I don’t think we differ at all in our analysis of the scenario you present above.

In particular, I don’t see converting paper notes held by individuals into electronic credits in Fed accounts as a particularly substantive change. A simpler way to make this change, in fact, would be to just acknowledge that the financial system has lost a layer, and let individuals open accounts at the Fed. Sacre bleu!

A comparable conversion might be an obligation to exchange newly-printed currency for worn, cut or damaged bills. This is an administrative responsibility in a sense, but I don’t know that I’d call it a real balance-sheet obligation. Again, corporations may provide for various classes of conversion between equity instruments. There is no way to turn a Google A share into a Google B share, or whatever, but there could be.

I’m not familiar with Mosler’s work – I’ll look at it. I know C.H. Douglas, Ezra Pound’s favorite economist, as a quack, but I don’t remember exactly why and I would not swear to that judgment without checking it. Nor am I confident that Mosler and Douglas are on the same page.

Thanks for your response.

I’ve given Mosler’s work only a cursory look, just enough to know I agree with some of his starting points. I’m not sure I’ll end up agreeing with all of it, or any ideological conclusions drawn from it.

I haven’t seen CH Douglas’ writing before. A couple of points seem relatable to Mosler, but the so-called “self-liquidating” problem is not obvious to me, intuitively or analytically. I find it quite counterintuitive. I’d have to spend more time on it. You are clearly much further along on this.

Not being an economist, I’m not familiar with Marxist theory, but my guess is the Douglas analytical framework is connected to it. It’s interesting that the original Canadian Social Credit movement apparently took its name from his work (ref. Wiki).

I’m slightly out of date on the subject of bank capital ratios. Commercial bank capital requirements are based on the translation of nominal assets to risk-adjusted assets, with requirements applying on that transformed basis. The methodologies for investment banks are more or less anchored in value at risk type calculations, which depend on imputed price volatility measures. These methodologies have migrated where appropriate to commercial bank balance sheets, so market volatility does affect the risk adjusted asset measure to some degree. But some of the measures for commercial banks are softer I think, or at least less VAR sensitive. The only measures that really matter in the end are the big aggregates like Tier I and Tier II capital or tangible equity, etc. The requirements are Basel originated with tweaking in some cases by national regulators. And most banks have their own announced targets which often surpass regulatory minimums.

Someone recently pointed out that investment banks’ assets/capital ratio is flexible and determined by volatility measurements. Is the commercial bank ratio also now determined this way? Or is it still periodically reset by legislation? Or by its CB? My most recent text is from 1995 and I need an update.

The thrust of Mosler’s work is virtually identical to the work done in the 1920s and ’30s by CH Douglas who called his idea “social credit”. If you Google “money and the price system” you can read the text of a presentation he made to the King and government of Norway in 1935. It’s a concise presentation of the essentials of Douglas’ thinking.

Douglas’ basic observation is that an economy’s price system is not self-liquidating. If a business’ round of production distributes $1 million into the economy as its costs, there is only $1 million new money in the economy to recover via its prices. Profit is arithmetically impossible.

Savings further reduces the amount of earned or “owned” money in the system from which the producer hopes to recover his costs. Every other producer is in the same boat so Paul can rob Peter to earn a profit, but then Peter will not be able to recover even his costs.

Douglas observes that classical economics describes what is in fact, or is little advanced beyond, an 18th century barter economy where everybody works and produces and division of labor specializes their outputs which they trade for in-kind outputs of others. There is no “profit” in this system. I put X quantity of goods into the system and I purchase X quantity out of the system. There is no X + P in the system.

In this primitive economy money is used as a means of exchange, and the value of money behaves like a commodity value that is universally exchangeable for goods values. But in a more advanced capitalist economy profit is the essential driver of economic behavior. If you can’t get more out than you put in then the venture will be “unprofitable” and you won’t do it. So profit is necessary but the possibility of profit does not inhere within the system. This system needs an external source of money which can be collected as profits both by the industrial economy and by bankers.

Our banking system treats money as a “product” for sale at interest, just as industry produces goods for profit. But banks collectively only distribute an amount of money into the system P, the loan principal. Simultaneously those banks collectively distribute an additional amount of monetary debt into the system I, their interest. The total amount of money required for everyone to repay their principal + interest is P + I, but only P exists in the system.

If new lending stopped adding new money into the equation it would become impossible for everyone to pay their interest and our banking system would fail. Our bank-debt money system operates in parallel with the industrial economic system and suffers the same arithmetic inability to liquidate its prices (P + I) as does the industrial economy.

Douglas advocates a “national dividend” to correct this arithmetic problem, which would work much like Mosler’s “supplementary government workers”. The same effect could be achieved via a guaranteed annual income (GAI) or any other kind of direct government spending of new money into the system that was not first taxed out of the system.

In Mosler’s analysis the residual money in the system would = government “debt” to its CB. But as the economy grew the total “national debt” would have to grow along with it. As we have it now, both public and private debt are contributing to the presence of profit/interest money in our system. Without ever-increasing debt, ongoing profit and interest are not possible.

Mosler quoted several politicians bemoaning the rise of debt. Individuals are stressed by their personal debts. Human nature does not respond well to indebtedness. So there are limits to how long one of these runs of capitalism can go on before we require financial collapse with foreclosures and bankruptcies and attendant large scale writedowns of debts. People can tolerate only so much debt.

The solution offered by Mosler and Douglas, on the other hand, brings its own problems. The same human nature that is debt intolerant also expects people to work for their living and loans to be repaid in kind. If your borrowed money purchases my economic efforts, then I want you to produce some economic efforts for me to purchase with the money I “earned” from you, so you earn the loan repayment money. Borrowed money must be repaid with earned money.

When you throw national dividends or supplementary government work into this psychological mix I fear you unmoor the basis of our economic incentive: if you don’t work you don’t get paid. Payment without work is charity. Even if, as Mosler suggests, you keep the supplementary income (or GAI) at just survival levels so people collecting it will still have incentive to take work that comes available, I am not sure ambitious workers would accept their output being consumed by their indigent neighbors who have been handed, rather than earned, the power of effective demand that is money.

I think the best way to pull off the balance is via government direct spending with consequent constant increase of its debt to its CB. As there gets to be too much “owned” money in the economy gov’t raises taxes to absorb it out and paydown its CB debt. But “national debt” will need to keep rising as long as the national economy is growing. It may or may not be difficult to reeducate policymakers about the post-barter nature of fiat money and government vs. private debt.

In any event, I think a deliberate policy to keep our money system working is better than running it until it crashes then writing it down and starting the next runup.

I think we have some points of convergence and some differences.

First, I agree with your closing point on the broader view of the consolidated G balance sheet, including the idea that government term debt financing is effectively a form of money “sterilization”.

Next, we have a difference regarding the relevance and importance of the composition of the monetary base. I’ll return to that.

Next, the insolvency question is an interesting one. I think as you say there are two different interpretations or perspectives on it. I’ve always been more suspicious when it comes to valuation approaches rather than cash flow ones, but I’ve been assuming for some time that the conventionally accepted definition was more along the lines of type a). I’ve tended to distinguish between bank runs as “liquidity events” and insolvency as a technical condition involving negative equity evaluation. Also, I’m not sufficiently familiar with bankruptcy laws, etc. to judge the more useful interpretation.

On the CB side specifically, let me run through an example, recalling that my original point of emphasis was the existence of a particular CB liability. I’m interested in demonstrating the existence of such a liability more on the basis of principle and logic than on the basis of the probability that its existence might be tested. So I’ll test it in theory by way of an extreme but thinkable example.

Suppose the Federal Reserve, having loaded up its balance sheet with credit crisis risk, incurs a significant marked to market loss on those assets. Assume this results in type a) (i.e. capital) insolvency. USG then recapitalizes the Fed by selling it USG bonds and using the proceeds to fund a capital injection. (This is purely internal bookkeeping at this point, involving transactions only within the USG consolidated balance sheet. There is no external cash flow. It could be viewed in effect as an asset swap – bonds for capital.) (I’m not sure your implied description of such a capitalization corresponds to my portrayal here. I got the impression that you included an external capital issue instead. That shouldn’t take place as a part of the capitalization per se.)

Suppose the public for whatever reason wants to redeem its holdings of Fed notes in exchange for commercial bank deposits. (Irrationally or not, the public may be concerned about the Fed’s asset deterioration. The reason doesn’t matter for purposes of illustration.)

As per my previous comment, the public will present their notes to the commercial banks for redemption in return for credits to their deposit accounts. The banks in turn will present these notes to the Fed in expectation that the Fed will credit their reserve accounts. The full effect is a sort of run on the Fed.

This is the inflection point of liability.

If the Fed or USG are run by madmen, they may refuse to redeem these notes. What will happen? At that point, the commercial banks have issued deposit credits that are essentially invested in useless Fed notes. The notes really have no value if the public doesn’t want them and the Fed won’t redeem them. They don’t earn interest. The banks might as well write them off. The Fed in refusing to redeem these notes has technically defaulted and is insolvent in the type b) sense.

You say the Fed can’t default.

I agree.

My point is that the Fed’s liability to redeem these notes overrides the possibility of technical default or insolvency of type b).

So we assume the Fed redeems the notes. What happens then?

The new effect of Fed note redemption is that bank reserve accounts have been boosted to obscene levels for the system as a whole (even more so than recently). Fed note liabilities of some $ 700 billion effectively have been converted to reserve balances in the same amount.

These days, the Fed could simply pay interest on these excess balances. That’s the new backdoor approach to sterilization in terms of the interest rate effect (although the Fed seems to be having some problem controlling the funds rate since it implemented interest payments in September). Or it could sell its assets and shrink its balance sheet. It could sell its credit risk assets at their residual value and sell the bonds that it purchased from USG in its recapitalization into the market.

The taxpayer’s position doesn’t really change as a result of the initial issue of recapitalization bonds (an error in my previous comment). The taxpayer’s loss is due to the loss on the original CB assets, however that may be identified. Bond interest paid by USG to the Fed just increases the profit the Fed remits back to USG. Nevertheless, the sale of the recapitalization bonds to the public now changes the situation. The Fed no longer has the free funding of publically issued notes.

Thus, the internal bond interest wash becomes a net external cost if the government sells the bonds into the market – i.e. to the banks. This cost isn’t due to the original asset loss, but to the disintermediation and corresponding loss of profit for the central bank. Alternatively, if the Fed chooses to retain the extra $ 700 billion in reserve balances, that also generates a new external net interest cost.

Then, on a consolidated basis, we arrive at the point of your more general analysis of the nature of a government bond. At this point, it doesn’t matter what it’s funding, although I think I’ve demonstrated the existence of a liability at the CB level.

I’ll leave more detailed discussion of monetary base components for another time. I think the distinction is quite important and is generally overlooked. Suffice to say here, it is an interesting aspect that when the public elects to increase its mobile liquidity access (physically mobile inventory versus electronic or paper portal access), it also increases its asset credit quality (central bank versus commercial bank). And the monetary policy considerations around the two components of the base are entirely different.

Finally, you may be familiar with Warren Mosler’s writing on the subject. I wasn’t until a few weeks ago. It’s the first time I’ve seen anybody else express in print the idea that the so-called reserve multiplier actually works in reverse to its textbook portrayal. (Maybe I haven’t looked hard enough. But this is a fairly important idea as it has ramifications for related areas. For one, it more or less destroys the theory of fractional reserve banking. (FRB theory should have been destroyed anyway, since banks lend on the basis of capital underpinnings more than cash or liquidity reserves.)) He also has an interesting comprehensive operational perspective on monetary policy that draws government budgetary impacts more directly into central bank reserve management – sort of compatible with the idea of government bonds being an extension of central bank sterilization. My initial impression is that he’s on to some correct ideas and has been for some time.