Monday, July 6, 2009

Debt and Equity

Like touching a snake

My friend Aquinum has written:

"Possessing physical dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it.... To summarize: physical paper money is equity. Bank deposit money is backed by debt...."

Paper money is equity. This is an astounding observation. Aquinum refers me to Unqualified Reservations for a technical definition of money-as-equity:

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....

I'm no accountant. Maybe that's an accurate technical description. Maybe it's only a metaphor. Either way, it works for me. UR also points out a typical resolution of bankruptcy proceedings: "Conversion of debt to equity is the normal procedure in bankruptcy."

Conversion of debt to equity is the typical solution. The same solution will work for the U.S. economy. Given current conditions, it is the solution we need.

Over the last 50 years or more, the growth of debt has outpaced the growth of equity (money) at a geometric rate. An exponential rate. The immediate solution, the best way to restore the balance between debt and money, is to convert some of this debt to equity. Convert debt to money. Monetize the debt.

It is the normal solution to a recurring problem, the current problem of the U.S. economy, the currency problem. It is not a question of whether the U.S. government is technically bankrupt. The question is simply, what is the best way out of this mess?

The quickest way out is just to print money and use it to pay off debt. But it's like touching a snake, isn't it? You can't stand the thought of it.

5 comments:

The Arthurian said...

As an afterthought I will say this:

If we print money and use it to pay off existing debt, debtors get out of debt and creditors get their money back. And the newly printed money is destroyed by the repayment of debt. So everybody should be happy.

We are left with the threat of inflation from all that newly available credit. But inflation is a separate problem, and one just as easily disposed of.

Mansoor Hasan Khan said...

Arthurian,

You are close but not quite there. Think of a bank as a two column excel table. The column on the left is a list of deposits (liabilities to the bank) and the column on the right is the list of loans it has made (assets to the bank). All we have to do is print money and give it to the deposit holdesr and take the deposits from the bank and convert it to equity and give the equity to the government. The government can then sell the equity.

Also, as part of the rescue of banks should require banks to provide 100% reserve accounts as an option and then remove FDIC protection. The newly created money is 100% reserves so it can easily move to the 100% reserve accounts. Then the main question is how much inflation will this create. That depends on how many people use the non-100% reserve accounts vs. 100% reserve accounts for demand deposits and small time deposits. Remember, 100% reserve deposits cannot be leveraged (by definition). The banks may begin to leverage the non-100% reserves but if the government stops bailing out banks at that point, the next large bank failure that is not rescued will teach the public that “no more bailouts” and no FDIC insurance. This will stop the inflationary money creation by the fractional reserve lending process dead in its tracks because a large number of people will move their money to the 100% reserve accounts. Yes, there will be boom and bust cycles since people forget but these cycles will not cause a total meltdown of the payment system and the money in the 100% reserve account can be used to re-start the economy without total chaos.

The Arthurian said...

Hello Aquinum,
I am confused by your first paragraph there. Suppose I have $100 in the bank. Now the Fed prints $100 and uses it to purchase my bank-account. (Basically, I withdraw my 100.) And the Fed ends up with the bank-account money. This is as you describe: "print money and give it to the deposit holders and take the deposits from the bank..."
As for the rest of that paragraph: "...and convert it to equity and give the equity to the government. The government can then sell the equity." -- This is where I get lost!

Greg Hall said...

My question is: are we just discussing money qua currency; or, does this principal extend to treasury notes and securitized debt in general?

The Arthurian said...

Wellsir, when I use the word money, I think medium of exchange. So I am not discussing money as currency only, and not discussing treasury notes or broader measures of debt.
For me, when I say "convert debt to money" I mean "convert debt to M1 money," convert it to money-of-exchange. Greenbacks will do. But any kind of money that we don't have to pay interest for using it, will do.
For me, that interest charge is the difference between money and debt. As I see it, that charge grows with our growing reliance on credit. And as I see it, that interest charge is an additional "factor" cost that has consequences for the price level, for the rate of profit, and for the rate of economic growth.