Thursday, September 18, 2008 31 Comments

A clean-slate accounting of the dollar (part 1)

There seems to be a bit of a commotion in the financial markets. As one mugwump put it: "this would be extremely interesting from an analytic perspective, if it wasn't happening to us."

And the yellow dog has barked. Woof! The Au/USD ratio or "gold price" rose about 10% on Wednesday. This may not sound like a lot, but it's basically unprecedented. A Moldenstein moment? Possibly, but I wouldn't write off the global financial system just quite yet.

Looking at the chart, what seems to have happened is that a little before 10 AM, someone chose to either acquire a fat slice of the yellow dog, or relieve themselves of a negative slice. I suspect the latter. "Actually, Brooke, we used to have our very own place in the Hamptons. But then Daddy decided a massive financial crisis was the perfect time to short precious metals."

If the details of this matter interest you, see my comments Monday at Macro Man's. The subject was the decoupling of gold and oil, which moved in sharply opposite directions Monday. Hopefully causing someone to lose a large amount of money. I would like to think that the events of the last year - or at least the last day - convince the wizards of Connecticut, or at least the wizards' little black boxes, that the marginal market for gold is dominated by its role as a natural currency, and that it does not form reliable correlations with industrial raw materials ("commodities") or official currencies (the hidden denominator of "the dollar," as in "the dollar rose today" - meaning, basically, USD/EUR).

(Not that I expect raw material/USD ratios to crater. The basic driver of rising material/USD ratios is the US trade deficit, which ships large numbers of dollars to large numbers of people with a large marginal propensity to demand raw materials and products thereof. Eg, China. Since the basic cause of the trade deficit is underpriced currencies in emerging markets, and since this underpricing is not an accident but a policy, there is no reason to expect this trend to reverse. Of course speculators can overshoot it, but they can also undershoot it.)

You can also read this thread at Brad Setser's, in which I explain my modified Austrian theory of banking, and the rather extreme crisis medicine it implies, to skeptical but friendly bankers. Here at UR we're never afraid to go head to head with the heavy hitters.

But all of this is written for those with some pre-existing knowledge of the system. The great thing about being a skeptical generalist is that you trust your own ability to think about X, instead of trusting those with actual knowledge and experience in X. I am certainly no opponent of knowledge or experience, but it should be plain to everyone at this point that our financial system is, in at least one mysterious and incomprehensible way, broken.

So those who know it, know the broken thing. Worse, they believe that the dollar system is exactly what it purports itself to be - money is money, bonds are bonds, banks are banks, etc. And they have built a large superstructure of models on these understandings. Said models do not appear to be in perfect working order.

When we analyze the dollar with no assumptions about economics, finance, or accounting, we may make our own mistakes, but they will be our own mistakes. Think of it as rather like analyzing a Soviet nickel company in 1991. Does the company even exist? Does it even produce nickel? Does it own any mineral rights of any sort? If we buy it, do we really own it? Etc.

So think of our clean-slate dollar analysis as a sort of forensic accounting, on a very special Soviet nickel company: USG, also known as "America."

First, let's start by looking at a dollar. You probably have one in your wallet. This exercise may seem pointless. And to some extent it is. But it reminds us of the first rule of accounting: always trust your own eyes.

On the back of my dollar, there are some trippy engravings with Latin text. I don't know Latin, but the context seems purely decorative and contractually void. Hopefully this is actually so. There is also the phrase "In God We Trust," which sounds vaguely like a financial obligation. But we know not what liabilities are being ascribed to God, whether He has actually agreed to any such contract, or what will happen if He defaults on it. So we'll call this one void as well.

On the front, more decoration, but also what seems like actual content. We learn that our dollar is a "Federal Reserve Note," issued by "The United States of America." The latter is our Soviet nickel mine - USG. The "Federal Reserve" is apparently some unit or subsidiary thereof. Perhaps it has some relationship to the "Federal Reserve Bank of San Francisco." Also appearing is the "Department of the Treasury," apparently some other unit, employing a "Treasurer of the United States" and a "Secretary of the Treasury." Oddly, these are not the same person. Perhaps the latter is the former's admin. Their signatures are reproduced - context, unclear. Are the Treasurer and her secretary personally liable for any obligation? If USG tanks, must they step in and make me whole? We'll take a wild stab and say no.

We do not understand the internal structure of USG. We don't want to understand it. We will treat it as a single entity with a single balance sheet. Presumably if we decide to do the deal, we'll bring in our own people and reorg everything. For now, if USG is lending to itself, or whatever, these transactions will cancel out. Simplifying everyone's life. Life is short. Accounting is boring. Or at least, it should be boring. If it's not, something is probably up.

There is also what looks like a serial number. Mine is "L68082696L." This suggests that there is a list of serial numbers somewhere. Probably on a crumbling, makhorka-stained notebook filled out by hand in Cyrillic. But still, this is excellent. It suggests that we may be able to know how many dollars are outstanding. As we'll see, this is too optimistic, but one can hope.

It also suggests that the Cyrillic notebook might record that I, Mencius Moldbug, am the owner of L68082696L. But this can't be so - I know that no one knows that I have this note. This is useful information; it means the dollar is some sort of bearer security.

Finally, there is a fascinating phrase. It reads: "this note is legal tender for all debts, public and private." When we investigate this, we find it refers to a rule in the operating handbook for USG's internal security forces - 31 USC 5103:
United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.
Does this actually mean anything? Or is it purely decorative? As we'll see, it is decorative. Or more properly, historical. It doesn't mean anything now, but it once did.

Today, if I sign a contract promising to deliver a hundred dollars, I need to deliver a hundred dollars. If I sign a contract promising to deliver a barrel of oil, or a tenth of an ounce of gold, or five shares of Cisco, I need to deliver a barrel of oil, or a tenth of an ounce of gold, or five shares of Cisco. All of this would be true with or without "31 USC 5103."

So we have learned the following from our examination: the "dollar" is some sort of bearer security, issued by USG, attractive and portable, conveying no rights whatsoever. Well, it was worth a try.

But we know something else, which is not written on the note but is implicit in its design. We know that every dollar is equivalent. Each dollar is a member of a homogeneous class of goods, each of which confers the same rights as every other. Moreover, bills of higher denominations obey the same rule. A five-dollar bill will always be worth five dollars. It will never trade up to $5.23, or down to $4.65.

This minimal amount of information enables us to classify the dollar as a financial instrument. The dollar is equity.

Compared to your average equity issue - say, a share of Cisco - the dollar is a highly inferior class of stock. It never has paid any dividends and probably never will. It conveys no voting rights. We have no idea how many shares are outstanding. And we're not at all sure what you'd own, if you owned all of them - but it is definitely not all of USG.

But this is par for the course for your Soviet nickel company. The forensic accountant is trying to make some kind of structured sense out of half a century of Communist nonsense. Is this a problem? It is. Does this mean you shouldn't buy the company, or its shares? Well, nickel is nickel. Some of the world's richest men got that way by buying Soviet nickel companies.

Any financial instrument is one of three things: a deed of ownership of some good (a title), a liability to fulfill some obligation, possibly contingent (a debt or option), or none of the above (equity). The dollar is equity because (a) it is definitely not a title or a debt, and (b) every dollar is created equal; whatever benefits USG may choose to shower on the holder of L68082696L, it will provide to the holder of any other dollar. It's not much, but it's a start.

Perhaps you think of the dollar as "money" or "currency," and you are very confused by all this. "Money" and "currency" are nice words, but they have no precise accounting definition. They just refer to a good or security commonly held for the purpose of savings and/or exchange. Historically, we can identify four classes of currency:

(1) Direct goods, such as coins of a standardized weight of precious metal.
(2) Titles or warehouse receipts to (1).
(3) Obligations to pay (1) or (2), or redeemable currency.
(4) Mere equity, or fiat currency.

These are (excluding the common 4-to-1 transition) in order of historical evolution. Explaining the evolution is not of direct assistance in analyzing the dollar, but it helps us get our bearings - and it defines terms which will be useful later on.

Class 1 currency (standardized metal) evolves into class 2 currency (titles) because titles are more portable, secure and convenient. Digital gold is a modern class 2 currency.

Class 2 currency (titles) evolves into class 3 currency (redeemable notes), because the change is generally profitable for the currency issuer, and the marks are too dumb to know the difference. A title or warehouse receipt is a title because the issuer holds goods that match it; otherwise, he is a thief. A redeemable note is a mere debt, and does not default until redemption fails. And even then, the issuer is only bankrupt, not in jail.

Suppose I have 100 ounces of gold, and issue 100 titles against it, each title stating that the bearer owns one ounce of gold. This makes me a respectable issuer of class 2 currency.

Suppose I have 100 ounces of gold, and issue 200 redeemable notes against it, each note stating that I will issue the bearer one ounce of gold on demand. This makes me a scoundrel.

However, it also makes me wealthier than I was before, at least until more than 100 bearers show up to claim their gold at the same time. Will my notes trade at par? Ie: will people accept them as equivalent to the class 2 titles? Well, every time someone starts to get suspicious and tries to redeem one, it works. So I don't see why they shouldn't. We have just reinvented the wildcat bank - a staple of early American finance.

There is a cure for wildcat banking: those who accept class 3 notes should ensure that the issuer is solvent. A financial institution is solvent if and only if the sum of all the payments it is obligated to make equals or exceeds the total price of all the assets it holds. So our Scoundrel Bank above is not solvent, because it is obligated to pay 200 ounces and it only has 100 ounces.

One way to see a redeemable note is to see it as a very short-term loan from the noteholder to the bank, which is automatically renewed or "rolled over" when the noteholder does not redeem. If the term of the loan is an hour, a minute or even a second, the effect is redeemability. And note that when making a loan, what you want to know is whether the loan will be paid back. And collectively, what all loanholders want to know is that they all can be paid back. First come, first served, is not solvency.

Scoundrel Bank can redeem for some of its noteholders. But not all of them. Therefore, all unfortunate holders of its notes can agree on a fair - or "equitable" - bankruptcy restructuring: every holder of a Scoundrel ounce note should receive half an ounce of gold. As for the scoundrel himself, trees abound, and perhaps the noteholders can pitch in for a rope.

But there is a tricky intermediate case - call it Questionable Bank - between Respectable Warehouse and Scoundrel Bank. Respectable Warehouse issued 100 one-ounce titles. It has 100 ounces. Verifying the quality of the titles is as easy as verifying these facts. Scoundrel Bank issued 200 one-ounce notes. It does not have 200 ounces. Verifying its insolvency is just as easy.

Questionable Bank also issued 200 ounce notes. It also has only 100 ounces. But it also has 100 old pianos. Each piano, it asserts, is worth an ounce of gold. "Easily. Easily. No sweat, man. These are fine pianos. Here, play this one. Hear that sound? That's a sweet tone. Check out the action on the keys. Totally smooth. You could move this piano for an ounce fifty, no problem.")

Suddenly our noteholder, or at least the accountant he hires, is required to be a piano appraiser. Should you trade a Respectable title to one ounce, for a Questionable note paying one ounce? It depends on the quality of the pianos. Obviously, every piano is different. You can't just play the one up front in Questionable's office. You need to go into the back room and tinkle away.

Moreover, even if each piano could be sold on the piano market for an ounce or more, it is hard to know that all the pianos could be sold at once. Since price is set by supply and demand, the appearance of a large splodge of pianos, even fine pianos, on the market all at once, is liable to depress the piano price. And "at once," let's not forget, is the term of the Questionable notes.

In real life, of course, the good in question is typically not pianos but loans. Usually long-term loans. Pricing a piano is difficult, but it is nothing on pricing a loan. And the result of dropping a glut of loans on the market all at once is even more astonishing and disastrous.

If you are interested in the details of this issue, see the discussion at bsetser's. But in this case Questionable has an easy solution for its problem. Like most currency issuers, it is sovereign. It is not just a bank. It is also the government. One, nobody can go into its back room and tinkle its pianos. And two, if people don't want to accept its one-ounce notes as equal to one ounce, it can make them.

This provides an interesting explanation for the mysterious "legal tender" phrase on the front of our dollar. It is easy for a sovereign currency issuer to transition its units from a class 1 or class 2 currency, to a class 3. The class 3 currency is still defined as the same weight of metal. But it is no longer backed by enough metal to redeem the entire currency issue (otherwise, it might as well be class 2, like the old Bank of Amsterdam). Besides metal, the issuer holds pianos, loans, Honus Wagner baseball cards, etc, all of whose total market price exceeds the sum of the notes. Or at least allegedly exceeds them.

It is highly desirable for the class 3 currency to trade "at par," eg, be exchanged one-to-one for the metal or the title. And for a sovereign issuer, this is no problem. If the subjects arrogantly persist in scorning the King's honor by discounting his perfectly good notes, the King's sword will discount their necks. Even the flagrantly insolvent Scoundrel Bank will do just fine as a sovereign issuer. If Jews and speculators try to stop the King's loyal subjects from paying their debts with the King's good one-ounce notes, which they maliciously insist are worth only half an ounce, their heads are forfeit.

And it is easy to see that the King's notes are worth one ounce, because anyone can take them to the Castle and exchange them for an ounce of pure gold. No tricks or shenanigans. Of course, speculators and Jews may assert that King Scoundrel has used his sword to perform what is essentially an act of alchemy, an art of interest to all kings past, present and future. But swords speak louder than words.

However, when King Scoundrel pushes his alchemy too far, the seams begin to show. Foreigners, for example, have a nasty tendency to redeem the notes and skip the country with the gold. This won't do at all. And it can be repressed in various ways, but it leaks. The domestic price of Scoundrel notes will always be one ounce, but the foreign price might be a bit lower. There is a perennial incentive to redeem notes and smuggle gold. Bad.

This problem can be solved in a very simple way. Cut the Gordian knot. Suspend redemption. Even better, terminate it permanently. Just default on the loan. You're the King, after all. Who's going to mess with you? Certainly not the Jews and speculators.

The result is a class 4 currency - equity. Conversion of debt to equity is the normal procedure in bankruptcy. Scoundrel Bank still has plenty of assets, after all, just not enough to keep its pesky subjects from redeeming their notes and selling the gold to speculators and Jews. The class 4 currency is not, by any means, worthless. Holders of notes are treated equitably. In theory they may even collectively own all of Scoundrel Bank, although the King is generous enough to manage it for them.

Is it possible that our present dollar evolved through this process? Today we are practicing accounting, not history. We do not know how the dollar came to be what it is. All we know is that it's a class 4 currency. This conclusion is produced solely by our own eyes, above.

To regularize this equity structure, to retrieve it from the realm of Soviet nickel and bring it back into the realm of sane accounting, we need to do two things. One: we need to decide how many shares there are. Two: we need to decide what you own, if you own all the shares. For example, in the case of Cisco, the answer to the first question is "5.9 billion," the answer to the second is "Cisco." These answers may be slightly blurry around the edges, but only slightly.

Let's start by declining to answer the second question. Clearly, if you own all the dollars, you do not own USG, including the highly lucrative (and nickel-rich) continent of North America. While it might be great fun to elect a CEO of USG with one vote per dollar, it is not essential to a proper accounting of the instrument. We would also like to avoid restructuring USG as a whole, at least in this blog post.

For the moment, let's say our goal is to construct and spin off a new entity, DollarCo, whose shareholders are current dollarholders on a 1:1 basis - each dollar will become one share in DollarCo. As for DollarCo's assets, this is a political question. But just to get in the right ballpark, let's start by throwing in USG's gold reserves: 264 million ounces.

The first question is all we have left. How many dollars are there in the world? There is a nice official answer to this question. The figure is known as M0, the monetary base, and its current value is about 825 billion. Thus, DollarCo will have 825 billion shares.

One of the nicest things about modeling a dollar as a DollarCo share is that the process of equity dilution - creating new shares - is extremely well-understood. Whereas the process of creating new dollars is, in classic Soviet nickel-company style, shrouded in deep mystery. Everyone has a sense that there are a lot more dollars around than there used to be, but few are quite sure why.

It is immediately obvious that creating new DollarCo shares cannot add more gold to Fort Knox. But the process of dilution is still useful for various events in the corporate lifecycle. Dilution confiscates a pro rata percentage of each share from all shareholders, collects it all together, and assigns it to whatever party is granted the new shares - presumably in exchange for some consideration which benefits the old shareholders, making the confiscation worthwhile for all. For instance, if DollarCo is to acquire PesoCo, it can issue new shares in exchange for all the shares of PesoCo, according to whatever ratio the dealmakers work out.

What we don't want to see happening, however, is covert dilution. The party secretary of our Soviet nickel company may well be running off shares on his laser printer, and handing them out to his vodka buddies. This is a no-no. And we are not sure what's happening in this "Treasury" place - but the number is definitely increasing. For now, we would like to not only ascertain, but also lock, the number of dollars outstanding. PesoCo will have to wait for another day.

It's important to recognize that DollarCo is a product of the accounting process. It does not exist yet. All we have is USG, which owns Fort Knox among many other things, and has issued some number of dollars. Before we can form DollarCo, converting dollars to DollarCo shares and transferring USG assets to make DollarCo worth something, we need to ascertain and lock the dollar count - first.

A dollar need not be a physical object. It can be an electronic entry, as many dollars are at present. However, we need to know exactly how many dollars are outstanding. A foolproof way to do this is to assign every dollar, electronic or paper, a consecutive serial number - or as we programmers put it, a sequence number. If there are n dollars, the first dollar is sequence number 0 (we can frame this one), and the last is (n - 1). Rocket science this is not. And, most importantly, n is final - it cannot be increased.

But we already know n, right? Isn't it 825 billion - M0?

Wrong. The problem is that this assignment, n = M0, simply does not make sense. It is not consistent with economic reality. Of course USG can enforce it, as it can enforce anything, but the result will be social and economic disaster. North America will become a burned-out Mad Max wasteland, patrolled by marauding gangs and packs of radioactive mutant wolves.

To think about this, let's make sure we fully appreciate the ramifications of permanently setting n = M0 by imagining that each dollar is not just a piece of paper, but an alien artifact, roughly the size of a poker chip but made using alien technology which cannot be duplicated. These alien poker chips are a strange, glowing purple color that no Earth technology can imitate. There are 825 billion of them, and no aliens are around to extend the supply.

Everything else about our world, however, remains the same. Including the fact that USG has a national debt of roughly $10 trillion - not counting unfunded entitlements. Moreover, this debt is not even discounted. Quite the contrary: it is considered "risk-free."

Question: how, exactly, in a world that contains only 825 billion dollars, can a debt of $10 trillion be risk-free?

Moreover, USG runs an annual trade deficit of $750 billion. Even if it started each January 1 with all 825 billion of these dollars in the country, which it most certainly didn't, its subjects should be feeling pretty impoverished by Christmas. But no. They run the same trade deficit, year after year after year. Perhaps the dollars are being lent back to them - but why?

There can only be one answer: this $825 billion number is just plain wrong.

825 billion is the number of formal dollars outstanding. It is not the droid we are looking for, though. What we need, in order to set up DollarCo and properly account for the dollar, is the number of fully diluted dollars. Somewhere out there in Soviet nickel-company land, there are trillions and trillions of covert, informal, virtual, contingent, or otherwise mysterious dollars.

The goal of any clean-slate accounting must be to (a) describe these virtual dollars, (b) figure out who owns them, (c) understand the process that produces them, (d) shut this process off, and (e) map the virtual dollars to sensible financial instruments, ideally just regular dollars.

Come back next Thursday for part 2 of this exciting series, in which we'll solve these problems, or at least pretend to. (If you want the solution to actually be implemented, I'm afraid you'll have to call your Congressman.)


Blogger Aaron Davies said...

This reminds me, have any of you seen Wolf and Spice? It's an anime about medieval forex arbitrage (well, seigneurage arbitrage, really, I guess) and a cute Shinto wolf goddess. Highly entertaining.

September 18, 2008 at 8:48 AM  
Anonymous Blode said...

I can't make head or tail of this. I'll have to reread. On a positive note, I'll say that this post title doesn't make me get that Smashing Pumpkins song (the one that begins "The world is a vampire") stuck in my head.

September 18, 2008 at 11:40 AM  
Blogger TGGP said...

There don't seem to be as many comments as the usual post. Monetary economics just doesn't excite the same passions as Universalism and proles.

For those who love nothing more than it, an old audio-lecture from Jeff Hummel entited "Why Fractional Reserve Banking Is more Libertarian than the Gold Standard‏" is here. More recently Hummel has urged the government to default on its debts.

September 18, 2008 at 11:41 AM  
Anonymous Blode said...

I would certainly like to talk about monetary policy, I'm just not really up to speed on it. Moldbug's heresies on class structure, the history of anti-communism, etc., ring true to me. His heresies on monetary policy just sound like ... heresies, I guess. In any event, I did reply to your most recent comments on UR's Sarah Palin thread.

September 18, 2008 at 12:23 PM  
Blogger racketmensch said...

Fascinating as always, yet it occurs to me - since there's evidently no law against USG nationalizing private concerns, why can't they (we?) nationalize some profitable businesses as well, just to balance accounts? I suggest we start with Goldman-Sachs, Lockheed and Exxon and keep going until we're ALL fat and happy. Fuck Iraq and Afganistan, lets take over England and Germany. I bet they wouldn't even fight back, and on the seventh day we rest!

September 18, 2008 at 1:00 PM  
Anonymous m said...

tggp: I've noticed comment volume decrease over the past couple of months. I personally think the posts are becoming harder to read, that the focus and clarity has dropped. But I don't blame Mencius, he has a child to care for after all! Still, I agree with you that hammering Progressives in a short and concise manner ratches up the excitement level.

September 18, 2008 at 1:34 PM  
Blogger Sally said...

Well, hate to differ with everybody but IMO, this is the first post in a long time that is plain, understandable and valuable (until this I'd not encountered a metaphor for "money" that made sense for longer than 2 minutes).
Looking forward to part II.

September 18, 2008 at 4:04 PM  
Blogger Mitchell said...

"Conversion of debt to equity is the normal procedure in bankruptcy."

Did the US go bankrupt in 1971, then? I'd never thought of it that way.

September 18, 2008 at 5:28 PM  
Anonymous Anonymous said...

The posts seem to me to be clear, interesting, and logical. I haven't commented because, besides reading the most recent posts, I am currently in the process of reading every post since April 2007, in order. It has already occurred to me that this would be much easier if these posts were available in book form, for say, $20. Or the equivalent in gold less any transaction fees. The present value of commenting is, for me, normally less than the present value of the satisfaction I expect to have felt at reading every post. After finishing said reading I may come back to comment. However, since I very much enjoy reading these posts, I thought it in my own best interest to comment this time and note that A) this is an excellent blog, B) number of comments is an arbitrary and really foolish measure of the excellentness of this blog, and C) the excellentness of this blog, regardless of the measure thereof, has real value.

- Dirty Rotten Varmint

September 18, 2008 at 6:43 PM  
Anonymous Libra said...

I love it when Mencius talks economics. But I find I usually enjoy the comment thread debates he links to more than I do the actual post. I also wish he would write up everything formally in once place. He's made some very interesting advancements over traditional Austrian economics, and it would be nice if it was more widely known.

September 18, 2008 at 8:24 PM  
Blogger G. M. Palmer said...

If your assets don't equal your debts then, yeah, you're bankrupt. Whether you get caught or not is the tricky part.

The question is whether or not fiat currency backed by a wholly sov. sovcorp (as opposed to Weimar or any current hyperinflative state) like USG can get caught in bankruptcy.

I mean, if their guns say "take the damn payment" I think we'll take it, even if it's nearly worthless pieces of high-quality paper.

September 18, 2008 at 8:57 PM  
Blogger G. M. Palmer said...

I suppose, then, that USG can never really go bankrupt as long as it owns America.

If states start leaving (again), all bets are off (and all safety locks, too).

September 18, 2008 at 8:59 PM  
Blogger MarcWPhoto said...

I enjoy your commentaries very much, but I must vigorously protest your assertion that ownership of a dollar extends no voting rights. Ownership of dollars endows the owner with MASSIVE voting rights. The problem is, of course, share dilution.

But those with sufficient shares can use them to influence policy like nobody's business. :) Mr. Dimon, through his control of large numbers of such shares, can say, "I move that the government should indemnify me from losses for a particular financial transaction, although of course the government does not get to participate in any gains." And he can carry the vote. On the other hand, Mr. Lewis can raise a similar motion, but if his votes are inadequate, the motion will fail.

Alternatively, one could argue that those with large amounts of dollars get to select most elected officials. While we do theoretically have the general franchise, no candidate without a certain level of dollars backing them can gain a place on the ballot. Hence, voting with dollars is what selects all possible winners in elections.

Of course TECHNICALLY dollars do not endow someone with an actual voting right, not least because there is no fixed ratio between shares and participation.


September 19, 2008 at 7:50 AM  
Blogger TGGP said...

blode, I responded in the Palin thread and also decided to turn my response into a post at my own blog.

m, when has Mencius does anything in a short and concise manner? We come here for the sort of mondo-posts that daily twittery bloggers can't provide.

September 19, 2008 at 7:52 AM  
Anonymous Michael S. said...

Whether dollars in circulation be considered debt or equity, they obviously belong on the liability side of the U.S. government's balance sheet.

This brings up a point about which I have never found a satisfactory discussion - what is the value of U.S. government assets? We hear constantly about budget deficits and often about the national debt, but almost nothing about government assets. They are huge: over 90% of the land in some states, for example. It is not easy to assign a value to them because there is in many cases no comparable property, and no one can predict what a market-clearing price would be. Politics keeps many such government assets from being put to their most profitable use (e.g., ANWR) or causes the sale of some sort of limited tenure (e.g., mineral rights or grazing rights) to take place at arbitrary prices rather than allowing them to be set by an auction market.

It is appropriate to distinguish between bankruptcy (a circumstance in which liabilities exceed assets, i.e., the entity in question has negative net worth) and insolvency (a circumstance in which liquid assets are insufficient to pay current debts). I think it is likely that the U.S. government will at some point become insolvent. Whether it will be truly bankrupt is quite another question.

Inflation has been the usual political remedy for governmental insolvency. It enables the state to borrow dear and pay off cheap, and politicians are willing to live with its other effects.

Another possible remedy that has not been tried is the liquidation of significant amounts of government assets, or even opening to market pricing the ongoing sale of less-than-freehold tenures in mineral rights, grazing rights, fish and game, etc. Whether the political will to take such steps can ever be mustered short of the most severe economic distress is doubtful.

September 19, 2008 at 10:06 AM  
Blogger Independent Accountant said...

A dollar equity? How? Equity gives you a claim on assets. Which USG assets does a dollar give you a claim on? What is in the USG's capital structure that is a senior claim to the dollar? Treasury Bonds? Social Security actuarial debt? When I buy shares of say IBM, I get to vote at the annual meeting, one vote per share. If I have $1,000 do I get 1,000 times as many USG "votes" as a person with $1? If I turn the $1 into the USG what will it give me? Another dollar. At least if IBM liquidates I have the potential to get some asset in return for my shares.
I look at a dollar and see a note. An IOU. It says Federal Reseve Note. It has no maturity date and no interest rate. What is the present value of a piece of paper due in say 1,000 years at 0 percent annual interest? Not much, if discounted say at 3% per year. It is worth nothing except for being able to be transferred to someone else for something of value. If is the ability of the dollar to be transferred to get other things of value that gives it value.
To understand the dollar, you must understand why counterfeiting is a crime. When Joe Schmoe does work, he gets a number of "preexisiting" dollars from a third party who did something to earn them. The counterfeiter spends say 2 cents on paper and ink and gets a 98 cent profit, "seignorage", if you will. That's what Helicopter Ben does and we call it monetary policy.
What am I missing?

September 19, 2008 at 6:57 PM  
Blogger Independent Accountant said...

I reread your post and realized how close we are. You write, "To think about this, let's make sure we fully appreciate the ramifications. ... roughly the size of a poker chip but made using alien technology which cannot be duplicated". Hooray! This is my "rock economy model" which I proposed in February 1980. The key: "no aliens are around to extend the supply". You ask, "how, exactly, in a world that contains only 825 billion dollars, can a debt of $10 trillion be risk free?" It can't. I remember at Chicago learing about the CAPM "risk free asset". I later concluded there is no such thing. The most you can have is a "least risky asset". You want to account for "fully diluted dollars". Not very easy. At my blog, post 24 December 2007,, I discuss some possible "values" for gold based on various Ms. I see no "right" answer.

September 19, 2008 at 7:47 PM  
Anonymous P.M.Lawrence said...

Mencius Moldbug has veered off course in going from type 3 to type 4. The thing is, even a fiat currency is still type 3, backed by debts to the government. The "fiat" part is when the government makes up these debts, which it calls taxes. The government never has to be so crass as to threaten people directly into taking its money at all, if it's careful, instead just threatening indirectly with the tax system (of course, the government often finds it more convenient just to dilute the currency rather than raise taxes to maintain the backing). These bearer titles never move to an equity stage at all.

September 20, 2008 at 3:23 AM  
Blogger Independent Accountant said...

PM Lawrence:
I agree with you. I can't get from step 3 to step 4 either.

September 20, 2008 at 12:56 PM  
Anonymous Anonymous said...

One tiny nit:

"U.S. Currency and Coin Outstanding and in Circulation"

The number given there is $1027.4 Billion for June. Certainly not a huge departure from the number you gave; perhaps the monetary base doesn't count the non-circulating dollars?

On a related note: does anyone have any idea of the total US Dollar denominated debts outstanding?


September 21, 2008 at 3:29 PM  
Anonymous Anonymous said...


You are talking about informal powers of dollar ownership. Mencius is talking about formal powers of dollar ownership. The two are not the same.


Even with taxes, you are still dealing with dollars. The quality that differentiates class 3 currency from class 4 currency is the way one values the currency.

With class 4 currency, like with any other form of equity, the only reason the currency is valued is access to the market - selling currency in exchange for goods that are fundamentally valuable (although, from what I hear pennies and nickels are class 1 currency now).

With class 3 currency the issuer, like with any other form of debt, is obligated to exchange the notes for something else - presumably something of fundamental value.

It is true that in both cases the holder of the currency can sell it on the market, the difference lies in the formal responsibilities of the issuer.


September 21, 2008 at 4:13 PM  
Blogger MarcWPhoto said...


1) As I pointed out, people with large amounts of dollars select all elected officials of any consequence. A difference without a difference is no difference. :) However, to the extent that our elected officials are dishonest - i.e. they don't always stay bribed - then you are correct in that dollar ownership doesn't allow any direct governance ability.

2) To answer your question about how much dollar-denominated debt there is: No. No one has the faintest idea. Anyone who claims to know is either delusional or a liar. You can probably get a reasonably good estimate of the national debt of any given national government (although whatever the government itself claims is certain to be understated.) But all the sub-national public, let alone private debt? No way is it all on anybody's books in a reliable figure.

If you count all the derivatives in all possible permutations - which admittedly isn't fair because a lot of them would actually cancel each other out - it must be in the high tens of trillions if not the hundreds of trillions. If you just count actual debt, I would guess in the tens of trillions. I wouldn't be surprised to learn that either or both of those estimates were too low.


September 21, 2008 at 4:37 PM  
Anonymous m said...

It's becoming clear. Paulson and Bernanke didn't dissolve the preferred shares in FNM and FRE in order to save the taxpayer; they dissolved the preferred shares, after encouraging smaller regional banks to buy in, because they wanted them to go bankrupt or to sell assets for pennies on the dollar, in which case they will inevitably end up at Goldman Sachs.

Here's another hint:

"Key changes in the guidelines include allowing an investor to buy up to a 15 percent voting stake instead of the previous 9.9 percent limit. Investors can also buy up to 33 percent total equity interest, including voting and non-voting shares, instead of the 25 percent prior limit."

This will allow private equity companies to own a larger share of a bank without being designated a "bank holding company" and falling under the supervision of the Federal Reserve.

Bernanke and Paulson will screw over this country until it's bled dry to save and promote their buddies on Wall Street, and NO ONE IS DOING ANYTHING. Man, are we screwed.

September 23, 2008 at 7:08 AM  
Anonymous m said...

Sorry, non-truncated links:

Read this link:

It's becoming clear. Paulson and Bernanke didn't dissolve the preferred shares in FNM and FRE in order to save the taxpayer; they dissolved the preferred shares, after encouraging smaller regional banks to buy in, because they wanted them to go bankrupt or to sell assets for pennies on the dollar, in which case they will inevitably end up at Goldman Sachs.

Here's another hint:

"Key changes in the guidelines include allowing an investor to buy up to a 15 percent voting stake instead of the previous 9.9 percent limit. Investors can also buy up to 33 percent total equity interest, including voting and non-voting shares, instead of the 25 percent prior limit."

This will allow private equity companies to own a larger share of a bank without being designated a "bank holding company" and falling under the supervision of the Federal Reserve.

Bernanke and Paulson will screw over this country until it's bled dry to save and promote their buddies on Wall Street, and NO ONE IS DOING ANYTHING. Man, are we screwed.


A blogger who agrees with me:

When Paulson/Bernanke nationalized Fannie/Freddie and wiped out the preferred stock they made an announcement to the effect that 'local/regional banks that were adversely effected by the wipe out should contact the treasury for relief' (paraphrased).

What happened to the relief? Has it been conveinently forgotten?

I predicted, prior to the take over of the GSEs, that the long term goal was to bk local/regional banks and that the Wall St pirates would have these banks for pennies. This IS their new biz model, their reason for being.

Since the Wall St pirates no longer have a large revenue stream from 'financial innovation' the regional/local banks will provide a replacement revenue stream.

Paulson, with unlimited resources, exemption from rules and laws, and exemption from prosecution, will plunder any and all entities (banks) that are not 'friends of Hank'.


September 23, 2008 at 7:09 AM  
Anonymous Anonymous said...

Let's clear up a couple misconceptions.

"If your assets don't equal your debts then, yeah, you're bankrupt. Whether you get caught or not is the tricky part."

Actually, no. If your assets are not equal to or greater than your liabilities, then you have more liabilities than assets. That's all. It's just accounting. Accounting is a wonderful tool, but many people are confused by it. They think that because accounting involves numbers, and math involves numbers, accounting is math. This is incorrect. Accounting is simply a language. As a language, it is a tool to describe reality. Like all languages other than math, it can only describe reality imperfectly. Accounting does not "mean" anything. It is a signaling tool we use to indicate meaning. These are not the same thing.

Bankruptcy. You are bankrupt when your creditors legitimately force you to make good your promises to pay them, and you are unable to do so. If your liabilities exceed your assets, that is a good indication that you may be at risk of bankruptcy. However, it is not sufficient. So long as your creditors do not demand payment, you're fine. This is very common and there is nothing at all wrong with it.

"What is the value of U.S. government assets?"

As with anything else: what you sell them for. Any other "valuation" is just playing with numbers. It can be an interesting and informative indication of potential value, but (like accounting) it does not equal reality. Economic value is subjective: whatever you're selling is worth whatever you sell it for.

"Inflation has been the usual political remedy for governmental insolvency."

Inflation gets an unnecessarily bad rap. Inflation is neutral. What is inflation? Inflation just means that instead of being able to buy internet access for 40 alien tokens per month, it now costs 41. Who cares? These are just alien tokens. Whether it takes 40 or 41 or 401 or .041 is immaterial. Unless you are into numerology.

The problem is uneven inflation: the change in price for some things (e.g., oil) exceeds the change in price for other things (e.g., an hour of work) over the same specific period of time. This is a problem of imperfect information. The function of the market is to set, through the market process, prices, which prices represent to all market participants the best information regarding the potential subjective value of a good or service at a particular point in space-time. True, government intervention (such as creating loans - a product - at a below-market rate of interest - a price) typically obfuscates the true market price and contributes to information imperfection. Inflation by itself, however, is not even an interesting concept. If instead of 4000 alien tokens, today there are 4400, and everyone gets this information at the exact same time and all prices are immediately multiplied by 1.1, there has been no material change.

The post accusing Paulson and Bernanke of colluding to steer assets to friends in private equity is interesting. While it smacks of looniness, it's important not to dismiss concerns like this too casually, because it is true (as we've seen described in past posts) that our current non-neocameralist government breeds and incubates corruption.

That said, however, it usually turns out to be the case that it is unnecessary and incorrect to ascribe to unethical greed and malice what can be easily explained by standard run-of-the-mill incompetence. In other words: Do not underestimate the ability of a Polygon-trained economist to get it all brilliantly wrong.

- Dirtyrottenvarmint

September 23, 2008 at 8:26 AM  
Anonymous Michael S. said...

Anon., an entity is not bankrupt merely because it has entered a bankruptcy proceeding. Usually entry into such a proceeding occurs as a result of insolvency - i.e., inability to pay current debt with liquid assets on hand. However an insolvent entity may still have more assets than liabilities, i.e., a positive net worth. It will emerge from bankruptcy. One that has more liabilities than assets, i.e., a negative net worth, will be declared bankrupt.

The question is whether the U.S. government, when all is said and done, has a positive or a negative net worth. It is not even insolvent at this point, since creditors continue to accept its instruments of indebtedness. You are correct in pointing out that as long as creditors do not demand settlement of debts owed them, the debtor may have a negative net worth and continue to operate. The difference between an ordinary business and a sovereign government is that the former eventually will have to settle its debts using currency it does not print. It may have to sell off its hard assets, such as land, buildings, production equipment, or inventory in order to get that currency. The latter, when pressed to settle, simply prints more currency. As long as people accept the currency - and the law, made by government, says it is "legal tender for all debts public and private" - the issue of government's net worth need never be addressed.

The mechanism by which currency is issued in this country through the Federal Reserve Bank is less direct than the printing of assignats or continentals, but the effect is the same - it enables government to pay off cheaply what it has borrowed dear, which is not an option for the ordinary insolvent business.

Inflation in the sense of a rise in the price of commodities as expressed in the currency thus diluted is a consequence of such monetization of government debt. I used the term "inflation" as a sort of synecdoche for government's monetization of its debt. Your comments indicate that you understand inflation is a monetary phenomenon. It is not, however, as "neutral" as you claim with respect to lenders and borrowers. Inflation favors the borrower at the expense of the lender. Lenders may try to compensate for this by charging enough interest to make up for it, but because they do not control the monetary printing-press they are always at a disadvantage.

There is a built-in bias towards inflation whenever government is a substantial debtor. Inflation primarily benefits it and incidentally benefits private debtors. In a democracy private debtors may be a big enough constituency that they demand inflation. The real estate boom went on for a long time because of such demand. Fannie and Freddie were, after all, political creatures that came into existence to provide mortgage loans on a ridiculously generous basis. Politicians gave "the peepul" what they wanted, which was to benefit from government's monetization of its debt. This was incompetence (the road to hell is paved with such good intentions) rather than malice, though I would not call it 'run of the mill.'

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February 12, 2009 at 1:37 AM  
Anonymous Anonymous said...

^^ nice blog!! thanks a lot! ^^

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March 2, 2009 at 10:25 PM  
Anonymous Anonymous said...

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March 2, 2009 at 10:26 PM  

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