Andolfatto vs. Sproul: who was right?

Who else misses the good old days when JP Koning wrote mostly about actual, not fake money, and Nick Rowe experimented with red money?

The debate between David Andolfatto and Mike Sproul below is nearly 12 years old but, considering how little has changed since then, could just as well have taken place yesterday.

David starts his blog post Fiat money in theory and in Somalia (2011) with a correct observation: money serves a record-keeping purpose. David explains: “The money in my possession constitutes information about my past contributions to society”. In other words, money is used to track agents’ trading histories.

What David fails to highlight is that in every single trade, there is a buyer and a seller. By giving up goods, the seller makes a contribution to society while the buyer receives something from society. We might call it a negative contribution, although accepting goods from others is of course nothing to be ashamed of. Anyway, such a negative contribution must also be recorded. When the buyer hands out currency to the seller, the reduction in his holdings of currency is that record. Today, most of the recording takes place in banks’ accounting systems, where a debit entry on the buyer’s account is a record of this negative contribution.

In every single trade of goods or services there is a credit entry and a debit entry to record the positive (giving) and negative contribution (receiving). Crucially, this also applies to situations where money is said to be issued or created. Anything else would lead to an imbalance, where the holders of money — having given up goods earlier — would be entitled to receive goods from other people without there being anyone, in aggregate, liable to deliver goods[1].

David does not seem to recognize this balance between records of positive and negative contributions. In the post he says:

“According to this view, the market value of fiat money consists exclusively of a liquidity premium. The asset has no intrinsic value, and yet it has a positive price. Fiat money is a "bubble" asset -- but this is a bubble that plays a useful social role (it economizes on commodities that have uses other than record-keeping).”

 

A record of a past contribution to the society is not a bubble asset if there is another record, of the same nominal value, of a negative contribution to society and a related liability to give up goods later. The beauty of accounting is that that record always exists because you cannot credit an account without debiting another. 

In the comments to David’s post, Mike Sproul takes on David’s claim about fiat money being a bubble asset:

“Scientists used to bend over backwards trying to explain nonexistent substances like phlogiston, ether, and caloric. Nowadays they bend over backwards trying to explain the nonexistent substance called fiat money.

We all know that money can be backed by assets. ... The US dollar, for example, is backed by the assets of the Fed, but it is not convertible into metal. People observe the fact that the dollar is inconvertible, and jump to the conclusion that it is not backed. This in spite of the fact that the dollar is the acknowledged liability of the Fed, and the Fed holds assets designated as ‘collateral held against federal reserve notes’.”

 

David agrees that commercial bank liabilities are fully backed, but doesn’t see how central bank liabilities could be:

“I think you are off base on your observation that Fed notes are backed by assets. They are largely backed by Treasuries, which are claims to future Fed notes. So a Fed note is backed by a future Fed note. What sort of backing is that?”

 

To which Mike replies:

“The dollar is backed by treasury bonds, which are in turn backed by taxes, so the dollar is ultimately backed by the government's ability to take real resources by taxation.”

 

So, who is right? Both are, in their own way. David is right about money serving a recordkeeping purpose, but he doesn’t follow that idea to its logical conclusion. If he did, he would see that Mike is right about full backing extending to central bank "liabilities" (we would not use that term, though).

That full backing takes the form of the balancing records of negative contributions mentioned above. If, as David says, Fed notes are records of positive contributions (goods given to others) made by their holder, then they must be balanced by records of negative contributions referring to agents who have received goods in excess of what they have given up. These records of negative contributions are the debit balances on the Fed ledger. While the holder of a note — in general, a credit balance — is entitled to receive goods from others due to an earlier positive contribution, the debtors are liable to deliver goods to others.

Here is what is “backing” Fed notes: U.S. Treasury, agency debt, and mortgage-backed securities pledged.[2]

The debtors behind mortgage-backed securities (MBS) in the Fed’s books are liable to deliver goods — usually labor — to others. That’s how they pay back their mortgage debt. The periodic debit entries on their bank accounts, and credit entries on loan accounts, are done to amend the records to reflect the repayment. The “backing”, if you will, is the debtors’ ability to sell labor to their employers.

When it comes to Treasury debt, Mike is right. Its value lies in the real resources taxpayers give up, not in any Fed notes. This is public debt which has been incurred by the government acting on behalf of the people and which the people pay back by delivering goods to others. The periodic debit entries made on taxpayers’ accounts — misleadingly called “tax payments” — lead to a situation where they cumulatively give up more goods than they receive. That is what taxes are about: you give up some resources for communal use without any direct compensation. (We don’t think David disagrees with this.)

It should actually be fairly easy to prove that Fed money is not a bubble. As a thought-experiment, why don’t we make George Selgin happy and end the Fed. During, say, a 30-year winding-up period, mortgagors and taxpayers will in effect deliver stuff to Fed noteholders[3], who are due goods, and receive Fed notes from them as a record of these sales[4]. The MBS trusts and the Treasury will deliver the notes they receive from mortgagors and taxpayers to the Fed. The notes will be presented as proof that the debt has been repaid, after which the Fed will credit the accounts for MBSs and Treasuries, writing the debt down. Simultaneously, the Fed will debit the account for currency, thereby recording its removal from circulation.

So the ones who owed stuff, delivered stuff, while the ones who were owed to, received stuff. The Fed as the economy’s ultimate accountant kept track of these trades and made sure that debtors delivered on their promises. We can see that the Fed balance sheet consists of records of trading histories, and nothing else[5]. The balance sheet is emptied when the cumulative trading balances of all participants hit zero.

Now, we don’t think what we say about the “real side” of things is that controversial or even new. Any sensible economist would agree with John Stuart Mill when he says[6]:

"It is not with money that things are really purchased... The pounds or shillings which a person receives weekly or yearly are not what constitutes his income; they are a sort of tickets or orders which he can present for payment at any shop he pleases, and which entitle him to receive a certain value of any commodity that he makes choice of."

In our work we don’t differentiate between a real and a monetary level. Instead, we describe — in concrete terms and in detail — the latter as recordkeeping of the former. But Mill continues (and nearly all economists nod in agreement):

"In point of fact, money is bought and sold like other things, whenever other things are bought and sold for money. Whoever sells corn, or tallow, or cotton, buys money. Whoever buys bread, or wine, or clothes, sells money to the dealer in those articles. The money with which people are offering to buy, is money offered for sale."

What we argue is that it just looks like money is being traded, especially when one has coins or paper bills in mind. And people understandably think they are trading money, while in fact — no matter the shape or material of the recordkeeping device — they are recording goods transactions or amending previously made records.

Thus, taking the “money as a record-keeping device” view to its logical conclusion requires accepting that money as a tradable object — whether one calls it a special good or an IOU — doesn’t exist. The “device” does not refer to a thing that is issued so that it can be traded for goods but rather to the service that the monetary system provides - namely that of recording goods trades.

One needs to accept that both monetarists and credit-theorists have been partly wrong. Then again, considering how controversial money as a topic has been for centuries, that shouldn’t come as a surprise. Our modest proposal is that all this controversy can be resolved if one accepts that money as a tradeable thing does not exist[7]. 

To paraphrase Mike Sproul:

Scientists used to bend over backwards trying to explain nonexistent substances like phlogiston, ether, and caloric. They still bend over backwards trying to explain the nonexistent substance called money.

Antti & Oliver

[1] These entitlements and liabilities are related to an intertemporal budget balance requirement. If you have a cumulative credit balance (consolidated across all recordkeepers), you are entitled to receive — but not demand, as this is not a 1:1 credit relation — goods from others to hit a balanced budget. Likewise, if you have a cumulative debit balance, you are liable to deliver goods to others in order to balance your intertemporal/lifetime budget.

[2] See  “7. Collateral Held against Federal Reserve Notes” here.

[3] For simplicity’s sake we assume a currency-only economy. Commercial bank deposits and bank reserves would just add an additional link to the accounting.

[4] Of course, they don’t need to trade directly with each other.

[5] The Fed is like the monetary authority Ostroy described 50 years ago: ”As a monetary version of the model of a trading economy, introduce a central receiving station called a monetary authority. Its function is to collect and collate the bits of information individuals have about each others' trading histories. Each will require his trading partner to write a signed statement, a check, indicating the amount by which the partner's purchases exceed his sales. This record is forwarded to the monetary authority who revises individual accounts on the basis of this new information. Sellers, by requiring payment in money, are guaranteeing a steady flow of information such that the monetary authority, and it alone, is able to monitor trading behavior. Of course, there is every incentive to require and deposit this information with the monetary authority; otherwise, one would not receive credit for sales and so have to cut back on purchases.” - Ostroy, Joseph M. (1973). “The Informational Efficiency of Monetary Exchange”. The American Economic Review, Vol. 63, No. 4 (Sep.) (p. 607).

[6] Mill, John Stuart (1885). "Principles Of Political Economy". New York: D. Appleton and Co. (first quote p. 341, second quote p. 344).

[7] This might also explain why mainstream macroeconomic models without money have been so popular.