Smith and Keynes on the history of money

In The Wealth of Nations Adam Smith writes that after division of labor is established, people begin to save a bit of some commodity to trade for things they need. This could have been cattle, salt, shells, cod, tobacco, hides, nails, and so on, but "In all countries, however, men seem at last to have been determined by irresistible reasons to give the preference, for this employment, to metals above every other commodity." (Smith, p. 127) Metal was preferred because it's not perishable, can be divided into parts, and can be fused together. Eventually, people started making coins to prevent having to weigh the metal for every transaction, the public office of the mint was created to stamp money, William the Conqueror introduced the custom of paying taxes in money, avaricious and unjust princes would consistently reduce the metal in the coins, and so on. "It is in this manner that money has become in all civilized nations the universal instrument of commerce, by the intervention of which goods of all kinds are bought and sold, or exchanged for one another." (p. 131) It all sounds fine, I believed that story for about a decade. But it is so obviously wrong.

Money started when humans organized into states and those states started requiring money for taxes -- whether that money was in the form of corn, cows, or coin.

An excerpt from Carter's The Price of Peace, showing what Keynes discovered about the history of money (p. 187-8):

"Keynes had discovered an ancient history that upended some basic tenets of economics going back to Adam Smith and undermined nearly tree centuries of Enlightenment political theory. Ever since Thomas Hobbes had published Leviathan in 1651, most European philosophers had imagined government as an artificial imposition on what Hobbes called "the state of nature." For Hobbes, the state of nature was a nightmare of violent disorder where life was "nasty, brutish and short," making government--especially monarchy--a source of human salvation. Even thinkers who rejected Hobbes' politics accepted his history. In The Wealth of Nations, Smith had presented markets for trade as a primordial force that came into being long before the development of the political state. Commercial life had started with people bartering goods, trading goats for wheat or cloth for buttons. They eventually adopted money as a medium of exchange, since passing tokens to each other proved to be more convenient than toting wagonloads of cumbersome goods. All of this activity had taken place among free individuals undisturbed by the machinations of capricious, meddling sovereigns, who entered the scene much later. The market was natural, while the state was a relatively recent artifice that intervened in or distorted the independent rhythms of trade. 

"Studying Athens, Babylon, Assyria, Persia, and Rome, Keynes concluded that this history was all wrong. Capitalism itself was an ancient creation of government, dating back at least as far as the Babylonian Empire of the third millennium B.C. "Individualistic capitalism and the economic practices pertaining to that system were undoubtedly invented in Babylonia and carried to a high degree of development in epochs more distant than the archaeologists have yet explored," he wrote--one of several startling observations recorded in seventy pages of unpublished notes and fragmentary argument from his 1920s research. Money, moreover, was not a custom developed by local traders for convenience but a sophisticated tool or rulership that had emerged simultaneously with other developments of the state, including written language and standardized weights and measures. 

"Smith and other thinkers had been led astray by confusing the development of coinage with the invention of money. Coinage, according to Keynes, was "just a piece of bold vanity ... with no far-reaching importance"; money had existed in "representative" form much longer. Its real significance was as a "unit of account"--the demarcation of debt and "the legal discharge of obligations," which governments had been maintaining in ledger books, scrolls, or clay tablets for millennia. Powerful, economically sophisticated empires had developed without using coinage at all.

"States, moreover, had always maintained a policy of active monetary management as a basic condition of rulership. They created and abolished debts as reward or punishment and reformed units of measurement, depreciating or debasing their currency not merely as a trick on unsophisticated subjects but to stimulate trade and ease social tension. Inflation--viewed by orthodox economists of the 1920s as an underhanded sovereign's subversion of the natural order--had instead been a near-constant condition "throughout almost lal periods of recorded history."

"... Money, he argued, was an inherently political tool. It was the state that determined what substance--gold, paper, whatever--actually counted as money--what "thing" people and the government would accept as valid paymnt. The state thus created money and had always regulated its value. "This right is claimed by all modern states and has been so claimed for some four thousand years at least." ... The true source of monetary stability was the public legitimacy of the political authority."

What makes money make money?

A sentence from Henry Miller's Tropic of Capricorn in the comments of Stephanie Kelton's New York Times op-ed Learn to Love Trillion-Dollar Deficits:

"To walk in money through the night crowd, protected by money, lulled by money, dulled by money, the crowd itself a money, the breath money, no least single object anywhere that is not money, money, money everywhere and still not enough, and then no money or a little money or less money or more money, but money, always money, and if you have money or you don't have money it is the money that counts and money makes money, but what makes money make money?"

Collateral in a market-based credit system

In 2012 Cardiff Garcia wrote a nice summary of a Credit Suisse research note. The research note is a good explanation of the market-based credit system and implications for policy. Here I make some notes for myself, summarizing the article, part of an eventual post(?) about money creation and the efficiency of private money allocation vs. the resilience (stability?) of public money creation.

Main points

Liquid collateral is the lifeblood of the modern economy -- the main form of money for large firms, asset managers, and financial institutions. The collateral-based financial system reduces the need for the bank deposit system. As with any credit system, the velocity of money & collateral and the cost and availability of credit tends to be pro-cyclical.

Higher levels of economic activity make all forms of collateral more liquid, fostering optimistic expectations about future returns, leading to asset price bubbles [Minsky-esque]. And vice versa -- when a credit bubble busts, collateral shrinks, haircuts rise, LTV ratios fall. After major shocks the velocity of money and collateral falls steeply.

In response to these shocks, central banks must provide liquidity and/or the government must sell money-like collateral on a vast scale to preempt and prevent deflation. The fragility of the financial system as it de-levers leaves a deflationary undertow that can flare up quickly in response to new shocks [we saw this in the repo market as the Fed started decreasing the size of its balance sheet in 2019].

Collateral as lifeblood

Central banks have been undertaking credit and maturity transformation on a large scale (as well as their traditional role of assuring funding liquidity) to prevent a deleveraging of the financial system that would lead to a deflationary cascade of shrinking money, credit, and output.

"In our view, that is the response to a classic information problem after a credit shock -- heightened uncertainty as to who is solvent or not, and thus an excessive contraction in the natural stock of safe liquid collateral on which so much financing and funding now depends." [emphasis mine]

The stock of liquid private collateral not growing is the modern monetary equivalent of a large output gap. It's "not some arcane technical point; it is above all about jobs, hardship, and hope in the high foreclosure counties and states, where recovery in income, spending, and collateral values have clearly lagged the rest of the country."

Households' most valuable source of collateral is the house, also cars and other valuables. The household sector owned $20.8 trillion of real estate in 2007, $16.0 trillion in 2012. [links between this section and Mian, Straub, Sufi's 2020 Saving glut of the rich]

In financial markets, debt securities are the most common collateral. These include corporate bonds, money market securities (more info here), asset-backed securities (cards, cars, and student loans), and exclude agency mortgages (I think just for the purpose of summing values. The outstanding value was over $15.4 trillion in 2007 and below $13.6 trillion in 2012.

Debt securities serve most often as collateral in financial markets. For collateral, three factors matter:

1. Value: how much is your house worth,
2. Haircuts: how much can you borrow against your home equity, and
3. Velocity: how many times can your house be used as collateral, i.e., rehypothecated

Shadow money

The IMF's Manmohan Singh estimated that collateral had a velocity or churn factor of roughly 3 in 2007 and 2.4 in 2012. This makes a big difference in the level of "Total Dealer Received Collateral" generated from a given amount of "Total Source Collateral".

The paper defines "shadow money" as the pool of debt securities that can easily be borrowed against. CS estimates shadow money based on the total outstanding value of various classes of debt, adjusted by each market's average repo haircut. If you've got a $100 bond and can easily borrow against it at a 5% haircut, you have $95 of shadow money and might not need to hold as much cash as you would if the haircut had been 10%. There was a negative correlation between levels of available HELOC credit and checking account balances -- as households had more credit they held less money.

The paper distinguishes between public and private shadow money. Public shadow money is based on the value of Treasury, mortgage-backed, and agency securities . Private shadow money is based on the value of corporate bonds, asset-backed securities, and non-agency mortgages [I think ~30% in 2020].

In 2008, private shadow money collapsed -- with negative net debt issuance, falls in the market value of debt, and sharp increases in repo haircuts. The S&P 500 moved in line with the level of private shadow money because equity prices are sensitive to deflationary risks. The drop also damaged real economic activity by tightening trade and inventory finance globally and causing a fall in business confidence.

Government then created a flood of safe collateral, sending the value of public shadow money soaring and offsetting the contraction in private shadow money. Central banks lowered interest rates and worked on other ways to improve the liquidity, value, and moneyness of public and private collateral through balance sheet operations.

"We believe this perspective [shadow money and market-based credit driving policy behavior more than the simultaneous shock to growth] shows a far more accurate and complete view of the money and credit dimension of this cycle, and offers a stark alternative to the traditional bank and money multiplier-based approach many people still use."

Effective money

CS defines "effective money" as shadow money + M2

• Public effective money = public shadow money + Monetary Base
• Private effective money = private shadow money + M2 - Monetary Base

(Note- not a big deal but I think this isn't perfectly consistent, since MB includes notes and coins in circulation, notes and coins in bank vaults, and Federal Reserve Bank credit (required reserves and excess reserves not physically present in banks), while M2 includes notes and coins in circulation but not in bank faults or FRB credit, as well as checking and savings accounts, and other types of deposit accounts and CDs worth less than $100,000.)

"Crucially, this chart and the shadow money perspective allows one to see that there has been (1) a huge and necessary change in the composition of the effective money stock, (2) a big reduction in the velocity of circulation of liquid collateral, (3) a sharp reduction in the value of illiquid collateral (houses [maybe today CRE to a greater extent]), (4) an increase in the "haircuts" on illiquid collateral (higher LTV ratios), and (5) a  big increase in precautionary demand for money by firms and households."

It seems to me that only (1) is a policy response. (2) through (5) are driven by the private sector driven, even if policymakers eventually require things like higher LTV ratios. And (5) goes back to Keynes -- the precautionary motive as "the desire for security as to the future cash equivalent of a certain proportion of total resources" (GT p. 146).

"The net result cannot be reasonably characterized as posing a major inflationary threat -- at least until such time as financial system deleveraging is more complete, collateral values, especially house prices have recovered substantially, and overall private sector credit demand is growing strongly."

Key takeaways

Until output gaps close and private collateral begins to grow again

1. Underlying deflation risks will persist.
2. Central bank balance sheets and fiscal debt may need to expand further.
3. Interest rates will stay in an historically low range, though not always as low as now.
4. The more macroprudential regulation is driven by hostility to shadow banking (money and credit chains backed by safe liquid collateral) the longer the conditions above will last.

I need to know more to know whether I agree with all these takeaways, but overall they seem reasonable.

Coda

Perry Mehrling proposes a new regime for monetary policy in "Three Principles for Market-based Credit Regulation". Mehrling observes three fundamental risk exposures that the Fed is taking on now: "a kind of overnight index swap, a kind of interest rate swap, and a kind of credit default swap. In all three dimensions, the Fed is operating to support market liquidity, much as our idealized Global Money Dealer and Derivative Dealer do in their balance sheets. In all three dimensions, the Fed can be seen as adapting to its new role as liquidity backstop for the emerging new market-based credit system."

This is a new notion of a central bank. Instead of manipulating the level of bank reserves, policymakers now stand as guardians of collateral and collateral liquidity ... This is Bagehot for the collateral-based financial system".

In conclusion, shadow banking is not well understood but is "a core part of the complex ecosystem of fund flows that is the financial foundation of modern global capitalism." How much better do we understand it today?

Final final note

In today's FT Stephen Roach wrote that inflation may be the only way out. But I wonder- given the importance of collateral to money markets today, how much more destabilizing will it be when the bond markets that provide so much of the collateral "tremble" in response to eventual inflation.

https://www.ft.com/content/5f4ef4f6-8ad6-11ea-a109-483c62d17528

How the economic machine works

In 2013 Ray Dalio published How The Economic Machine Works.

Summary

The economy is made up of transactions, which are driven by human nature. Transactions create the three main forces that drive the economy: (1) productivity growth, (2) the short term debt cycle, and (3) the long term debt cycle.

Transactions

The transaction is the building block of the economic machine. Each transaction consists of a buyer exchanging money or credit with a seller for goods, services, or financial assets. Markets consist of the buyers and sellers for things such as wheat, cars, and steel.

Credit spends just like money. Credit + money = total spending, which drives the economy. Total spending / total quantity = price. If you add up total spending and total quantity of goods and services sold you have what you need to understand the economy.

Government

The biggest buyer and seller is the government, which comprises the central government and the central bank, which controls the amount of money and credit in the economy via interest rates and printing money. The central bank is an important player in the flow of credit, which is the most important part of the economy since it is the biggest and most volatile part.

Credit: borrowing creates cycles

Any two people can create credit -- which happens when borrowers promise to repay and lenders believe them. In contrast to money, which is used to settle transactions, credit is more like a bar tab. Most of what people call money is actually credit ($50 trillion vs. $3 trillion). In an economy without credit, the only way to make more money is to produce more.

When a borrower receives credit, he can increase spending, which drives the economy. Because one person's spending is another's income, increased income --> increased borrowing --> increased spending --> increased income --> and so on. Credit sets in motion a series of mechanical predictable events. We have cycles because we borrow.

As soon as credit is created, so is debt. Debt allows us to consume more than we produce when we acquire it and vice versa. An economy with credit has more spending and allows incomes to rise faster than productivity in the short run. Credit is fine when it finances investment in productive resources like a tractor and bad when it finances over-consumption that can't be paid back.

Productivity, Short-term debt cycle, Long-term debt cycle

Productivity creates long run growth. The overall trend of economic growth is positively sloped because of slow, steady productivity growth. Fluctuations around the trend are caused by short-term and long-term debt cycles (as mentioned- caused by borrowing).

The short-term debt cycle lasts 5-8 years. In the expansion phase, spending rises more than quantity produced. Eventually inflation picks up, and in response the central bank raises interest rates, leading to a contraction in which spending decreases faster than quantity produced.

The long-term debt cycle lasts 50-75 years. The ratio of debt to income -- the debt burden [private and public debt burdens] -- builds up over time through the short-term debt cycles. Eventually, the debt burden is simply too high and must come down. The long-term debt cycle ends in a deleveraging.

Deleveraging

At the end of a long-term debt cycle, a vicious cycle begins: Less spending -> less income -> less wealth -> less credit -> less borrowing

Lower interest rates stimulate borrowing in a recession but not a deleveraging because interest rates are already low. Rates hit 0% in the deleveraging of the 1930s and in 2008. Borrowers' debt burdens have gotten too big and can't be relieved by lowering interest rates. Lenders realize that debts have become too large to pay back, borrowers don't even want more debt, the entire economy is not creditworthy.

Four things happen in a deleveraging: (1) cut spending, (2) reduce debt, (3) redistribute wealth, and (4) print money. We saw all four in 1930s US, 1950s England, 1990s Japan, 2010s Spain and Italy.

(1) Cut spending: Spending is cut first. Austerity is deflationary because incomes fall faster than debts are repaid.

(2) Reduce debt: Next, banks get squeezed and we enter a depression where people discover that what they thought was their wealth isn't really there. At this point we need to default or restructure. Lenders don't want their assets to disappear (default) so eventually they agree to debt restructuring. Restructuring happens in one of three ways -- lower principal, lower interest rate, or extended maturity. Even though debt disappears, restructuring causes income and asset values to disappear faster, so the debt burden gets worse.

(3) Redistribute wealth: All of this affects the central government through lower tax revenues and higher unemployment spending. Governments need to raise taxes or borrow -- who does money come from? The rich [MMT might disagree..]. It facilitates redistribution from haves to have nots. The haves and have nots begin to resent each other. Tensions can arise not just within countries but also between debtor and creditor countries.

(4) Print money: People are desperate for money, and the central bank can print it. Printing money is inflationary and stimulative. The central bank prints money to buy financial assets and government bonds (over $2 trillion worth after the 2008 crash). Buying financial assets drives up asset prices, making people more creditworthy (the rich who already own financial assets). The central government on the other hand can buy goods and services. By buying government bonds, the central bank lends money to the government, allowing it to run a deficit and increase spending on goods & services (stimulus) and unemployment. This increases government debt but lowers the overall debt burden.

These deflationary and inflationary responses need to balance together for A Beautiful Deleveraging, in which (1) debts decline relative to income, (2) real economic growth is positive, and (3) inflation isn't a problem. It is achieved by having the right balance.

Inflation

Will printing money raise inflation? Not if it offsets falling credit, since a dollar in spending paid for with money has the same effect on price as a dollar in spending paid for with credit.

The central bank needs to print enough money to get the rate of income growth above the rate of interest, but it needs to avoid printing too much money, creating unacceptably high inflation.

Three rules of thumb

1) Don't have debt rise faster than income (because your debt burdens will eventually crush you)
2) Don't have income rise faster than productivity (because you'll eventually become uncompetitive)
3) Do all that you can to raise your productivity (because in the long run that's what matters most)

Notes

I have not seen a better 30-minute introduction to the economy. Of course I have some thoughts and mini gripes

• Minsky characterized the economic system as a system of interlocking balance sheets. Dalio's transactions focus is the "flow" version of that?
• Curious about the relative size of private and public debt burdens (usually I see these statistics as the assets/liabilities as a percent of GDP, not a comparison of the debt service coverage ratios)
• What's the link between the debt cycle and natural rate of interest (i.e., does it account for the decrease in interest rates due to the accumulation of capital and lack of investment opportunities)
• Makes austerity sound like a necessary -- I don't know if that's the case, although it is usually demanded first by creditors
• Rule of thumb number 3 --> ties into innovation policy

M2 vs. inflation

The federal government's $2.2 trillion stimulus package* has raised the question of whether we'll face excessive inflation over the next months and years.

One preliminary data point: from the start of 1983 through March 2020, there has been a slight negative correlation (-0.16) between year-over-year changes in the broad money supply (M2) and inflation as measured by the consumer price index (CPI). The following charts all show the same M2 and CPI data -- by levels, changes, and a scatter plot of changes.