I am a big fan of coinsplainers like Andreas Antonopoulos. Listening to Andreas explain how bitcoin works is a great learning opportunity for folks like myself who know far less about the topic. I am less impressed when bitcoiners engage in fiatsplainin', since they generally have an iffy understanding of the actual financial system and central banking in particular.
So for the benefit of not only bitcoiners, but anyone interested in the topic of money, I'm going to fiatsplain' a bit. (I really like this term, I got it from an Elaine Ou blog post)
Paul Krugman recently had this to say about the difference between bitcoin and fiat money:
"So are Bitcoins a superior alternative to $100 bills, allowing you to make secret transactions without lugging around suitcases full of cash? Not really, because they lack one crucial feature: a tether to reality.
Although the modern dollar is a “fiat” currency, not backed by any other asset, like gold, its value is ultimately backed by the fact that the U.S. government will accept it, in fact demands it, in payment for taxes. Its purchasing power is also stabilized by the Federal Reserve, which will reduce the outstanding supply of dollars if inflation runs too high, increase that supply to prevent deflation.
Bitcoin, by contrast, has no intrinsic value at all. Combine that lack of a tether to reality with the very limited extent to which Bitcoin is used for anything, and you have an asset whose price is almost purely speculative, and hence incredibly volatile."Now if you've been reading my blog for a while, you'll know that I agree with Krugman's point that bitcoin lacks a tether to reality while a banknote doesn't. He mentions two forces that anchor a $100 banknote, or provide it with intrinsic value: tax acceptability and a central bank's guarantee to regulate its quantity. Let's explore each of these anchors separately, starting with tax acceptability.
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The idea that taxes can determine the value of a fiat currency is easier to grasp by looking at currencies issued during the American colonial era. Coins tended to be scarce in the 1700s and there were few private banks, so the legislatures of the colonies issued paper money to meet the public's demand for a circulating medium. They had a neat trick for ensuring that this paper money wasn't deemed worthless by citizens. A fixed quantity of paper money was issued concurrently with tax legislation that scheduled a series of future levies large enough to withdraw each of the notes that the legislature had issued. This combination of a fixed quantity of notes and future taxes of the same size was sufficient to give paper money value, since the public would need every bit of paper to satisfy their tax obligations. |
| Examples of colonial currency (it's worth enlarging this image to see the detail) From: Early Paper Money of America |
Crucially, once a colonial government had received a note in payment of taxes, it removed said note from circulation and destroyed it. If the government re-spent notes that had already been used to discharge taxes, this would be problematic. The tax obligation would be more-than-used-up, leaving no reason for the public to demand outstanding banknotes. Krugman's "tether to reality" would have been removed.
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The modern day version of Krugman's tax acceptability argument is a bit more complicated. For starters, no one actually pays their taxes with banknotes. Rather, the tax acceptability argument applies to a second instrument issued by central banks otherwise known as reserves (in the U.S.) or settlement balances (in Canada). All commercial banks keep accounts at the central bank, these accounts allowing them to make instant electronic payments to other banks during the course of the business day, or to the government, which typically will also have an account at the central bank.
When Joe or Jane Public are ready to settle their taxes, they initiate a set of financial transactions that ultimately results in their bank depositing funds on their behalf into the government's account at the central bank. To satisfy the public's demand to make tax payment, commercial banks will want to have some central bank settlement balances on hand. So the existence of taxes "drives" banks to hold a certain quantity of central bank settlement balances, thus generating a positive price for these instruments. And since a banknote is in turn tethered to a central bank deposit via the central bank's promise to convert between the two at par, by transitivity the banknote is also tethered.
Unlike the colonial era, however, the tax authority—the government—can't destroy money. The government can either accumulate central bank deposits, or spend them, but it can't cancel them. What generally happens with the government's account at the central bank is that as soon as it is topped up with some tax receipts, they get quickly spent on government programs, salaries, and other expenses. So these funds simply boomerang right back into the accounts that commercial banks keep at the central bank, undoing the tethering that is achieved by tax acceptability.
Put differently, for every bank that demands settlement balances to pay taxes, and thus help gives those balances value, there is a government official who spends them away, and negates this value. So government taxes by themselves don't anchor modern central bank money.
To really anchor the value of central bank money, the government needs to withhold from spending the money it has received from taxes. The more it resists spending incoming tax flows, the more balances accumulate in its account at the central bank. If the government keeps doing this, at some point almost every single deposit that the central bank has ever issued will have been sucked up into the government's account. With almost no deposits remaining for paying taxes—and thus no way for the public to avoid arrest for failure to meet their tax obligations—the value that banks collectively place on deposits will reach incredible heights.
And that explains how tax acceptability (combined with a strategy of not spending taxes received) can provide modern fiat money with backing sufficient to generate a positive price.
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Let's turn now to Krugman's second reason for central bank money having intrinsic value, the central bank itself. As I said earlier, a government can freeze deposits by accumulating them, but it can't destroy them. The only entity that can destroy money is the central bank. It achieves this is by conducting open market sales of bonds and other assets. When it sells a bond to a bank, the central bank gets one of its own deposits in return, which it proceeds to destroy.
Imagine that banks collectively decide they have too many central bank deposits and start to sell them (a scenario I discussed here). This sudden urge to rid themselves of money will cause inflation. In a worst case scenario, they will get so desperate that the purchasing power of money falls to zero. The central bank can counter this by selling assets and destroying deposits. In the extreme, it can sell each and every one of the assets it owns, shrinking the deposit base to zero. Its actions will drive the value of deposits into the stratosphere, since banks need a token amount to make interbank payments.
And that, in short, explains how central banks can provide dollars with backing sufficient to generate a positive price.
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Which of Krugman's two forces—tax acceptability or a central bank's guarantee to regulate the quantity of money—is more important for imbuing little electronic bits with value?
We know that a government can anchor a fiat money purely through tax acceptability. Colonial money proves it. (Here is another example from the Greenback era) But can a fiat currency be anchored solely through the actions of the central bank, without the help of tax acceptability? Let's set the scene. Imagine that the government has unplugged itself from the central bank by closing its account and instead opening accounts at each of the nation's commercial banks. Since all incoming tax receipts and outgoing government payments are now made using private bank deposits, the government no longer generates a demand for central bank settlement balances.
This "unplugging" needn't drive the value of central bank money to zero. The central bank has assets in its vault, after all, so any decline in the value of central bank money can be easily offset by an appropriate set of central bank open market sales and concomitant reductions in the quantity of deposits. So the answer to my question in the previous paragraph is that money doesn't require tax acceptability to have intrinsic value. Tax acceptability is sufficient, but not necessary.
That being said, on a day-to-day basis the value of modern central bank money is regulated by a messy combination of both factors. Money is constantly flowing in and out of the government's account at the central bank, and this can have an effect on the purchasing power of money. Likewise, central bank open market operations are frequently conducted on a daily basis in order to ensure the system has neither a deficiency nor an excess of balances. It's complicated.
And that ends this episode of fiatsplainin.' Fiat money is indeed backed and has intrinsic value, as Krugman says, and it does so for several reasons.
PS. If you are interested in colonial currency, you should read some of Farley Grubb's papers.
Addendum:
On Twitter, someone had this to say about my post:
฿ryce gives me the perfect opportunity to keep fiatsplainin'. Contrary to ฿ryce's claim, the fact that Arizona plans to accept tax payments in the form of bitcoin does not provide bitcoin with a tether to reality. For every bitcoin that Arizona accepts, it will just as quickly spend it away. The first is undone by the other. You'll notice that this is the same reason I gave for modern central bank money not necessarily being anchored by tax acceptability; whereas taxes vacuum up central bank money, government officials typically reverse this vacuum by quickly spending it, so the net effect is a wash.Ummm one may pay taxes in Arizona in Bitcoin.— ฿ryce Weiner (@BryceWeiner) March 22, 2018
Argument fails on factual grounds.
Bitcoin is tethered to reality. @paulkrugman https://t.co/Z8ojvzw8FX
To tether central bank money to reality, governments need to not only make it tax acceptable but also be ready to let those balances pool up in its account, thus setting a limit on the overall supply of balances. Likewise with bitcoin. If the Arizona government were to accumulate incoming bitcoins as part of an overall policy of never spending them, then it would be removing bitcoins from circulation, in essence "destroying" them. And this would provide bitcoin with a true anchor. Of course the Arizona government isn't going to do this. It will want to rid themselves of bitcoins the moment it gets them.
Interesting, and nicely explained.
ReplyDelete“So the answer to my question in the previous paragraph is that money doesn't require tax acceptability to have intrinsic value. Tax acceptability is sufficient, but not necessary.”
I don’t think so.
You have in effect redirected the root cause of demand from taxation to the demand for bank reserves. But with taxation out of the picture, there is nothing (in theory) preventing Crypto Mad Max from creating his own banking system with bitcoin. That’s sort of idea is inherent in the agenda. The notion that the central bank can control bank reserves becomes moot if the kids successfully establish their own banking system using bitcoin, and take over the world, as is their want.
I think “the idea that taxes can determine the value of a fiat currency” may be better expressed as “the idea that taxes determine that a fiat currency has value”.
Once value is assured, the value determined is determined by other things such monetary policy and fiscal policy as used around that tax system.
Without taxes, there may be no value to be determined. Crypto Mad Max has other ideas.
As you say, real world “bitcoiners … generally have an iffy understanding of the actual financial system and central banking in particular.”
This point is highly underappreciated, and one that should be known when evaluating prospects for the ultimate outcome of various cryptocurrency projects.
"I think “the idea that taxes can determine the value of a fiat currency” may be better expressed as “the idea that taxes determine that a fiat currency has value”. Once value is assured, the value determined is determined by other things such monetary policy and fiscal policy as used around that tax system."
DeleteI'm not quite sure what you wanted to say here, but what understood is false. Suppose that the government, in addition to money, would also accept a special tax token that is useless for anything except paying taxes. Even though this token would not be subject to Fed monetary policy, and wouldn't be accepted by the Fed, if there were only a tiny amount in circulation, they would trade on the market essentially at par.
And on the other hand, if the Fed (or a commercial bank) were to issue a new type of dollar (such as Fedcoin), yet the government decided that it would not accept such dollars directly, those dollars would trade with very little discount, because the issuer would exchange them for different dollars for a tiny fee.
In each case, a single promise can give close-to-par value to the instrument.
"The notion that the central bank can control bank reserves becomes moot if the kids successfully establish their own banking system using bitcoin, and take over the world, as is their want."
DeleteJKH, I am pretty skeptical of bitcoin because it is so volatile, and thus don't think it is likely to take over the world. But even if bitcoin does take hold, the central bank will steadily withdraw settlement balances as the demand to hold them declines, and this will keep up their value. At some point all settlement balances will have been withdrawn, and they will cease to exist, but their purchasing power would have been maintained throughout the entire withdrawal process. (This is similar to what Basil is saying in his second last paragraph.)
I think your argument applies more to how prolific a currency is than what upholds its value. You could be right that tax acceptance encourages the wider circulation of a currency, particularly in the face of competition, and the lack of tax acceptance could hobble its range.
"But even if bitcoin does take hold, the central bank will steadily withdraw settlement balances as the demand to hold them declines"
DeleteSorry JP - I don't understand what you're saying here.
You're considering the possibility that the central bank would denominate reserves in bitcoin?
Why on earth would it do that?
And why would Treasury want to accept bitcoin for tax payments?
Seems like you're assuming the conclusion. But maybe I completely misunderstand you point. I must be.
(My point about "the kids" and their idea was intended as sarcasm)
Perhaps I misunderstood your point. You seem to be intimating in your original post that without tax acceptability, currency competition might lead to a situation in which existing fiat money is no longer valued. i.e. its purchasing power falls to zero.
DeleteI was only saying that as the competition heated up, and demand for the existing fiat money slowly declined, it would not lose value. Rather, the central bank would steadily repurchase it so that its purchasing power held up. At some point the fiat currency might entirely cease to circulate, but the last unit of currency would be repurchased at a price consistent with the central bank's inflation target.
I would add 1 item to JKH's points, with which I agree. That is that that taxes are a *necessary* but *insufficient* condition to determine that a fiat currency has value.
ReplyDelete
ReplyDeleteImagine that the government has unplugged itself from the central bank by closing its account and instead opening accounts at each of the nation's commercial banks. Since all incoming tax receipts and outgoing government payments are now made using private bank deposits, the government no longer generates a demand for central bank settlement balances.
But by current satndards, banks would still have to make payments to one another and, assuming a positive reserve requirement, would have to hold balances at the CB equal to that requirement, no? They usually do this by using their accounts at the CB, aka reserves, no?
This "unplugging" needn't drive the value of central bank money to zero. The central bank has assets in its vault, after all, so any decline in the value of central bank money can be easily offset by an appropriate set of central bank open market sales and concomitant reductions in the quantity of deposits.
I think you can construct an analogy between government spending and taxation and private borrowing and repayment starting with your 'unplugged' model. It is clear that if I, the representative private borrower (corporate or individual), can take out loans from a commercial bank but never repay them, that the credits generated with such loans would in short become worthless. In that sense, banks control the value of their credits by ensuring a sufficient reflux (= destruction) of their credits via loan repayments. Now just replace the term 'loan repayment' with the word 'taxation' and you find the exact same mechanism at work. Does it really matter whether government banks with the central bank or a private bank? Were not central banks once all private banks? I'm assuming you agree so far?
Do you also agree that that analogy now covers virtually all payments within an economy, as opposed to only those made by government? My point is that chartalism isn't wrong as such, it's just too short-sighted. It's a special case.
And, taking my first comment above, would you agree that if there were only one commercial bank, there would be no need for that one bank to hold an account with the CB, as there would be no other bank to settle with?
My point is that interbank settlement balances, aka reserves, are a feature, albeit not a required one, of a setup with more than one comercial bank.
This paper might be of interest:
https://www.minneapolisfed.org/publications/the-region/interbank-settlement-and-the-emergence-of-central-banks
In that sense it seems wrong to construct the question about what it is that guarantees the value and stability of money starting from an institution (a CB) and its books (reserve accounts of commercial banks or governments) that are neither historically nor logically necessary. Instead, it is logical to me and also historically consistent, I think, to start from the smallest common denominator between all transactions within a currency realm, as I have outlined above (and probably many times before :-)).
Yeah, I think we've been through this before. I can't remember how it ended, but it sure was a long discussion.
DeleteYour'e right, that's probably one too many now. I get carried away... But disregarding everything I wrote, do you agree with the article in the link that it is the role in interbank settlement that brought us central banking?
DeleteAnd getting back to fiatsplaining, I found this article which I thought you might like. It fiatsplains in reaction to the upcoming initiative (vote) on 'sovereign money' in Switzerland. That's our version of 'Sound money'. As Antti pointed out to me, there are many parallels between what the crypto crowd imagines money is about and what the sound money / full reserve / sovereign money types do. So I think this fits in with your post.
http://www.swissbanking.org/fr/medias/positions-et-communiques-de-presse/initiative-monnaie-pleine-ses-consequences-potentielles-en-suisse-au-centre-d2019une-etude/the-sovereign-money-initiative-in-switzerland-an-assessement.pdf
(in English)
"Your'e right, that's probably one too many now. I get carried away.."
DeleteI didn't mean to be curt. I'm still trying to digest our epic long thread from last year, and until I get somewhere I don't have much to say.
"... do you agree with the article in the link that it is the role in interbank settlement that brought us central banking?"
Yes, I think that article makes a lot of sense. (Although they never get into private clearinghouses, which can replicate what a central bank does)
Thanks for the link to the paper on Sovereign money, I'll check it out. I've been following events in Switzerland but not closely. It's quite a radical proposal; my preference is for small changes to the existing system.
I don't think there is a practical difference between literally destroying money and keeping it in gvt accounts in the CB. It is not the existence of money per se that plays any role in determining its value. Money not spent is as good as non-existent.
ReplyDeleteAfter all, gvt accounts at the CB are not part of any measure of the money supply.
"I don't think there is a practical difference between literally destroying money and keeping it in gvt accounts in the CB."
DeleteYep, I agree.
"Although the modern dollar is a “fiat” currency, not backed by any other asset, like gold, its value is ultimately backed by the fact that the U.S. government will accept it, in fact demands it, in payment for taxes. Its purchasing power is also stabilized by the Federal Reserve"
ReplyDeleteThat was a very interestingly wrong way to put it by Mr. Krugman. As you have explained in several articles, dollars are backed by the Fed's assets. Does "fiat" simply mean that the issuer is not a currency board, but has some kind of "floating" monetary policy?
Obviously, the fact that the Fed's assets are mostly dollar-denominated, plus that dollars are bonds rather than shares, makes this backing analysis quite difficult. In some sense, it would be far easier if we weren't talking about a central bank but a central ETF. :-D
"Put differently, for every bank that demands settlement balances to pay taxes, and thus help gives those balances value, there is a government official who spends them away, and negates this value. So government taxes by themselves don't anchor modern central bank money."
As far as I understand, this is not what chartalism says. Even if the government tax-tokens weren't very liquid, as long as each person had only a few months' worth in their safes, they would trade with fairly shallow discounts on the market. It is only if the economy is hip-deep in these zero-coupon bonds, so that the marginal one's maturity is several years away, that its value is heavily discounted. Consequently, as long as the marginal maturity is kept short, the government can keep recirculating them with little loss between acceptance at face value and spending at some discount. Withholding them is only necessary if the govt wants to raise their market value by shortening the marginal maturity---and if the tokens also function as money, raise their liquidity premium, but that's quantity theory.
"In the extreme, it can sell each and every one of the assets it owns, shrinking the deposit base to zero."
Nitpick, but central banks have some equity, thus they would run out of deposits&cash outstanding before they would run out of assets. Unless their enormous sale would push down the assets' prices so much that by mark-to-market accounting, they would go central bankrupt.
"Likewise, central bank open market operations are frequently conducted on a daily basis in order to ensure the system has neither a deficiency nor an excess of balances. It's complicated."
I wonder what would happen if the Fed, instead of actively pushing or pulling, would passively allow reflux (in both directions). Effectively it would become a currency board, putting the dollar on a T-bill standard. I wonder because, naturally, T-bills are dollar-denominated, thus both sides of the exchange would float together "in midair", as it were.
"That was a very interestingly wrong way to put it by Mr. Krugman. As you have explained in several articles, dollars are backed by the Fed's assets. Does "fiat" simply mean that the issuer is not a currency board, but has some kind of "floating" monetary policy?"
DeleteKrugman's statement "Its purchasing power is also stabilized by the Federal Reserve" implicitly assumes that the central bank has assets that it will use to "back," or buyback, money.
I think by "fiat" he might mean "not redeemable on demand." Its easy to get bogged down in the semantics in these debates.
As long as taxes are collected periodically and spent periodically, taxes remain a tether.
ReplyDeleteNo, the spending of money earned from taxing undoes the tether.
DeleteTaxes *do* remain a tether. Imagine an illiquid tax token.
DeleteIf there is a fixed M face value in circulation (100 million fabatka, for example), the level of taxation-and-respending determines their value. Let's say that there is an 50 million fabatka/year tax burden on the whole economy, and the yearly interest rate is a whopping 10%. The average tax token would be outstanding for 2 years. And because it works as a zero-coupon bond, it would trade on the market with a two-year discount, i.e. at 81% face value.
If either the tax burden doubled or the outstanding quantity of tax tokens halved, their average time outstanding would drop to 1 year, and consequently they would appreciate to 90% face value. On the other hand, if the tax burden lightened, or the state would try to spend more into circulation than it takes out of it, the average time would increase, and the tokens would drop to a larger discount. In the limit case of no taxation, the tokens would be discounted over infinite time, giving a market value of 0.
The above approach implies through the EMH that everybody will have approximately the same time's worth of tokens with them. If Alice only had one year's worth, while Bob had three years' worth, then she would discount the marginal token less than Bob, and would bid above his ask.
Basil, we could be saying the same thing.
DeleteMy point is that a tax is only effective at giving fiat money value if there is also a mechanism for destroying incoming tax tokens, or freezing them. If the tokens are automatically respent the moment after coming into the Treasury, then that is not sufficient to give them a positive value, since the Treasury is not exerting any influence on the total stock of tokens.
I think I know what we assumed differently. I imagined that if the Treasury had a fixed exchange rate of sorts (each tax token covers 1$ worth of tax obligation), then even if the received tokens were immediately and automatically spent, that could anchor the token's value in terms of the $. If the tax obligation somehow creates an exchange/substitution rate to real goods, then the value of the token is anchored in real terms.
DeleteI *guess* you thought in terms of a scenario where the Treasury accepted the tokens at their floating, market value. In the latter case, if the received tokens are automatically spent on, then indeed their price is not anchored, and as time rolls forward, eventually tends toward zero.
If this is the case, then both of us are right. Either a mechanism to decrease the quantity of tokens, or a fixed exchange rate is required.
You could be right. Maybe you can explain your scheme in terms of colonial currency, which is much more simple to understand than modern fiat money?
DeleteFor instance, colonial taxes were denominated in terms of silver coins. Colonial paper currency was denominated in terms of these coins, so one shilling worth of colonial currency would discharge a shilling's worth of taxes. My contention is that if the government re-spent paper money rather than destroying it, any paper currency in excess of the tax obligation would be worthless.
That was the sort of scenario I imagined. The unit/medium of account is the silver shilling. Then the govt. introduces a security that is illiquid, but secures immunity from taxation to its fixed face value. If someone offered to sell you one of these before the day your tax was due and you didn't yet have any, you would accept it essentially at face value. If you managed to get it at any discount, then after you give the token to the tax collector, you will have more coins left than if you didn't buy it and paid your tax in coin.
Delete(A: pay 100 shillings tomorrow. B: pay 100-x shillings today, hand the 100 sh token in as payment, have x shillings profit left over.)
If you already have your tax obligations covered for some time, then an additional tax token's NPV is less. 1/(1+r)^t. Notice that it doesn't matter who sells you the token. If the government itself is willing to sell the token at a discount, you are willing to buy it from the govt. Then you put it in your pillow, and next year discharge 100 sh worth of tax obligation with it.
So, if you have this year's taxes covered, you have 100 shillings to pay next year, and the interest rate is 10%, then you are willing to give 90 shillings for a 100 shilling tax token. If the government accepts the deal, i.e. it gives you a 100 shilling tax token as payment for work worth 90 shillings, then the transaction happens.
As the government is taking in the tokens at face value, but only gets a discounted value when spending (your 90 shillings of work), it is effectively paying interest on the stock of tokens in peoples' pockets. Of course, for the sake of simplicity, I assumed that the tax tokens are illiquid. If they throw off liquidity services, then they discount at a lower rate. I could say that in this case the government is paying interest in the form of liquidity services, rather than as a pecuniary return. :-) And in this case, the "surplus liquidity" makes coins' premium lower in the colony than elsewhere, so the colony exports some of its coin in exchange for goods. But that's a different story.
To go back on topic: if the government accept the tax tokens at their face value, but is willing to spend them into circulation at their market value (which is discounted), then it doesn't matter if they immediately respend them. And qty in circulation / yearly tax burden is the time (in years) by which the tokens are discounted in the market.
When you are paying your taxes with the token, you are getting the zero-coupon bond to mature.
I agree with a lot of what you're saying.
Delete"To go back on topic: if the government accept the tax tokens at their face value, but is willing to spend them into circulation at their market value (which is discounted), then it doesn't matter if they immediately respend them. "
Let's go a bit further. Say it is 1730 and the colony of New Jersey prints up £30,000 in green notes to pay for bridges and roads. Simultaneously, it publishes a schedule for tax payments for the upcoming two years. At the end of the first year the public will owe £20,000 green notes and at the end of second year they will owe another £10,000, for a total of £30,000. To discharge their tax obligation, each taxpayer must acquire a sufficient quantity of green notes and bring them to the tax office. So in theory, the tax obligation will result in the removal of all £30,000 green notes.
Say that after £20,000 in taxes have been paid in the first year, the government burns just £19,000 of the green notes, respending £1,000. So there is now £11,000 in notes in circulation but only £10,000 in taxes that must be paid at the end of the second year. Since the tax obligation will be used-up before the entire stock of notes has been withdrawn, the public won't demand the last £1,000 green banknotes, and so they will be worth zero.
So that's what I meant when I said that a decision to respend rather than destroy has important consequences for the value of paper money. It's easier to think about this with colonial money, which had a definite tax schedule for each note issue. But I think it applies as well to modern money, although it's tougher to puzzle through, or at least I find it tougher.
I didn't imagine a scenario where taxation stopped in peacetime. I thought in terms of a fairly constant and predictable taxation level, and that is why I insisted that the government is free to respend notes. In your scenario, after the £30,000 is covered, indeed surplus notes will be discounted for infinite time, falling to zero value.
DeleteUnless the public expects that the government will levy taxes again a few years later, *and* that it will accept the 1730 issue notes at face value in e.g. 1740. In this case, the surplus notes fall to a rather steep discount (including the risk that the government won't accept them), but will stay floating somewhere well above zero. (E.g. 6% over 10 years still gives NPV more than 50% of face value.) I suppose this could work similarly to the surprise demonetizations ("When money ceases to be an IOU"), where notes didn't immediately fall to zero.
Alternatively, suppose the government levies £30,000 in tax, but only issues £10,000 in notes. After all notes are paid as tax in the first year (+£10,000 in coin), they can be spent into circulation for a second time.
"I didn't imagine a scenario where taxation stopped in peacetime. I thought in terms of a fairly constant and predictable taxation level, and that is why I insisted that the government is free to respend notes."
DeleteRight, I should have better explained this in my post. In my first draft I had included this example, but took it out for brevity's sake.
So if tax acceptance isn't sufficient to generate a positive price in the colonial example (i.e. you need an extra condition, no respending), wouldn't this also apply to our modern system?
Say that after £20,000 in taxes have been paid in the first year, the government burns just £19,000 of the green notes, respending £1,000. So there is now £11,000 in notes in circulation but only £10,000 in taxes that must be paid at the end of the second year. Since the tax obligation will be used-up before the entire stock of notes has been withdrawn, the public won't demand the last £1,000 green banknotes, and so they will be worth zero.
DeleteWhy would the respending of 1'000 not carry an equivalent tax burden of 1'000? If I borrowed 20'000 from a bank and then repayed half and then borrowed another 1'000, I would still have borrowed 21'000 in total. It doesn't matter whether the bank uses the old notes for the new loan or burns the old ones and prints new ones. That's just a technicality. The books record 21'000 in loans. And if I did not continue borrowing, the bank might as well burn the notes. They are no longer featured in its books.
"So if tax acceptance isn't sufficient to generate a positive price in the colonial example (i.e. you need an extra condition [...]), wouldn't this also apply to our modern system?"
DeleteWe just agreed that the extra condition is more complicated than that. If future taxation and acceptance is expected (i.e. the government isn't losing a war), it can give a positive net present value to surplus notes. You wrote an article about this just a few months ago: http://jpkoning.blogspot.hu/2017/10/an-example-of-tax-driven-money-during.html
"So all that was needed to have irredeemable demand notes trade near the value of gold was a permanent market of tax payers who demanded those notes, and a flow of new notes that did not exceed the rate of drainage provided by the tax outlet. After all, if the supply of notes overwhelmed the amount of tax that needed to be paid, then notes would accumulate in importers pockets with no one willing to bid for them. Once everyone's taxes had all been paid up, demand notes would trade at a discount to gold coins."
Chartalism doesn't apply to the modern system, because the tax-acceptable money is also the unit of account. Thus there isn't any fixed 'real face value' at which money is accepted. If chartalism did apply, then fiscal policy would be monetary policy as well; this is inherent in the theory.
"Tax acceptability is sufficient, but not necessary."
ReplyDeleteActually no. Look up Horsefield's book British Monetary Experiments 1650-1710 (1962). Horsefield gives the example of Exchequer Bills which the government made acceptable in taxes (around 1695 I think) precisely in hopes of putting them into circulation. This, however, was inadequate to get them into circulation. The Government ended up having to draft the Bank of England to stand ready to exchange them into gold in order to get them sold.
Carolyn Sissoko
Strictly speaking, Exchequer bills aren't a fiat object, since they pay interest. They didn't need tax acceptability to be valued since they already had a source of value. What I'm really interested in is why a fiat object doesn't trade at $0, tax acceptability being one of the potential answers.
DeleteI agree entirely that tax acceptability is one of the answers, just not that it is either necessary or sufficient. The contextual details always matter.
DeleteBTW, very interesting post. I just tend to nitpick.
CS
“You'll notice that this is the same reason I gave for modern central bank money not necessarily being anchored by tax acceptability; whereas taxes vacuum up central bank money, government officials typically reverse this vacuum by quickly spending it, so the net effect is a wash. To tether central bank money to reality, governments need to not only make it tax acceptable but also be ready to let those balances pool up in its account, thus setting a limit on the overall supply of balances.”
ReplyDeleteThe Arizona example has its own problems because Arizona is a user of the dollar rather than an issuer (to make the point in very simplistic MMT terminology)
But consider your language above applied to the US government – Treasury and central bank.
“The net effect is a wash” is irrelevant. The currency has value and is demanded because the federal government determines that it is the monetary form that is required for taxes. It is needed for that purpose. The quantification of that value in real terms depends on monetary policy and fiscal policy – but mostly through CPI targeting via central bank interest rate policy. The CB controls either the quantity of reserves or the IOR or both as part of that policy. The fact that dollars move around the system and in and out of various types of bank accounts is irrelevant – whether they flow through the Treasury account at the central bank or through bank reserve accounts at the central bank or through corporate accounts at the commercial banks. It’s all cash management. It's all essentially the same function. All cash managers seek to optimize their holdings of balances - which means netting most of the inflows and outflows away.
I don't think my point about it being a wash is irrelevant. A government (not the central bank) can only provide a fiat currency with what Krugman refers to as a 'tether to reality' if it is capable of reducing its supply in the face of falling demand for money, in the extreme collapsing it to zero.
DeleteTaxes achieved this in the colonial period because incoming currency was immediately burned. But today, a government can only collapse the money supply by taxing it and also freezing it in its account. If it doesn't freeze it, the net effect is a wash (taxes in taxes out) i.e. the government has no effect on the money supply, so it is not providing the fiat currency with a tether.
I find this truly bizarre.
DeleteYou are describing a requirement which in fact doesn't exist and does not happen in practice. How can that sort of fantasy be relevant? The government does not in fact accumulate balances in its central bank account. The opposite happens. Balances are kept to a minimum. That's part of efficient cash management, as I described. How can an institutional mechanism whose logic is effectively the opposite of what you theorize be the basis of value?
Moreover, back to your more fundamental point, the government does in fact "destroy" (private sector held) money - at the margin - and constantly. That's what a Treasury account credit and the corresponding debits through bank reserve accounts and deposit liability accounts achieve. Money disappears at that particular moment. Such accounting entries are directly comparable to the destruction of bank notes. That's a fact, and in itself is also not particularly relevant to what gives value to money.
Its the constant marginal destruction of private sector money that flows into the Treasury account at the central bank that is the manifestation of the value proposition - not the accumulation of those flows as a stock.
DeletePart of that flow is required - taxes - and the other part is desired - bond proceeds. These are complementary forces in the context of currency acceptance.
It's the required part that forces the use of the particular currency in nominal terms. But the "precise" real value is determined outside of that fact - through monetary and fiscal policy.
The quantity theory, to the degree that it is a relevant aspect seen through central bank operations, does not work through the Treasury account. It works through bank reserves. That's inherent in the institutional separation of responsibilities.
The accumulation of Treasury balances is designed to be minimal/optional within that framework. Its not a material factor in the determination of real value, and it is just a small part of the overall institutional architecture for the operating framework that determines the currency that gains general acceptance.
Slow down, I can't keep up! :)
Delete"The government does not in fact accumulate balances in its central bank account. The opposite happens. Balances are kept to a minimum"
Sometimes settlement balances have to be drained from the system because there are too many of them. If not, we get hyperinflation. To maintain the purchasing power of money, balances can be moved from the government's accounts at private banks to the government's account at the central bank, and frozen. And that stops the hyperinflation (what did they used to call this in Canada, the drawdown/redeposit facility?) If the balances in the government account at the central bank aren't frozen, but are instead spent by the government, then the hyperinflation will go ahead anyways.
Or the central bank can just do some open market sales. Or both. None of this seems "truly bizarre" to me.
The institutional structure is designed to minimize/immunize any net reserve drain or add due to Treasury activity. That’s the whole point of a facility like the drawdown/redeposit mechanism. E.g. it redeposits any excess of taxes over spending on a particular day. So the net reserve effect is zero or close to it. Treasury is intentionally precluded from being involved in active monetary policy reserve adjustment as a result of this arrangement. It reflects a clear separation of responsibilities between Treasury and the central bank. The net reserve change effect is left up to the central bank as part of its monetary policy.
DeleteSo one thing I find odd is why you would focus on scenarios for the Treasury account effect, when net reserve adjustment operations clearly fall under the responsibilities and operations of the central bank.
Anyway, all of this is quite separate from the idea of the demand for the currency in the sense of Chartalism (for example). The demand for the currency according to that view comes about from the government's demand for taxes payable in the currency of choice. Its not about the quantity of the currency available. Its about why there's a demand for that particular currency at all. The real value of the currency as it might be affected by monetary policy is a separate issue from that basic demand. Central bank monetary policy per se does not explain why the dollar remains more popular than Bitcoin. The deeper question is the actual choice of the currency that is on the receiving end of that monetary policy. And that choice integrates with the same choice for the currency in which sovereign level taxes will be payable.
P.S.
DeleteThe old drawdown/redeposit mechanism evolved – see section 3.1 here:
https://www.bankofcanada.ca/wp-content/uploads/2010/07/lvtsmp3.pdf
But, exactly the same objective as the old one:
“The difference between the government’s maturing deposits and its new term deposits tendered at both the morning and afternoon auctions will neutralize the net government disbursements or receipts and any Bank of Canada flows for the day.”
(I’ve seen this paper often, but never gotten around to reading it. It seems like a good one for updating understanding compared to the old system)
"So one thing I find odd is why you would focus on scenarios for the Treasury account effect, when net reserve adjustment operations clearly fall under the responsibilities and operations of the central bank."
DeleteYeah, fair enough. I agree that the whole process is run by the central bank. So if the overnight rate needs to be pushed down because there aren't enough reserves, and a reduction in the government's account at the central bank will do the trick, it is the central bank who would be deciding on this tool.
I don't think this affects my point that mere tax acceptance is not sufficient to give modern fiat money a positive value. The government has to also destroy or freeze the stuff, which as you point out is not even under its control but rests with the central bank.
As I don't expect you'll publish my rebuttal to your update, I shall contribute it here. Even in the update the author makes the logical fallacy of assuming that Bitcoin is a store of value when it is clearly that everyone else other than Bitcoiners (including the state of Arizona), disagree.
ReplyDeleteBryce, I don't follow. How do I insert store of value into the conversation? Even if I do, how is this relevant?
DeleteJust take one thing, control over reserve levels. That one thing is a requirement for all types of currency issuance, nothing central bankish about it. This is relevant because the explanation left us with the impression that only central bank issuers control reserves. I do not know why is was brought up, it is a prior. Central banks have no claim to be better at reserve control than any other monetary system.
ReplyDelete"...the explanation left us with the impression that only central bank issuers control reserves."
DeleteIn the context of my post, reserves (or settlement balances) are deposits held at the central bank. Since they are issued by the central bank, the central bank has the ability to control their quantity.
The CB doesn't in operational practice control the quantity. The CB has its interest rate target and the commercial banks have there requirements depending on factors such as clearing, and then the CB provides the quantity and IOER to hit the target. To look at the monetary system its better to start with commercial bank deposits and work backwards. Commercial bank deposits are the predominant form of money in the monetary system. It makes sense to discuss the monetary system in terms of commercial bank deposits rather than central bank deposits as it is the value of commercial bank deposits that the central bank targets when doing CPI targeting and its is the purchasing power of commercial bank deposits that consequentially set the value of central bank notes.
DeleteYou'll notice that this is the same reason I gave for modern central bank money not necessarily being anchored by tax acceptability; whereas taxes vacuum up central bank money, government officials typically reverse this vacuum by quickly spending it, so the net effect is a wash. To tether central bank money to reality, governments need to not only make it tax acceptable but also be ready to let those balances pool up in its account, thus setting a limit on the overall supply of balances
ReplyDeleteI think you're not accounting for the things government is spending on. Take the following example:
Government issues bond and is credited the equivalent amount to its account which it then spends on some public service. So in the first instance, gvt. is down x$ in bonds and up x$ in credits. After spending it is down those x$ in credits and up x$ in services while the reverse it true for the public.
To recouperate its money it then taxes the public x$. It uses those taxes to pay back the bond, leaving all its accounts at 0. = destruction of money by government, no?
And if that were the only act of said government, the story would end here. In reality though, such spending and taxation cycles are overlapping and ongoing and bonds are rolled over etc.. The same goes for the goods and services that are constantly being commissioned. It is by not matching spending with taxation 1:1 or by over- or underpaying for the things it spends on which, as a de facto monopolist, it can easily do, that both prices and levels of money in or out of circulation are influenced by the treasury. Also, should balances indeed pile up in its account, there is nothing to say that they must be kept in that form. They can be used to pay down outstanding debt, on buying more goods and services (increases in government spending) or on things like a sovereign investment fund etc.. in any case, the size of positive balances in its account at any point says nothing about what's going on in the economy.
"It uses those taxes to pay back the bond, leaving all its accounts at 0"
DeleteAt which point settlement balances just boomerang back into the accounts of the private sector. In order for the value of central bank money to be sustained (say in the face of massive dishoarding) the government needs to freeze it, thus reducing the total supply.
You've added bonds to the story. I definitely agree that bonds are one of the way to freeze balances. For instance, the government can issue bonds specifically to vacuum up excess settlement balances, and then keep them lodged at the central bank unspent. This is what the U.S. Treasury and the Fed did in 2008 to keep the supply of reserves tight.
At which point settlement balances just boomerang back into the accounts of the private sector.
DeleteYes, but that's where they would have been anyway. The question then shifts to whether the private sector can get rid of balances and what determines whether such balances are considered 'excess'. So yes, it's correct that government, and I'm assuming you mean treasury, cannot control balances that are no longer on its accounts and that thus, per your original post, there is more to managing money in our modern economies than tax acceptability. And if, in a hypothetical world, there were only government to manage our money, it would have to perform the function of the CB as well.
I don't agree with the fact that, for that to work, balances have to accumulate somewhere or be mopped up with bonds. You can just as well construct the central bank as an overdraft type, in which settlement balances must be borrowed at the going rate from the CB (or government, if there is no CB). That way, banks just pay back their debt to the CB, destroying balances in the process, if settlement balances happen to be in excess of what they need / want for settlement purposes. The actual set-up in the US and other places is just an (unnecessary) complication of such a system.
I can't recall previously seeing an argument that conflates chartalism with monetarism - as this post seems to do.
ReplyDeleteChartalism does not depend on monetarism.
Chartalism is about what creates the ultimate demand for a particular form of currency.
Not about what gives a unit of that currency its particular real value.
Real value determination is one step past fundamental acceptance.
And real value determination doesn’t require a monetarist argument – certainly not one that focuses on the particular monetary effect of Treasury balances at the central bank.
It might be useful to split the issue between nominal value and real value. The Chartalist argument basically says that taxes anchor the demand for the nominal currency. So it anchors the demand for the US dollar compared to bitcoin, for example. This is not a theory of real value determination. As a simple example, suppose there is an across the board uniform inflation. So nominal GDP, nominal government spending, and nominal income all increase in proportion to the inflation rate. Taxes will go up proportionately – albeit very roughly speaking – due to taxation rates based on income. So there is nothing to say that the Chartalist tax linkage and anchorage shouldn’t be preserved under these conditions. Under extreme conditions of either deflation or inflation, people still need to find the currency to pay their taxes in a nominally proportionate way. There are variations of course. But real value of the currency is apart from this.
ReplyDeleteReal value of the currency is a separate step in the value proposition. Governments can run fiscal policy and monetary policy according to targets for inflation and therefore targets for the real value of the currency.
I find the post interesting partly because the Treasury account part reminds me of how MMT frames its argument for monetary theory. MMT talks about government spending or lending being the temporal/logical precursor to taxation. They do this in the context of the Fed having to add sufficient reserves to allow banks to pay taxes on behalf of their customers. They generalize this to the level of the sovereign – regardless of institutional structure – having to create the money that is used to pay taxes. I’m not sure why they dwell on this, except that it’s part of their general argument that sovereign currency issuers can’t run out of money, etc. Your post focuses on vaguely similar idea at the deconsolidated level of the Treasury account at the central bank – in the sense that this account can easily be interpreted as a draining of reserves through taxation. Still, the Treasury account is not normally used to create a net drain, because the money goes out the other side in spending or debt retirement. And that’s due to institutional separation of responsibilities – it’s not Treasury’s job to manage the excess bank reserve position.
I purposefully left terms like monetarism, MMT and chartalism out of this post so they wouldn't introduce any baggage.
DeleteI feel that it is quite similar to Nick Rowe's old post:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/hahn-vs-wicksteed-stocks-vs-flows.html
Both of us are saying that for fiat money to have value, it is not sufficient for the government to require it for payment of taxes. You need something else.
The first sentence of that post is outright wrong (think normal quantity bank reserves). And I can't grasp the connection with the rest of it.
DeleteAnyway, I haven't really opined on whether its necessary or sufficient. Just a bit puzzled by the analytical approach toward the question.
I finally got to read some of your latest posts. Good stuff again, but I'm afraid I join too late. We need to discuss them in depth another time (perhaps at the Moneyness discussion forum).
ReplyDeleteI just wanted to point out a minor detail:
Arizona possibly accepting Bitcoin does nothing to tether Bitcoin to reality, unless Arizona somehow fixes BTC/USD rate. I assume they accept Bitcoin at the market rate, so that 1 BTC takes care of $1 of taxes if that happens to be the market price of BTC at the time of tax payment. I don't see how this would be changed even if they didn't spend/convert the BTC right away.
I might be wrong, having given the discussion just a quick read, but it might be that you are too wedded to quantity theory of money when thinking about the value of money, at least in this particular instance. That's what I think was going on between you and JKH. When it comes to colonial currency, I think you put too much weight on the tokens being burned or kept stashed in vaults. As Oliver, I think, pointed out, they could very well be re-used, as long as spending = taxation also in the future. I think you agree on this one. But one could get the picture you don't, because you seemed to be so strictly against re-spending the tokens.
To clarify: It's not the stocks, but the flows that matter. And the quantity theory is mostly about the stocks, isn't it?
Delete