Wednesday, December 26, 2012

Corporations are currency issuers, governments are not

Corporate stock: a perpetually inconvertible currency

In this post I play around with the distinction between a currency user and a currency issuer.

Modern Monetary Theory (MMT) draws a line between currency issuer and currency user. Households and businesses are currency users. They can "run out of money" and become insolvent. Central banks, on the other hand, are currency issuers. Issuers can never run out of money and, as such, face no solvency constraint. As long as the government is not legally separated from the nation's central bank, it too enjoys the benefits of being a currency issuer. After all, the government can always have the central bank issue liabilities to pay for all governmental obligations. The only constraint on a currency issuer is inflation, not solvency. For if a central bank's liabilities inflate to worthlessness, they can no longer be used to meet either the government's or the central bank's obligations.

While MMT associates currency issuance with the state and currency use with the private sector, this needn't be the case. Private businesses can be thought of as currency issuers facing an inflation constraint, whereas governments are almost always currency users facing a solvency constraint.

My translation of these MMT ideas is that the key to escaping the solvency constraint is this: can the institution under consideration issue perpetual inconvertible liabilities? If so, the institution can never become insolvent and qualifies as a currency issuer. The beauty of perpetually inconvertible liabilities is that they never expire, nor can their holder take the initiative and force the issuer to redeem them for some underlying asset. Lacking any revenues whatsoever, an institution can function indefinitely as long as its perpetually inconvertible liabilities have some positive value and can be sold to obtain resources. If these liabilities inflate to nothing, the issuer loses its ability to function.

Consider central banks first. Say that a central bank issues perpetual liabilities convertible into gold. This central bank is not a currency issuer, for if the gold is not forthcoming, the central bank will be rendered insolvent. Modern central banks, on the other hand, are safe from the solvency constraint because they no longer issue perpetual liabilities convertible into gold. Rather, modern central bank liabilities are inconvertible. The central bank can simply spend these liabilities into the economy, thereby financing its continued existence. Only when these liabilities are worth zero will the bank have breathed its last.

Modern corporation can also issue perpetual inconvertible liabilities. This is called equity. Much like a central bank, modern corporations face no solvency constraint because they can always meet their obligations with new equity issuance. Only when a corporation's equity has inflated away to nothing i.e. the price of the stock they issue is worth zero, have corporations finally hit the wall. Fledgling companies with no revenues and large expenses can function for many years by constantly issuing perpetual inconvertible equity.

Unlike businesses, individuals can't issue equity in themselves. Society has rendered it taboo to alienate shares in one's self, even if this is done in a voluntary manner. People can only issue personal IOUs that must be paid back at some point in time, or debt. Because individuals can't issue perpetual inconvertible liabilities they face a solvency constraint and therefore qualify as currency users.

Modern governments are very much like individuals. They can't issue equity. Nor can modern governments rely on their central bank to meet governmental obligations. The practice of independent central banking puts a strict divide between state and central bank, rendering it illegal for the central bank to use its perpetual inconvertible liabilities to finance the government and shelter it from the solvency constraint.

In sum, the line between a user facing a solvency constraint and an issuer facing an inflation constraint is defined by the ability to "print" perpetual inconvertible liabilities. Both corporations and modern central banks have the ability to issue these instruments and therefore face only an inflation constraint. Governments and households, on the other hand, are prohibited from issuing these instruments and therefore qualify as currency users that face solvency constraints.

18 comments:

  1. Hmmm. I would say that a corporation that issues both debt and equity is like a government that issues both domestic currency bonds and foreign currency bonds.

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    1. As long as the government is amalgamated with a central bank that issues inconvertible paper, I'd agree with that.

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  2. A landlord whose land is worth 1000 oz can spend his own 1 oz. IOU's at the grocery store, as long as he agrees to accept them for rent. He could issue up to 1000 of those IOU's without becoming insolvent, and then (assuming R=5%) he could accept 50 of those IOU's in rent each year, which he immediately re-spends. He can do this forever, so there is a perpetual float of 1000 oz of his IOU's in circulation. He could even issue another 2000 oz of IOU's, use them to buy new land worth 2000 oz, and thereby triple both sides of his balance sheet, with no effect on his net worth.

    This looks like an exception to the "line" in the first sentence of your last paragraph.

    But it gets worse, because what if the land loses 40% of its value? Maybe the landlord can be forced to liquidate, in which case his creditors get 60% of what was promised to them, or maybe for some reason it is not practical to force him to liquidate, in which case his IOU's trade at 60% of their old value. Now he resembles a central bank facing only an inflation constraint.

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  3. "He could issue up to 1000 of those IOU's without becoming insolvent..."

    It seems that the landlord in your first paragraph only faces an inflation constraint.

    By insolvent, I mean unable to meet promises. So if the landlord only has 1000 oz worth of land he can keep on issuing IOUs without having to worry about insolvency since these IOUs are not directly convertible into underlying land or gold. (You point out that these IOUs can be used to discharge a rent obligation, but because only 50 are accepted a year, IOU holders are prevented from putting the IOU back to the landlord on demand. They are pretty much perpetually inconvertible.) Therefore the landlord can keep spending IOUs at the grocery store until they're worth 0.

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  4. "Modern corporation can also issue perpetual inconvertible liabilities. This is called equity. Much like a central bank, modern corporations face no solvency constraint because they can always meet their obligations with new equity issuance. Only when a corporation's equity has inflated away to nothing i.e. the price of the stock they issue is worth zero, have corporations finally hit the wall."

    Sorry, but I think you need to read some firm theory and insolvency law. A firm's shares can never be worthless, because they have an embedded call option on the firm's assets. The existing shareholders and creditors can be expected to object, and I am pretty sure that it would be illegal to issue shares if your liabilities exceed your assets.

    There are I think some really silly things written by people who should know better about currency issuers being defined by not being able to go bust, which provides false hopes. If I had enough net worth, there is no theoretical reason why I could not set myself up as a rival to an official central bank that was abusing its trust - I'd love to do that in the UK. But if so I could certainly go bust. If I tried to continue trading with negative net worth, the "fraudulent conveyance laws would get me. Of course a curreny issuer can go bust.

    If official central banks cannot go bust it is because the laws are rigged in their favour - ie, as you know, in Canada you can't issue money, and I am pretty sure that you could have a hard time suing the central bank for fraudulent conveyance. But it does not help the existing issuer that much, because the punters vote with their feet - as you know many economies are practically dollarised.

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    1. You're right that I'm ignoring laws on insolvency. That adds a whole new level of complexity, especially in the realm of banking.

      But say we abstract from the laws. I still think that as long as I constantly issue only perpetually inconvertible equity/currency, there's no way for me to default on my promises since the instruments I've issued don't provide any sort of immediate or binding promise that I must fulfill. When my assets are all gone, the embedded call option that my shares carry are worth nothing, at which point my shares are worthless and I go bust.

      I agree that in a lawless free-banking world, you or I could set ourselves up as rivals to an irresponsible central bank by issuing our own currency and stealing most of its business. Currency competition should be one of the greatest constraints on currency issuers. Unfortunately, it's a muted constraint these days.

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    2. "as long as I constantly issue only perpetually inconvertible equity/currency, there's no way for me to default on my promises since the instruments I've issued don't provide any sort of immediate or binding promise that I must fulfill"

      Why would I accept (ie buy) them then?

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    3. You don't have to accept them directly. Say you only accept some liquid item x. All I have to do is sell my equity on an organized equity exchange for x and then we can trade. We can trade as long as my equity has some value on the equity exchange.

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    4. I put my point in a rhetorical way; I don't see why anyone else would accept them either.

      What is really behind my questioning is that I believe that there is not enough recognition that central banks cannot just force money into circulation. In an OMO system, they have to pay up. Many of the peddlers of monetary magic like MMT or NGDPLT ignore this point.

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    5. On that I'd agree. MMTers are often guilty of peddling their brand as if it were a panacea. The main point of my post was to re-purpose MMT language to show how the word "currency-issuer" also applies to corporations. One would hope that this forces MMTers to confront the fact that there's nothing magical about a central bank and the instruments it issues. We are all subject to the same grinding market forces, and the ability to issue perpetually inconvertible instruments only delays the inevitable.

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  5. Central banks promise price stability, which depends on solvency. Money isn't an equity claim on the assets of the central bank. Nobody cares what the assets are, as long as the CB is able to keep its promise. Just like buyers of AAA corporate bonds don't care about the company's assets.

    One can imagine a system where money is equity, but it's not the current system.

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    1. Nah, I don't think central bank liabilities are equity either - they're perpetually inconvertible debt claims. By promising price stability, a central bank creates a pseudo form of redemption... its liabilities are no longer truly inconvertible.

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    2. The next question is, if money is debt, what's the difference between central bank money and government bonds?

      My answer is that money is senior government debt; bonds are junior government debt. At least, that's how it ought to be. Government insolvency should trigger a bond default, not hyperinflation. Government bonds shouldn't be riskless.

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    3. It's tough to find a ranking of government debts in terms of seniority. I know that notes are a first claim on the Federal Reserve, I've never read anywhere that they are (or are not) a first claim on the government. I'd be interested to read any evidence you have.

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    4. It's more of an ideal than a reality. If the CB has priority, then it can maintain price stability regardless of fiscal policy. If money and bonds are equal obligations (in other words, if bond default is impossible), then fiscal policy can override monetary policy, which is contrary to the ideal of an 'independent' central bank.

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  6. "the practice of independent central banking puts a strict divide between state and central bank"..."Governments and households, on the other hand, are prohibited from issuing these instruments"
    Governments can easily override the silly "strict" divide, as well they should. We can't owe ourselves money, greenbacks are a very workable concept.
    I only saw this post after the metallist v chartalist post, or I would have mentioned these related posts there Modern Monetary Theory & Full Reserve Banking: Connected by Fiat

    MMT can address operational realities or analyze a Chartalist system. But it cannot do both
    Headed over to the Chartalism=McDonalds coupons post now, should be interesting

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    1. I'm not interested in debating whether governments *should* be able to issue greenbacks.

      Issuing government equity is a far more interesting topic. How do you think government should go about issuing equity? Do you think the prohibition on people issuing perpetually irredeemable equity should be overridden too? Everyone should have the ability to be a currency issuer, no?

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