The budget battles

[hrothgar]

But that 35:1 is just an exchange rate, as we have today between currencies. Don't you think that gold is subject to the same fluctuations as any other medium of exchange, relying upon the confidence that the demand for gold remains stable?

 

The difference is that the government agrees to main a specific exchange rate between a dollar and gold.

In doing so, the government is typically compelled to buy / sell gold on the open market to maintain whatever standard it chooses.

[Winstonm]

Nowadays, you can't "redeem" a dollar bill (or a dollar coin, which these days is "base metal") for anything

 

This is absolutely untrue - it is simply that we are not used to thinking in correct terms. Dollars redeem debt - they are debt-backed. It says so right on the bill: this bill is legal tender for all debt, both public and private. If you have a $50K mortgage and you give the banker who holds the mortgage $50K your money is redeemed for a unencumbered title to the property. The IRS will accept dollars and your debt to Uncle Sam is redeemed.

 

The libertarian/austrian concept of money is inaccurate. They say that money is a store of value. But money is nothing more than the exchange medium that represents labor, either manual or intellectual. Island nations have successfully used sea shells as currency - the shell has no worth other than to represent a value, and that value is the value of a work product. Those shells are worthless today.

 

There is no magic in gold or a gold standard. I know Richard may jump my case about this next statement, but IMO there is no such thing as inflation with fiat currency, as inflation is simply a change in prices. Adding to the money supply, if done equally across the board all at once, affects nothing. If an item today costs $10 instead of the $5 it cost yesterday, that has no affect on me if my salary and savings also doubled overnight - relative cost is the same. The only time you can have a genuine inflation is with a commodity-backed currency, where creating new bills without a compensating increase in the amount of the commodity backing it will devalue the currency, and goods and services truly will cost more because of it.

 

What we see as inflation IMO is the temporary imbalance in the supply of new fiat money, because it is not distributed evenly across the board.

[blackshoe]

This is absolutely untrue - it is simply that we are not used to thinking in correct terms. Dollars redeem debt - they are debt-backed. It says so right on the bill: this bill is legal tender for all debt, both public and private. If you have a $50K mortgage and you give the banker who holds the mortgage $50K your money is redeemed for a unencumbered title to the property. The IRS will accept dollars and your debt to Uncle Sam is redeemed.

 

You're twisting my words, Winston. Of course you can use a dollar to pay a debt. But the dollar isn't backed by your debt — it's "backed" by the country's debt. Or so they claim.

 

BTW, there's no such thing as an unencumbered title to real property. Ever heard of eminent domain? Or property taxes?

[Winstonm]

You're twisting my words, Winston. Of course you can use a dollar to pay a debt. But the dollar isn't backed by your debt — it's "backed" by the country's debt. Or so they claim.

 

BTW, there's no such thing as an unencumbered title to real property. Ever heard of eminent domain? Or property taxes?

 

I am not attempting to twist your words but to point out how our money supply works. The government will no longer exchange your dollar bill for a certain amount of gold, but it will accept your dollar bill as payment for tax debt. In that sense the dollar is redeemed for your debt.

 

Money is not created from nothing - it is created as a response to borrowing. If no one wants to borrow, there is no money creation. There is a 1:1 asset/liability relationship between money and debt when money is created. It remains that way when money is paid back. Where it falls to pieces is when loans are made against collateral that is overvalued and then the loans cannot be repaid - then the 1:1 relationship is destroyed and the underlying collateral is not enough to make up the losses - this is what happened in the Great Recession - a debt/deflation event that was centered around the housing bubble/collapse but occured in the debt markets.

 

BTW, your point about unencumbered titles applies regardless of whether money is gold backed or fiat. The issue is that the debt is redeemable with fiat currency, because it is debt-backed. Its value is determined by the value of the trust in repayment. This is why a default would be so serious for the U.S. borrowing abilities - although I suspect that as Top Economic Dog, the default in the U.S. debt would be harder on countries like Greece, Spain, Ireland, Italy, etc. as the reasoning would be that if the Top Dog can default then these other countries are no better than junk bonds.

[kenberg]

Money is not created from nothing - it is created as a response to borrowing. If no one wants to borrow, there is no money creation. There is a 1:1 asset/liability relationship between money and debt when money is created. It remains that way when money is paid back.

[/Quote]

 

As is frequently the case in theoretical discussions of economics, I have no idea what this means. Economics and philosophy both produce that effect with me. I am sure the speaker means something, I just have no idea what it is.

 

I teach a class and I am not given potatoes and a goat, I am given money. I use the money to buy potatoes and, if I wish, a goat. Who is borrowing what from whom? What is the 1:1 asset to liability? It seems to me that the basis of money is the faith that it will buy something for a roughly predictable price. I agree to perform a job for, say, $30,000. I know roughly the amount that I will have to pay in taxes and I know what a new car costs. Even if I won't receive the money for, say, three months I figure I can do the job, get paid, buy a new Honda, pay my taxes, and maybe have a little left over. I accept or do not accept the job based on whether I think that the reward is worth the effort. This, to me, is a clear way to think about money. I have no idea how to recast it in some debt mode with assets and liabilities.

 

There is some point beyond abstraction here. I see the government's job as preserving a predictability stable dollar. A good part of today's economic problems is said to be that no one is confident about the future. This seems right to me. It's critical that big time investors and small time spenders believe that we will get our debt under control and we will honor our financial obligations. It's not hard to see why many people have doubts about this happening.

 

I have often claimed that one of the results of spending a life in mathematics is to make me be very cautious about theoretical concepts, and the theory of money that you espouse fits right into that. I honestly don't get it. It's not so much that I disagree as that I have no idea what it means or how to bring it to bear on any actual problem.

[helene_t]

I teach a class and I am not given potatoes and a goat, I am given money. I use the money to buy potatoes and, if I wish, a goat. Who is borrowing what from whom? What is the 1:1 asset to liability?

If your employer gives you 30000 bucks in banknotes then it means that the government (or is it the FED? Here in UK the two are the same more or less) owed your employer 30000 bucks before and now the government owes you 30000. This is because a bank note is a debt certificate issued by the FED. If they transfer 30000 to your bank account then it could mean that your employer's bank used to be owed 30000 by the fed which balances the bank's 30000 debt to your employer, but now it is your bank who is owed 30000 by the FED (and it turn it owes 30000 to you). In practice the two banks will not usually involve the FED in such transactions but adjust their mutual credit sheet, and of course the banks 30000 debt to you (or your employer) is not entirely backed by FED credits but can be invested in assets that give a higher yield.

 

The government (or the FED or whoever is in charge of the US monetary policies, dunno how it works by you) can control money production by requiring banks to back a certain percentage of their debts by FED credits (in the form of banknotes or otherwise). Say banks are required to back 20% of their debts by FED credits. That would mean that the total amount of "money" (i.e. balances of bank accounts) would be limited to 5 times the FED debt to the banks. This would limit the amount of money people and companies could easily spend (since not all vendors will accept payment by other means than transfer from bank accounts, or cash) and thereby limit the circulation of money. Limiting the money supply in that way could lead to less inflation than would otherwise have happened (prices dropping when money are in short supply) or it could lead to recession (companies getting less business because potential buyers don't have money to pay with). Monetarists and keynesians disagree about which of the two effects is more pronounced (keynesians believe it will largely affect the inflation) but they agree that both will happen to some extent.

[kenberg]

Thanks, H, I will try to digest that. There are times that I seem to be sort of theory-phobic. Perhaps it is a recognized personality disorder. Anyway, thanks and I will work on it.

[Winstonm]

Ken,

 

I don't profess to be an expert on economics or money but I do have an interest and have done a lot of reading on the subject. Still, I wouldn't expect anyone to take my word on the subject, so instead here is an explanation I got off the internet - this information is readily available with a simple search if you want to confirm it.

 

The creation of money

 

When the State needs money, it does not order the Central Bank to credit some money to the treasury’s account. The State has only two ways to obtain money. One is taxation of it's citizens, the other is borrowing from the banks.

 

When the Central Bank issues money, this is done in the form of a loan. The State has to borrow this money, and must promise to repay it, with interest.

 

The same is true of course for a private person who needs money borrowing from a commercial bank. The bank is happy to loan, as long as you can show you have security, and promise to repay with interest.

 

How can the banks "create" money? That is a good question. Is it not the State's printing office that prints all the banknotes?

 

Banknotes, when they are printed, are considered the property of the Central Bank. They are not given to the State to spend, but are brought into circulation against a corresponding debt. Anyone wanting some of those notes to spend, has to "buy" them by giving up some of their credit. And in any case, most of the money in circulation (more than 90%) is not banknotes but "credit".

 

When you go to your bank asking for money, the loan you get is created right there in your bank. The "money" consists of figures on your bank account, and it can be spent writing checks, giving an order to transfer or drawing the cash. Banks only have to have a small percentage of their loaned-out money actually available. The rest can be paid out just by moving some figures from one account to another. The important thing to know: Money is created just by inserting some numbers into a computer.

 

In practice, it works like this: For every 10.000 a bank gives out as loans, 1000 or 2000 have to be deposited at the central bank. That means, if a bank collects 100.000 in deposits, it could keep 10.000 for liquid cash, put 90.000 into deposit with the central bank, and it is then allowed to create 900.000 of fresh money just by writing the figures on someone’s accounts.

 

In the case of the government needing money to spend, the procedure is slightly different, but the result is the same. The government has to issue papers that promise interest and repayment. Those papers are "bought" by the banks, who "sell" them to their wealthy clients, or who may also keep them, and the government gets credited an equivalent sum of money.

[kenberg]

OK, I went to the Wikipedia.

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

There is a lot of stuff there with further references. But as a start:

 

Quantitative easing

Main article: Quantitative easing

 

Quantitative easing involves the creation of a significant amount of new base money by a central bank by the buying of assets that it usually does not buy. Usually, a central bank will conduct open market operations by buying short-term government bonds or foreign currency. However, during a financial crisis, the central bank may buy other types of financial assets as well. The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans. The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when interest rates cannot be pushed any lower.

 

Quantitative easing increases reserves in the banking system (i.e. deposits of commercial banks at the central bank), giving depository institutions the ability to make new loans. Quantitative easing is usually used when lowering the discount rate is no longer effective because they are already close to or at zero. In such a case, normal monetary policy cannot further lower interest rates, and the economy is in a liquidity trap.

[edit] Physical currency

 

In modern economies, relatively little of the money supply is in physical currency. For example, in December 2010 in the U.S., of the $8853.4 billion in broad money supply (M2), only $915.7 billion (about 10%) consisted of physical coins and paper money.[2] The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury.

 

Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central bank expands the money supply through open market operations (e.g. by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.[3]

[/Quote]

 

They are speaking of money creation, as they do elsewhere in the article, and to call the process "borrowing" or matching assets with liabilities in some 1:1 manner seems to me to require a fair stretch of words. Take, for example, "The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans." The things that are being bought may, in some way, involve loaned money but the money creation is not accomplished by the government borrowing something, they seem to be buying something. This description matches what I thought happened.

 

 

Possibly we are speaking of different things. There is "How does the government get money for its daily operations?". Yes, taxation and borrowing would seem to be the way. There is "How is the money supply created, expanded, shrunk, manipulated?". The description above seems more to the point for this question.

[Winstonm]

OK, I went to the Wikipedia.

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

There is a lot of stuff there with further references. But as a start:

 

 

 

They are speaking of money creation, as they do elsewhere in the article, and to call the process "borrowing" or matching assets with liabilities in some 1:1 manner seems to me to require a fair stretch of words. Take, for example, "The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans." The things that are being bought may, in some way, involve loaned money but the money creation is not accomplished by the government borrowing something, they seem to be buying something. This description matches what I thought happened.

 

 

Possibly we are speaking of different things. There is "How does the government get money for its daily operations?". Yes, taxation and borrowing would seem to be the way. There is "How is the money supply created, expanded, shrunk, manipulated?". The description above seems more to the point for this question.

 

Hi, Ken,

 

It is important to note that QE (quantitative easing) is not a normal operation for the Federal Reserve, and buying assets like MBS with QE does expand the money supply without a compensating debt creation. That is why the exercise is so rare. Currently, QE has been about purchasing treasury bonds, which is a compensating debt - the U.S. wants to borrow and the Fed funds them. But QE is not an ideal candidate to study to understand normal monetary policy.

 

The normal fractional reserve banking process is a 1:1 asset/liability exchange, and the money creation is a response to a debt.

[blackshoe]

Question: what is the purpose of bank reserves?

 

I know when I have a debt, the first thing I want to do is pay it off. It seems the first thing the government wants to do is to go further into debt. Why is that? How can it possibly work?

[Winstonm]

Question: what is the purpose of bank reserves?

 

I know when I have a debt, the first thing I want to do is pay it off. It seems the first thing the government wants to do is to go further into debt. Why is that? How can it possibly work?

 

The best person to ask would be Mike777, but I can give you my take for what that is worth.

 

Bank Reserves are the money customers lend to the bank at interest, i.e., our savings, CDs, and checking accounts. To the bank, these are liabilities, money that is owed.

 

Although there is now quite a complex formula, to simplify let's simply say that the rules allow 10% reserves. That means that for every $100 deposited (liability) the bank can lend out $900 (asset).

 

The banking model is built on the bank's ability to borrow in order to lend. Without their liability, they have nothing do lend.

[blackshoe]

So after they loan out $900 of the $100 I deposited, what happens when I go back and say "gimme my $100"? They don't have it — they loaned it out.

[Winstonm]

So after they loan out $900 of the $100 I deposited, what happens when I go back and say "gimme my $100"? They don't have it — they loaned it out.

 

Your money is there as reserves. That's the whole idea of fractional reserve banking, that not everyone will try to withdraw all their money at the same time - a bank run. What affect does your withdrawl make?

 

If the bank had total reserves of $1000 they could lend $9000. Your withdrawl means they can only lend $8100 because their reserves now are only $900. If the bank had $9000 in loans outstanding, they would have to borrow $100 in reserves from another bank who had excess reserves.

 

If no other bank is willing to loan them, they have to go to the Federal Reserve's discount window for the loan.

[blackshoe]

Seems awfully complicated — in fact, seems like it's more complicated than it needs to be, unless the purpose is to allow bankers to get richer.

[helene_t]

Take, for example, "The central bank may buy long-term government bonds, company bonds, asset backed securities, stocks, or even extend commercial loans." The things that are being bought may, in some way, involve loaned money but the money creation is not accomplished by the government borrowing something, they seem to be buying something.

Depends. If the central bank buys newly issued govt bonds then it means that the govt is borrowing from the central bank - issuing treasure certificates is a way for the government to borrow money. This will inject money into the economy because the government will spend the revenue from the sale of the bonds by (say) paying you for giving classes, and you can then spend the money buying potatoes, and the potato farmer can ... so (unless one subscribes to the extreme view that it just creates inflation and does nothing to improve the real economy) this will lead to growth.

 

If, on the other hand, the central bank buys bonds on the open market then the govt is not involved so the govt debt is not elevated, but the private bond holders will get liquid money for their bonds so they can buy more potatoes. This, also, stimulates growth and/or inflation.

[helene_t]

Question: what is the purpose of bank reserves?

 

I know when I have a debt, the first thing I want to do is pay it off. It seems the first thing the government wants to do is to go further into debt. Why is that? How can it possibly work?

When I was a kid there was a Danish bank (Finansbanken) that offered high interests on their accounts, they achieved this buy investing the money in risky assets and didn't hold a sufficient reserve in banknotes and other central bank credits and government credits which are deemed safe (maybe today US or Greek govt bonds are not so safe but normally govt bonds will be considered very safe).

 

When the rumour spread that the bank might not be able to honour withdrawals from account holders in the event of a default by one of the bank's major deptors, account holders reacted by withdrawing their funds because everyone wanted to be before the other suckers. With the consequence that the bank went bust. If they had had sufficient govt credits they could have honoured the withdrawals because if an account holder wants to transfer his money from Finansbanken to a different bank, the other bank is happy to take govt credits in return. What the other bank will not accept in return (at least not without lengthy negotiations of the price) is stuff like subprime bonds or shares in start-ups.

 

Of course there are other ways of assessing a bank's solidity than on the basis of the amount of fed/govt credits it holds and I am sure that the auditing of banks take a lot more into account. But the govt/fed credits is a simple thing to measure.

 

Also, by forcing the banks to backing a specific fraction of their debt by gov/fed credits the govt has a simple instrument to control the money supply and thereby taming inflation.

[hrothgar]

Seems awfully complicated — in fact, seems like it's more complicated than it needs to be, unless the purpose is to allow bankers to get richer.

 

Two simple questions for you:

 

1. What's your alternative to fractional reserve banking?

 

If banks have to maintain 100% of your reserves on hand at all time, where does the money that they lend come from?

How would they be able to pay any interest to savers (as opposed to charging money for the privilege of storing your $$$ in their safe?)

 

2. How do you propose to stop fractional reserve banking?

 

Most governments force banks to maintain a reserve. They actually set a value called the reserve ratio.

This is a restriction on the fraction of their reserves that banks can relend. (It's something like 10% in the US)

 

I thought that you were the one constantly arguing against government interference in banking...

Is this an exception to that rule?

[kenberg]

The thread is jumping faster than I can keep up, but the fractional bit led me back to the Wikipedia where I found

 

Fractional-reserve banking is a type of banking whereby the bank does not retain all of a customer’s deposits within the bank. Funds received by the bank are generally on-loaned to other customers. This means that available funds (called bank reserves) are only a fraction (called the reserve ratio) of the quantity of deposits at the bank. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money.

[/Quote]

 

I like the "said to create money". It has the proper skeptical tone for me.

 

What I have come to, regarding the "creation of money", is that QE definitely creates money and fractional reserves is sort of a leveraging idea that "creates money" in the same way that any leveraging does. Whether it should really be called creation is mostly a semantic issue, but the distinction between QE on the one hand, which really does unambiguously create money,and the lowering of reserve requirements which enables greater leveraging, is worth keeping, whatever words we choose to use.

 

However: As we look to the looming crisis I see this, as I said before, as being like a discussion of aerodynamics as the stuff hits the fan. Aerodynamics is an important subject, as is banking theory and regulation, but these jokers who get paid to lead the country need to get their act together. It's the Republicans who have threatened the train wreck if their butts are not kissed in exactly the right manner so I hold them mostly responsible. But if the crash happens, no one will look good.

 

See http://www.washingtonpost.com/opinions/what-happens-to-american-politics-if-we-default-hello-third-party/2011/07/11/gIQAu869FI_story.html

for an amusing (?) fantasy along these lines.

[blackshoe]

Good link, Ken. :)

 

The problem is that in order to fix a thing, you have to know how that thing works. There are various theories about how money works. No doubt some are right and some are wrong. But I don't think most Congresscritters have a clue either way. They should have done their homework a long time ago. So, probably, should we, as citizens. But we didn't. I'm trying to correct that for myself, anyway. That's why I'm in this thread. It may be too late — it's almost certainly too late for the 'critters, since they need to make a decision now. No doubt, given they don't know what they're doing, it'll be a wrong decision. If we're lucky, it'll only be a little bit wrong, and we'll have time to tweak it later. But as a CO of mine once taught me, sometimes it's not so important which decision you make as it is that you make a decision.

[PassedOut]

All of the spending that has occurred so far (and until the end of the fiscal year) has already been authorized by the US congress. The argument about raising the debt limit is about whether or not to pay the bills for the spending that congress itself has authorized.

 

The administration, everyone in business, and all of the smarter folks in congress recognize that it debases credibility to run up bills and then stiff the creditors. A default will have tremendous consequences for the US, and even the threat of a default has already started to cause problems.

 

Of course, running up bills and stiffing the creditors is a way of life for the free lunch crowd. One thing for sure: everyone in congress who still argues against raising the debt ceiling is an irresponsible fool.

[blackshoe]

If we're going to raise the "debt ceiling" every time we get close to it, then effectively we don't have a debt ceiling. If we aren't going to have one, or are going to ignore the one we supposedly do have, maybe we ought to abandon the concept and find some other way to control federal spending. Summary executions come to mind. ;)

[PassedOut]

If we're going to raise the "debt ceiling" every time we get close to it, then effectively we don't have a debt ceiling. If we aren't going to have one, or are going to ignore the one we supposedly do have, maybe we ought to abandon the concept and find some other way to control federal spending. Summary executions come to mind. ;)

Originally an administration had to come to congress for authorization to pay for every expenditure, even though the expenditure had been authorized. This is the same procedure as we see in local governments today, where the board gets a list of bills from the clerk, looks it over, asks some questions, and the authorizes payment (or delays payment if questions arise about whether the full amount is really owed).

 

But the US government has a lot of bills, so that procedure became a time-consuming nightmare. Instead, the debt-limit was established as a more practical higher-level check on the adminstration, and congress could potentially refuse to authorize payment for bills received for overruns, etc.

 

However, no one in congress has questioned whether the bills the administration needs to pay are legitimate. The argument in congress is whether or not to allow the timely payment of legitimate bills or to default on payment.

 

The way to handle this is to avoid authorizing unnecessary expenditures in the first place, and to collect the revenue to pay for expenditures that have been authorized. Only irresponsible fools advocate stiffing the creditors of the US government. You can watch them on television and see instantly that that is so.

[Winstonm]

These clueless morons called tea-baggers are holding the U.S. hostage to their dogmatic belief in fantasies. As Passed Out pointed out, the debt ceiling is about money already approved to be spent, so crying foul now is disingenuous. The time to address the national debt is after the debt ceiling had been raised, while working on the next budget.

 

Maybe the solution is for the President to throw all these new tea-bagger House Republicans in jail for attempted extortion and suspend habeus corpus until after August 2.

 

If nothing else, it would give Rush something meaningful to rale about.

[cherdano]

Wow this thread has a lot of non-sense in it, even by watercooler standards. (I am happy to back up my statement by pointing out non-sense in any recent post that wasn't written by hrothgar, helene_t, PassedOut, kenberg.)

If we're going to raise the "debt ceiling" every time we get close to it, then effectively we don't have a debt ceiling. If we aren't going to have one, or are going to ignore the one we supposedly do have, maybe we ought to abandon the concept and find some other way to control federal spending. Summary executions come to mind. ;)

I would propose that Congress should pass a law every year that lays out allowed government spending in big details, along with projected revenues and borrowing. I would call this "passing a budget". Passing two contradictory laws instead seems a bit silly to me. (Law 1: US government will need to borrow x billion dollars this year. Law 2: US government isn't allowed to be in bigger debt than y billiion, where y < x + debt at the beginning this year.)

 

Anyway, any 14-year old should be able to figure out that constantly growing debt is not a problem as long as the debt/GDP ratio isn't rising. So the debt ceiling is a silly concept in the first place.