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Banknotes in bottles in coal mines

Summary:
[This is a guest post by Mike Sproul. Here are a few previous posts by Mike that I've posted to the Moneyess blog.]“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well tried principles of Laissez Faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical

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Banknotes in bottles in coal mines

[This is a guest post by Mike Sproul. Here are a few previous posts by Mike that I've posted to the Moneyess blog.]

“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well tried principles of Laissez Faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

-J.M. Keynes, The General Theory.

Keynes’ ruminations about bank notes and coal mines are a good place to draw a dividing line between classical economists and Keynesians.  In contrast to Keynesian optimism about the coal mine scheme, classical economists tell us that the newly dug-up bank notes will only succeed in causing inflation, while wasting the labor of those who dig up the notes.

Surprisingly, there is some middle ground about burying bank notes. Economists of both stripes generally agree that money shortages cause recessions. If there is not enough money for people to conduct business conveniently, then people are forced to revert to barter or other less efficient means of trade. Trade slows, and productivity suffers.  Some economists will call it a “money shortage”. Others will say “liquidity crisis”, “credit crunch”, “tight money”, “failure of aggregate demand”, and so on. Whatever the terminology, economists have been saying for centuries that money shortages cause recessions.

In the year 1722-3, the Governor and Assembly…thought themselves obliged to take into their serious consideration the distressed circumstances and sufferings of the people, through the extreme want of some kind of currency…These bills being emitted, their effect very sensibly appeared, in giving new life to business, and raising the country in some measure, from its languishing state. (Pennsylvania Assembly to the Board of Trade, 1726. Cited in Brock, 1941, p. 76)
Now we begin to see the middle ground. Both Keynesians and Classicals agree that the coal mine scheme could potentially provide badly needed liquidity and thus end a recession. Once this is agreed, the rest is just dickering over the size of various forces. A Keynesian might think that the misallocation of labor spent digging up bank notes might drag down national production by 5%, but that the notes dug up might lubricate trade enough to boost production by 20%.  A Classical might put the figures at 10% drag and 15% boost.

The backing theory of money gives us a way to clear up some confusion between these two views, and provides a liquidity-based theory of recessions that both Keynesians and Classicals can live with.

The backing theory is summed up in figure 1:

Banknotes in bottles in coal mines

In line (1), the bank (which may be a central bank or a private bank) receives 100 ounces of silver on deposit, and issues $100 of bank notes in exchange. Each dollar note is worth 1 ounce of silver.

In line (2) the bank issues another $200 in exchange for 200 ounces worth (or dollars’ worth) of bonds. The backing theory view is that even though the bank tripled the money supply, the bank also tripled the assets backing that money, so it remains true that $1=1 ounce.

Now suppose that the $300 in circulation is 10% less than the “ideal” quantity of money, and that the economy is therefore in recession. A well-functioning bank would respond to the money shortage by issuing another $30 of bank notes, while getting 30 ounces (or $30) of bonds or other assets in exchange. This open-market purchase of bonds would relieve the money shortage, end the recession, and leave the value of the dollar at $1=1 ounce. The open-market purchase method gives excellent results. Keynesians would not be surprised at this, but Classicals might be surprised that the money injection caused no inflation.

Next, let’s try the bottles-in-coal-mines method. The bank prints $30 of bank notes, places them in bottles, and buries them in coal mines. Workers will waste (at most) $30 worth of labor digging up the notes. The bank gets no new assets as it issues the $30 of bank notes, so the value of the dollar falls by about 10% relative to silver. While there are 10% more dollars in circulation, each dollar is worth 10% less silver. The real value of the aggregate circulating cash is thus unchanged. There is no relief of the money shortage, and so the recession continues. The bottles-in-coal-mines method gives terrible results, just as Classicals would expect. Keynesians might be surprised to see that even in a recession, the money injection still causes inflation and fails to stimulate production.

We can improve on the bottles-in-coal-mines method by following Keynes’ suggestion and issuing bank notes in exchange for houses and such. The bank prints $30 of bank notes and spends them acquiring 30 ounces (or $30) worth of houses. The bank’s assets (including houses) rise in step with its money-issue, so the value of the dollar remains at $1=1 ounce. This method relieves the money shortage, ends the recession, and causes no inflation. Excellent results, and not especially surprising to either Keynesians or Classicals. The problem is that it is not always easy for the bank’s assets to keep up with its money-issue. If the bank had spent its $30 of new notes on houses that were only worth 29 ounces, then money-issue would outrun the bank’s assets, and inflation would result. Overall, it’s safer for the bank to spend its $30 buying bonds than buying houses.

There are many more methods of issuing banknotes, but I’ll mention just one: Print $30 of bank notes and give them away to passers-by outside the bank. Then have the government give $30 of bonds to the bank. The bank’s assets will rise in step with its note issue, so there is no inflation. At the same time, the real money supply rises by 10%, so the money shortage is relieved and the recession ends. Excellent results once again. The only problem is that the government will eventually run out of wealth, and will be unable to help the money-issuing bank’s assets keep up with its money issue.

Conclusions:
1) Money shortages cause recessions, and the solution is to issue more money.
2) Issuing new money won’t cause inflation, as long as the new money is adequately backed.
3) It is best to issue new money via conventional open-market purchases of bonds. Failing that, it’s ok to issue new money for houses, or even to give it away, provided the government can cover the give-away. But whatever you do, don’t bury the money in coal mines.

About Jp Koning
Jp Koning
Working in the bowels of the finance industry. Blogging about monetary phenomena is my side gig.

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