprising. As Nick usually says, he's arguing against the mainstream view. The odds always were that I'd land in the same bucket as the majority. Anyways, for what it's worth, those were my two-cents.

Before I sign off, let's follow one final tangent. Thanks to higher deposit rates, one of the features of my final resting point is lower durable and perishable asset prices. But after a few months, our central bank will notice that the incoming data is showing that the price of perishable assets has ticked down. The perishable asset category, which includes things like jeans, apples, and soap, is the category of assets the prices of which a modern central banker targets. In an effort to right deflation in the perishable goods market, our central banker will counter by reducing the return on reserves. (He/she can do so by conducting open market purchases and/or by reducing the interest rate corridor). Banks will react by simultaneously trying to offload their inferior-yielding reserves in favour of durable and perishable assets. Prices will rise back to the central bank's target.

So a fall in prices that was kicked off by commercial banks sweetening the return on deposits is ultimately reversed by a central bank reducing the return on central bank liabilities. Tit-for-tat. Here I definitely agree with Nick Rowe—central banks are alpha banks. Commercial banks can only have a passing influence on the price level if a central banker decides to have his or her way.

Do banks have a widow's cruse?

Elijah and the Widow of Zarephath

James Tobin wrote a paper back in 1963 called Commercial Banks as Creators of Money in which he pointed out that banks don't possess a widow's cruse. There has been a bit of a blog uproar over Tobin's paper (See Paul Krugman, Winterspeak, JKH, L. Randall Wray, Nick Rowe, Cullen Roche, Ramanan, Roger Sparks, and Steve Randy Waldman). My two bits will hone in on the widow's cruse aspect of the debate.

The phrase widow's cruse is defined as "an inexhaustible supply of something," which in turn is a reference to an obscure Bible story. Flip to I Kings 17:7–16 and there is a short passage in which the prophet Elijah asks a destitute widow to make him a loaf of bread. The Lord blesses the widow saying that the "jar of flour will not be used up and the jug of oil will not run dry until the day the Lord sends rain on the land."

What Tobin was referring to in his paper is that unlike the widow and her jug of oil, commercial banks aren't blessed with the ability to expand their liabilities indefinitely. When it comes to bank deposits, there is an "economic mechanism of extinction as well as creation, contraction as well as expansion."

Modern central bank's, on the other hand, do have such a cruse. Once central bank liabilities are created, there is no way for the economy to get rid of the excess. The hot potato analogy "truly applies", noted Tobin, because central bank money cannot be extinguished.

We know that the actions of any institution in possession of a widow's cruse will have major macroeconomic effects. With its cruse, a central bank can create excess media of exchange which, as it is passes from hand to hand, pushes up nominal income. An increase in quantities and/or prices is the only release valve for unwanted exchange media. A commercial bank, which has no cruse, might create an excess of deposits but this will not have any lasting influence on nominal income. After all, if the public doesn't desire new deposits, this excess will either quickly reflux back to the issuer, or it will displace competing deposits created by another bank and these deposits will reflux. To keep its deposits suspended in the economy will require a commitment of resources (say a superior interest rate). But resources are finite, unlike the widow's cruse.

Central banks didn't always have cruse. As David Glasner reminds us, when a central bank's liabilities, say those of the Bank of England, were convertible into gold, the Bank couldn't issue in excess of the public's desire for central bank notes. Unwanted notes would quickly return back to the Bank, inhibiting the Bank from having any macroeconomically important effects. The Bank of England, much like a modern commercial bank, could affect neither prices nor quantities via excess note issuance.

So what are the sufficient conditions for having a cruse? Consider that there are all sorts of financial instruments that can be expanded indefinitely. A company can continue issuing corporate stock, for instance, as long as it wants. To crib from Tobin, any expansion of corporate assets will generate a corresponding expansion of corporate liabilities, or in this case, equity. The mechanism for the creation of stock does not have an equivalent mechanism for the extinction and contraction of said stock. Without an instant-convertibility clause, stock is a perpetual instrument, much like modern central bank money. [For more along this line, see Money: is it immortal or does it die young?].

Despite its perpetual nature, I don't think that a stock-issuing company is blessed with a widow's cruse. An exogenous increase in the quantity of an individual company's stock will only affect relative asset prices; it won't change an economy's nominal income. To paraphrase Tobin, the burden of adaptation to an increase in the quantity of a corporate stock is not placed on the entire economy. This is because prices in an economy are not denominated in units of a given corporate stock, but in dollars, pounds, or whatever. Central bank money, on the other hand, is the economy's unit of account. The entire economy is burdened by the necessity of adapting to an increase in its supply.

So what does it take to have a widow's cruse? Two things. The liabilities of the issuer must be perpetual and non-convertible upon demand. Secondly, shops and markets must use those liabilities as a unit of account. Only when these two conditions will a widow's cruse have emerged. Commercial banks pass the latter but fail the former. Stock-issuing non-financial corporations pass the former but fail the latter. Only modern central bank money is both.

Real or unreal: Sorting out the various real bills doctrines

In the comments section of my post on Adam Smith and the Ayr Bank, frequent commenter John S. brought up the real bills doctrine. The phrase real bills doctrine gets thrown around a lot on the internet. To muddy the waters, there are several versions of the doctrine. In this post I hope to dehomogenize the various versions in order to add some clarity.

1. Lloyd Mints's version

We may as well start with Lloyd Mints's version, since he coined the phrase real bills doctrine back in 1945 on his way to denouncing the doctrine. Mints taught at the University of Chicago and mentored Milton Friedman. [1] Here is Mints:

The real-bills doctrine runs to the effect that restriction of bank earning assets to real bills of exchange will automatically limit, in the most desirable manner, the quantity of bank liabilities; it will cause them to vary in quantity in accordance with the "needs of business"; and it will mean that the bank's assets will be of such a nature that they can be turned into cash on a short notice and thus place the bank in the position to meet unlooked-for calls for cash. - A History of Banking Theory

Mints's RBD states that so long as only real-bills (short term liquid debt instruments created by merchants to finance inventory) are discounted by the banking system, an excess amount of notes can never be issued. When businesses require cash, they'll simply discount bills at a bank, and when that cash is no longer required, they'll pay back their borrowing. Even in a world *without* note convertibility into specie (a "fiat standard")  the real bills stipulation alone is sufficient to keep the price level anchored.

Mints rightly declared that this version of the RBD was "completely wrong". After all, a central bank not constrained by convertibility might discount only real bills, yet by discounting at an unreal price, it would alter the purchasing power of the notes it issues and create either runaway inflation or deflation). The price level was indeterminate in Mints's RBD-world.

Mints singled out Adam Smith for being "the first thoroughgoing exponent of the real-bills doctrine". For the next forty years, Smith's reputation as a monetary theorist would be tarnished. [2]

2. Adam Smith's version

Though tarred and vilified, poor Adam Smith never actually conformed to the real bills doctrine as described by Mints. This has been pointed out by David Laidler in his 1981 paper Adam Smith as a Monetary Economist, one of the first efforts to rehabilitate Smith's reputation as a monetary theorist.

Smith lived in an era in which paper money was fully convertible into a fixed amount of gold. Mints's description of the RBD, on the other hand, applies to a fiat world. For Smith, the gold convertibility clause was sufficient to ensure that the economy needn't endure an excess amount of notes. After all, should banks as a whole issue more than was desired, the public would return the notes en masse for specie. This is the so-called reflux process.

That being said, Smith did mention real bills several times in the Wealth of Nations. He famously advises banks that they should only discount "real bills of exchange drawn by a real creditor upon a real debtor." (I go into some detail in my last post on the personal and historical reasons that may have motivated Smith to advocate this position).

Why limit discounts to real bills? When the banking system issues excess paper currency, gold convertibility ensures that this excess will soon reflux back to issuer. A bank that holds long term loans and bonds issued by speculators will be insufficiently prepared to meet the demands of reflux since liquidating such debts might take time. A bank that holds short term bills issued by credit-worthy merchants will be better equipped to meet redemption demands, and less likely to meet the same demise as that experienced by the Ayr Bank, a bank run that Smith personally witnessed.

Thus Smith's admonishment to only discount real bills wasn't a mechanism for anchoring the economy's price level—gold convertibility served this purpose. Smith's real bills stipulation was just good advice for individual banks: stay liquid and don't take on too much credit and term risk. This distinction has been aptly described by David Glasner in his paper the Real Bills Doctrine in the Light of the Law of Reflux, and for his part Laidler notes that "as advice to an individual bank, it's probably pretty sound, as a principle of
monetary policy under commodity convertibility it is relatively harmless..." [link]

3. The Bank Directors' version

Why did Mint's cast Adam Smith as his first thorough-going exponent of the RBD?

In 1797, some seven years after Smith had died, Britain went off the gold standard. (See this post for details). The pound soon began to trade at a discount to its pre-1797 gold value. In other words, the pound was capable of purchasing less gold. The Directors of the Bank of England found themselves accused of creating inflation, notably by the members of the 1810 Bullion Committee. One of the apologizers for the Directors, Charles Bosanquet, a pamphleteer, wrote a famous rebuttal in 1810 that insisted that by limiting discounts to "solid paper for real transactions," the Bank could not have contributed to a deprecation of the pound. According to Bosanquet, several factors outside of the Bank's control had caused the deprecation.

To help buttress his point, Bosanquet invoked the name of Adam Smith. Wrote Bosanquet: "The axiom, or rule of conduct, on which the Committee has been pleased to heap contempt and ridicule, respecting which they have declared that the doctrine is fallacious, and leads to dangerous results, was promulgated by, and is founded on, the authority of Dr. Adam Smith."

Bosanquet's appropriation of Smith's name was inappropriate since Smith implicitly assumed gold convertibility. But the damage had been done. From then on, economic historians like Mints would automatically associate Smith's name with the arguments of the Directors.

The Directors' RBD is very much a manifestation of Lloyd Mints's RBD, which we already know was a poor guide for monetary policy. Years later, Walter Bagehot would write that when the Directors were examined by the Bullion Committee in 1810, "they gave answers that have become almost classical by their nonsense". If anyone deserved to be castigated as the first thoroughgoing exponents of Mints's real bills doctrine, it was the Directors and not Smith.

4. Antal Fekete's version

If you've spent some time wading through the online monetary economics community, you'll have run into Antal Fekete's real bills doctrine. This is an attempt to apply a warmed over version of Adam Smith's RBD mixed in with some Austrian free market economics.

The use of bills of exchange began to diminish in the late 1800s and today they are a relatively unimportant financial instrument, having been replaced in bank portfolios by commercial paper, bonds, mortgages, and other types of debt. Fekete tries to draw a number of broad based conclusions from this trend. The crowding out of real bills by non-real bills (longer term finance bills and government issued treasury bills), for instance, is seen by Fekete as the reason for the Great Depression and the creation of the modern Welfare state:

When real bills were replaced by non-self-liquidating finance bills, payment of wages has become haphazard. Employment was made touch-and go, hiring, ‘hand-to-mouth’. This threatened with unemployment on a massive scale, unless governments were willing to assume responsibility for paying wages. [Link]

Conversely, rehabilitating the real-bills system would end chronic unemployment and reduce the size of government. I only have a passing knowledge of Fekete's thinking — it really doesn't do much for me —so hopefully someone in the comments section can pick up the slack.

5. Mike Sproul's version

Of the modern reincarnations of the RBD, I'm far more familiar with Mike Sproul's version.

Mike's version is an application of modern finance to monetary economics. The price of a financial asset is determined by the discounted value of the expected flows of cash thrown off by underlying capital. Alcoa's stock price, for instance, will equal the sum of discounted earnings that Alcoa's machinery and employees are expected to generate. Transferring this idea to the monetary landscape, Mike says that value of modern central bank liabilities should be determined by the earnings power of the assets held by that central bank.

Like the other versions of the RBD, Mike's version shares a preoccupation with the asset side of a bank's balance sheet. But that ends their similarity. For instance, Mike doesn't have a fetish for actual real bills. I doubt he'd agree with the Directors that so long as they only discounted short-term mercantile bills of exchange, they'd never cause a decline in the value of the pound.

That's why I prefer to call Mike's RBD the backing theory. It's a very different beast from the RBDs of Mints, Smith, Fekete, and the Bank Directors, and to share the same name only adds to the confusion.

So there you have it. If you're going to have an argument over the RBD, make sure you know which one you're arguing about!

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1. Fischer Black received this letter from Milton Friedman on August 6, 1971: "With respect to your so-called passive monetary policy, here you are simply falling into a fallacy that has persisted for hundreds of years. I recommend to you Lloyd Mints' book on The History of Banking Theories for an analysis of the real bills doctrine which is the ancient form of the fallacy you express. Do let me urge you to reconsider your analysis and not let yourself get misled by a slick argument, even if it is your own. " Ouch. Play nicely, Milt. I get this via Perry Mehrling's book on Fischer Black.
2. Here's a video of Lloyd Mints in 1988 upon his 100th birthday.

Money: is it immortal or does it die young?

Dreaming of Immortality in a Thatched Cottage - 1500s

Exogenous/endogenous money, reflux, hot potato money, helicopter money, inelastic vs elastic currency. These are all part of the colourful lexicon developed by monetary economists over the centuries to outline a general set of problems: how does money get emitted from source, and when, if at all, does it return to source?

We usually describe money as exogenous, hot potato, helicopter, or inelastic if it is emitted at the initiative of the issuer, and the issuer doesn't allow the public to exercise any initiative in returning this money back to source. Once it has been air-dropped into circulation from a helicopter, this kind of money becomes immortal, passing like a hot potato from person to person forever.

We describe money as elastic or endogenous when the money-using public exercises its own initiative in both drawing money out from an issuing source and pushing (refluxing) this money back to the source. This sort of money never strays far from its issuer, snapping back like a rubber band to be destroyed when it is no longer wanted. Rather than being a hot-potato zombie, elastic money lives fast and dies young.

There's a big debate among monetary economics about whether money is exogenous/hot potato/helicopter/elastic inelastic or if it is endogenous/elastic/refluxible. This debate goes all the way back to the banking-currency school battle of the early 1800s. Currency school advocates wanted to limit the note issuing power of private banks in order to prevent the overissue of notes, whereas members of the banking school believed such regulation unnecessary since in a competitive banking system, unwanted notes would simply reflux back to the issuer. The currency school won that debate, but the war continues.

I find it helpful to skirt around the skirmish and re-orientate the debate around finance, not monetary economics. This means that we've got to translate the language of monetary economists—hot potatoes, exogenous/endogenous, reflux, and the like—into the lexicon of financial instruments.

Let's head over to the stock market first. I'm going to hypothesize that the common stock is a thoroughly exogenous financial instrument. A firm decides when to issue new stock and at what price. Once stock has been issued, there's no way for an investor to automatically return the stock to the issuer. Stock wanders zombie-like through the financial world until the issuing firm is wound up, if ever. General Electric's original 1000 shares, for instance, have been hot-potatoing through financial markets since June 23, 1892.

Also found on stock markets are exchange-traded funds, or ETFs. Unlike stocks, though, I would say that ETFs are thoroughly endogenous financial instruments. Take the SPDR Gold Trust ETF. When investor demand for the Gold Trust heats up, ETF units will trade at a premium to their implied gold value. Large authorized-participants buy units from the ETF originator at par, paying with gold, and then sell these blocks to the public until the premium has disappeared. Vice versa when GLD units are at a discount to their real gold value. Now the authorized-participants buy units from the public at a depressed price and sell them to the ETF originator at par for gold. The result is that the quantity of outstanding units fluctuates quite widely, as the chart shows, but the price, specifically the premium/discount, stays constant. The public, through the intermediation of authorized-participants, sucks out whatever quantity of ETF units from the issuer that it desires, and then refluxes unwanted units back to it.

Unlike ETFs, bonds are exogenous financial instruments. Firms issue bonds when they need funding and these instruments stay outstanding until redemption date or firm instigated early-retirement. Until then, bonds pass hot potato-like from hand to hand in the secondary market.

Not all bonds are like this though. A retractible bond, or retractible debenture, is a different beast. Investors can choose to exercise the retractibility feature of this species of bond and force its issuer to buy it back. If we break down a retractable bond into its parts we see that it is a bond with an embedded put option. The put allows investors take the initiative and "reflux" the bond back to the issuer.

Retractability, or puttability, is a feature that gets often gets added to preferred shares and sometimes even common stock. The interesting thing about retractibility and puttability is that it turns what was once an exogenous hot potato asset into a semi-endogenous instrument. While investors can not "pull" retractible bonds or puttable stock out of an issuer, they can easily push, or "put", already-issued retractibles back to the issuer when those instruments are no longer desired.

How can we turn our semi-endogenous retractible bond or puttable share into a fully endogenous instrument? Let's consider another financial instrument, the gift card. Indigo, a bookstore up here in Canada, allows consumers to buy any quantity of gift certificates at the till. These gift certificates are puttable—their owner can immediately return the card for redemption. That the public can take the initiative in both buying unlimited amounts of gift cards and returning those coupons whenever they want qualifies them as fully endogenous. Not only is the "discount window"* for endogenous instruments like puttable gift certificates and ETF units always open, there is also a well-defined rule for pricing the emission of new units. Retractible bonds, which already have the put feature, would qualify as fully endogenous if their issuer were to set up a "window" with a set of rules so that investors could draw out new bonds on their own accord.**

Because endogenous and exogenous instruments are structured differently, they act in peculiar ways when market conditions change. When the demand for an exogenous instrument like GE stock increases, its price will quickly rise to meet that demand while its quantity stays fixed. When demand falls, the only way for investors to rid themselves of GE is to bid its price down until it reaches a real value at which the market willingly holds it. Things work differently with endogenous instruments. When the demand for an endogenous instrument like a coupon or gift certificate increases, its quantity quickly rises whereas its price stays fixed. When demand falls, investors can exercise their put option and send them back to their issuer. In sum, prices do all the work in exogenous adjustment whereas quantities do all the work with endogenous adjustment. Exogenous issuers can choose the quantity of their issue, but not the price, whereas endogenous issuers can choose the price but not the quantity.

So back to the great debate. Is money endogenous or exogenous? If money is defined as a certain narrow set of financial instruments (cash + deposits, M1, M2, whatever) then we need to appraise each instrument's structure to see whether its issuer provides an associated discount window and embeds a put option—or not. A quick glance through the instruments found on the narrowest lists of money (say M1) shows that almost all of these instruments have embedded put options and discount windows, so narrow money is primarily endogenous.

This is different from a few centuries ago when gold and silver constituted a significant share of the narrow money supply. Since the only way to get rid of an ounce of metal is to pass it on, gold, like stock, is exogenous and immortal, with the very same gold coin once used 5000 years ago still circulating today, though perhaps in bar form. Modern monetary economists are beginning to add exogenous assets like t-bills, bonds, and other AAA-rated debt securities to the list of money since these assets can be easily collateralized. In doing so, economists are slowly returning to a world in which a larger percentage of the assets on the list of money are exogenous.***

And finally, there's the moneyness, or liquidity, view. From this perspective, there is no limited list of money-items. Rather, all assets provide varying degrees of money-services. Put differently, moneyness is a vector which spans all assets. Because it inheres to a degree in all assets, moneyness is both endogenous and exogenous. After all, the universe of assets is comprised of both types of assets. A change in the demand for liquidity/moneyness results in a complex shift in prices and quantities. Liquid endogenous instruments are drawn out of issuers and less-liquid endogenous instruments refluxed back to issuers. Liquid exogenous instruments rise in price while less liquid exogenous instruments fall in price.
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*In modern days, the discount window refers to a central bank's ability to lend. In the old days, banks had actual "windows" behind which stood a bank officer who would accept securities in return for bank deposits or cash. A "discount" to its market value was applied to the securities, a sort of haircut that also provided the banks with income. See this image from the Philly Fed.

**A bank deposit is the quintessential endogenous instrument. There are multiple windows for buying a deposit -- one can either sell cash to get deposits, or sell personal IOU to get them, with each window offering different rules and rates. When deposits are no longer needed, one can "put" them back at any point by requesting cash or a return of one's personal IOU.

***With the emergence of Bitcoin, Ripple XRPs, and the other alt-currencies, we're seeing the return of exogenous monies with a vengeance.

Note: For more on reflux, I'd definitely recommend Mike Sproul's The Law of Reflux. For more on exogenous money, Nick Rowe is who you should be reading.

Hot or not?

The Rowe/Glasner/Sproul debate continues over hot potato-ish-ness of money. Here is Nick Rowe:

The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs. But why would they want to do that? If I have opals I want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money I want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999?

Mike Sproul jumps in, but David doesn't, so instead I left a comment trying to anticipate what David would say:

Decoding Glasner on reflux, inside and outside money, and reflux

I had a few comments on a recent David Glasner post. Basically, I was trying to understand the way he reconciles various aspects of the monetary system, namely, inside and outside money, the arbitrage mechanism that links these two assets, and the price level.

David responded to me-

Inside money cannot trade at a discount relative to outside money because inside money is issued on the condition of its being convertible into outside money, so they always are exchangeable at par. If too much inside money is created (i.e., more than the public desires to hold given the relative attractiveness of holding inside money relative to alternatives including outside money) it refluxes back to the issuing banks. 

David says that excess inside money (say convertible bank notes) will reflux back to an issuing bank. But the only way this can happen, as far as I can see, is if somehow that bank's inside money trades at a slight discount to outside money (gold). David in his first sentence above says that inside money cannot trade at a discount. But how else can a reflux process emerge if one can't fall to a discount with the other?

So a temporary price discrepancy is necessary to enforce reflux and keep the quantity of outside money equal to demand. But what happens if inside money - say convertible bank notes - and outside money - fiat notes - are considered perfect substitutes by their users? After all, they can both be used to pay taxes, buy stuff, and "store value" over time.

David, for instance, points out that-

Because inside money and outside money are fairly close substitutes, the value of outside money is determined simultaneously in the markets for inside and outside money, just as the value of butter is determined simultaneously in the markets for butter and margarine. 

The problem here is... if inside and outside money are perfect substitutes, then given an excess issuance of convertible bank notes by a bank, why would the price discrepancy between inside and outside money that is necessary to drive reflux ever arise to begin with?

Rather, in an effort on the part of individuals and firms to rid themselves of their extra balances (either inside or outside money, they are indifferent) they will spend away both willy nilly. In spending away outside money, they will cause the price level to increase (the value of outside money to fall). David points this out:

If, however, the quantity of inside money increases because the public wants to hold the additional balances and are induced to hold inside money instead of outside money, then the value of outside money will tend to fall (causing the value of inside money to fall as well) unless the value of outside money is maintained by some form of convertibility or a price rule.

But doesn't this mean that issuing banks might cause infinite inflation by issuing inside money no one wants, thereby confirming Milton Friedman's wariness of free banking?

It would if currency users did in fact treat inside and outside money as equal.

But we live in a competitive banking system in which multiple banks issue inside money and receive other bank's inside money via cheque deposits and money transfers. Furthermore, currency users do not have uniform views about the quality of various money-like assets. Unlike individuals, competitive banks are picky and prefer to hold outside money rather than another bank's inside money. Put differently, banks are very sensitive to the store-of-value nature of inside money... they tend to view it as a financial asset characterized by risk and return, and not as a medium of exchange, and therefore view inside money as inferior to outside money due to its riskiness. Furthermore, holding another bank's inside money because they value its liquidity would be silly, since the bank already has its own liquidity factory. Thus the moment they receive another bank's inside money, a bank returns it to that issuer as fast as they can, settling with outside money. A reflux mechanism is thereby enforced by interbank settlement.

In sum, excess issuance of inside money by banks will not cause the price level to rise - it will cause the inside money to return to issuer.