Friday, December 12, 2014

Short selling and monetary theory

Jacob Little, legendary short seller.
The Great Bear of Wall Street
1794 - 186
This is a guest post by Mike Sproul

To understand short-selling, start with three words: “Borrow and sell.” The short-seller in figure 1 borrows a share of GM stock from a stockholder and then sells that share of stock to a buyer for $60 cash. If GM subsequently drops to $50, then the short-seller can buy a share of GM on the open market for $50, repay that share to the stock-lender, and profit $10. But if GM instead rises to $70, then the short-seller loses $10, since he must pay $70 to buy the stock before repaying it to the stock-lender.                                                      

As the short-seller borrows one share of GM, he hands his IOU to the stock-lender. This IOU promises to deliver a share of GM stock. (It would also promise to compensate the stock lender for any dividends missed as a result of lending the stock.) Since the IOU can be redeemed for a genuine share, the IOU will be worth the same as a genuine share. This means that the stock lender does not have much reason to care whether he holds the genuine stock or the IOU (unless he cares about losing his voting rights in the corporation).

Figure 2 shows a simpler way to sell short. The short-seller simply writes up an IOU and sells it directly to a buyer. This kind of short sale gives the same payoff as the “borrow and sell” short sale of figure 1. If GM falls to $50, the short-seller gets a $10 profit, while if GM rises to $70, the short-seller loses $10. This method of short selling is so simple that it can happen by accident. Suppose you're a stockbroker, and a client calls asking you to buy one share of GM for him. You answer, “OK, you got it”, and hang up, planning to deliver the actual stock later in the day. You have just gone short, and you stand to gain $1 for every dollar the stock falls, while losing $1 for every dollar it rises.

A still simpler way to go short is to make a bet with someone, as shown in figure 3. The terms of the bet are that for every dollar GM falls, the buyer pays the short seller $1, while for every dollar GM rises, the short seller pays the buyer $1. The payoffs from this bet are the same as the other two methods of short selling. The bet shown in figure 3 is like a futures trade: There is no actual delivery of GM stock, and gains and losses are settled periodically, including adjustments for dividends. In contrast, the trade in figure 2 is like a forward trade: There is a promise to deliver GM stock, and gains and losses accumulate until the position is closed out.

Some common misunderstandings about short selling:

1. Are these IOUs counterfeit shares? Do they dilute the underlying stock and reduce its value?

No, no, and no. And never mind what CEO Patrick Byrne says. The short seller who issues the IOU puts his name on that IOU, recognizes the IOU as his liability, and stands ready to deliver a genuine share to the holder of the IOU. These are not the actions of a counterfeiter. But suppose there are 1 million genuine shares of GM stock in existence, and that short sellers have collectively issued 2 million IOUs. In a sense, the quantity of GM shares has tripled, and you might expect the share price to fall to 1/3 of its former level. But don't forget that GM did not issue the IOUs, and they are not GM’s liability. They are the liabilities of the short sellers. The issuance of IOUs through short sales does not affect the number of genuine GM shares, nor does it affect GM’s assets, so it can't affect share price. If short selling somehow did put share price out of line with the firm's actual value, then arbitragers would pounce. There will occasionally be liquidity crises when markets break down, stocks are hard to borrow or hard to buy, and arbitrage can't play its usual role; but in normal conditions, arbitrage assures that short selling does not affect share prices. Besides, short selling itself helps to keep markets liquid, and makes these liquidity crises less likely to occur in the first place.

2. What is a naked short?

In figure 1, a naked short would occur if the short seller failed to deliver the genuine share to the buyer within 3 business days. If this happens, the “borrow and sell” short of figure 1 reverts to the “forward style” short of figure 2. The buyer ends up holding the short seller's IOU, rather than the genuine share. If the short seller fails to deliver the genuine share even after an extended period, then the two traders could still settle up with each other in cash or other securities. The “forward style” short of figure 2 would thus revert to the “futures style” short of figure 3. If worse comes to worst and the short seller defaults, then either the stock exchange will make good the loss, or the traders will get a costly lesson in placing too much trust in their fellow man. Sometimes the SEC will step in, and traders will get an even costlier lesson in placing too much trust in the government.

Note that in all three methods of short selling, the dollar payoffs to both traders are identical. This highlights the futility of the numerous restrictions that governments place on short selling in general, and on naked short selling in particular. In the first place, any legal restriction on one type of short selling will only cause traders to switch to a different kind that is not so easily restricted. In the second place, studies show that when governments do succeed in suppressing short sales, markets become less efficient.

3. Short selling and money

When you buy a house, you borrow dollars and then sell those dollars for a house. This makes you short in dollars, just like borrowing and selling GM makes you short in GM (figure 1). Alternatively, you might buy that house by handing your IOU directly to the house seller. This would put you in a “forward style” short position in dollars (figure 2). If you are well known and trusted, then your IOU can actually circulate as money. But normally a bank would act as a broker between borrower and lender, and the bank would issue its own IOU (a checking account) in exchange for your IOU. The bank's IOU will circulate more easily than your IOU, so we commonly talk as if the bank has created money. This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money.

It's reasonable to think that short selling of money is governed by the same principles that govern short selling of stocks. Specifically, the fact that short selling of stocks does not affect stock price makes us expect that short selling of money will not affect the value of money. I think this view is correct, but it puts me at odds with every economics textbook I have ever seen. The textbook view is that as borrowers (and their banks) create new money, they reduce the demand for base money, and this causes inflation. This is where things get weird, because the borrowers, being short in dollars, would gain from the very inflation that they caused! Nobody thinks this happens with GM stock, but just about everyone thinks that it happens with money.

If the textbooks are right, then the value of the dollar is determined by money supply and money demand, and not by the amount of backing the Fed holds against the dollars it has issued. For example, if the Fed has issued $100 of paper currency, and its assets are worth 30 ounces of silver, then the backing value of each paper dollar is 0.30 oz/$. But if the money supply and money demand curves intersect at a value of 1 oz/$, then the dollar will supposedly trade at a premium of 0.70 oz/$ over and above its backing value of 0.30 oz/$.

This is where short sellers pounce. They could borrow 10 dollars and sell them for 10 oz. of silver, as in figure 4. As they borrow dollars, the short sellers issue dollar-denominated IOUs that promise to repay $10 worth of assets (ignoring interest). These IOUs can either be used as money directly, or they can be traded for a bank's IOU, which could then be used as money. The proliferation of these IOUs will, on textbook principles, reduce the demand for the Fed’s paper currency, causing it to fall in value, let's say to 0.9 oz/$. Now the short sellers can repay their $10 loan with only 9 oz. of their silver, earning an arbitrage profit of 1 oz. (Note that they don't repay their loan with currency, since buying currency with silver would drive the dollar back up.). The short sellers profited from the inflation that they caused. As the short selling continues, the dollar will continue to fall until it reaches its backing value of 0.3 oz/$, at which point short selling is no longer profitable. (Reality check: Currency traders don't usually deal in silver. A more realistic scenario would have traders borrowing dollars and selling them for British bonds (denominated in pounds). This would reduce the monetary demand for dollars and the dollar would lose value, at which point the traders would swap their British bonds for depreciated US bonds, which they would use to repay their dollar loans.)

So here’s the problem with textbook monetary theory: If you think that money's value is determined by money supply and money demand, and that money trades at a premium over its backing value, then you'd have a hard time explaining how money holds its value in the face of speculative attacks by short sellers. You’d also have to wonder why central banks bother to hold any assets at all. But if you think that asset backing determines money's value, there's nothing to explain. Money's value is governed by its backing, just like stocks, bonds, and every other financial security, and short selling will not affect its value.


  1. Suppose that for some reason the convention was for normal loans to be made in GM stock rather than dollars. So if you wanted a mortgage, you'd have to borrow GM stock and sell it for cash. People might not desperately want to short GM, but plenty would still do so if it were the only way to borrow. So there would be a huge gross long position in GM and investors with positive financial net worth would on average be holding a significant portion of their assets in GM exposure. Would you not expect this to have some impact on the price?, Even though GM's earning potential would be unchanged, I'd expect the rate at which people discount to increase, reflecting the increased concentration risk.

  2. Nick:

    The huge gross long position would be offset by an equal short position, so on balance there would be no effect on the price of GM stock.

    As for the sort selling of money, there is one area where short selling could cause inflation. Let's say that everyone trades with silver, and then paper money is invented ($1=1 oz). People who borrow silver and sell it would create paper money (dollars) in the process. The proliferation of paper money would reduce the demand for silver, so silver would buy less at the grocery store, but $1 of paper will still buy 1 oz. of silver. I'd say there's been "silver inflation", but no "paper inflation". But once silver has lost all its monetary premium, additional creation of paper dollars (through short selling) can't cause silver to fall any further. At that point the backing theory would be fully correct. The creation of new paper dollars will not cause either kind of inflation.

    1. Certainly if each person had a short position to offset their long position, it would make no difference. But it's fairly key to what I'm saying that different people are taking different positions.

      Out of interest. If someone wanted to buy a house, they could borrow dollars or theoretically they could borrow GM stock and sell it. Amongst other things, it would depend on whether they wanted to be short dollars or short GM stock. In practice, the vast majority of borrowing is carried out in dollars. Presumably the reason for this is not simply that lots of people are trying to take short positions on the dollar.

    2. Nick:

      What I mean is that whenever anyone takes a short position, he issues an IOU. Someone has to hold that IOU, so for everyone who goes short, someone goes long. It's just like saying that for every seller there is a buyer.

      Your second paragraph sounds right.

  3. "This is not quite right because the bank is not short in dollars on net. The bank went short in dollars as it issued its IOU, but it took an offsetting long position in dollars when it accepted your IOU. The bank is therefore neutral in dollars, while the borrower is short in dollars. This is why it makes sense to say that borrowers are the original issuers of money, while the banks only help out by putting their name on the money."

    Why is the borrower short in dollars on net? A borrower goes short in dollars as it issues its IOU to the bank, but takes an offsetting long position in dollars when it accepts the bank's IOU.

    1. The borrower only holds the bank's IOU momentarily. Once the borrower buys a house, the borrower is short in dollars and long in houses. The lender, who was long in dollars to begin with, is still just as long in dollars, since he holds the IOU instead of his original dollars. Meanwhile, the bank is neutral in dollars, since it owes dollars to the lender (aka depositor) at the same time that it holds the borrower's IOU

    2. What if the borrower buys a dollar-denominated bond instead of a house? What if the banker sells the borrower's IOU, say via a securitization? I'm not trying to be difficult here, just trying to nail down what it means to be 'short in dollars'. I think I'm trying to draw out the point that rather than borrowers being the 'original issuers of money', the origination process seems like a simultaneous one.

    3. In fig 4, replace "silver seller" with "bond seller", and "10 oz silver" with $10 bond".

      Assuming the bond seller owned the $bond already, he was long $ to begin with. Then he swaps his $ bond for $10 cash, and he is just as long as before. The short seller, meanwhile, issues his $10 IOU, which makes him short $, but he also gets the $10 bond, which makes him long. So overall, he is neutral. The transaction thus doesn't change anyone's longness or shortness in $.

      Suppose the bond seller was also the writer of the bond. He was neutral in $ to begin with, but writing the bond makes him short $. But at the same time he gets $10 cash, which makes him long $ and neutralizes his $ position. Meanwhile the short seller's issue of the $10 IOU makes him short $, while his receipt of the $10 bond lakes him long $, so his position is also neutral in $.

      The origination process is simultaneous in the same way that as minting coins is. The "originator" brings an ounce of silver to the mint, and the mint stamps it into a $ coin. Both had a hand in the process, but the originator provided the silver, while the mint only put his name on it. I suppose we can imagine situations where the bank's name was more important than the ounce of silver, and so, rather than saying that the borrower was the creator of the money and the bank was only the rubber stamp, I should have said that there is (variable) input from both. But of course the textbooks always say it's the banks that create the money, and the borrower gets no credit. So my defense is that the textbooks are more wrong than I am.

  4. I have some comments on the is post

    In figure 1 the short seller's "IOU" is know as a Securities Lending Agreement (SLA). The SLA will require the short seller (or borrower) to post collateral (cash or securities) with the securities owner which is at least equal to the market value of the stock. This collateral position is adjusted as the market price of the stock the short seller "borrowed".

    Figure 2 is nonsense. If a seller fails to deliver the stock at the end of 3 days the buyer will send a "buy in" notice to the seller (with copies to the exchange and the SEC). The "buy in" notice gives the seller 2 days to deliver the stock and if the seller fails to deliver the buyer will buy the stock in the open market and the cost of the trade will be charged directly to the short seller. There is no seller "IOU" generated for a failure to deliver the stock traded and there is actually no "naked short selling." in the stock market. A short sell's "failed" trade will quickly be corrected by the buyer.

  5. Anonymous:

    You are correct that a borrower of stock (figure 1) must post collateral, just as the borrower of cash would do in figure 4. I didn't mention the collateral in either case, since this was unrelated to my larger point about monetary theory.

    Figure 2 is valid. In the first place, many short sales happen exactly that way. A currency trader promises to deliver pounds in exchange for a payment of dollars. A farmer promises to deliver wheat in exchange for a cash payment. A home seller promises to deliver a house, etc.

    But let's use your example: Suppose that a short seller fails to deliver the stock in 3 days. The buyer is left holding the seller's IOU, just as in figure 2. The 'buy in' just announces the buyer's intention to close on the IOU within 2 days. The law might say 2 days or two years, but the economic principle, the fact of the IOU, is the same. Even if we follow the letter of the law and only allow 3 days to deliver plus 2 more for the buy in, that's 5 days that a naked short sale existed in the stock market. But what about other markets? Naked short sales occur in commodities markets, currency markets, home loan markets, etc, and they follow the pattern of figure 2. And of course, part of my point is that laws such as you mentioned, that restrict naked shorts, are misguided.

    1. "Figure 2 is valid. In the first place, many short sales happen exactly that way."

      The problem is the examples you give are not short sales (guess we are leaving out the "naked" part). They are simply ordinary business agreements or contracts to conduct a trade or exchange in the future when certain conditions have been met. The currency trader is paid when he delivers the pounds, the farmer is paid the wheat is delivered to the buyer, and the home seller is paid at closing when the title to the house is transferred to the buyer. No short positions (naked or otherwise) taken.

      In your example of a "naked short" stock trade (fig. 2) the buyer pays the seller $32 for 1 share of GM stock but the seller fails to deliver the 1 share of stock (aka a fail) but instead sends the buyer an "IOU" saying something like "I owe you 1 share of GM common stock. Keep in touch." If your were the buyer and out $32 (try multiplying that by 1,000) what would you think? I have been investing in the stock markets for almost 40 years and have been on the buy side of a couple of fails. I have never seen or heard of this "naked-short-selling-IOU" thing. If some seller did sent an "IOU" it would be forwarded to the exchange officials and the SEC for investigation as soon as everyone stopped laughing. The stock market is a cash settlement market - if you have shares of a stock you can sell them for cash and if you have cash you can buy the shares of a stock. There are no stock trades that involve IOUs on either the sell or the buy side. These IOUs don't exist.

      The 3 day deliver period is the time allowed the seller to send the information of the trade to the stock transfer agent and for the agent to transfer the number of shares of the stock traded from the seller to the buyer. Most failures to deliver occur because: (a) the brokerage client did not provide the stock certificate in a timely manner (much more common prior to 1980) or (b) the brokerage firm's back office failed to process the trade in a properly or timely manner or both.

      The term "naked short seller" has a restricted meaning in the securities industry. It refers to a short seller who sells the stock first then goes out and borrows the stock for delivery to the buyer. But this does not involve issuing this "IOU thing" to the buyer.

      I don't believe "naked short sales" exist in the cash markets for commodities, currency, home loans (?), etc., (futures markets are another matter) for the simple reason that "naked short sales" are a form of fraud (or theft by deception in some jurisdictions). To offer for sale or trade goods, commodities, or items and then accept payment or trade and then not deliver or provide the items sold is one form of fraud and subject to civil and/or criminal legal action. The securities exchanges and SEC have constructed a legal strong legal defense for the member firms for any "failures to deliver/naked short sales" with the "buy in" procedures which are a part of the exchanges regulations (and approved by the SEC) and govern the member firms. The "buy in" procedures are a quick, efficient, and no-cost way to correct errors or harmful actions by the member firms and an almost foolproof way to cut off any legal action by individuals that may have suffered harm.

      I am a little surprised to see you think the restriction of naked shorts is misguided.
      How so?

    2. Anonymous:

      If A promises to deliver so many pounds to B, and B promises to deliver so many dollars to A, then A is short in pounds and B is short in dollars. It's no different if the promises are to deliver wheat, shares of stock, or houses. I don't see how you can say that no short positions are taken, since A stands to lose if the pound rises and win if the pound falls. That's the defining characteristic of a short position. If your terminology is different then OK, but there can't be any argument about gains and losses from price movements.

      The promises traders make will go by various names, but I use "IOU" because people understand that more readily than other terms. Sorry if this puts me out of line with standard industry terminology.

      Let's say a short contract has been signed, like in figure 1, but the 3 days is not yet up and the short seller has not yet borrowed the share. What is the buyer holding for those 3 days? He is holding the short seller's IOU, just like in figure 2. If the law were changed and 3 days became 3 years, nothing important would change.

      Going back to traders A and B above, the first thing to notice is that the swapping of IOU's (which creates naked short positions) is a voluntary trade. Just like you and me swapping apples for oranges. I'm saying that restricting naked short sales is misguided for the same reason that restricting apple/orange swaps is misguided.

    3. "I don't believe "naked short sales" exist..."

      It's very common in bond markets and it is not illegal. Bond traders will fail to deliver for long periods of time. Until a fails penalty fee was introduced in 2009, traders could fail for free!

    4. Mike Sproul:

      This discussion seems to be going around in circles. A hypothetical example may help me explain my point. Say I want to buy 1,000 shares of GM stock. I place an order with my broker to buy 1,000 shares of GM at the current market price. My broker finds a seller offering 1,000 GM shares any buy them. My broker deducts $32,000 from my margin account (GM was at $32/share) and pays the seller $32,000. The seller sends the information on the trade to the stock transfer agent who in turn transfers 1,000 GM share from the seller's name to my name. In 1, 2, or 3 days after the trade my margin account is credited with 1,000 shares of GM. I don't know if the seller was an individual who owned GM stock, or an individual who was doing a short sale with stock he "borrowed", or a mutual fund, or whatever and I don't care. Now if the transfer of the GM shares was not completed at the end of the 3rd day after the trade I would expect my broker to send a "buy in" notice to the seller and if the stock was not transferred to my account after two days I would expect my broker to go back into the market and buy 1,000 shares of GM for my margin account. During this 3 or 5 day period my margin account has been reduced by the $32,000 I paid for the GM stock.

      Now according to your example the seller was "naked short" and he sends me an IOU. To me an IOU would be worthless and my broker will think an IOU is worthless. All it means is that I would be out $32,000 and have a not from some clown's to show for it. And if would make no difference if it was 3 days or 3 years - are you serious.

      Now for your two currency traders A and B. OK they trade IOU's. Now suppose a client comes the B and asks to buy pounds to pay for a shipment of Jaguar F types he is importing from Great Britain. So B gives his client A's IOU to pay for the shipment of cars? Is that suppose to be a joke?

      You think "naked short sales" are OK because it is like you and me swapping apples for oranges. It is actually like you giving me an apple and I give you a hand drawn picture of an orange.

      JP Koning:

      In the Treasuries market the payment and the securities transfer happen at the same time. A failure to settle means the seller did not provide the custodian with instructions to complete the trade so securities are not transferred from the seller to the buyer and the buyer does pay any monies to the seller. A settlement failure is really just a non-trade. But a "naked short sale" would be were the buyer pays the seller but the seller does not deliver the securities because the seller does not own them. The NY Fed research report is really good. I did not realize trades of Treasuries could be reversed so easily. That is not true in other markets.

      I still don't believe there are "naked short sales".

      Nice try thou.

    5. " securities are not transferred from the seller to the buyer and the buyer does pay any monies to the seller. A settlement failure is really just a non-trade."

      No, settlement failure does not mean a non-trade. Even if cash isn't transferred and delivery fails, both parties to a trade have transferred IOUs to each other -- an IOU to deliver a bond and an IOU to deliver cash. We know that a trade has occurred because even though settlement may fail for a period of weeks, subsequent changes in the bond's price will affect the wealth of both transactors. That's because the relative value of the IOUs will fluctuate as the underlying securities change.

    6. Anonymous:

      We agreed at the start of the discussion that these IOU's are backed by collateral, so assume for the same of discussion that the IOU's are issued by an honest, solvent trader with plenty of money in his margin account. In that case, people are just as willing to hold Merrill Lynch's promise to deliver a share of GM as they are to hold a genuine share of GM (assuming they don't care about voting rights.)

      If I have $100 in a checking account, then I am holding the Bank's IOU, which promises to deliver up to 100 federal reserve notes on demand. I occasionally demand delivery of FRN's, but for the most part I am holding the bank's IOU. The bank and I have entered a naked short position, and we will stay in it for an indefinite period. Most of this country's money supply is a permanent float of money created by naked short positions in dollars.

      If I wanted to enter an extended naked short in GM, then I could sell my GM IOU, and just roll my position over every 3 days, staying in a naked short as long as I want. With a simple change in the law, I would only have to roll it over every 3 years.

      Also, I'd be happy to accept your drawing of an orange, as long as you posted collateral.

    7. Mike Sproul:

      " We agreed at the start of the discussion that these IOU's are backed by collateral,"
      The issue of collateral was raised in connection with the Securities Lending Agreement (short sellers IOU) in fig. 1 and you said that something in fig. 4 was collateralized but now collateral is springing up all over the place. Now this mythical "short seller IOU's" are collateralized? That is something new? What are the collateral parameters? Any how, why do you assume a buyer of GM shares who was "naked shorted" would be willing to accept Merrill Lynch's promises? Also, neither the broker nor the broker"s customer who bought the GM "naked shorts" would have any knowledge of the financial position of the Merrill Lynch customer selling the mythical GM "naked shorts" and it would be illegal for Merrill to disclose such information. Also, who would be responsible for getting these mythical "GM IOU's" listed on a securities exchange and who would be responsible for selecting and paying a transfer agent?

      "If I wanted to enter an extended naked short in GM, then I could sell my GM IOU".
      You as a "naked short" seller issued your "GM IOU" to the poor sap on the buy side of the trade. You don't hold any "GM IOU's" to sell.

      JP Koning:
      "No, settlement failure does not mean a non-trade."

      I know that a settlement failure will not change either the sellers or the buyers balance sheets since no securities were transferred and no cash was paid. I also know that the standard buy/sell order form incorporates by reference provisions which in effect creates a contract between the counterparties in the trade. I did not realize that the counterparties also exchanged "IOU's". How are these "IOU's" recorded on the sellers and buyers balance sheets and how are they priced?

    8. Anon: I don't know the specifics about how the accountants would handle it.

    9. Anonymous:

      I suppose we've reached an impasse. Against your point that there are no naked short sales, I've given examples from foreign currency markets, and commodity markets, and JP has given examples from bond markets. Even in the stock market, where naked shorts have been wrongly outlawed, they occur for 3-5 day periods. And if, for example, some major trader signed a deal to deliver GM shares 6 months from now in exchange for cash payable either now or in 6 months, that would be a naked short too.

  6. Great post (once again)!

    I wonder if commodities held by the Central Bank are more of a legacy but the actual backing is provided by the expected future taxation/production? The assets held are insufficient anyway to provide the value observed.

    1. Jussi:

      Thanks! I'm not sure what you mean when you say the assets are insufficient. The Fed's balance sheet shows enough bonds and gold certificates to buy back all of the federal reserve notes that the fed has issued, at par.

      The backing theory answer to your question is that the fed's assets (mostly gold and bonds) are the actual backing for the money issued by the fed (FRN's + federal funds). Of course the bonds are backed by the tax-collecting ability of the federal government, so in that sense most of the actual backing consists of the government's expected future tax stream, which in turn depends on productivity of the broader economy.

    2. Thanks Mike,

      My last sentence was inaccurate. I meant that the metals held alone are not enough. So part of the backing comes through bonds and I'm aware the way you have dealt with them in your examples and I fully agree.

      The question/assumption I had was that do you see the Central Bank could lose all the physical assets and rely only on bonds, other papers assets and perhaps its government support to protect the value of the currency?

    3. Jussi:

      There must be some tie to physical goods, or the central bank would be backing a dollar with another dollar. The thing is that the tie to physical goods can take many forms. The most obvious form is for the central bank to own gold and maintain gold convertibility. A much less obvious form is for the government or central bank to declare a 2% inflation target, measured against a CPI bundle, and then make dollars acceptable for taxes. If you fail to pay $1 of your taxes, then the tax man will take your property from you, valued at the target rate.

    4. Thanks Mike,

      I remember you commented somewhere that backing can be based on taxes. I think that part is now clearer to me. You also had a land owner issuing rent receipts example. For me it was a good modern or "fiat" example.

      I was at first puzzled whether you were talking only about gold standard type of world. I understand why you usually link backing to silver/golds in your posts/examples but I think it is good to keep in mind and emphasis occasionally that backing works in modern economy too.

    5. @Mike @Jussi, I don't think that there even is any necessity to make money acceptable for taxes. If the central bank buys, say secured commercial bank debt (ie repo), once a currency unit of interest is owed, the central bank has MORE than sufficient assets to maintain the value of its currency.

  7. I think there are some problems with this. I wrote a detailed critique.

    1. Hi Mike:

      Good to hear from you! Your post is pretty long, so I might be a day or three writing a reply.

    2. No problem, I can wait. (Also, it's gets a little snarky in some places, I can't help it, but I don't mean any disrespect. I think you are close to seeing what I see but this backing thing is in the way.)