Wednesday, November 9, 2016

The NGC Model, Banking and the Creation of Money

Nick Rowe is a prolific and creative author to whom we all owe thanks. Today he gives us a model that we can use to create a new vision of the creation of money.

Nick writes
You decide to make a new monetary system from scratch. You give everyone a chequing account on your computer, with an initial balance of 0 units. If Andy buys bananas from Betty and pays her 100 units, Betty now has a positive balance and Andy now has a negative balance.
Nick may disagree but I think his model first presupposes a monetary system and then calls our attention to a nearly complete monetary event. The focus of this post will be on the events that had to occur before Nick's model begins. It is these background-events that are interesting and offer us additional insight into the creation of money.

Establish a Frame of Reference

These background events need a frame of reference to make them plausible, easily described, and comparable to actual macroeconomic events. The framework we will use is the National Gift Certificate Model (NGC) which treats money as an analog of the well known gift-certificate.

The possibility of a NGC model of money creation first appears in a comment to Nick's post:

Using the NGC example, the issuing store prepares to sell a gift certificate by printing the certificate. Then the store has a choice: recognize the increase in inventory and expense of production immediately OR wait until actual sale and then recognize the event. The first choice makes sense if the intended use of the gift-certificates is to pay for goods and services; the second choice makes sense if the intended use is to sell the gift-certificate for money in the future.
In either case, the actual creation of money or NGC is not visible to the usual measuring tools available to the public. The actual issuance of new money is more visible but identical to using old money; issuance is just another exchange of goods and services for money/NGC.

It is obvious that any store offering gift certificates can do some accounting behind the curtains as just described. We need to notice that the store is providing not only accounting services behind the curtains--it is providing banking services. With the issuance of a gift certificate, the store is providing a certificate with future value (like a check written on a bank). The store is also providing storage for future value that will be claimed when the gift certificate is presented for redemption (store products will be available in the future which is comparable to bank money that will be available when a check is written).

A Model of Money Creation

We have not yet created money. An analog with newly created money comes from the observation that a gift certificate can be issued by a store in payment of goods and services received. This event can be compared directly with a barter transaction in which goods are traded for goods. The only difference is that this is a partially delayed transaction: the services are delivered first; payment is made later when the gift certificate is redeemed. The creation of a money certificate is easily compared to the creation of this delayed-payment* gift-certificate.

To see the comparison, we look at the creation of money by a bank when a bank makes a loan. The bank creates a deposit in the borrowers name and will ask the borrower to sign a promise to repay the amount borrowed (and a small charge in repayment for the bank's services). This action creates an increase in the money supply and is widely recognized as a creation of money.

If you are like me, you don't immediately see these two events (the store's certificate and bank's new deposit) as being nearly identical. To see this clearly, we need to go behind the curtain. The bank can perform the identical steps just completed by a store preparing to offer gift-certificates as payment. Whether either store or bank actually does these steps in preparation or not, the important take-away is that observably identical results are obtained.

There are two behind-the-curtain tasks that both banks and gift-certificate issuing stores perform:

1.  Prepare a certificate that will be delivered to the customer. A store will prepare a gift-certificate. A bank will open an account with a positive balance in place. In both cases, before delivery to the customer, the name on the instrument will be the name of the issuing entity (or blank).

2. Make a record that the certificate/account has been backed by an asset. A store will reserve goods/value owned by the store.  A bank will create a bond signed by the bank and promising to repay the amount on deposit.  (Yes, this is a bank lending to itself but no problem, the actions are entirely within the bank, hidden behind a curtain.)

With the instruments in place and funded, a store or bank is ready to pay a bill or service a new customer.

When a bank borrower actually comes through the door, he is asked to sign a loan agreement. If he does, the account is signed over to the borrower. The bank's loan document is now secondly backed by the borrowers signed repayment commitment.

We can see that money has been created ad nihilum. Or has it? When the borrower reduces the deposit by spending money the deposit represents, other banks will receive money.  In the fiat monetary system, the bank transferring funds must transfer money that all banks will accept. There has to be a problem if all banks are lending money created by assigning accounts and backing them with bank guarantees.

The Dilution Problem

There is a problem. The observed money supply rapidly increases which effectively dilutes the base money supply that was first used to begin the repeated-lending-sequence. In the modern fiat monetary system, this expansion is controlled by the central bank.

The control process is simple. The central bank creates a block of money using the bank money creating process previously described. This would be considered as "base money". Base money is then distributed to private banks, usually through the sponsoring government when government pays for goods and services. Once received, private banks are allowed to re-loan the new deposits. Control of the loan process is maintained by the central bank with a requirement that a "tax" be collected on deposits in every private bank. This "tax" drains original funds at a rate proportionate to the "tax rate",  amount, and number of loan events. After several events, the entire original money issue will be returned to the central bank, allowing the central bank to know when the original base money supply has been completely loaned-to-limit. (This sequence is partially described in the Federal Reserve document "Reserve Maintenance Manual").

We have seen how the NGC model can be used to understand the creation of money.

Another Look at Nick's illustration--Motive

We now have the opportunity to examine Nick's illustration from a new perspective. We can see that behind the curtain, some entity must have prepared the green entry that Betty would receive in trade. Some entity would have prepared the red entry that Andy received. Further, Andy would have been given the red entry along with the green entry that he later traded to Betty. The entity behind the curtain can be assumed to have authorized all of this activity.

Why would any entity carry out all this activity? One logical possibility is that Andy thought that bananas were worth more than the 100 units and the added obligation-to-repay that he incurred. At the same time, the sponsoring entity could have thought that Andy's obligation to repay 100 units in the future (together with service charges)  was worth more than the 100 units that the entity would render temporarily unavailable. We can safely believe that Nick's illustration has described a three-way mutually advantageous trade.

Nick inconveniently omitted the events that occurred behind the curtain.

The Value of Money

It does not seem logical to extend the creation of money into the value of money. We can safely believe that Betty willingly traded 100 units for bananas but we don't know how many bananas she traded. We only safely observe that 100 units have been found.

Conclusion

The NGC model provides a powerful analogy to processes found in the broader monetary system. This descriptive path-of-creation for money is yet another example in the use of the model.

Thanks

Thanks to Nick Rowe, whose cryptic yet tantalizing posts on macroeconomics repeatedly inspire many amateurs and professionals.

*[11/10/2016 update] The combined words "delayed-payment" were inserted to call attention to the important fact that the comparison of money to a gift-certificate depends upon the store FIRST receiving goods or services THEN providing a gift-certificate in acknowledgement. The gift-certificate is evidence of an obligation for the store, only payable by trade within the store. We could think of the certificate as being Delayed Evidence of a Barter Transaction (DEBT).

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