Doesn't it follow that all the interest over and above what banks and governments pay can never be repaid in aggregate, because it nets out to 0?

Actually the interest in the private sector comes mainly from income generated in the private sector. When I grow a tomato and sell it the income goes to pay off my mortgage (the capital part). The rest of the income goes to me as the compensation for labor part. As long as I can still grow tomatoes I should be able to make those payment every year.

Essentially I am borrowing from future income in order to get current capital. The capital invested in my land allows me to make greater income than if I did not have the additional land. Obviously the above example is about the business use of capital, but the same principal even applies to consumption type loans such as credit cards. As long as there is a sufficient source of income from somewhere to service the debt then it can be repaid.

George Parkanyi elaborates:

I understand how an individual, business, or bank deals in interest in their own micro context. My question is more macro/mathematical. Where does this surplus interest come from in the total pool of "money" that is created by governments and banks? You can't create money out of thin air (or can you?), so that interest over and above government and bank interest paid must be 0 net. What am I missing? (In fact bank interest paid is on deposits that already comes from somewhere, so that money has already been created.)Implication: the global banking system is a de-facto Ponzi scheme in the mathematical sense.

Phil McDonnell replies:

You can't create money out of thin air (or can you?), so that interest over and above government and bank interest paid must be 0 net.

Think of my simple tomato example. It is created out of nothing and has a value. It is mostly hydrocarbons. Where does the carbon come from? It comes from CO2 that Obama calls poisonous but is fresh air that the plants breathe. The hydrogen falls from the sky as rain (H2O). So it is not too much of a stretch to say that tomatoes come out of thin air.

The other thing that you may be missing is that income can increase simply by the artifice of having more transactions - the velocity of money. The quantity of money may be constant at any given point in time but the velocity can rise or fall. If I grow the tomato and sell it that is a transaction (increased velocity) and income to me. If I do not grow the tomato there is no transaction (reduced velocity) and no income to me. The macro formula is:

GDP = V * M

where: V is velocity M is Money supply

The point is that when business is booming the velocity often rises simply because more transactions occur.

Another point that you may be missing is that when a bank loans money, new money is usually created. It does not come from the deposits nor the Fed or the Treasury. The banks create it (out of thin air). They typically keep reserves of about 10%. The banks stopped lending in late 2008. It is terrifying what has happened to the velocity since then.

See this graph and this one. 

George Parkanyi responds:

I understand money to be a proxy for productivity, which roughly equates to the velocity. Like a shark needs to keep swimming constantly to stay alive so must money move. But when a bank creates/lends 1000 dollars, and insists on 1050 coming back, the 50 physically has to come from somewhere. No-one created 1050; they created 1000 (of the currency, not the productivity, to be clear). That 50 has to come from someone else's 1000, which means someone somewhere not only has to default on interest (that doesn't really exist), but on $50 worth of principle in order for the bank to gain 50 in interest.

Ultimately money is continuously being fed out there - but if all the principal in theory were to be repaid, no interest could be, because it was never created. (You'll have to take it in tomatoes).

I agree with you Phil that real productivity is the grown tomato, which can be traded for dental work let's say, but I can see how easy it can be for money - a paper proxy, or scoring system, for productivity - actually to de-couple from the value of the tomato (or root canal). Too much money and you have a $1000 tomato, too little and you'd better start getting used to eating a lot of tomatoes.

Interestingly however, gold would have the same problem, mathematically speaking. It doesn't have any instrinsic value. It's a rock, basically. Given the choice between a handful of gold and a tomato in a starving situation, I'm pretty sure I'd take the tomato. (Though I might use the gold to try to bludgeon a rabbit with - but that would be a long-shot at best.) The ONLY advantage (and perhaps disadvantage) gold has is that you can't just create more out of thin air.

Charles Pennington steps in:

I don't think George is asking how wealth is created–he's asking about the actual number of dollars out there, and trying to understand whether or not some kind of conservation law is broken.

Here's an illustration with an economy that only has these entities:

1) the Fed, 2) a Bank, 3) the Farmer, and 4) the Cowman. To keep it simple, nobody ever, ever holds any cash dollars in their wallets–all money is just a credit to your account in the Bank.

At the start, the bank has $100 in reserves at the fed, and those $100 are all that exist anywhere.

Then the Farmer borrows $500 from the bank, agreeing to pay the bank $600 after 1 year–20% interest. The $500 was created by the bank out of thin air. The Farmer pays the Cowman $500 for some of the Cowman's land and equipment, and then the Farmer starts to grow tomatoes. The Cowman now has $500 on deposit at the bank. The bank is now owed $500 from the Farmer, and it owes $500 to the Cowman.

After one year, the Cowman agrees to buy the Farmer's tomatoes for $650, in order to feed his cows. The Cowman only has $500 on deposit, so he borrows $150 from the bank. Then he pays the Farmer $650. The Farmer pays off his $600 loan from the Bank and deposits an additional $50.

Now the Farmer has no debt and $50 deposited in the bank.

The Cowman now has some tomatoes and a debt of $150 owed to the bank.

The Farmer's deposit minus the Cowman's debt equal minus $100, which is, not coincidentally, the amount of interest paid to the bank. So the interest ended up in the form of a debt to the bank.

The reason that this all sounds so crazy is that the bank just created the $500 out of nothing. That is the privilege of being a bank under the central banking system. A sometime List member points out that banks are the ultimate "GSE" (government sponsored enterprise). Fannie Mae and Freddie Mac are recognized as GSEs, but banks are usually not thought of in that way. They should be.

Rudolf Hauser interrupts:

You are the one making things complex by creating a situation totally divorced from reality. Unless this bank had the power to use force to cause people to accepts its accounts as payment, it would not be able to function. In real life banks started because they kept prudent reserve ratios when accepting gold for deposit. As trust was established, with time they figured out how to lend some of it out safely. This bank you describe would have no trust. But you made the situation more complex by assuming a central bank in addition at the same time you treat a private bank as the central bank. This is like saying the bank has an already accepted currency of $100, that might say be backed by gold at the central bank. That, not the deposits at the bank would be the accepted medium of exchange and is accepted by the public. Why would anyone accept the farmer's check payments if they could not be cashed for an accepted form of money, i.e. those reserve balances, which could well be backed by gold? 

Yishen Kuik submits:

I think of saved money as proportionate voting control over the deployment of available future man hours (either hiring someone to do something or buying something which then sends signals to get people to make more of it in the future).

So all notions of real wealth are inextricably linked to the productivity & quantity of future man hours.

George Parkanyi clarifies:

Charles is the one that has best understood my original question– articulating it as "has some law of conservation been broken?" Exactly.

I define money to be that which you credit or debit on an income statement or balance sheet denominated in a currency.

Because all money created through lending originates as principal, interest must paid from other sources. That means money would have to be created other than by debt issuance, by different mechanisms. Presumably this could happen if the authority allowed to issue money (a government or a bank) either granted money without an obligation to repay, or paid in kind for goods and services. Presumably the government collects taxes to do part of that, which would not create new money. Therefore I see only the following ways a surplus over and above the original face value of total debt issued can happen:

1 - The government/bank pays interest or in kind for goods and services consumed by government/bank by issuing new money

2 - The government or banks forgive debt (the obligation to repay)

3 - The borrower defaults; the money remains "out there" now unencumbered by the obligation to repay. (Essentially bankruptcy is a source of unencumbered money - ironic)

Either way, it seems to involve the voluntary or forced forgiving of principal. So an interesting (at least to me) question becomes - what's the mix? And how does it relate to the health of an economy?

Rudolf Hauser argues:


No law of conservation has been broken. Debt and interest thereon are real transactions. They are a measure of claims on the goods and services produced by human labor. Borrowings are consumed and invested in physical capital and hire of labor and sold. The proceeds of the sale and other income in the case of consumers are where repayment and interest come from. Money is only a transfer form. The goods are sold for money and that money than pays the debt. It only need held for short periods of time. That is you get the money, deposit in your bank and then when it clears you can write a check to pay your debt and interest. With currency you do not even have to wait at all other than to physically go from place of your sale to the place you repay the debt. The same quantity of money can be turned over an infinite number of times. The rate of turnover can change. Hence, all of your assumptions regarding laws of conservation are therefore wrong. 

Sushil Kedia writes:

I strongly refute the contention that banks create money out of thin air. They are only borrowing and lending money.

Money being a store of value can either be created by a guarantee from the State that a piece of paper shall fulfill the promise of returning value on being presented or when through value addition (real and perceived) hard assets or utility producing assets accumulate in an economy that can be considered storage of value and thus a creation of money.

A bank issuing a debt security which can be used by another bank as a collateral for gaining access to the Central Bank created money is in itself not an increase in the "stock" of money.

In that same way if one corporation issued equity shares to another corporation in lieu of the equity shares of the other corporation and both went on to sell these new shares in the market or pawned them or proffered them as collateral they have not raised the "value" of their corporations and hence they have not created a store of value but only smaller containers (number of shares going up and thus book value per share going down) storing the same total amount of value.

That partly explains the rational why its printed on the US Dollar, "In God we trust, rest strictly cash" that eventually the paper money/ fiat money regime is based on an implicit trust that the mints/gummints are backed by God still whether or not they represent the choice of a democracy or elsewhere in the world implants atop anarchies.

However when the velocity of exchange rises, either as explained in the money multiplier formula for GDP or in the trading pits of various securities, the stock of "near moneyness" rises. A year or two ago the lists had discussed where all the money has gone. I argued at that point too that what has gone was never money, but a state of "near moneyness".

So to return to the point, banks are not creating money out of nowhere. Money of cause is getting created since the collapse of Bretton Woods out of nowhere even if it is supposed to be backed by value and wealth. If anyone is creating money out of nowhere it is the Mint. The rest of the humbler souls, including those of the banks are only left holding a Trust in God.

On another yet related note I would say if you got people queue up across Manhattan and kept on passing currency notes down that queue with automated note passing-and-catching machines to reach the highest possible velocity with which money could change hands, it would do nothing to the economy (perhaps that disguised unemployment alone would go up). The real essence of velocity of money being real exchange of real goods and real services it stands to reason that money too needs to be real. For now, we are living with a belief and trust that the currency note in our wallets has real assets backing it and that's the only reason for which it is real. No one else, other than the mint has got this privilege.

Jeff Watson writes in:

The Mises Institute would respectfully disagree with you. Their discussion on fractional reserves says it all. http://mises.org/rothbard/moneyback.asp Of course, the followers of Keynes would probably disagree with this assessment

Many others, including the Fed, congress, Milton Friedman, and other central banks share the opinion of money being created out of thin air via fractional reserves.

"Banks do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts."
- 1960s Chicago Federal Reserve Bank booklet entitled "Modern Money Mechanics

"The process by which banks create money is so simple that the mind is repelled."
- Economist John Kenneth Galbraith "When a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone elses deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower."
- Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

"Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don't necessarily take it from anyone else to lend. Thus they 'create' it."
-Congressman Wright Patman, (House Committee on Banking and Currency, 1964)

"The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented."- Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s."Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money."- Graham Towers, Governor of the Bank of Canada from 1935 to 1955Maybe these folks are wrong?

Stefan Jovanovich disagrees:

I hate to disagree with Jeff, but the answer is that these folks are wrong. Rothbard never understood what was at the heart of the problem about inflation/money debasement: (1) how do you reconcile the Constitutional requirement that Congress have a monopoly authority to create legal tender with the inescapably desire of human beings to deal in credits with one another? (2) how do you prevent Congress from debasing the Federal Money through extensions of the Federal Debt? Rothbard and the Paulistas think that banks, by their very nature, are somehow the source of the evils of inflation/profligate credit creation. Being, at heart, prohibitionists they have always thought that they could destroy sinfulness by outlawing bank credit itself. Hayek, who was - Gold bless him - anything but a Puritan, knew this was the worst kind of folly (BTW, this explains why Rothbard and most Miesians would like to kick Hayek out of the Austrian club). As Hayek gently pointed out, there is no logical difference between the Misean argument against fractional reserve banking and an argument against trade bills, options, futures, swaps and all the other forms of credit. If the Bank of 100% Reserves cannot create credits against its Money Reserves, then how can Fred's Pizza Parlor be allowed to promise to pay in 30 days for its latest delivery of flour and yeast? Hayek had a logical solution to the problem of monetary debasement/inflation - competing private monies. The problem is that Hayek never explained how the government would determine whose private monies will be accepted as legal tender under our Federal Constitution. (If you think the current favoritism of banks too big to fail is an abuse of government, wait until you have a system where the government can decide whose private money is "good" and whose is "bad".) I think Hayek had problems with the question of legal tender. He knew a great deal about American and British law but tax questions never interested him; and the American notion of fundamentally limited government always escaped him (he was, to the end of his life, a supporter of conscription). Milton Friedman was right about "money being created out of thin air" via fractional reserves, but he failed to understand that it was the government's ability to use its own Credit as reserves for the central bank and its members that was the problem. If the government, with its monopoly legal tender authority, was not disciplined by the requirement that it pay up, on demand, in gold, then Congress would write checks; and the Federal Reserve would cash them. We have had a solution to these problems. It was the one President Grant proposed and pushed through Congress (against the "better judgment" (sic) of both the Republican and Democrat leadership). Grant knew that, if the United States of America restored the Constitutional promise that the Federal government 's Debts will be paid in Money of a specified Weight and Measure - i.e. specie, it would be possible to have a system of competing near-monies through private banking while still preserving the Federal government's legal tender monopoly. Grant forced through the Congress not only the promise that the Federal government would redeem its outstanding greenbacks in gold but also the requirement that the banks authorized to issue Federal bank notes could not use (1) greenbacks, (2) other banks' Federal notes or (3) Federal debt itself (!!!!) as reserves. Only specie could satisfy the banks' reserve requirements. The result was an age where the impossible happened year after year: real incomes rose for Americans, including the flood of new immigrants, while at the same time prices fell. Banks engaged in fractional reserve lending, and some of them did, as always, fail - just as they had under the Scottish free banking system in the 18th century - but there were no system-wide panics. On the contrary, as with the Scottish free banking system, the fact that banks had to clear each other's notes (that they could not hand off the credit risk to a central bank) made them highly sensitive to any profligacy by a counter-party. 

Rocky Humbert disagrees:

I had to disagree with Stefan, but he is mixing microeconomics with political philosophy.
As any economics textbook will attest, Jeff's definitions are consistent with the current state of economic theory. The underlying assumptions in microeconomics may be questionable (as all simplifying models are,) but the math in our fractional reserve banking system is straightforward and leads to logical conclusions.
MV=PY … where money supply x velocity = price x output. (price x output=nominal gdp)

Stefan has written previously about his problems with the separation between money and credit. The fact is that he never really cuts to the practical heart of what makes money useful. If I buy an ice cream cone from Stefan, I can give him, and he may accept, an IOU. That's a creation of credit. But he can't use my IOU to buy cream at the dairy. And he can't deposit my IOU in a bank. And because it's outside of the banking system, that transaction will not affect the money supply as defined. And, so long as other (unrelated) people do not accept that IOU as payment for goods and services it's not money. In a complex economy, it's absolutely essential to have a universal legal tender. And the gov't monopoly doesn't interfere with credit between direct counterparties at all.

A contrary example…. what's the difference between American Express Traveler's Chex and money? Very little. The ONLY difference is that I am NOT legally obligated to accept an Amex Traveler Check as payment for goods and services and I AM required to accept a greenback. (I am not commenting on the nonconvertibility of greenbacks here.)

Rudolf Hauser comments:

Ever since George raised the question of where does interest come from, I have been astonished by the amount of misunderstanding with regard to the issues of money and credit revealed in the discussion that followed. Let me try to clarify some of these issues.

First we have to know what money and credit are. We live in a economy of specialization. Most of what we produce is not used for our own consumption but traded for the goods and services produced by others available in the market economy. As barter is very inefficient and more so the larger the economy becomes, we need a common substance that is widely accepted in trade for any good and service. This not only facilitates transactions but allows for pricing in standard units (rather than say a bushel of wheat buys half a pair of shoes, 3/4s of a bushel of potatoes, a gallon of oil, etc.) and provides a store of value. The use of such money in the form of a commodity (such as gold) or fiat money provides such a service.Money today comes in a variety of levels. First we have money accepted by all governments in exchanges among themselves. Traditionally this has been gold or silver. Today we also have reserve currencies, namely the dollar, that are widely accepted in payment, but that could change if confidence in the value of the dollar were to decline. Then we have money that can be used for transactions among banks. This consists of high-powered money (the monetary base) composed of demand deposits held at the Federal Reserve and currency. These are created when the Fed buys anything with newly a created check given to the selling dealer in the private sector that will eventually give a bank a claim on the Fed (reserves). Then you have narrowly defined money, M1, that is money that is generally accepted in transactions among the general population. When banks buy securities or make loans they pay for them with high powered money. Those payments are then placed in the checking accounts of recipients, creating new deposits, that is, more money. Banks have to keep some of their reserves but expecting that the amounts on deposit with them will not shrink drastically overnight are willing to lend out some of those reserves. That reserve ratio determines, along with a few other factors such as the ratio of high-powered money in the form of currency, the high-powered money multiplier. While M1 money is required for transactions, the need for a private reserve of money can be supplemented by near-moneys, that is items that can quickly be converted to M1 type money with minimal on no cost or depreciation in value. Various items serve this purpose to varying degrees depending on how close to those noted requirements are met. Very close are savings deposits. Short-term time deposits have a lesser degree of "moneyness" (to coin a word). Short-term securities also have a degree of moneyness. You can be assured that the degree of moneyness of commercial paper declined to almost nothing in 2008 before the Fed stepped in to support that market. Ready access to credit might also be considered a factor in reducing the need for more narrow definitions of money.

Money is held to insure that the holder is liquid enough to meet his or her needs to be able to engage in transactions in the near-term to modestly distant future. It is a function of the amount of and degree of moneyness in near-money assets, income and wealth levels, the amount of nominal transactions in the economy, the efficiency of the payments system, the level of real economic activity, opportunity costs, inflation concerns and the degree of perceived risks in the economy and financial markets. When the amount of money supplied exceeds the demand for money, you get inflation. When supply is less than demand you get deflation. When you grow money (or at times contract it) at an appropriate rate relative to real non-inflationary economic activity and the change in demand for money in such an economy, you get a non-inflationary economy. Attaining the latter should be the goal of central banks.

Money is a medium of exchange. MONEY IS NOT CREDIT, AND CREDIT IS NOT MONEY.

As noted, in an economy of specialization, which is what has allowed us to have real economic growth on a per capita basis, people use their time and talent to produce and trade their production or labor for payment in money, which they can then consume or save. Savings is that which is not consumed. It might consist of inventories of goods, goods that are consumed over time such as a car or housing (the annual depreciation thereon is the consumption of such goods) or productive assets which increase productivity of labor and/or are necessary to produce certain goods or services. One can save by buying such assets for oneself or one can provide credit either in the form or a loan or equity investment. (I would classify equity investment in which the shareholder has no active role in the activities of the corporation as in essence a form of credit in which the rewards and return of capital depend on the profitability of the business in the context of this particular analysis.) If such credit is not provided and used one will end up with unwanted inventories. This will necessitate production cutbacks and unemployment and underutilization of productive capital and a reduced amount of economic prosperity. Because most people do not work for themselves and are dependent on jobs to earn a living, it is important that there are entrepreneurs and equity investors willing and able to make the capital investments that will employ people. It should be noted that on the micro level, savers can also lend for the purpose of others consuming more than they currently produce. This changes who consumes and by enabling some to consume more than they would otherwise to increase overall consumption at the cost of those borrowers having less consumption than they otherwise would have from their current incomes in the future when they repay those loans. That repayment need not change overall consumption as those repaid savers might use the return of those funds to consume more. Interest is paid from the profits or equity of the business borrowers and the future income or other assets of non-business borrowers. In the case of government borrowing, it would come from taxes if the overall debt levels are being reduced, which is the exception rather than the usual case.

When one borrows or makes an equity investment, it is made with money. So is a purchase of any good or service. The money is not the credit. It is the medium of exchange in which all transactions are made. The recipient can then buy goods and services with the funds, invest them in capital or financial assets or even use them to hold cash balances. It can also build up cash balances with proceeds from the sale of its goods and services. Money is money no matter what the source (aside from counterfeit money). It is not credit. It is an asset that is used as a medium of exchange and the numerar in which obligations are expressed. A debt could be expressed in barrels of oil. It would still be an obligation. The fact that it is expressed in money does not make money credit or credit money.

Now with those basics noted, with regard to George's question, money is a medium of exchange that is in constant circulation. It is used and passed on. When someone sells goods produced or services, or sells any existing assets, one is paid in money and that money can be used to repay a debt with interest. It is then used by the recipient of that payment to make other transactions. The ability to repay has nothing to do with the amount of money in circulation as long as that overall stock of money is consistent with the overall demand for money. ( A shortage of money led to Shays' Rebellion as debts had to be repaid in money but money was not available for payment for goods and services.)

The Fed does earn interest on the securities it purchases in the process of creating money. It buys outstanding assets but the sellers of those securities now have funds to invest elsewhere. But that would be equally true if those sellers had sold to someone in the private sector. It is the Fed that benefits, but it returns those funds earned in excess of its expenses to the Federal government, which benefits. This has nothing to do with inflation, which is a different sort of tax. If the money created is held in the aggregate because of an increased demand to accommodate a growing level of real production and other factors and the product of money held and velocity not increased relative to the level of real economic activity at an unchanged price level, it will not be inflationary. The dollar sitting idly in your bank account will not be driving up any prices and will result in lower velocity. The bank obtains funds from deposits that increase its liabilities. It is not getting a free ride. The only way it gets a free ride is if it can borrow from the Fed at rates below those it would pay in the private markets. Contrary to the Google video someone posted a link to, banks do not create money out of thin air. All the funds they receive are in the form of high-powered money in the sense if they are in the form of a check that the bank they are drawn on will be paid out in the reserves that bank holds at the Fed and currency of course is high-powered money. So the money banks lend out in loans is obtained by either receiving deposits, selling assets, or borrowing from the markets (non-deposit liabilities) or the Fed. Only the Fed creates money out of thin air.

Sushil writes that "The article below makes too many assumptions. One of which is that a loan taken from a bank is deposited into another bank and the new bank uses this deposit to create more loans. It's simply silly. Mr. X borrows from bank Y at 6% per annum and puts it back in bank Z for a term deposit earning at 4% to go broke? It does not happen in real life." It should be clear by now that that Mr. X will use the money to buy something and that to do so he will have to have a checking account balance and that the person who he buys from will also put that check in his checking or savings account until he or she are ready to spend it. Nor need it be in bank Z but could be in any bank.
George makes reference to a chart on velocity but is really a chart on the money multiplier. As I have noted before on one of these lists that the multiplier refers to a measure of money such as M1 or M2 divided by high-powered money (the monetary base). It has declined sharply because of the increase in excess reserves. You would not have to double money as someone suggested to make up for the decline in velocity because velocity did not drop as much. Using my favorite measure of M2 lagged two quarters, income velocity (GDP/M2t-2) declined a maximum of only 10.65% as of the third quarter of 2009 on a year-over-year basis. This is the inverse in the demand for money. On a quarterly basis it has risen in the past two quarters, implying that the demand for money was declining as confidence was gradually being restored. Banks are keeping such high excess reserves because they still are cautious and a 25 basis return exceeds the cost of Fed funds. If the Fed wanted to increase money growth, it would just have to lower the interest rate it pays on excess reserves. As the Fed funds rate has risen a few basis points the level of excess reserves has peaked.

As to the Rothbard article from the "Freeman" on the Mises Institute website that Jeff references, I have a number of disagreements. One is that Rothbard ignores the rule I noted above that when money supply is less than demand you get deflation. He seems to ignore this when he implies that a flat supply of money would give you no inflation or deflation.

One major problem with a gold system is that real growth might result in more of an increase in the demand for money than can be supplied by gold reserves. A modest amount of deflation can be tolerated as evidenced by real economic growth in the latter part of the 19th century. But because nominal interest rates have a 0% floor, deflation increases the real interest rate and at some point will squeeze out too much capital investment limiting real growth potential.

Contrary to what Rothbard says, you would still have fractional banking under a gold standard. While banks have to pay other banks in high-powered money, which would mainly be gold in his world of no central banks, they are also constantly receiving new deposits and having loans repaid. So banks would only have to hold enough gold to meet what they expect to be the worst net outflow. The major risk is a panic in which a run on all banks for direct holding of gold would create a negative situation. As experience has shown, after a long period of prosperity people tend to become more confident and less prudent in their behavior. There is no reason to expect any difference were we to move to free banking and no central bank in our current culture. One form of money has been repo financing by investment banks. These were backed by collateral that consisted in part in highly rated mortgage paper that turned out to be junk. As confidence waned, rising collateral requirements could not be met and there was a sharp decline in this unmeasured form of money and selling of assets at distress prices that greatly contributed to the financial crisis. Need I say more?

Rothbard fears a run on banks when confidence goes (writing back in 1995) and says the Fed would have to make up the difference between deposit balances and actual liquid reserves that banks hold. He considers this inflationary. Actually this would increase high-powered money but would not change the broader measures of money, just substitute currency for deposits. He is correct that this would be inflationary when the funds are returned to the banking system. But an alert Fed would then contract reserves to offset this reverse inflow and as such it would not have to become inflationary.

I have other disagreements with his case for the impact of ending the Fed that I will not go into since they get us away from the discussion at hand.

Tyler Mclellan adds:


This is excellent. I was going to write a long note, and spent a few days arranging my ideas in order to write concisely on the topic.

You have touched most of the salient points. There is one area though where I think you might not have provided clarity.

"Money is held to insure that the holder is liquid enough to meet his or her needs to be able to engage in transactions in the near-term to modestly distant future"

I think this is not the best way to go about getting at this important idea. The above may be why people choose to hold money, but it is not "what money does". Lets go about it from the opposite point of view, lets say no one had any faith in the government to maintain the purchasing power of money even on very short term time horizons. Now money is a residual, people are forced to hold it to the extent the inconvenience of constantly changing money into goods is still less that the inconvenience of changing goods into other goods.

Now let us posit that the monthly inflation rates are something like 1% and the costs of barter much greater than the resulting "menu costs, etc.." here you have a 12+% annual inflation rate that in no way obviates the usefulness of money as a means of exchange.

But the usefulness of money as a store of value has been significantly diminished. Why does this matter? It matters because there is tremendous demand to hold risk free near term savings. This is because people have a very intuitive sense that there is opportunity cost to doing things, opportunity cost to consuming today and investing in a specific opportunity today.

BUT, this is simply a convention. Aggregate savings has to equal aggregate demanded investment. Excess aggregate demanded savings can only by definition end up being consumed by someone else. If it does not get consumed by someone else, that income will simply disappear.

I have to restate what I said above, because it is the key insight, and something very few people understand. We have huge desire to save risk free near term, but that savings needs to get used up by an equally large desire to consume in the near term or it needs to get used up by matching near term savers with long term demanded investment. If it gets used up by consuming, then in the aggregate sense it is not really saved. If it gets used up by investment, then it is actually saved.

The confusion arise because the store of wealth convention of moneyness is actually quite difficult to get around. What I mean by this is, the false notion that money is a store of wealth is important to allowing demanded savings and either demanded investment or demanded consumption to be successfully intermediated. THIS NEED NOT BE LOGICALLY SO. It is true only because there are very few people who actually want to lend their money, or iphones, or wheat, or gold in exchange for 30 year equity claims or in multi-year consumption smoothing schemes with their children, which in both of these cases would clearly separate the store of value function from the transaction function. (think of how it makes no sense to speak of the transaction usefulness of a 30 year loan in 30 years, we all have an intuitive notion that the currency im paid back in 30 years from now is a CONVENTION, and unrelated to moneyness. If you work backwards to all savings even at small time horizons, you'll realize this is true of even very short term credit provision. What the person has is a claim on the future, and it is never different from that.)

And, to circle back, the reason the convention that money is a store of wealth is so useful, is because this notion actually serves to coordinate economic activity (investment, consumption smoothing, inventories, vender finance) that maximally use the available resources. This doesn't need to be true, it simply is as a result of the above. Hence the illusion that money as a store of credit (I say store of value, and this is where I think Rudolf's approach might prove confusing) creates economic activity comes into being. This is because money as a store of value serves a purpose unrelated to its moneyness. A purpose that has nothing to do with the character of money, but rather has to do with the needs of savers in a complex economy.

With very few exceptions, the FED realizes this, and hence conducts monetary policy with this mantra in mind. paraphrasing fed speak "Generally we dont care about the relative prices of store's of value, and we certainly dont care about the supply of "money" or store's of value outstanding. If the banking system wants to make new loans, we will in aggregate supply infinite overnight money at the interest rate we determine to be useful to achieving our goals. Most of the time the banks wont actually use us to get the actual money because they'll borrow it from each other or from other institutional savers, and the loans they previously made will show up as checking deposits (that is a liability to offset the asset of the loan) anyways. And basically all these banks will perform all sorts of lending price discovery around our offer of unlimited funds for short maturity at a fixed interest rate. they'll have duration curves, risk curves, liquidity curves. But regardless of what they lend to, they'll be taking risk over and above the risk free rate of one form or another. And because the populace generally trusts us to set what rate we'll all get for our massive demand to save short term, the financial markets are just the mechanism of spreading that demanded savings out over the demanded investment and consumption that society actually wants. Society wants to save short term, but borrow long term. But collectively all of us are equal to society, the banks just perform the very useful function we all want. otherwise the demanded savings would not be actualized and all of our income would go down to the point where a new equilibrium emerges.

But, sometimes, our ability to set overnight money is not sufficient to add a "store of value" confidence to other parts of the capital stock. but, hey, we get the joke and realize that even our overnight money isnt actually a store of value. So if by convention people want to believe that it is, why not just extend that imprimatur to other things. Like for example, what if we said that mortgage bonds would be exchangeable with no haircut for overnight money from now until maturity? well then we would build more houses, which is a source of income, and some of that income would in turn be saved in the sense that it would create a real store of value in the form of a long lived assets. maybe also if we finance credit card receivables, etc.. really cheaply then people will actually borrow some of the excess demanded savings and provide a source of income that actually allows that savings to be actualized (although this time not savings in the true sense because at a macro level it is just consumption trading).

Well all of the above is certainly better than all of us planning to save a great deal, but also planning to invest very little and consume very little, which means in aggregate, enough income will have to be destroyed in the form of firing or idling or etc…such that ultimately (after inventory effects wear off) our expenditure and investment is again equal to our income. for truly it cannot ever be different. and of course, the irony being in this case, that actual savings will have gone down in this latter case, which is universally true empirically."

And I as a fed observer say, they certainly understand the above better than this list appears to.

Stefan Jovanovich comments:

Rudolph: In offering legal tender as the definition of money, I was trying to avoid the circularity that is implicit in any discussions about money and credit that are rooted in the German historical school/Keynesian history tale - money as a medium of exchange, a store of value, etc. Leaving aside the fact that sovereignty and seignorage seem to be the actual origins of money, we know from our current experience that there are no practical differences between liquid credits and the ultimate pure M other than the fact that the U.S. Treasury Department will only accept certain Ms in payment and not others. At heart these discussions always end up being theological - how many monies can be counted on the heads of the Federal Reserve governors? — and they avoid the central issue– how can democracies and dictatorships avoid monetary debasements that punish the poor and the thrifty to the benefit of the rich and well-connected? 

Tyler McLellan replies:

Monetary debasement?

Why are we talking about this. We have had the longest, most long standing era of price stability ever in human history since we abandoned monetarism and the gold standard. we might have problems, but debasement is not one of them.

Stefan Jovanovich comments:

In 1880, according to Leslie Stephen, it was the mark of an intelligent economist that he or she did not think "aggregate savings equal(ed) aggregated demanded investment". Savings and investment had to be constantly jostling each other; otherwise, how could prices fluctuate? The classical view - which extends up to Frank Knight and Hayek - was that money was of primary importance because it was the unit in which prices were denominated; and that the risk to trade and invention and enterprise was that the government would corrupt pricing by tampering with money.

We now live in a parallel theoretical universe. The currently fashionable academic answer is, as Tyler just wrote, "that money is a residual", that it is what is left over after all time and goods preferences have settled out and the central bank has finished conducting "monetary policy". Tyler is being too modest. Under his theories even prices are a residual; the goal is not an honest count but to keep the wheel turning - i.e. have all the Ms change hands. Our present monetary system can be described in its simplest terms as (1) the U.S. Treasury auctions debt to the primary dealers who pay for their purchases by having their accounts debited at the Federal Reserve and (2) the U.S. Treasury collects "the money" by having its account at the Fed credited. It is - truly - a perfect merry-go-round. And that is the problem: there is no place where anyone can step off .

There is no reconciling these two views. I would note that "the law" clearly has a bias in favor of supporting the academic fashion. Under the present U.S. Code the mere act of holding cash is considered subversive. Anyone who accumulates a sizable stash of legal tender is subject to property forfeiture under provisions that place the burden of proving that the cash was not obtained by illegal means on the owner, not the government. 4th Amendment? What 4th Amendment? It is actually safer right now to hold specie than currency. You and your bank both have to tell the government every time you receive and they hand over $10K or more in cash; for bullion there are - currently - no such reporting requirements.

I would suggest that any theory that honestly believes that "people are forced to hold (money) to the extent the inconvenience of constantly changing money into goods is still less (than) the inconvenience of changing goods into other goods" needs at least a slight reality check. Those of us who make our living from CICO (cash in cash out) hold money because there is no one cutting us a check each month and we have the unavoidable uncertainty about how many customers will call us because they want our goods instead of someone else's. There is an old story about a peasant soldier who saw running water for the first time and was entranced. It was something he must bring back to his village. Imagine his shock and anger when he discovered that the faucet he had brought home and hammered into the tree outside his hut would not provide water when he opened the valve. Clearly, the solution was to get another faucet.

Charles Pennington provides a chart:

Here is a plot of CPI since 1914 on a semi-log scale and set to 100 in July 1983, with data from FRED. (I don't know why they picked the 7/1983 date to normalize it.)

There's a change in the slope starting around 1982, with the curve
becoming less steep (corresponding to a lower inflation rate).


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