Iranian Oil Bourse

I got an email asking me about the Iranian Oil Bourse, which is causing great excitement among the Peak Oil crowd. Here’s my draft response. Comments appreciated.


“Bourse” is just another word for “exchange”, and the creation of one in Iran is an attempt to capture more of the economic activity associated with international oil markets and also perhaps to exert more control over oil markets.

The US gains directly from the fact that people hold US currency (since it costs almost nothing to print, but can be used by the US government to buy goods and services – this is called “seignorage”) and indirectly in terms of perceived power and influence from the fact that the $US is the dominant world currency. The switch to euros threatens both. However, the total benefits are not that great. The seignorage benefit to the US from overseas holdings of $US is between $15 billion and $50 billion per year, and the United States has many more important sources of power and influence than the $US.

There is a lot of talk, as in the Peak Oil article linked above, about how Saddam’s switch to euros led to the Iraq War. Actually, as the Iran example shows, overt decisions to switch are usually the result of bad relations with the US, not the cause. Still, this is part of a general pattern of incidents, small in themselves, where aggressive US foreign policy is exacerbating conflict over economic issues, and thereby weakening the US economy.

127 thoughts on “Iranian Oil Bourse

  1. Terje,

    That there was no hard and fast “system” guiding Greenspan’s policy decisions (or Bernanke’s for that matter) does not mean there were not guiding principles. Greenspan’s guiding principals were never explicitly stated but were in any case pretty clear: ease at any hint of systemic stress, at home or abroad, and do so with reckless abandon (“asymmetric risk of deflation”). Tighten only when resource utilization, unit labor costs and end inflation, (if core PCE counts as such), forces your hand. Ignore as irrelevant the explosive growth in the monetary aggregates, (especially those including repo finance, etc.), as the “market knows best”.

    His policies were not the output of some formulaic model, but then, neither were Volcker’s and neither will be Bernanke’s (with or without inflation targeting- see the ECB). Most unforgivably, Greenspan doggedly adhered to these principles even as evidence of their incompleteness grew harder and harder to ignore (notably apologizing for many asset bubbles along the way). This intransigence in the face of the massive responsibility bestowed on him makes him an ideologue in my book- or possibly just a coward.

    Volcker contrasts with that picture strongly. He had his opinions, his economic training, his inherited biases, no doubt- but he also had the requisite sense of his awesome responsibilities, an open mind and a humbleness in the face of economic complexity, and, as a result, made far better decisions. Now, that assessment is markedly different from yours:

    It was a shocking system in terms of results, although it did have the merits of being a system.

    which I would be curious to hear you elaborate on. As I say, IMHO (and many others), Volcker did a good job in his tenure at the Fed, typified by his extinguishing the pernicious inflation expectations and commodity bubbles that were distorting the real economy. For an example of how level headed a man he is, (which is certainly not to say wishy washy), this is a good read:(http://www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html)

    Finally, as regards the importance of a system, I have yet to hear of one that trumps honest judgment in all cases (i.e. one that will not also break down from time to time- and sometimes in predictible ways). Certainly some sort of gold standard would have prevented the calamitous situation that we are now faced with, but as you will recall, this system broke down precisely because commodity production cannot be expected to be a guide to credit growth. That said, as we have seen, honest judgment can be hard to find. Alternatively, “a whole lot of intelligence can be invested in ignorance when the need is great”.

  2. Your explanation of a feedback mechanism that regulates the value of curreny against gold is probably only true in a punctuated equilibrium sense – brief periods of desperate government issuing of money to fund wars etc tended to cause sudden devaluatons in that currency, or the replacement all together of that currency, but not in the practical utilty value of the equivalent amount of gold. An acre of land still costs roughly the same in gold, regardless of the currency the gold is valued in (ie, exactly your argument about commodity prices). I’m sure you’ve heard all this blather 101.

    Inflation funding or war generally involved an explicit suspension of the gold standard. For instance the American civil war saw a temporary suspension of the gold standard and a process of inflation taxation or what we might call printing money to pay for stuff.

    We also say the same thing with Great Britian (and hence the entire Commonwealth) during WWI, when they left the gold standard to print themselves some artillary. Or in other words to implement a hidden tax quickly.

    After both these events the gold standard was restored. And in both instances they went back on at the pre-war gold price. As such they suffered post war deflation. Which is a bit like backing up a truck after realising you just ran somebody over.

    When Churchill restored the gold standard in 1925 he deployed a deflation across the entire commonwealth and played no insignificant part in creating the Great Depression.

    I have discussed the feedback mechanism that stabilises the value of gold in more detail in an earlier thread. I will try and find it next week. Must go now but more later.

    Majorajam, I will have to respond to you later. In the interum let me just say that it is possible to apply honest judgement and still be wrong. Perhaps we should hope for “honest and wise judgement”.

  3. Volcker did a good job in his tenure at the Fed, typified by his extinguishing the pernicious inflation expectations and commodity bubbles that were distorting the real economy.

    Just a puzzle for you to sweat on until I am back online next week.

    1. Assume a system that fixes the base money supply at a static quantity of cash in the economy.

    2. Assume strong economic expansion.

    Will this tend to cause inflation or deflation. In other words will the value of money rise or fall. My answer next week.

  4. Paul Volker achieved what he set out to do, lower inflation, that’s history. Terje, you need to give credit when it’s due or widen your reading.

  5. Terje,

    If you assume a policy that restricts growth in base money to zero (0), and a velocity of money that doesn’t change or doesn’t change enough to rival in magnitude a positive change in real GDP, all else equal, than that policy would lead to a decline in the price level, i.e. the policy is deflationary. This follows from MV = YP, (note that the assumption about V is mandatory otherwise the answer to the question is indeterminate). Note also, I’ve assumed you are not asking whether a system that targets a static mix of the components of M0 is inflationary or deflationary, because that is pretty much indeterminate. Last note, the “all else equal” is a pretty large fudge because the Fed doesn’t totally control the money supply (and didn’t in Volcker’s tenure either, notably including the epidemic of disintermediation in the banking industry circa 1979) or collective behaviors that influence the various variables and, most importantly, the multiplicative feedback effects across each of the variables. It is in reality a very hairy very indeterminate problem.

    Two quick bits: First, in my positive evaluation of Volcker’s Fed there is a fair amount of value judgment, (i.e. my appreciation of independence and conservatism- little c), and a tacit acknowledgement of imperfection. I don’t expect perfection in monetary policy making, merely the avoidance of cataclysmic folly, and anyone who does is kidding themselves. Second, the FOMC under Volcker didn’t restrict M1 growth to zero, but to preset targets a la classic monetarism. Measurement errors were notable and problematic including but not limited to the major omission of the deceleration of the velocity of money (which they arguably should’ve been looking out for), and the decreasing relevance of M1, (which was largely unforeseeable and out of the Fed’s control).

    I leave you with some quotes from an article I have stored that allude to the most unforgivable (and consequential) flaws in the Greenspan/Bernanke Fed:

    “Thus, Irving Fisher, in the wake of the Great Depression, placed a good deal of the blame on an excess of debt. Such excesses commonly followed an earlier period when technological, regulatory, or financial innovations improved the environment for investment. The initial period of rational growth in investment then spiraled into a “euphoricâ€? phase of overinvestment and overborrowing. Businesses and investors, in turn, sought to grow their way out of their heavy debt burdens through speculation, often worsening their financial positions in the process. Eventually, some event, perhaps a rise in interest rates or an increase in credit rationing, would lead to a retrenchment in which financial intermediaries called in loans, forcing borrowers with insufficient liquidity to go bankrupt. The subsequent deflation, in both asset and goods prices, further aggravated the circumstances of debtors and their creditors and intensified the downturn.”

    “While a marked deviation from past experience and widespread investor focus on capital gains without regard to the strength of underlying earnings may suggest to the cautious observer that a speculative bubble is under way, during the bubble eminent scholars and financiers usually emerge with plausible explanations for why circumstances have changed and why higher asset prices are justified. Fisher himself defended the valuations of financial assets in October 1929!”

    “For example, rapid increases in stock and real estate prices are often supported by rapid increases in bank and other forms of credit. Thus, unusual surges in asset prices may provide a warning that lenders’ portfolios and underwriting standards deserve more intense scrutiny.”

    “When asset prices are rising, the most successful investors are those who are most concentrated in the assets with the greatest gains. Competition to do business with these investors can lead lenders to become dependent on these same assets and to reduce their lending standards, since successful customers can readily take their business elsewhere if they feel loan conditions are onerous.”

    “After all, if central bankers feel compelled to offset the systemic/real impacts of a significant decline in asset prices, they may validate
    investor mistakes. And if investors assume that the central bank will act to offset the fallout from a major market correction, an element of “moral
    hazardâ€? may creep into the equation.”

    “But admittedly, if removing the punch bowl seems hard when the concern is accelerating consumer prices, the difficulty will be even greater in the case of overheated asset prices.”

  6. Keynes believed that the French post-1918 approach to gold was sounder, if you had to go back to gold at all. That was to go back after locking in a 50% drop in the gold value. The catch for Britain was that this meant effective repudiation of certain debts, and risked Britain’s financial as well as ethical position.

    Overall, it might have been better to adopt the French approach combined with, as it were, post dated cheques for full value (including interest) on government bonds. Then the shock would have been spread out and recovery would partly have financed it (maybe just in time for 1939). Details of implementation would have been tricky, too.

  7. all else equal, than that policy would lead to a decline in the price level, i.e. the policy is deflationary.

    Yes, spot on. An expanding economy means more goods chasing the same money so it is deflationary.

    The USA had a decline in inflation pressure in the Volker years in a big part because the Reagan fiscal policy (ie lower taxation rates) was expanding the economy. And this expansion (like all economic expansions) was deflationary in nature.

    The value of money (ie base money) is determined by supply and demand. A growing economy generally demands more cash because there are more transactions to fascilitate in a bigger economy. So all else being equal a growing economy will need more base currency in order to avoid deflation.

    Credit, such as a bank loan, is not base currency. Its principle value is not set by supply and demand (although the interest rate on that principle value is). The principle value of a loan is defined by a contract in terms of a “unit of account”. And the typical unit of account is the base currency.

    Hence if the base currency falls in value so does the principle value of all loans. And if the base currency rises in value then so does the principle value of all loans.

    So long as you control the value of the base currency you control the value of all money substitutes that are denominated using that base currency.

    Credit can however circulate as a money substitute. As a substitute it may dampen the demand for base money because it fascilitates an alternate means of conducting transactions. So an expansion in credit fascilities can dampen the demand for base currency and all else being equal this would be inflationary.

    However non of this need overly concern a central bank tasked with maintaining the value of the national currency. Because such a central bank has complete control over the supply of the base currency.

    So if an expansion in credit fascilities dampens demand for the base currency then the central bank can respond by withdrawing cash from circulation.

    And if a contraction in the economy dampens demand for the base currency the central bank can also respond accordingly.

    Of course with an appropriate reference for the value of money (eg gold or an appropriate foreign currency) the central bank need not concern itself with the cause behind a change in demand but rather it can merely trim the sales to maintain its heading.

    Regards,
    Terje.

    P.S. Of course none of this fits with the demand talk that eminates from modern central banks where they talk of “cooling the economy” to avoid inflation. In practice an economic contraction is one of the most inflationary things that can happen.

  8. Before debating lengthly about the Iranian Oil Bourse and its influence on the $ hegemony, has anyone checked about its reality on the Iranian side ?
    As for now, for the Iranian Energy ministry, nothing is for sure, if something is to be trade, it’s not crude oil for starter, and no currency has been specified !
    Well, so bad for the conspiracists this fad resembles that much to vaporware. But I trust them to find something else to spend their time on after March.

  9. Terje,

    I’m not sure I follow your reply. “Base money” is a function of reserve requirements. Without knowing them it is impossible to discern the line between base money and money created due to lending activities. The regulation itself is sits more or less astride capital adequacy ratios which would exist with or without a central bank, but which would almost assuredly be far less adequate without regulatory oversight (see hedge funds and their next foray- catastrophic reinsurance, i.e. heads I win, tails you lose). All of which is to say, credit is not so much a substitute for money as it is money. In a simple, closed, cash-less, and highly regulated banking system with no excess reserves and a reserve requirement ratio of r, x liabilities of the central bank imply x/r demand deposits in the system, which is to say x/r money in circulation (x/r – x of it the result of lending activity).

    Of course, our system is anything but simple. Between the ability of structured financiers/derivative dealers to propogate the issuance of all manner of unsound “asset” based credit, the incredible degree to which our investing and lending institutions have embraced risk in general and leverage in particular, our recklessly undercapitalized derivative toting quasi-government institutions, (i.e. the GSE’s), and speculative financiers with no capital backstop, the Fed actually only directly controls a relatively small fragment of the money supply (which is not to say it couldn’t affect the remainder by playing with the portion that it does control- although in this there is mounting evidence that it requires the help of other central banks, notably Japan’s).

    To quote Full Metal Jacket, it’s one big sh*t sandwich and we’re all gonna have to take a bite.

  10. Of course none of this fits with the demand talk that eminates from modern central banks where they talk of “cooling the economy� to avoid inflation. In practice an economic contraction is one of the most inflationary things that can happen.

    Are you suggesting higher interest rates cause more inflation? Or do you think higher interest rates don’t slow growth?

  11. In Australia we don’t have fixed reserve requirments. However we do have regulations that dictate the quality of debts that banks should have across their portfolio. Which may or may not achieve the same outcomes.

    All of which is to say, credit is not so much a substitute for money as it is money.

    Credit is not money. Or at least not in the strict sence of the term. It is a money substitute. It can’t be money because it is unable to act as a “unit of account”. Without base currency our debts would need to be denominated in something entirely different (eg cows or gold or drums of oil).

    Depositing money in a bank is like investing in any managed fund in so far as your capital is now at risk. This only becomes problematic when governments transfer the risk to taxpayers or when they create the illusion that no such risk exists. The whole notion of government promoted risk free investment is the real sh*t sandwich.

  12. Are you suggesting higher interest rates cause more inflation? Or do you think higher interest rates don’t slow growth?

    Neither.

    I am suggesting that an economy that is contracting will be inflationary in nature (ie demand for the national currency will be in decline and hence the national currency will tend to lose value). And as such the rhetoric of central banks (when they say that the economy needs cooling to avoid inflation) is simply wrong. An economy that is cooling, as in contracting or growing slower, will always be more prone to inflation than an economy that is growing strongly.

    High interest rates may or may not slow growth. If they are increased in order to slow growth then they are a dumb initiative.

    A growing economy will typically result in an increased demand for financial capital. And if savings are constrained, then in a free market one would expect interest rates to rise. So a policy of increasing interest rates may be perfectly consistent with how a free market in credit with a fixed value monetary policy might respond. If you are using open market operations to target interest rates then lifting the target during a time of strong economic growth may be appropriate (within the constraints of the monetary policy).

    In so far as growth will be constrained by supply limitations (including limited savings) then constraints on financial capital are merely a natural limitation and rising interest rates may in fact be little different to a rise in the price of labour or any other constraining factor of production in a growing economy.

    What is worth watching during such episodes is the amount of currency (M0) in circulation. If a central bank says that it is tightening monetary policy in order to “cool” the economy and yet we see the amount of currency in circulation continues to be increased (via the printing press) then how should we interpret the central banks rhetoric?

    Given the constraints of the monetary policy choosen I am certainly not saying that a policy decision of a central banks that targets a higher interest rate is wrong. I am merely saying that the rhetoric is wrong. And of course I disagree with the self imposed constraints of the current monetary policy that we have.

    Interest rates are a price. They are the price of credit. And in so far as current monetary policy targets a price of something bought and sold in the private sector it at least has its feedback mechanisms roughly aligned with market stability. Still it is not the best of targets to choose and the stability that it achieves is superficial. In my view interest rates should float. And monetary policy should target a different market variable.

    Of course if you’re vague about the difference between money and credit this may all seem very confusing.

    Regards,
    Terje.

  13. Terje,

    Agreed with you that when money is multiplied through lending institutions risk is multiplied along with it. However, that doesn’t change the fact that, for all intensive purposes, bank deposits are money. You cannot buy any more with cash than I with a check or, nowadays, a check card (excepting the occasionally tacked on transaction cost). What’s more, both are liabilities. The cash is a liability of the central bank (in days gone by a liability backed by gold though contemporaneously of the more nebulous kind) while the check is a liability of a retail commercial bank. The fact that all money is simultaneously a liability explains the many definitions of it in the first place, (e.g. M1, M2, M3), with many people firmly of the belief that even M3 is not representative of the true money stock in for example its limited representation of repo finance.

    But your point is well taken and does illustrate a very important feature of the modern monetary environment. The dramatic collapse of risk aversion, (the penultimate example of which being the proliferating carry trades that have flooded world asset markets with liquidity), has been a necessary condition of the current unsound credit boom. Participant’s belief in the ‘moneyness’ of certain claims- or at least behavior of theirs that implies as much- e.g. the stockpiling of US treasury and agency bonds by foreign central banks, the securitization of all manner of receivables without concern as to the viability of the ‘diversified’ receivables, (an acquaintance of a friend with little credit history was able to buy a $22K car with zero (0) down on a gross annual salary of $28K), etc. are responsible for the explosion of credit- i.e. money. Without that degree of carelessness, the money supply would not have exploded over the past few years as it has, and, in all likelihood, the equity market bust of 2000 would have precipitated a far more severe disruption in world output (and asset prices).

    What naturally follows from the understanding of money as a creature of credit is that economic slowdowns reduce the money stock (or, more commonly, a reduced money stock produces slow downs in real economic activity, hence monetary accommodation/tightening). This was true of the Great Depression where the money supply collapsed on itself, (as financial intermediation collapsed), and the price level fell. This was also true of post real estate bubble Japan. However, it is not a necessary condition for a collapse in real activity to cause the price level to fall. Argentina’s recent experience illustrates that a loss of confidence in the currency causes the price level to spike despite a collapse in real economic activity. Germany in the early 1920’s is another example of the same. And when the impending dollar crisis meets Chairman Helicopter Money, the US may get its first taste of triple digit inflation.

  14. The cash is a liability of the central bank (in days gone by a liability backed by gold though contemporaneously of the more nebulous kind) while the check is a liability of a retail commercial bank.

    If a gold window were in operation I would agree. However no such window exists and there is no means to have currency redeemed for anything. The central bank makes no promise at all with regards to the currency it produces. Its value is held aloft merely by market demand. This is why currency that was once a promisory note, now truely is money in the proper sence of the word.

    The deposit in a bank is different. Its value derives from the credibility of the bank and the implicit promise to repay in currency. It is in essence a contact denominated in a “unit of account”. In other words it is a contract that will be settled with the fiat currency that denominates it. If you pay me with a cheque then my bank will not credit my bank account until it sees the cash from your bank. Clearly my bank does not trust your bank as much as you do.

    If your bank ceased to exist tomorrow then your deposit would be worthless. If the US government ceased to exist tomorrow then US currency would continue to be worth whatever the market decided it would be worth. If the Swiss Dinar is any indication then the US dollar would do just fine without the US government, just as the Swiss Dinar did just fine for more than a decade without the Iraqi government.

    http://en.wikipedia.org/wiki/Swiss_Dinar

    The real problem with risk is that governments are so embeded into the banking system (eg central banks) these days that we have prolific moral hazard. Governments should not be in banking unless it fixes some problems. Hence lots of problems that arises become the taxpayers problem rather than the banks or its customers. Risk has been socialised to a large degree. Although in banking it seems to be worse in the USA than in Australia.

    The Great Depression was preceded by a process of deflation across the Commonwealth nations due to Churchills deflationary return to gold in 1925. During any significant deflation it is inevitable that the banking system will collapse as the debt of borrowers gets ever larger in real terms whilst the zero point boundary for nominal interest rates blocks any form of conventional escape except for default. This is exactly what happened in Japan through the 1990s (although the government stepped in to prop up many of the borrowers) and in the Asian financial melt down of 1997 and subsequently Argentina (which lacked prudence in more ways than one).

    And ongoing and significant increase in the real value of the “unit of account” will ultimately cause a banking crisis. Fear of this situation is one of the reasons why central banks are biased towards inflation. It is why monetary policy must be concerned with ensuring that the value of the currency does not rise or fall excessively.

  15. QUOTE: The dramatic collapse of risk aversion, (the penultimate example of which being the proliferating carry trades that have flooded world asset markets with liquidity), has been a necessary condition of the current unsound credit boom.

    RESPONSE: A lot of the trading in futures, swaps and general currency speculation can be attributed to floating exchange rates.

  16. Terje,

    You said:

    If you pay me with a cheque then my bank will not credit my bank account until it sees the cash from your bank. Clearly my bank does not trust your bank as much as you do.

    This may be the case, however, it is not relevant to the person writing the checks. I can go on my merry way writing checks (or using check cards) and never have to carry a single central bank note, and it will not effect my ability to transact commerce one iota. Does this not demonstrate that deposits are money?

    As regards the nature of currency notes, they are indeed a liability of the central bank, gold window or no. This is why central banks have reserves, including gold and other currencies; to secure the liability their notes represent. When the gold window was in effect, this liability was explicit. Now, it is implicit, more akin to a promise, but it is a liability nonetheless (and what’s more, one explicitly stated in a statement of central bank accounts).

    A central bank’s reserves are largely analogous to a bank’s capital margin. Both can be inadequate as the many emerging market crises of the past few decades demonstrate. In the event that either is insuffient to ward off a bank or currency run, capital losses become the order of the day. For holders of central bank liabilities, the currency settles on some lesser value of exchange and that imputes to them some loss of purchasing power. For holders of the bank liabilities (deposits), its assets can be salvaged at some value lesser to that of its nominal liabilities, and that loss is shared pro-rata with its creditors (more or less). In both cases, real ‘money’ is lost because the liability that backed it was unsound (or perceived to be). The bottom line remains the same: money is credit, credit is money. If money weren’t credit, it would have intrinsic value and we would be in a barter economy.

    As regards the Great Depression and Japan post 1990, both were preceded by dramatic increases in credit and attendant speculative asset bubbles. It’s highly contrary to every study I’ve ever read (or that I’m aware of) to postulate that this was coincidence. It also should be noted that in both cases deflation did not set in until after the collateral damage from exploding asset bubbles caused a precipitous decline in the money supply, (i.e. credit system), and attendant wrenching effects on the real economy. In particular, inflation statistics for both the US in 1929 and Japan in 1990 show a raising price level.

    As regards deflation, or the deflationary spiral, it is a problem because experience of inflation eventually shapes expectations of inflation. Inflation expectations matter because real interest rates are equal to nominal interest rates minus the expected change in prices. If people expect prices to decrease by 10 percent per annum, then even with nominal interest rates of 0, the effective interest rate is high (10%). In a stagnant to shrinking economy, real rates of even 1% can be restrictive, hence, since interest rates cannot go negative, deflation is problematic (what Keynes called the “liquidity trap”).

    Lastly, I agree with you somewhat when you say:

    The real problem with risk is that governments are so embeded into the banking system (eg central banks) these days that we have prolific moral hazard. Governments should not be in banking unless it fixes some problems. Hence lots of problems that arises become the taxpayers problem rather than the banks or its customers. Risk has been socialised to a large degree.

    Risk has been socialized and in so doing shared. Many economists would argue that this is a welfare benefit for society because only governments can pool risk of this magnitude. I would tend to agree except to say that their doing so has made it incumbent upon governmental institutions to appropriately regulate financial intermediaries, something that they have been grossly incompetent at doing. So far the tab for that incompetence has included such calamities as the Savings & Loan debacle. As Jon Stewart says, I’m looking forward to seeing what’s in store for us next.

  17. This may be the case, however, it is not relevant to the person writing the checks. I can go on my merry way writing checks (or using check cards) and never have to carry a single central bank note, and it will not effect my ability to transact commerce one iota. Does this not demonstrate that deposits are money?

    What it demonstrates is that deposits and cheque writing represent an effective “medium of exchange”. Which is an important characteristic of money but not the essential characteristic of money. In essence I reject the assertion that we can treat deposits as being like money proper. Even though it is popular in lots of literature to do so.

    I am not trying to split hairs and play semantics just for the sake of it. The distinction is important from an analytical point of view and in terms of understanding how the system operates and how credit works differently to money proper. The inter-play between the two can not be understood correctly if the distinction is not recognised.

    As regards the nature of currency notes, they are indeed a liability of the central bank, gold window or no. This is why central banks have reserves, including gold and other currencies; to secure the liability their notes represent. When the gold window was in effect, this liability was explicit. Now, it is implicit, more akin to a promise, but it is a liability nonetheless (and what’s more, one explicitly stated in a statement of central bank accounts).

    Central banks have reserves so that they can afford to redeem currency as part of their open market operations and in so doing achieve their monetary policy. However fiat currency is not a liability. Fiat money is like gold in so far as demand keeps the currency valuable. Fiat money offers nobody any promise at all. Hence it is not a liability.

    Money is a market phenomena. It is not about promises. Many currencies that are no longer even issued or endorsed by governments continue to retain value so long as their is no source of new production. This is often in spite of the fact that there is nobody that will redeem the currency.

    In fact the value of a given currencies is generally safer when the government ceases having anything to do with it. The Swiss Dinar retained value far better than the Iraqi Dinar that replaced it, even though the former was no longer endorsed by any government, backed by any reserves or redeemable through any authority anywhere. Did you review the reference I offered above to the Swiss Dinar? It offers an important insight into the nature of currencies and the origin of their value. It is not the only such example from history however it is certainly one of the most recent examples and it is a robust example.

    As regards the Great Depression and Japan post 1990, both were preceded by dramatic increases in credit and attendant speculative asset bubbles.

    More on this issue later.

    The points of disagreement between us are not trivial. However you are right to identify that there is a lot we actually do agree on.

  18. Terje,

    … the rhetoric of central banks (when they say that the economy needs cooling to avoid inflation) is simply wrong.

    If a policy of raising interest rates reduces inflation and slows growth (which you don’t seem to deny, correct me if I’m wrong), how is this much really much different from ‘cooling the economy to slow inflation’? I’m pretty sure central banks aren’t trying to say that anything that slows growth will slow inflation.

    I am suggesting that an economy that is contracting will be inflationary in nature

    That really depends on your assumptions. If, for example, you are assuming that the central bank targets the interest rate and that “a growing economy will typically result in an increased demand for financial capital”, as you have suggested, then it does not follow that a contraction will be inflationary.

    An economy that is cooling, as in contracting or growing slower, will always be more prone to inflation than an economy that is growing strongly.

    No, not always; it clearly depends on why the economy is contracting/growing slower.

    I am not trying to split hairs and play semantics just for the sake of it. The distinction is important from an analytical point of view and in terms of understanding how the system operates and how credit works differently to money proper. The inter-play between the two can not be understood correctly if the distinction is not recognised.

    Referring to credit as ‘money’ is hardly denying that there is any distinction. It seems like you are splitting hairs to me.

  19. If a policy of raising interest rates reduces inflation and slows growth (which you don’t seem to deny, correct me if I’m wrong), how is this much really much different from ‘cooling the economy to slow inflation’?

    The word “cooling” is in this context implies slowing economic growth. As if the cause of inflation is too much economic growth. The logic used to justify interest rates as a monetary target is the notion that demand drives the economy and higher interest rates will slow demand and take “heat” out of economy.

    That really depends on your assumptions. If, for example, you are assuming that the central bank targets the interest rate and that “a growing economy will typically result in an increased demand for financial capital�, as you have suggested, then it does not follow that a contraction will be inflationary.

    The contraction may be inflationary and the monetary policy may compensate (correctly) by being deflationary. So the net effect during an economic contraction may be as you point out something other than inflation.

    If we had a static amount of currency (ie no open market operations monetary lever) then a contraction would almost universally lead to inflation. With the monetary lever in use the contraction is still inflationary but the lever may be used to compensate (as it should).

    To use a metaphor I might say that an economic contraction is inflationary in the same way that gravity pulls things towards the ground. However due to other forces many things will not fall to the ground and some will in fact rise away from the ground. This is not to say that gravity has stopped its pulling.

    Referring to credit as ‘money’ is hardly denying that there is any distinction.

    It is the distinction that I am keen to defend. The semantics are very much secondary. If we merely blend the two concepts by using the same word “money” then the distinction gets too readily losts in any subsequent dialogue or analysis.

    When we give an identical name to two different things then it becomes hard to discuss them as if they were two different thngs. For all I care we could call them B1 and B2 so long as the integrity of the distinction is retained and its significance is recognised.

    Does this not demonstrate that deposits are money?

    What I will add as a further point of clarification is that promisory notes that are issued by private banks (illegal in Australia) and that circulate in the same manner as currency are essentially identical in function to bank deposits circulated by means of cheque writing or EFT.

    However private promisory notes are different to fiat or symbolic currencies. Promisory notes represent a contractural commitment, not a market commodity. Fiat currencies are a commodity and their value is not externally denominated. In each case the origin and maintenance of value is different.

  20. Terje
    The Swiss Dinar episode gives an interesting insight into social conventions and a fiat currency, unfortunately the Wiki article fails to provide the whole story. It misses the fact that it became more valuable as expectations of the US invasion of Iraq mounted. This in case you miss the point meant that it was increasingly likely that Swiss Dinars would be honoured by a future government or occupying power.

    As a thought experiment why don’t you imagine that aggregate demand does in fact exist. It might enable you to realise why some of your more bizarre assertions such as contractions are inflationary by nature don’t correlate with empirical evidence.

  21. As a thought experiment why don’t you imagine that aggregate demand does in fact exist. It might enable you to realise why some of your more bizarre assertions such as contractions are inflationary by nature don’t correlate with empirical evidence.

    What empiricle evidence?

  22. QUOTE: It misses the fact that it became more valuable as expectations of the US invasion of Iraq mounted.

    RESPONSE: Why are you so sure it was not a case of the US dollar getting weaker in anticipation of war? By what objective measure do you say that the Swiss dinar was gaining value.

  23. Because it rose about 400% in the space of a year from around mid 2002. From memory the USD was in broad depreciation at the time but it didn’t collapse.

    Now go to sleep, its late.

    PS. Could be wrong about the 400%. If I am we can settle on shitload as our basic unit of measure.

  24. Terje,

    The word “cooling� is in this context implies slowing economic growth. As if the cause of inflation is too much economic growth. The logic used to justify interest rates as a monetary target is the notion that demand drives the economy and higher interest rates will slow demand and take “heat� out of economy.

    I’m still not seeing what your point is exactly. You are disputing that raising interest rates will reduce demand, reduce inflation and reduce output growth?

    If we had a static amount of currency (ie no open market operations monetary lever) then a contraction would almost universally lead to inflation.

    It still depends on why there is a contraction, as well as on what other conditions are often associated with contraction (e.g. as you have said, “a growing economy will typically result in an increased demand for financial capital”, which would generally be inflationary).

    It is the distinction that I am keen to defend. The semantics are very much secondary. If we merely blend the two concepts by using the same word “money� then the distinction gets too readily losts in any subsequent dialogue or analysis.

    When we give an identical name to two different things then it becomes hard to discuss them as if they were two different thngs. For all I care we could call them B1 and B2 so long as the integrity of the distinction is retained and its significance is recognised.

    There is “base money” and there is “credit money”. Most people don’t have a problem with this (as far as I can tell), I’m not sure why you feel the need to be different. It is like saying we can’t refer to heat as “energy” in case we confuse the two concepts.

  25. “…the United States has many more important sources of power and influence than the $US.”

    NAME ONE?

  26. Terje,

    Let me see if I can summarize your argument: I can transact as easily with checks as with cash, but cash is money and checks are not money even as they are a “medium of exchange”. The distinction is not splitting hairs.

    Well maybe not, but whatever the distinction may be, it is certainly superfluous. The holder of cash doesn’t have the risk of a bank’s collapsing, but that risk is not consequential outside of its fruition. They continue to be able to transact in a way no different whatsoever from someone who chooses to do so in cash- ergo, if cash is money, deposits must surely also be money. This is not a controversial idea, so far as I’m aware.

    Central banks have reserves so that they can afford to redeem currency as part of their open market operations and in so doing achieve their monetary policy. However fiat currency is not a liability.

    Actually, central bank open market operations have nothing to do with redeeming currency. Central bank open market operations have to do with monetizing and selling government debt which has the effect of adding to and taking away from banking reserves (M0). The function of reserves is to instill confidence the liability that is the nation’s fiat currency. The central bank of Hong Kong is a prime example. Their Hong Kong dollar is backed dollar for dollar with USD underpinning confidence and making it impregnable to speculators.

    Fiat money is like gold in so far as demand keeps the currency valuable. Fiat money offers nobody any promise at all. Hence it is not a liability.

    That doesn’t follow. Fiat money is a liability of its creator, both nominally and effectively. Nominally it is a liability in the way in which the accounts of central banks are compiled. Effectively it is a liability in that if the bank prints too much of the stuff, (i.e. if its liabilities grow faster than its assets), it will not be able to maintain its purchasing power which is manifestly at odds with the goals of altruistic policy makers and their more human-like Machiavellian counterparts.

    So that we don’t lose sight of the forest for the trees, let me summarize at the more pertinent level. Money is indeed nothing more, nothing less than a “medium of exchange”:

    If people believe it is money, it is money (Swiss Dinars, coffee cups, come what may). The way money is currently managed in a market economy implies that it gets multiplied via financial intermediaries to many times the size of the banking reserves it directly prints (with a massive amount of that ‘money’ creation currently outside the remit of the banking system). There are many divergent points of view about how to determine when to supply more banking reserves and when to take some off the table. The recent history of the Federal Reserve suggests that, so long as narrow definitions of consumer prices are not rising, the Fed will not consider “taking away the punch bowl”. For a series of exogenous reasons, this policy has lead to asset bubbles of unprecedented scope and likewise buoyant economic activity. When these bubbles burst, economic history is instructive- there will be hell to pay (with Argentina 2001 being a better guide to American’s immediate plight than the US in 1929).

  27. The proposes iranian oil bourse was supposed to be open on 20th March. Does any one know the current status of this bourse?. How the U.N security council is likely to affect this opening. What about the rumours of Isarel’s planned strike of Iran on 28th.

  28. Because it rose about 400% in the space of a year from around mid 2002. From memory the USD was in broad depreciation at the time but it didn’t collapse.

    Given that the supply of Swiss Dinar in circulation an increase in value could merely reflect a lot of confidence that post war Iraq would quickly expand. However you don’t sound that convinced of your assertion and if possible a reference article or some actual data might be helpful.

    However I am more interested in hearing about your claimed empirical data that says economic expansions are not deflationary in nature.

    There is “base money� and there is “credit money�. Most people don’t have a problem with this (as far as I can tell), I’m not sure why you feel the need to be different.

    I am more than happy to settle for that terminology for the sake of this discussion. However if we do this then once people start talking about “money” as a generality I am again going to insist that they make clear whether they are talking about “base money” or “credit money”. As I said the semantics are secondary, more important is the distinction.

    You are disputing that raising interest rates will reduce demand, reduce inflation and reduce output growth?

    It depends how you raise them. If you raise them by draining currency from circulation or slowing the rate of currency creation, which is how they generally raise interest rates, then of course it will tend to reduce inflation relative to what it would have been. However anything that merely reduces economic trade (ie less goods being bought and sold) will tend to be inflationary (less goods chasing the same money). So it very much depends on multiple factors.

    Interest rates can rise due to open market operations that reduce the amount of currency that would have otherwise have been in circulation. Likewise inflation can fall due to open market operations that reduce the amount of currency that would have otherwise have been in circulation.

    You appear to be looking at specific overall outcomes. Whilst I am keen to look at the underlying forces. It is as if you look at a bridge and assume that there are no forces acting on the bridge because it is not moving. There certainly are forces, however they are in balance.

    Reducing the amount of base money is deflationary. Contracting the economy is inflationary. Do both at the same time and you may well get a neutral price effect.

    “…the United States has many more important sources of power and influence than the $US.�

    NAME ONE?

    Nuclear weapons.

  29. Actually, central bank open market operations have nothing to do with redeeming currency. Central bank open market operations have to do with monetizing and selling government debt which has the effect of adding to and taking away from banking reserves (M0).

    M0 is the amount of currency in circulation. It may be in the hands of private banks, private citizens or foreigners. It could be in the central bank of another nation.

    To redeem some currency the central bank sells some of its assets. That might mean selling government bonds, gold or foreign currency. Or it might mean playing about with repo contracts which have much the same effect. Either way open market operations means increasing or decreasing M0.

    Whether this operation is done in order to increase the gold price or to reduce interest rates depends entirely on the objective with which open market operations are conducted. In other words it depends on the policy that is pushing and pulling the open market operations lever.

    So that we don’t lose sight of the forest for the trees, let me summarize at the more pertinent level. Money is indeed nothing more, nothing less than a “medium of exchange�:

    If money was nothing more than a medium of exchange then none of us would care one bit about how much there was or what it was worth. If it halved in value over this coming year we would just use more of the stuff. Inflation and deflation would be irrelevant.

    However money is not just a “medium of exchange�. It is also a unit of account. It denominates the three year lease on my office. It denominates the size of the salaries that I have agreed to pay my employees. It denominates the size of the debt that I have with my bank.

    When the value of money falls or rises we care precisely because it upsets all the long term contracts that we have denominated using money. It changes the intent of tax and welfare policy.

    By saying that money is merely a “medium of exchange” you deny its far more important role as a “unit of account”.

    Inflation and deflation is nothing more than a change in the value of our “unit of account”. And for a host of institutional reasons any unanticipated change in the value of our “unit of account” will leave people feeling cheated. It will undermine trust between the various players in the process of production.

    If people believe it is money, it is money (Swiss Dinars, coffee cups, come what may). The way money is currently managed in a market economy implies that it gets multiplied via financial intermediaries to many times the size of the banking reserves it directly prints (with a massive amount of that ‘money’ creation currently outside the remit of the banking system).

    I agree with the first half of your statement. If enough people want coffee beans as money then it will happen. However I disagree with your second statement. All the fractional banking in the world will not change the number of coffee beans. It will merely increase the number of promises that people have made to eachother. The value of those promises will be denominated and valued with reference to coffee beans. However there will be no more coffee beans. Which should not generally matter because most of the people making these promises don’t want coffee beans anyway. They just want a tangible and objective way to pin a value on their promise so there is no argument later on. The fact that these promises are mediated through the banking system is secondary and merely a exercise in efficiency and specialisation.

    In such a system there will be some coffee beans used as a medium of exchange. And there will be a lot of promises documented and exchanged as a medium of exchange. If we had a doubling in the number of promises it would not generally matter.

    However lets say the market value of coffee beans now halves. All those promises denominated in coffee beans will suddenly change in value. And one counter party to each promise will win and one will lose.

    The “medium of exchange” is not terrible significant. On the other hand the “unit of account” is central to our entire system of commerce.

  30. You appear to be looking at specific overall outcomes. Whilst I am keen to look at the underlying forces.

    Well since you are the one trying to argue that “the rhetoric of central banks is simply wrong” I think that what the central banks are talking about is more relevant than what you are keen to look at.

    Reducing the amount of base money is deflationary. Contracting the economy is inflationary. Do both at the same time and you may well get a neutral price effect.

    The two are not independent. I think it’s fairly obvious that if a central bank says (in this day and age) they want to “cool the economy” then they implicitly mean by raising interest rates. You have to look at the total effect of raising rates to cool the economy if you want to say they are wrong. Identifying a single effect on the price level, that of a fall in (or slowing growth of) transactions demand for money due to a fall in (slowing growth of) output, does not prove that they are wrong.

  31. Terje

    This took about a minute to find, given you were the one talking about the Swiss dinar I would have assumed you were across the facts.

    Click to access MK-presentation.pdf

    As for the empirical evidence well that’s actually part of the historical record. Don’t be so lazy, check it out.

  32. Sdfc,

    The following is what your article says:-

    • For ten years, therefore, Iraq had two currencies: one issued by the official government and the other backed by no government at all. The Swiss dinar continued to circulate in the North, even though backed by no formal government, central bank, nor any law of legal tender.
    • Whatever gave the Swiss dinar its value was not the promise of the official Iraqi government, or indeed any other government.
    • After 1993 the Swiss dinar deviated from parity and rose to around 300
    Saddam dinars to the Swiss dinar by the time Saddam’s regime was
    deposed in 2003. The appreciation of the Swiss dinar is clearly a
    consequence of the evolution of the actual and expected money supplies in
    the two territories.

    Interestingly, the Swiss dinar rose sharply against the US dollar from the
    middle of 2002 as the prospect of an end to the Saddam regime increased.
    • That appreciation reflected expectations about :
    – The durability of the political and military separation of Kurdish from
    Saddam-controlled Iraq.
    – The likelihood that a new institution would be established governing
    monetary policy in Iraq as a whole that would retrospectively back the
    value of the Swiss dinar. The political complexion of Northern Iraq led
    to the assumption that the currency used there would have value once
    regime change had occurred.
    • In other words, the value of the Swiss dinar had everything to do with
    politics and nothing to do with the economic policies of the government
    issuing the Swiss dinar because no such government existed.
    • As someone might have said, “it’s the political economy, stupid!�

    Which confirms my point. A fiat currency does not need any government promise in order to retain market value. The Swiss Dinar did it successfully for a decade. And in its final days it actually gained value.

    The article does confirm your point that the Swiss Dinar rose in value by nearly 400% prior to the 2003 invasion. And the article does a good job of explaining the forces at work. A new form of demand for the Swiss Dinar was in the wings. The US authority subsequently paid a premium for the Dinar compared to its historical valuation.

    As for the empirical evidence well that’s actually part of the historical record. Don’t be so lazy, check it out.

    I have checked a lot of the historical record. I just thought you might have something to offer that might surprise me. Maybe not.

  33. Terje,

    M0 is the amount of currency in circulation. It may be in the hands of private banks, private citizens or foreigners. It could be in the central bank of another nation.

    True, but the easiest definition is, M0 = banking reserves (i.e. deposits at the fed) plus cash.

    To redeem some currency the central bank sells some of its assets. That might mean selling government bonds, gold or foreign currency. Or it might mean playing about with repo contracts which have much the same effect. Either way open market operations means increasing or decreasing M0.

    You’ve got the assets and liabilities straight, (and the fact that any time the central bank prints money or buys it it changes M0), but you are conflating two quite distinct policy aims; targeting the money supply & targeting the exchange value of the currency (relative to other currencies. I have not heard it asserted outside of gold-bug circles or seen any direct evidence of central banks targeting gold prices). This is not to say that policy to affect one doesn’t impact the other, but that you should be aware of the distinction (e.g. currency market intervention affects M0 identically to open market operations and therefore affects interest rates identically. Ceteris paribus, propping up a currency raises interest rates and selling it down a la Asia lowers them. This effect can be ‘sterilized’ with open market operations but not without ‘carry’ implication- often negative). In any case, the term, “open market operations” refers only to the affectation of M0 through the buying and selling of central government debt in the open market. The term, “currency redemption” is ambiguous and obfuscates the underlying dynamic which is the control of the size of the money supply.

    I agree with the first half of your statement. If enough people want coffee beans as money then it will happen. However I disagree with your second statement. All the fractional banking in the world will not change the number of coffee beans.

    Agreed, but provided the coffee bean notes were iron clad in the minds of the people transacting them, the stock of money would indeed grow through the banking system and the value of the coffee beans (discounting their value outside of their use as money) would be subject to that growth.

    The fact that these promises are mediated through the banking system is secondary and merely a exercise in efficiency and specialisation.

    In such a system there will be some coffee beans used as a medium of exchange. And there will be a lot of promises documented and exchanged as a medium of exchange. If we had a doubling in the number of promises it would not generally matter.

    It would indeed matter. These promises can be used to buy things. The more that chase goods, the lower the value of the promises in terms of goods. The more that chase assets, the lower the value of the promises in terms of assets. If the iron clad guarantee that these notes are no different than coffee beans is held up, then the value of the notes will continue to equate to the value of the coffee beans in terms of their purchasing power for goods and/or assets. That is to say, the market value. I wouldn’t want to give the impression that market values are not subject to (dramatic) change as nothing could be further from the truth.

    However lets say the market value of coffee beans now halves. All those promises denominated in coffee beans will suddenly change in value. And one counter party to each promise will win and one will lose.

    You said it. And in that case, the authority charged with maintaining the exchange value of coffee beans (money) will have been broken (provided it was working as per its charter to maintain that value). Which makes monetized coffee beans the same as every other form of money- a liability.

  34. What might surprise you Terje?

    If you know that economic contractions and disinflation have a tendancy to lead to disinflation as the historical record confirms then why argue that they are by nature inflationary?

    Actually I can answer my own question there Terje, its because of your failure to understand how demand effects output and prices.

    As for the Swiss Dinar, I have already said that it was a very interesting ocurrance but the fact remains that the currency did in fact appreciate substantially as a result of expectations that the liability would be honoured. This in due course proved to be correct. My point is that the Wiki article did not tell the entire story and that you should widen your reading.

    So what is your point?

  35. This is not to say that policy to affect one doesn’t impact the other, but that you should be aware of the distinction (e.g. currency market intervention affects M0 identically to open market operations and therefore affects interest rates identically. Ceteris paribus, propping up a currency raises interest rates and selling it down a la Asia lowers them. This effect can be ’sterilized’ with open market operations but not without ‘carry’ implication- often negative).

    Yes, yes, yes. I agree. The only point of difference is that you can sell down your currency beyond the point at which interest rates hit zero. This is what Japan has in essence being doing. And if they had stopped when interest rates hit zero they would still be stuck with inflation because a nominally zero interest rate in a deflationary environment can still be high in real terms.

    You can target interest rates and it will effect the exchange rate. Or you can target exchange rates and it will effect interest rates. With one arrow you can only hit one target and the other variables must float. If open market operations was your only monetary policy lever then you would only have one arrow.

    Agreed, but provided the coffee bean notes were iron clad in the minds of the people transacting them, the stock of money would indeed grow through the banking system and the value of the coffee beans (discounting their value outside of their use as money) would be subject to that growth.

    Yes, yes, yes. My point is that the monetary authority need only pre-occupy itself with the value of coffee beans. If credit creation dampens the value of coffee beans then the monetary authority needs to correct this by intervening on the supply side. The monetary authority does not need to measure the amount of credit being created but merely the effect that it has on the value of coffee beans. This is what I mean by a price rule as opposed to a quantity rule.

  36. If you know that economic contractions and disinflation have a tendancy to lead to disinflation as the historical record confirms then why argue that they are by nature inflationary?

    The historical record does not show what you says it shows.

    When the plague swept Europe in the middle ages production plumetted (ie economic contraction). Prices rose. Contraction lead to inflation.

    When western economies tanked in the 1970s prices rose. Contraction lead to inflation.

    When Britian industrial base expanded during the 1800s prices fell. Expansion lead to deflation.

    When China expanded during the 1990s prices fell. Expansion lead to deflation.

    So which part of the historical record are you referring to?

  37. This is what Japan has in essence being doing. And if they had stopped when interest rates hit zero they would still be stuck with inflation …

    I typed this wrong. The last word in the quoted section should be “deflation”.

  38. Well Terje you’ve got two labour supply shocks, a technology shock and an oil crisis there, well done.

  39. I think you’re being a bit disingenuous there, I came in at the Volker disinflation didn’t I? and yes I know oil prices began to fall in the early 80s.

  40. Terje,

    You can target interest rates and it will effect the exchange rate. Or you can target exchange rates and it will effect interest rates. With one arrow you can only hit one target and the other variables must float. If open market operations was your only monetary policy lever then you would only have one arrow.

    Yes and no. Yes if the central bank authority is trying to defend itself against a run on the currency. In such a case it is going to be essential that they reduce the money supply, and typically dramatically. No, however, in the case where a central bank is trying to devalue their currency. In this case they can prevent the expansion of the money supply by sterilizing the additional reserves. The operation is basically a reallocation of capital that is not driven by market mechanisms and only works when the institution running the intervention is also proprietor of the printing press of the desired currency.

    My point is that the monetary authority need only pre-occupy itself with the value of coffee beans. If credit creation dampens the value of coffee beans then the monetary authority needs to correct this by intervening on the supply side. The monetary authority does not need to measure the amount of credit being created but merely the effect that it has on the value of coffee beans. This is what I mean by a price rule as opposed to a quantity rule.

    If you mean by “value” the value in terms of a narrow basket encompassing only goods and services, (or, God forbid, ‘core’ goods and services), I would strenuously disagree. If you mean by “value” a broad based version to include goods, services, financial and non finacial assets, I would say that you would’ve made a better chair of the Federal Reserve than Alan Greenspan, (and out of courtesy I would’ve qualified that as not being damnation by faint praise).

  41. No, however, in the case where a central bank is trying to devalue their currency. In this case they can prevent the expansion of the money supply by sterilizing the additional reserves.

    Sterilisation will ultimately flow back around to neutralise both interest rates and/or exchange rates objectives. Although I will accept that in the short term you may be able to play both sides of the fence with some success (the transmission factors and arbitrage processes not working with 100% efficiency).

    If you mean by “value� the value in terms of a narrow basket encompassing only goods and services, (or, God forbid, ‘core’ goods and services), I would strenuously disagree. If you mean by “value� a broad based version to include goods, services, financial and non finacial assets, I would say that you would’ve made a better chair of the Federal Reserve than Alan Greenspan, (and out of courtesy I would’ve qualified that as not being damnation by faint praise).

    I think that there are narrow goods that can in the right circumstances represent a good proxy for a broad based basket. In particular gold did when used within a gold standard.

    The problem with the current CPI basket is that it is focused on consumer goods. And you can make a lot of monetary errors without any short term effect on consumer prices. In other words such a choise of basket allows for a lot of monetary errors to be made without it registering in your target numbers (CPI growth).

    My contention is that a basket of commodities does not suffer from this lag. Monetary errors are revealed almost immediately and hence they can be corrected almost immediately. The faster feedback leads to a more stable monetary climate.

    The notion of asset bubbles as some vague phenomena of irrational free markets is incorrect in my view. As and where they occur they are a response to a specific forms of government intervention (eg the Dutch tulip bubble) or else they are a response to accumulated monetary errors and corresponding errors in price signals (the 1990s tech bubble).

  42. I think you’re being a bit disingenuous there

    Look all I want are some historical examples that you believe represent an empirical counter point to my stated claim. If you don’t have any examples then withdraw your assertion that the empircal record proves me wrong. And if you do have such examples then lay them on the table and we can discuss why they do or don’t discredit my claim.

    To summaries my claim in basic terms:-

    * CONTRACTION leads to INFLATION (given a static M0).

    * EXPANSION leads to DEFLATION (given a static M0).

    * INFLATION leads to CONTRACTION (if tax/welfare/debts/contracts are not indexed).

    * DEFLATION leads to CONTRACTION (if debts/contracts are not indexed).

    The stated outcome of the first two in my list can be compensated for by correct adjustment of M0.

    A prolonged deflation will be characterised by higher than usual bankruptcies and businesses and individuals defaulting on debts.

    A prolonged inflation will be characterised by a wage/consumer price spiral and typically industrial strife.

    I would be very interested to review any examples from history that seriously contradict these basic claims. My statements are not 100% precise (I can elaborate if necessary) however they are correct in pretty broad terms.

  43. Well for a start Terge I have already given you an example, the Volker disinflation. You can also add our own similar disinflation of the early nineties, although this was due to monetary policy error rather than a deliberate act.

    Now lets start from the top – Contraction leads to inflation given a static money base. In a contracting economy the demand for goods and services will fall suppliers/producers will be forced to either raise their prices by less than they might when the economy is at potential or even lower prices in order to maintain market share/prevent themselves going out of business. This of course does not happen instantaneously because prices are sticky, hence slowdowns can develop into recessions but that is another story.

    However credit bubble fuelled expansions can lead to deflation or disinflation, US, Japan, SE Asia, China.

    The opposite happens in an expansion, ie higher demand I think I’ll put my prices up.

    Inflation leads to contraction? Not necessarily. By this reasoning we would be in consistent contraction.

    Deflation leads to contraction, Yes.

    I actually think it might be up to you to come up with some evidence now to support your assertions.

    Although try to leave out the supply shocks.

  44. Terje,

    My contention is that a basket of commodities does not suffer from this lag. Monetary errors are revealed almost immediately and hence they can be corrected almost immediately. The faster feedback leads to a more stable monetary climate.

    I’ll agree that commodity price spikes can be a red flag, i.e. that they can detect worrisome monetary flows independently of consumer goods and services. However, they too are insufficient in some cases. For example, gold and oil prices fell in the 90s along with consumer prices. Does that mean the correct monetary policy was struck? Far from it. Credit expansion during that period fueled some righteous asset bubbles. In particular, Greenspan’s long record of failure included not identifying the disorderly monetary processes that were driving the 90’s spectacular asset inflation, notably the eye watering expansion of GSE credit (or, as is more likely, enforcing strict cognitive dissonance on the matter). These bubbles would’ve had devastating enough consequences had their fallout not been diffused with the still more impossibly large ones of the present day. On that count, it is a running question on how many more times we can hit the snooze button to forestall that great getting up morning.

    The notion of asset bubbles as some vague phenomena of irrational free markets is incorrect in my view. As and where they occur they are a response to a specific forms of government intervention (eg the Dutch tulip bubble) or else they are a response to accumulated monetary errors and corresponding errors in price signals (the 1990s tech bubble).

    There is nothing vague about the growth of asset bubbles, nor is there anything irrational when you consider the perverse incentives they instill. This was true for the John Law’s Mississippi Company, 1920s Floridian real estate, vapid 1990s internet companies and every other of myriad iterations of Ponzi schemes that have been perpetrated since the invention of private property. When they occur they are a specific response to human greed. When they collapse they are a specific response to human fear. At the moment, we are smack dab in the middle of one very large one, (US dollar and credit), with its various manifestations (art, property, bond, etc. etc. etc. asset bubbles).

    Ironically, it is their highly specific, even formulaic nature that allows speculative bubbles to grow and prosper. While they inflate, they make many a fortune and promote a temporarily generalized prosperity. By consequence, asset bubbles have constituents galore (see income statements of Wall Street firms three years running) and no shortage of intellectual Dow 50,000,000,000,000 apologists (see Ben Bernanke when he opens his pie hole). It is only after they explode that their deleterious effects, most often to include vast wealth redistribution from the starry eyed poor and middle class to the rich (see Forbes recent list of billionaires). This also helps explain why political instability very often follows close behind such events.

    Time to sharpen up the guillotine me thinks.

  45. Well for a start Terge I have already given you an example, the Volker disinflation. You can also add our own similar disinflation of the early nineties, although this was due to monetary policy error rather than a deliberate act.

    Thats an interesting example. Reagan tax cuts were expanding the economy. And we would need to have a closer look at what was happening to M0 at the time. However I am certainly willing to explore this period. Can you pin it down to a specific set of years or are you just interested in the entire period during which Volker operated (ie can we look at aggregates across his entire term period).

  46. For example, gold and oil prices fell in the 90s along with consumer prices. Does that mean the correct monetary policy was struck? Far from it.

    The US was undergoing deflation. The Asian economies tied to the US dollar via their fixed exchange rate monetary policy were also undergoing deflation. Argentina joined the game late. The whole lot ended like most deflations end. Masses of non performing loans and bankruptcies. At the end of the period we had the Asian financial crisis and the tech wreck.

    You seem to assume that the wreck was due to irrational credit creation in the lead up to these events. I differ in opinion. I see the wreck as confirmation that deflation was moving through the system like a rat moves through a snake. The wreck would have been avoided if monetary policy had kept the price of commodities (oil and gold) stable. The wreck was due to a lack of base US currency not an abundance of credit.

    Countries like Malaysia avoided the worst of it by revaluing their currency. In effect they inflated their way out of the deflation.

    At this point in time with gold and oil heading upwards into the stratosphere I believe the US are being far too loose in with their currency. They need to tighten M0 to bring the value of the US dollar back up with respect to commodities. So does Australia. As I indicated earlier consumer prices are yet to reflect any error in monetary policy. Just as they failed in the late 1990s.

    The other spin off from the deflation of the 1990s was that declining commodity prices (eg oil) lead to a sence of commodity abundance. So we quite likely did not get the level of investment in oil exploration and new extraction that we perhaps should have.

  47. Terje,

    Consumer prices increasing throughout the 90s on a global basis with the exception of Japan, and with the exception of 1998 in certain Asian countries. At the same time, money supply growth was rapidly outpacing real GDP growth in most developed markets. On what basis do you claim that this was a deflationary environment? Because the price of raw materials and demonetized commodities were falling?

    If this is your definition of deflation it is certainly novel, but in any case, it certainly doesn’t portend economic difficulty. Why are declining commodity prices bad for an economy?

    As regards my “assumption” that credit growth is the root cause of monetary disorder and financial speculation, since you’ve mention the Asian financial crisis, let me avail you of the facts:

    Item: before the Asian financial crisis, there was 1) massive overinvestment in the real economy fueled largely by booming and unprecedented external capital flows 2) concomitant real estate and equity market speculation 3) Concomitant rapid growth in these markets’ money supplies and current account deficits.

    Item: Immediately preceding the crisis, Japan, the perennial provider of costless borrowed funds, hints at raising interest rates. Shortly thereafter, following a multiple round bout with speculators, Thailand floats the baht.

    Item: as the Asian financial crisis went full swing, there was a world-wide liquidity crisis. Bond and swap spreads exploded, nothing traded, and hedge funds and speculative investors far and wide got their arses handed to them. LTCM went bust. Most notably, this persistent tempest passed once the Fed, cut interest rates, as they did dramatically. The US equity markets assumed their unlikely march skyward.

    And given all that, is it really your assertion that the reckless build up of credit before, and the cascading defaults subsequent to the Asian financial crisis did not explain its fore and aft economic consequences?? That the empty skyscrapers and imploding financial systems that ensued in the wake of the massive credit contraction that followed on the heels of the crisis are not explained by the boom and bust dynamics of unchecked credit growth, but rather, the falling price of commodities? If so, you have a fair amount of explaining to do.

  48. In a contracting economy the demand for goods and services will fall suppliers/producers will be forced to either raise their prices by less than they might when the economy is at potential or even lower prices in order to maintain market share/prevent themselves going out of business.

    sdfc,

    If an industry in isolation experiences a slow down in demand then prices of the things that are produced by that industry will generally fall as supply is in surplus to demand. That is a microeconomic situation and pretty uncontroversial.

    However we are discussing macroeconomics. And we measure an economy by looking at production (hence the P in GDP). Although it is not just production to inventory that we are looking at but production that is actually sold to market.

    If M0 is static and we have less goods being sold to market across the board then in effect we have a reduced demand for currency (goods buy currency). So currency will fall in value.

    Of course there could be external demand for currency from foreign sources that counter act the effect. Which is why I advocated a price rule in the final analysis rather than a quantity rule. The monetary authority should mop up excess liquidity with open market operations.

    Marjorjam clearly understood my point earlier when he stated:-

    Majorajam Says:

    March 4th, 2006 at 10:49 am
    Terje,

    If you assume a policy that restricts growth in base money to zero (0), and a velocity of money that doesn’t change or doesn’t change enough to rival in magnitude a positive change in real GDP, all else equal, than that policy would lead to a decline in the price level, i.e. the policy is deflationary.

    Majorjam talks about the velocity of currency. I would be more inclined to talk about the demand for money (from domestic and foreign sources) and things that effect it (like efficiency in the credit markets) however otherwise we are both on the same page about the general impact of economic contaction. Economic contraction is inflationary in nature. The actual outcome will depend on how the monetary authority responds.

    Regards,
    Terje.

  49. Terje,

    Majorjam talks about the velocity of currency. I would be more inclined to talk about the demand for money (from domestic and foreign sources) and things that effect it (like efficiency in the credit markets) however otherwise we are both on the same page about the general impact of economic contaction. Economic contraction is inflationary in nature. The actual outcome will depend on how the monetary authority responds.

    What you are neglecting is the fact that the central bank does not totally control the money supply. More to the point, it can restrain it easier than it can grow it. This is what Keynes referred to as “pushing on a string”. So, in the case of a contraction, investment and therefore lending activity typically fall precipitously, which decreases the money supply. The net effect of that on the price level is indeterminate, but typically, the money supply effect swamps the output effect (especially as investment typically leads economic activity) and you have disinflation (if not deflation). The central bank can (and typically does) react to such an environment by trying to reverse the shrinkage in output by reducing the overnight rate, (Note that the reduction in investment demand with stable base money would precipitate a drop in the rate independent of a central bank’s actions. That only if the central bank targets the overnight rate would it need to act), thus reestablishing the economic incentives for lending institutions and borrowers to get together and grow the money supply. In extreme cases, such as the big time busts that ensue following rapid credit creation, the capital losses at financial intermediaries can frustrate any attempt of the central bank to resuscitate the economy. This is the part where Ben Bernanke calls in the fleet of helicopters.

    The point is, you’ve got the cart before the horse. When unsound credit booms go bust, money (recalling that it is a figment of our imagination backed by claims against uncertain future economic activity), goes up in smoke. The resulting environment is either hyperinflationary, if confidence in the currency is lost, or deflationary if money growth is not propped up as defaults cascade through the financial system on the way to systemic collapse.

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