Wednesday, April 3, 2019

Banknotes in bottles in coal mines

[This is a guest post by Mike Sproul. Mike has posted a few times before to the Moneyess blog.]

“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well tried principles of Laissez Faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

-J.M. Keynes, The General Theory.

Keynes’ ruminations about bank notes and coal mines are a good place to draw a dividing line between classical economists and Keynesians.  In contrast to Keynesian optimism about the coal mine scheme, classical economists tell us that the newly dug-up bank notes will only succeed in causing inflation, while wasting the labor of those who dig up the notes.

Surprisingly, there is some middle ground about burying bank notes. Economists of both stripes generally agree that money shortages cause recessions. If there is not enough money for people to conduct business conveniently, then people are forced to revert to barter or other less efficient means of trade. Trade slows, and productivity suffers.  Some economists will call it a “money shortage”. Others will say “liquidity crisis”, “credit crunch”, “tight money”, “failure of aggregate demand”, and so on. Whatever the terminology, economists have been saying for centuries that money shortages cause recessions.
In the year 1722-3, the Governor and Assembly…thought themselves obliged to take into their serious consideration the distressed circumstances and sufferings of the people, through the extreme want of some kind of currency…These bills being emitted, their effect very sensibly appeared, in giving new life to business, and raising the country in some measure, from its languishing state. (Pennsylvania Assembly to the Board of Trade, 1726. Cited in Brock, 1941, p. 76)
Now we begin to see the middle ground. Both Keynesians and Classicals agree that the coal mine scheme could potentially provide badly needed liquidity and thus end a recession. Once this is agreed, the rest is just dickering over the size of various forces. A Keynesian might think that the misallocation of labor spent digging up bank notes might drag down national production by 5%, but that the notes dug up might lubricate trade enough to boost production by 20%.  A Classical might put the figures at 10% drag and 15% boost.

The backing theory of money gives us a way to clear up some confusion between these two views, and provides a liquidity-based theory of recessions that both Keynesians and Classicals can live with.

The backing theory is summed up in figure 1:

In line (1), the bank (which may be a central bank or a private bank) receives 100 ounces of silver on deposit, and issues $100 of bank notes in exchange. Each dollar note is worth 1 ounce of silver.

In line (2) the bank issues another $200 in exchange for 200 ounces worth (or dollars’ worth) of bonds. The backing theory view is that even though the bank tripled the money supply, the bank also tripled the assets backing that money, so it remains true that $1=1 ounce.

Now suppose that the $300 in circulation is 10% less than the “ideal” quantity of money, and that the economy is therefore in recession. A well-functioning bank would respond to the money shortage by issuing another $30 of bank notes, while getting 30 ounces (or $30) of bonds or other assets in exchange. This open-market purchase of bonds would relieve the money shortage, end the recession, and leave the value of the dollar at $1=1 ounce. The open-market purchase method gives excellent results. Keynesians would not be surprised at this, but Classicals might be surprised that the money injection caused no inflation.

Next, let’s try the bottles-in-coal-mines method. The bank prints $30 of bank notes, places them in bottles, and buries them in coal mines. Workers will waste (at most) $30 worth of labor digging up the notes. The bank gets no new assets as it issues the $30 of bank notes, so the value of the dollar falls by about 10% relative to silver. While there are 10% more dollars in circulation, each dollar is worth 10% less silver. The real value of the aggregate circulating cash is thus unchanged. There is no relief of the money shortage, and so the recession continues. The bottles-in-coal-mines method gives terrible results, just as Classicals would expect. Keynesians might be surprised to see that even in a recession, the money injection still causes inflation and fails to stimulate production.

We can improve on the bottles-in-coal-mines method by following Keynes’ suggestion and issuing bank notes in exchange for houses and such. The bank prints $30 of bank notes and spends them acquiring 30 ounces (or $30) worth of houses. The bank’s assets (including houses) rise in step with its money-issue, so the value of the dollar remains at $1=1 ounce. This method relieves the money shortage, ends the recession, and causes no inflation. Excellent results, and not especially surprising to either Keynesians or Classicals. The problem is that it is not always easy for the bank’s assets to keep up with its money-issue. If the bank had spent its $30 of new notes on houses that were only worth 29 ounces, then money-issue would outrun the bank’s assets, and inflation would result. Overall, it’s safer for the bank to spend its $30 buying bonds than buying houses.

There are many more methods of issuing banknotes, but I’ll mention just one: Print $30 of bank notes and give them away to passers-by outside the bank. Then have the government give $30 of bonds to the bank. The bank’s assets will rise in step with its note issue, so there is no inflation. At the same time, the real money supply rises by 10%, so the money shortage is relieved and the recession ends. Excellent results once again. The only problem is that the government will eventually run out of wealth, and will be unable to help the money-issuing bank’s assets keep up with its money issue.

1) Money shortages cause recessions, and the solution is to issue more money.
2) Issuing new money won’t cause inflation, as long as the new money is adequately backed.
3) It is best to issue new money via conventional open-market purchases of bonds. Failing that, it’s ok to issue new money for houses, or even to give it away, provided the government can cover the give-away. But whatever you do, don’t bury the money in coal mines.


  1. The backing theory presented here does not have a mechanism for the banks assets and the balance sheet. Stating that $1 note = 1 ounce of silver when the sheet is in balance is only a mathematical tally, not a mechanism for affecting the notes held by the public.
    I suggest that the mechanism is that the assets can be sold thus reducing the notes at issue. Or alternatively the bonds can be repaid also reducing the amount of notes, also there is a constraint on the spending of holders of notes that are borrowers.

    1. Normally, the mechanism is that the bank maintains silver convertibility at $1=1 oz. But silver convertibility is suspended every night and every weekend, and the dollar remains worth 1 oz because of expected future silver convertibility. If that suspension is increased to 30 days, 24 years, or 84 years, then expectation still determines the dollar's value.
      But there are many other kinds of convertibility: Bond convertibility, loan convertibility, tax convertibility, etc., and the suspension of one kind of convertibility still leaves many other channels through which dollars can reflux to the issuing bank.

    2. There are two factors
      1. Expected future silver convertibility. What is the cause that maintains the expectation. Does everyone have a copy of the Balance sheet. If they did then yes that would work for maintaining silver value of each note.
      2. Your post is concerned with the price level of non financial goods , why would convertibility to silver maintain a price level. If you successfully denominate the notes in ounces of silver and have no mechanism governing the note issue then the silver and note rate is fixed but the price level of non financial goods to silver varies.

      I think the mechanism is the one to one relationship between the circulating notes and debt contracts, the goods and services bought with the debt contracts and with the goods and services sold to honour the debt contracts

    3. 1) Agreed, except that only a few key players need to see the balance sheet.
      2) You say "no mechanism governing the note issue". On backing theory principles, rational banks won't issue a dollar unless they get assets worth at least a dollar in return. So the mechanism in this case is that note issue moves in step with the issuer's assets. Whether you have 100 oz backing $100, or 300 oz backing $300, it remains true that $1=1 oz. And as long as 1 apple costs 1 oz, it's still true that $1=1 apple.

    4. So the convertabilaty of notes to silver does not affect the amount of note issue, the bank could have 1 ounce of silver and 1000,0000 of 1 ounce silver bonds The banks assets are mostly bonds.. The amount of notes is controled by the needs of the economy as judged by the bank. And so it is not the 1$ / 1 ounce ratio itself that warrants whether or not the issue is inflationary, its the correctness of the bank's judgement that does that.

    5. I don't see how you conclude that the 1 oz/$ ratio does not affect inflation. As long as the bank only issues a dollar for an oz. worth (or dollar's worth) of assets, the bank can't go wrong in issuing any amount of notes. $1 will always be worth 1 oz.

      But a bank (especially a monopolistic bank) can go very wrong in issuing too little money, thus causing a money shortage and recession.

    6. If a quantity of notes causes inflation because of the quantity, then that is the the case if 1 note is issued for 1 ounce of silver or 1 oz worth of bonds and 1 note is worth 1 ounce of silver, because those facts do not change the quantity.

    7. You have to keep in mind that a dollar note is only issued if someone wants it badly enough to hand over an equal value of silver or bonds, and if $1 ever deviated from 1 oz, then either people would bring them back to the bank like crazy, or the bank would issue them like crazy.

    8. As the aggregate of the total financial assets held by the public stays the same then swapping people's assets between silver, bonds, and notes does not affect inflation because the aggregate of financial assets and spending habits are the same. Buying silver and inflating silver prices does not affect inflation as changing the price of silver does not change the general price level. It could be said that buying bonds and inflating bond prices decreases interest rates so then there could be new spending by borrowers. Personally I see that the backing can include all possible goods and services supplied by debtors that are valued by the note holders, and are inherent in the bonds. Recollecting the real bills doctrine and the historical advent of banks purchasing bills of exchange denominated in the future production of commodities.

    9. Agreed. I would add that when a bank's money issue is small relative to the world market for silver, bonds, etc., then there are no price effects to worry about.

      And yes, the backing theory is 99% the same as the real bills doctrine.

  2. Hi Mike!

    "Money shortages cause recessions, and the solution is to issue more money."

    What about lowering the interest rate on reserves? Does that help solve a recession? How does backing theory account for the payment of interest on reserves? What are your thoughts about negative rates, like they have in Switzerland?

    1. Hi JP:

      Still thinking about it. I'll get back in a day or two.

    2. What about lowering the interest rate on reserves? Does that help solve a recession?

      Strange that I’ve been thinking lately about the effect of raising interest rates on reserves. The removal of regulation Q provides an analogy. The interest rate on checking accounts went from 0 up to the market rate. This would motivate banks to provide more checking account dollars, thus relieving any existing money shortage and relieving any existing recession. However, if we are in a world with several different kinds of money, then any shortage of one kind of money (e.g., checking account dollars) would be offset by some other kind of money (e.g., credit card dollars). This means the removal of regulation Q would have had little or no effect as far as ending a recession.

      The effects of the Fed starting to pay interest on reserves would be analogous to the removal of regulation Q, except that reserves held by banks at the Fed are barely used as money by anyone, so there would be even less chance of it ending a recession.

      As for your question about lowering interest on reserves to end a recession, I think I’m too turned around on the subject to answer, but my knee-jerk reaction is that it wouldn’t have any effect at all.

      How does backing theory account for the payment of interest on reserves?

      I think it removes an implicit tax that the Fed previously placed on reserves held by private banks at the Fed. One way to think of it is to assume that Federal Reserve Notes have handling costs of 3%/ year while reserves held at the Fed have handling costs of 1%/year. If FRN’s pay zero interest, then reserves held at the Fed should pay 2%/year.

      What are your thoughts about negative rates, like they have in Switzerland?

      I think of it like the old Bank of Amsterdam, which made no loans, and therefore charged 2%/ year storage fees to depositors—a negative interest rate. The fee was fine, since it was just a way to cover costs. Same for Switzerland.

  3. Mike, You said:

    "Economists of both stripes generally agree that money shortages cause recessions."

    I don't think that's accurate. I don't believe money shortages cause recessions, and AFAIK Keynesians don't believe that either. Instead, I think Keynesians believe that a reduction in the money supply (but no shortage) causes an increase in the value of money, which means deflation. Because nominal wages are sticky, deflation causes unemployment.

    Keynesians believe the bottle trick works because it causes inflation. (Phillips Curve, etc.) If they thought inflation would prevent it from working, then they wouldn't favor the policy.

    We had a money shortage in 1965 when all the silver coins were being hoarded, and an economic boom at the same time. It's money scarcity that is a problem (increased purchasing power) not money shortages.

  4. Good to hear from you Scott!

    I do a lot of reading about American colonial currency, and the writings from that period are saturated with stuff like this:

    "There is such a general scarcity of cash that nothing we have will command it,” New Jersey resident James Parker explained in November (1765)… country stores were “all shutt up,” the proprietors “either broke or obliged to decline that Business from a Real Inability to carry on… ”and the distress of the people was very great from an amazing scarcity of money”. (Ernst, 1973, p. 247-248)

    The (Maryland) House of Delegates in 1702 declared that to raise money by taxing the people “is utterly impracticable here for there’s several hundred families, nay the greatest part of the whole province, have not five shillings by them or any means to raise it because there is very little amongst us.” And in 1706 an official statement avowed that the province “is wholly destitute of any manner of coin for which we labor under the greatest difficulty. (Nettels, 1934, p. 206.)"

    I know, those are just quotes, but we can't always have a regression for everything. Sometimes eyewitness accounts are best, and sometimes in a small economy it's easier to tell what's going on than in a big economy. I'm thinking I might just spend a few months collecting similar quotes about other periods. There are lots of them.

    Keynesians definitely have a different take on money shortages, but in my own reading of Keynesians, I've been impressed by how many times you can use "money shortage" in place of "failure of aggregate demand", and still end up in the same place. The story of the Washington DC babysitting coop comes to mind as a case where there is clearly a money shortage.

  5. Mike, I suspect that the colonial episodes involved both a shortage and a scarcity of money, but I am not certain. They are clearly different concepts. Thus in 2009, I believe that scarce money led to mild deflation in the US, but there was clearly no money shortage. Anyone could go to a ATM machine and get cash whenever they wished to. As I recall, the colonial era problem was too little money at the going commodity price peg---a true shortage, but perhaps my memory is off.

    I'm not saying that money shortages are never an issue; I seem to recall that the recent Indian currency shortage caused a mild slowdown in their GDP growth. But the big problems come from deflationary monetary policies, which need not involve any money shortage at all.

  6. Yes, they weren't careful about distinguishing "scarcity" and "shortage" back then. There were several episodes where their system of rating commodities for money purposes effectively placed a price ceiling on silver or other forms of money, thus creating a true money shortage.

    I can think of 4 things that cause money shortage/scarcity:
    1) Price ceilings on money.
    2) bank runs, obviously
    3) worn coins, when Gresham's law comes into operation
    4) Government restrictions on money issue, such as the greenback era, where the government first taxed state bank paper out of existence, then placed a 110% backing requirement on National bank paper, and then froze the quantity of greenbacks because of a political stalemate between tight money/easy/money factions in congress.

    Recessions can also happen because of wars, disease, or disaster, but I think the most common cause of recession that I can think of is a money shortage/scarcity. Of course there's an observational equivalence problem if someone claims, as you do, that deflation was the problem.

    BTW: I forgot to mention that the coin shortage of 1965 was inconsequential, since there were plenty of other moneys to fill the void. The serious money shortages have happened when several moneys were suppressed, like in the Greenback era.

    1. The 1965 shortage wasn't a big deal since it only affected dimes, nickels and quarters, and at the time the number of transactions requiring small coins probably wasn't that big.

      I think the shortages that occurred in the UK in the 1700 and 1800s--the ones that George Selgin talks about in Good Money--were much more crippling. Silver and copper coins pretty much disappeared. But these coins dominated the denomination structure at the time, and thus would have accounted for a much wider range of society's transactions than the coins that were in shortage in 1965.

      That being said, I agree with the distinction between the two types of recessions, one due to a shortage and one to a scarcity.

    2. Agreed, with shortage of money being the result of a price ceiling on money, and scarcity of money being the result of bank runs, government bans, etc. That makes things consistent with Microeconomic theory.

  7. Mike and JP, I don't disagree that the 1965 coin shortage was not a huge problem, but keep in mind that credit cards were not used very often back then and the price level was 5 times higher, so coins played a somewhat bigger role than today.

    I can conceive of two distinct mechanisms here with shortages and scarcity. With shortages you have a reduction in transactions efficiency, as barter is less efficient than money. This would be a problem in any economy with a money shortage, even a flexible price economy. On the other hand, money scarcity (but no shortage) would just lead to deflation of prices (as with a 100 to 1 currency reform) if prices were flexible and money were neutral. To get real effects you need an extra assumption like price stickiness or misperceptions, something not needed with a money shortage, which directly reduces transactions efficiency.

    Is that also your understanding?

    1. "Is that also your understanding?"

      Yes, great summarization.

  8. Agreed about money shortages, but money scarcity is a hornet's nest, involving several issues.

    Short version:
    1) Trade has been hampered by money scarcity.
    2) In the legislature, the easy money faction urges more paper money be issued, having seen in the past how paper money stimulates business.
    3) The tight money faction opposes, believing that if they print 10% more money, they will only succeed in reducing the value of money by 10%, with no effect on real cash balances. They also wrongly liken the easy faction to children demanding a bigger allowance. A stalemate ensues.

    On backing theory principles, the tight faction is wrong to think that 10% more money will reduce the value of money by 10%, since as 10% more money is issued, the issuer's assets naturally rise by 10% and the money holds its value. The easy faction is right that 10% more money is needed, but they don't understand the backing theory either, and so they wrongly accept the epithet of "inflationists", when they really should be pointing out that they are only asking for 10% more money along with 10% more backing.

  9. Mike, It isn't just the easy and tight money factions that are confused. Asset markets also respond to unexpected Fed policy news as if Fed policy was effective at changing the value of the dollar. Thus the dollar fell 6 cents on the day QE1 was announced in March 2009, to take one of 100s of examples.

    Of course it's possible that the asset markets are wrong, but it's also possible that the backing theory is missing something important . . .

    In addition, inflation has averaged 1.95% since 1991. Hard to understand why this number is so close to 2% if the backing theory is true. Who is targeting inflation, Congress or the Fed?

  10. Scott:
    The backing theory implies that money is valued more like bonds than like stocks, so as long as the money (or bond) issuer is solvent, the net worth of the issuer can move a lot without affecting the value of the money (or bond). An issuer with excess wealth could maintain convertibility at $1=5 oz., but might choose to maintain it at $1=1 oz, or can maintain a 2% inflation rate.

    Just as bond values react to policy news, so can money value.

    The over-riding problem here is that pretty much any monetary event can be explained by both the quantity theory and the backing theory. Here are a few events where I think the backing theory does better:
    1) Tom Sargent's (1981) observation that price changes precede money changes (And Thomas Tooke's (1845) observation of the same thing.
    2) The near universal failure of central bank efforts to suppport their own currencies (Covered by Dean Taylor, "Bet Against the Central Bank"
    3) Thomas Cunningham's observation about Taiwan currency, which I can't remember much about, but he concluded the real bills view was supported by the data.
    4) Bruce Smith's observations about American colonial currency, which I think you and I both did papers on.

    If only we could find a decisive test of the two theories!

  11. Mike, I guess I don't follow that. What exactly is someone doing to keep inflation close to 2%. And who is that someone? My theory is that the Fed targets inflation at 2%. Others like John Cochrane have a fiscal theory of the price level. In your view, what causes inflation to be close to 2%? That's the Fed's goal, but what's causing that trend rate to occur, and not 0% or 4% or 10%?

    Is someone changing the backing of the dollar in such a way as to insure roughly 2% inflation? How's that done?

  12. Under silver convertibility, the answer would be trivial: The fed stands ready to buy or sell silver if the dollar ever deviates from some target number of ounces per dollar. Now, instead of silver flowing in and out of the fed, there are bonds flowing in and out whenever the dollar deviates from target.
    Also keep in mind that the Fed might have enough assets to cover a rate of 5 oz./$, but if they target 1 oz/$, then 1 oz./$ it is. The reverse is not true. If they target 5 oz./$ but can only cover 1 oz/$, then the fed would face a run.

  13. But does that analogy work? I agree on how the Fed would stabilize the price of silver, and the scenarios where they are not able to do so. (I wrote a whole book on the Great Depression that is consistent with backing theory.) I also agree with the FTPL people when they claim there are scenarios where the central bank cannot target inflation, due to a lack of resources. (Zimbabwe, Venezuela, etc.) What I have trouble understanding is how central banks do so when they do not lack the resources. They don't buy and sell a basket of consumer goods, the way a silver targeter could buy and sell silver.

  14. 1) FTPL=backing theory of money, with the difference that the backing theory says the dollar is backed by (potentially) all of the issuer's assets. (including, for example, government landholdings) Also, some FTPL'ers say that taxes create a demand for paper dollars, while the backing theory says its all about the money issuer's balance sheet, and not about money supply and money demand. For instance, the government's main asset is "taxes receivable", and this backs any paper dollars issued by the government. Just like a landlord has "rents receivable", and this serves as an asset to back any IOU's issued by the landlord.

    2) Still working on your question about targeting when they do not lack resources. My thoughts are running this way: The landlord above buys groceries by writing an IOU that says "IOU $1". His IOU circulates locally as money, since everyone knows he accepts them for rent at $1=1 ounce. He doesn't need to target the price of silver, since his rent collections do that automatically.

    At some point, the landlord might print up $10 and buy 10 oz of silver with it. This would allow him to maintain silver convertibility of his notes, as long as withdrawals stay below $10. Silver convertibility has no effect on the value of the dollar. It was $1=1 oz before he got the silver, and it's still $1=1 oz. afterwards. He could eventually suspend silver convertibility and that eouldn't matter either, because it was rents driving everything the whole time. (Something like that should explain why the Fed can target the dollar without using silver or commodity trading.)

  15. Still not seeing HOW the Fed targets inflation at a specific rate. The "concrete steps".

    1. 1) The fed wants the dollar to fall>>The fed lends at low rates>>the fed gets a little poorer>>the dollar falls, because there's less backing per dollar.

      2) The fed wants the dollar to rise>>the fed lends at high rates>>the fed gets a little richer>>the dollar rises, because there's more backing per dollar.

      Note that if the fed lends at high rates, it might not get any borrowers, so nothing happens. But if the economy is cash-starved, (which causes a recession) people might pay the fed's high rates, and the fed would get richer and the dollar would rise. That's why deflation and recession go together, and also why deflation is less common than inflation.

  16. Mike, I also think you are implicitly treating the Keynesian bottle burying scheme as equivalent to quantitative easing, when Keynes meant something very different by it. Keynes understood the possibilities of Friedman-style helicopter drops, and advocated for them in the early stages of the Depression (monetary policy "a outrance" he called it in 1930), but came to think they were ineffective in a liquidity trap. The Keynesian bottle scheme therefore did not work through increasing liquidity, and would not have been necessary for increasing liquidity. Keynes thought it created "work" which had a multiplier effect on total activity in the economy and pushed the IS curve out. I've come to view this as a little nonsensical (why not just pay people to do jumping jacks, or even better, cut out the unnecessary labor and just do the helicopter drop of cash?), but it comes from the Keynesian idea that there were two distinct portfolio decisions made by individuals, first, dividing current income between consumption and new savings, and second dividing total savings between money and bonds (or investments). Keynes for some reason thought that the money people earned as income was different from the money people got from open-market operations or helicopter drops, and led to more consumption, instead of, through monetary policy, just distinct types of savings, which could only reduce interest rates. Friedman effectively collapsed this distinction by putting consumption decisions back in the general individual portfolio, so there would be no need for bottles or jumping jacks. All new money into the economy (at least when holding demand constant) increased total spending.

    For what it's worth, I think modern New Keynesians have also forgotten the importance of keeping consumption in individuals' general portfolio decisions, which is why they have revived liquidity trap concerns and think some types of cash handouts (deficit "spending" or transfers) create multipliers but other (monetary policy or helicopter handouts) only lower interest rates. Anyway, just a side point but I think important to keep in mind when discussing the Keynesian schema.

  17. Yes, I see the bottle scheme as a way to increase liquidity, while Keynesians normally speak of spending and multipliers. (I don't buy into the spending/multiplier view.) I see the liquidity view as a theory that would be partly acceptable to Keynesians (The bottles could work if spent on houses.) and partly acceptable to Classicals (The bottles only work if the liquidity boost outweighs the drag created by resource-misallocation.)