Scott Sumner vs. the Real Bills Doctrine

This is a guest post by Mike Sproul. Mike's last guest post is here.

Scott Sumner and I have argued about the backing theory of money (aka the real bills doctrine) quite a bit over the years, starting in 2009 and continuing to the present. (link 1, link 2, link 3, link 4, …) Scott rejects the backing theory, while I favor it. I think that printing more money is not inflationary as long as the money is adequately backed, while Scott thinks that printing more money causes inflation even if it is adequately backed. Our discussions in the comments section of his Money Illusion blog extend well over 50 pages, so I’m going to try to condense those 50+ pages into two key points that cover the main arguments that Scott and I have had over the backing theory. (That’s John Law on the right. He was an early proponent of the real bills doctrine, oversaw a 60% increase in French industry in the space of two years, and was the architect of the western world’s first major hyperinflation and stock market crash.)

The key points:
1. Scott thinks that the liabilities of governments and central banks are not really liabilities.

For example:

“In what sense is cash a liability of the Fed? I thought once we left the gold standard the Fed was no longer required to redeem dollars?” (July, 2009)

“Dollar bills are not debt. The government is not required to redeem them for anything but themselves. That's not debt.” (August, 2009).

It would be cheating if I were to point out that the Federal Reserve’s own balance sheet identifies Federal Reserve notes (FRN’s) as the Fed’s liability, and that a large chunk of the Fed’s assets are classified as “Collateral Held Against Federal Reserve Notes”. Scott already knows that. It’s just that he thinks that the accountants are wrong, and that FRN’s are not a true liability of the Fed or of the government.

Scott’s argument is based on gold convertibility. On June 5, 1933, the Fed stopped redeeming FRN’s for a fixed quantity of gold. On that day, FRN’s supposedly stopped being the Fed’s liability. But there are at least three other ways that FRN’s can still be redeemed: (i) for the Fed’s bonds, (ii) for loans made by the Fed, (iii) for taxes owed to the federal government. The Fed closed one channel of redemption (the gold channel), while the other redemption channels (loan, tax, and bond) were left open. For example, suppose that 10% of FRN’s in circulation were originally issued in exchange for gold, 20% of FRN’s were originally issued on loan, another 30% were given to the federal government, which spent them on office buildings, and the remaining 40% of FRN’s were issued in exchange for bonds. That would mean that 90% (=20+30+40) of circulating FRN’s could be redeemed through the loan, tax, and bond channels alone. Only after those channels were used up and closed would it matter whether the Fed re-opened the gold channel. Assuming that the Fed still cared about maintaining the value of the dollar, the Fed would finally have to start using its gold to buy back the remaining 10% of FRN’s in circulation. But as long as the loan, bond, and tax channels remain open, the mere suspension of gold convertibility does not make FRN’s cease to be the liability of the Fed or of the government.

So Federal Reserve Notes are a true liability, whether or not they are gold-convertible. And like any liability, they are valued according to the assets backing them, just like the backing theory says. In the case of a gold-convertible currency, this is not disputed by Scott or anyone else. For example, as long as the Fed maintained gold convertibility of the dollar at $1=1 oz, it would not matter if the Fed held assets worth 100 oz as backing for $100 in FRN's, or 300 oz worth of assets as backing for $300 in FRN's. The quantity of convertible FRN's can be increased by any amount without affecting their value, as long as they are fully backed. Once we understand that both convertible and inconvertible FRN's are a true liability of the Fed, it is easy to see that the quantity of inconvertible FRN's could also be increased by any amount, and as long as the Fed's assets rose in step, there would be no effect on the value of the dollar. (There is a comparable result in Finance theory: that the value of a convertible call option is equal to the value of an inconvertible call option.)

2. Scott thinks that if the central bank issues more money, then the money will lose value even if the money is fully backed.

For example:
“ That’s where we disagree. I think open market operations have a huge impact on the price level, even if they involve the exchange of assets of equal market value.” (April 2012)

“ I understand what the backing theory says, I just don’t think it has much predictive power. Nor do I think it matches common sense. If you increase the monetary base 10-fold, prices will usually rise, even if the money is fully backed.” (July, 2009)

The problem with supposing a 10-fold increase in the monetary base is that we must ask how and why the money supply increased. If the new money was not adequately backed, then I agree that it would cause inflation. So if every dollar bill magically turned into ten dollar bills, or if helicopters showered us with newly-printed dollar bills, or if the Fed issued billions of new dollar bills in exchange for worthless bonds or worthless IOU’s, then Scott and I would both expect inflation. It’s just that I would expect inflation because the quantity of Federal Reserve Notes was outrunning the Fed’s assets, while Scott would expect inflation because the quantity of FRN’s was outrunning the quantity of goods being bought with those FRN’s.

But if the Fed issued billions of new dollars in exchange for assets of equal value, then I’d say there would be no inflation as long as the new dollars were fully backed by the Fed’s newly acquired assets. I’d also add a few words about how those dollars would only be issued if people wanted them badly enough to hand over bonds or other assets equal in value to the FRN’s that they received from the Fed.

This is where things get sticky, because Scott would once again agree that under these conditions, there would be no inflation. Except that Scott would say that the billions of new dollars would only be issued in response to a corresponding increase in money demand. So while I’d say that there was no inflation because the new money was backed by the Fed’s new assets, Scott would say that there was no inflation because the new money was matched by an increase in money demand. It seems that for every empirical observation, he has his explanation and I have mine. We are stuck with an observational equivalence problem, with neither of us able to point to an empirical observation that the other guy's theory can't explain.

But what if the Fed lost some or all of its assets while the quantity of FRN’s stayed constant? The backing theory would predict inflation because the Fed would have less backing per dollar, and the quantity theory would predict no inflation, since the same number of dollars would still be chasing the same amount of goods. It looks like we finally have a testable difference in the two theories. But here again, it’s easy for both Scott and me to get weaselly. If inflation happened in spite of Scott’s prediction, he could answer that money demand must have fallen. If my expected inflation failed to materialize, I could answer that the government stands behind the Fed, so any loss of assets by the Fed would be compensated by a government bailout. Empirical testing, it turns out, is hard to do. But at least I can claim one small victory: Scott is clearly wrong when he says that the backing theory doesn't have much predictive power. It obviously has just as much predictive power as Scott's theory, since every episode that can be explained by Scott's theory can also be explained by my theory.

Scott is also wrong to claim that the backing theory doesn't match common sense. Clearly, it makes perfect sense. Everyone agrees that the value of stocks and bonds is determined by the value of the assets backing them, and the backing theory says, very sensibly, that the same is true of money. Actually, it's when we start to use our common sense that the backing theory gains the advantage over the quantity theory. There are many aspects of the quantity theory that defy common sense, but I'll focus on four of them:

(i) The rival money problem. When the Mexican central bank issues a paper peso, it will get 1 peso’s worth of assets in return. The quantity theory implies that those assets are a free lunch to the Mexican central bank, and that they could actually be thrown away without affecting the value of the peso. This free lunch would attract rival moneys. For example, if US dollars started being used in Mexican border towns, then the Mexicans would lose some of their free lunch to the Americans. As the dollar invaded Mexico, the demand for pesos would fall, and the value of the peso would fall with it. More and more of the free lunch would be transferred from Mexico to the US, until the peso lost all value. If the quantity theory were right, one wonders how currencies like the peso have kept any value at all.

(ii) The counterfeiter problem. If the Fed increased the quantity of FRN’s by 10% through open-market operations, the quantity theory predicts about 10% inflation. If the same 10% increase in the money supply were caused by counterfeiters, the quantity theory predicts the same 10% inflation. In this topsy-turvy quantity theory world, the Fed is supposedly no better than a counterfeiter, even though the Fed puts its name on its FRN’s, recognizes those FRN’s as its liability, holds assets against those FRN’s, and stands ready to use its assets to buy back the FRN’s that it issued.

(iii) The currency buy-back problem. Quantity theorists often claim that central banks don’t need assets, since the value of the currency is supposedly maintained merely by the interaction of money supply and money demand. But suppose the demand for money falls by 20%. If the central bank does not buy back 20% of the money in circulation, then the quantity theory says that the money will fall in value. But then it becomes clear that the central bank does need assets, to buy back any refluxing currency. And since the demand for money could fall to zero, the central bank must hold enough assets to buy back 100% of the money it has issued. In other words, even the quantity theory implies that the central bank must back its money.

(iv) The last period problem. I’ll leave this one to David Glasner:

“For a pure medium of exchange, a fiat money, to have value, there must be an expectation that it will be accepted in exchange by someone else. Without that expectation, a fiat money could not, by definition, have value. But at some point, before the world comes to its end, it will be clear that there will be no one who will accept the money because there will be no one left with whom to exchange it. But if it is clear that at some time in the future, no one will accept fiat money and it will then lose its value, a logical process of backward induction implies that it must lose its value now.”

Taken together, I think these four problems are fatal to the quantity theory. Scott is welcome to bring up any problems that he thinks might be similarly fatal to the backing theory, but it will be a tough job. It’s easy to make the quantity theory fit the data. It’s harder to reconcile it with common sense.

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Addendum: Scott Sumner responds.And Mike Freimuth comments. Over at Scott's blog, Mike Sproul writes a rejoinder to Scott. And now David Glasner has chimed in.