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An economic paradox?

September 5, 2009

The following letter was published in the Financial Times of London. 

It appealed to Rocky’s sensibilities:

From Mr Eric Keetch.

Sir, In a sleepy European holiday resort town in a depressed economy and therefore no visitors, there is great excitement when a wealthy Russian guest appears in the local hotel reception, announces that he intends to stay for an extended period and places a €100 note on the counter as surety while he demands to be shown the available rooms.

While he is being shown the room, the hotelier takes the €100 note round to his butcher, who is pressing for payment. The butcher in turn pays his wholesaler who, in turn, pays his farmer supplier.

The farmer takes the note round to his favourite “good time girl” to whom he owes €100 for services rendered. She, in turn, rushes round to the hotel to settle her bill for rooms provided on credit.

In the meantime, the Russian returns to the lobby, announces that no rooms are satisfactory, takes back his €100 note and leaves, never to be seen again.

No new money has been introduced into the local economy, but everyone’s debts have been settled. Is this “quantitative easing”?

Eric Keetch,
London W4, UK

Source: http://www.ft.com/cms/s/0/2536287a-86d7-11de-9e8e-00144feabdc0.html?nclick_check=1

 

[Disclosure: Consistent with Rocky’s past practice, any reader who can identify the logical flaw in the above, should contact Rocky and claim a prize of dubious monetary value.]

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  1. allocator
    September 6, 2009 at 9:25 am

    THe hotelier is now out 100 euro because the net effect is that he has cancelled the “good-time girl’s” debt – he does not actually receive the 100 euro as the Russian takes it back. But, he CAN write it off as a marketing expense, since our “good time girl” presumably introduces many new prospective patrons to the hotel.

  2. September 6, 2009 at 10:35 am

    George: Good job! That is one of several possible right answers. (Please send an email to rocky at rockyhumbert.com and provide the delivery address for your prize of dubious monetary value.)

    The hotelier is indeed out 100 euros. However, another thing which may be missing from this allegory is that all of the previous credit was extended by non-financial institutions and there may have been no money supply. When a bank takes deposits and makes loans, there should be a money multiplier effect… In this example, there was a fixed amount of credit in “the system.” If the Russian had forgotten to pick up his 100 Euros (or left it on the counter for long enough,) the money supply would have increased by 100 Euros, and at the end of the daisy chain, someone would have been left with 100 Euros to spend or invest/lend (i.e. the entity that made the original loan). That does not happen here.

  3. MDan
    September 6, 2009 at 10:50 am

    George, you’re forgetting that the hotelier has also payed his debt to the butcher.

    Everybody in the town owed and was owed 100$, which means that everybody was solvent. They only had a liquidity problem because they didn’t have physical cash to move around and settle the debt circle.

    Once the Russian’s cash completed a full circle around the town, everybody’s debt was settled. The money could then be taken out because the town did not have any debt (as in, the town as a whole did not owe money to anyone).

    This looks pretty straightforward and, to be honest, I don’t see where the paradox or flaw in logic resides.

    Of course, comparing this to the real world of banking would be a flaw in logic, because the banking system, unlike our hypothetical town, does have some serious debt (as in, it owes a lot of people a lot of money).

  4. MDan
    September 6, 2009 at 10:53 am

    @Rocky: You’re wrong. Nobody is out 100€.

  5. MDan
    September 6, 2009 at 11:00 am

    @Rocky: You’re also wrong when saying that the town did not exhibit a money multiplier effect. In fact, the multiplier was infinite.

    Think of it this way: everybody was able to lend out just as much money as they attracted. They weren’t forced to keep, say, 10€ as reserve in the way banks are forced to. This means that the fractional reserve rate was 0%. Considering the money multiplier is equal to 1/fractional reserve rate, the result is infinite.

  6. September 6, 2009 at 11:09 am

    MDan: I understand what you mean about the hotelier settling his debt to the butcher… however, he has to come up with a 100E note somewhere… to give back to the Russian … so he needs to borrow 100E from somewhere. So, while you are right that he settled his debt, he’s the only one that owes someone money at the end of the day…

    The paradox/flaw is that this process reduced debt/credit in the system. The objective of quantitative easing is to increase lending and money velocity … not the opposite.

    On your point of fractional reserves, your point is taken — however, if someone engages in barter, are there credit effects?
    Rocky

    p.s. Thanks for your comment — even if you disagree with Rocky!

  7. MDan
    September 6, 2009 at 11:23 am

    Rocky, the Russian gave the hotelier 100€. The note switched a few hands and landed back on the hotelier’s desk, from where the Russian took it back. There is no flaw in logic.

    All of the debt was circular among the people in the town. That’s why nobody owes money at the end of the day: because everybody owed as much as they were owed, meaning the net debt was zero. No debt was reduced because there was no debt to begin with.

    The system only needed cash that could move around and settle the debt.

    In regards to your question about barter, I’ll have to admit that I have no idea.

  8. MDan
    September 6, 2009 at 11:25 am

    Rocky, I love debates, especially if I’m winning them.

  9. September 6, 2009 at 11:37 am

    MDan: Again, your point is taken. EXCEPT that Rocky assumes that the cycle continues — past the end of the story — and that the 100E note continued to float around the town…extinguishing debts between counterparties. Whichever entity originally lent E100 (Rocky assumed perhaps incorrectly, that it is the hotel) that party is worse off — because it now (speaking as a bank) has an asset but no liability.

    If there was no debt originally (and you assume that is the case) — and there is no debt now; then absolutely nothing has changed — and all that happened was a netting agreement among a daisy chain of counterparties. But that is neither a credit creating or a credit destroying event. It was just a netting off. That is not quantitative easing either. Right?

  10. September 6, 2009 at 11:42 am

    MDan:
    Here’s the paradox… if you believe that there was an infinite money multiplier originally when the transactions were openend … then the closing transactions should be opposite and cause a reverse infinite multiplier/collapse of money and credit.

    However, you claim that everything is the same as when the process began… because “there was no debt to begin with.”

    How do you reconcile the two statements?

  11. MDan
    September 6, 2009 at 12:23 pm

    Rocky, the whole story does not illustrate what quantitative easing is (because, simply put, QE = low interest rates + REPO), but rather what it’s effects are.

    Of course one player is disadvantaged (the Russian, or the Central Bank), because he is the one that lends money to the entire system.

    You are correct when saying that, when looking at the town as a whole, nothing has changed. But you are missing the point.

    Try to think of it in terms of banks. A situation in which all of the banks owe large ammounts of money to each other and they also experience a lack of liquidity is very similar to the initial state of the town. Once the Central Bank comes in and lends (or REPO’s) some money into the system, the banks can quickly circulate the money through the daisy chain and settle the outstanding debt among themselves.

    In the end, the money gets back to the Central Bank.

    If you look at the banking system as a whole, then nothing has changed. The system still has the same liabilites/assets in regards to the outside. However, the banks have cancelled the ‘intra-bank’ debt.

    Apparently, there is no benefit. But try to look at it from an individual bank’s perspective. If you had 100$ in liabilities and 100$ in assets, out of which 50/50 was against other banks at the start of the story, than at the end of the story you would stand at 50$ in liabilities and 50$ in assets.

    If your capital was 5$, then your liquidity ratio has just increased from 5% to 10%. Voila, you can lend money again.

    Again, QE simply means very low interest rates + REPO. However, what I have just described is the effect that I have the impression that Central Banks have been trying to obtain through QE in the wake of the financial crysis.

    Sorry if I wasn’t able to express myself clearly, but English is not my native language 🙂

  12. MDan
    September 6, 2009 at 12:42 pm

    There also is another more simple way in which QE helps improve the financial ratios of the banks: if you are a bank with 100$ in assets and 100$ in liabilities and 5$ capital, your liquidity ratio is very low at 5%.

    If the Central Bank comes in and REPO’s 20$ worth of treasuries from you, then you can repay 20$ of debt from that money. This will leave you at 80/80$ and 5$ capital. Fundamentally, your net debt is the same, but your liquidity ratio has just improved to 6.25%.

  13. September 6, 2009 at 12:57 pm

    MDan – thank you very much for your comments. Much appreciated.

    Your IP address is either from Amsterdam or Bucharest. In either case, your English is excellent!

    Cheers
    Rocky

  14. MDan
    September 6, 2009 at 1:09 pm

    Rocky, I’m from Romania.

    Does that make me eligible for your prize of dubious monetary value? 🙂

    Cheers!

  15. September 6, 2009 at 2:58 pm

    Someone once said,”economics is the only field in which two people can get a Nobel Prize for saying exactly the opposite thing”.

  16. allocator
    September 7, 2009 at 12:09 am

    MDan,

    The hotelier is out 100 euro in cash because he paid the butcher, but that has no effect on the income statement – as it was a balance sheet transaction where an asset offset a liability.

    The “good-time girl” is another matter. He cancelled her debt, but did not receive the cash, so he has to expense the loss somewhere.

    Vis a vis his banker, much better to call it a marketing expense that cries out “savvy businessman in touch with his market” than a bad debt that suggests “dumb-ass who doesn’t know how to manage risk”. 🙂

    Cheers,
    George

  17. MDan
    September 7, 2009 at 6:48 am

    George, the hotelier ‘borrowed’ 100 eur from the Russian, which he used to pay his butcher and, in the end, he got back from girl. The hotelier then paid back the Russion. He wasn’t duped.

  18. September 7, 2009 at 8:10 am

    Rocky shared a pitcher of frozen margaritas with a former central bank economist last night. Here’s the economist’s observations:

    1) This is most definitely NOT quantitative easing — which is designed to increase money supply. The Russian is not a Central Bank and so he cannot create money (technically defined). Unless he is a counterfeiter, the 100E note has no effect on money supply. Nor does the transactions between the business people. Only private and central banks can create/destroy money. This last sentence is key!

    2 This is a credit destruction event. The Hotelier can extend credit to the butcher. But the hotelier cannot give an IOU to the butcher which will be accepted as payment by the farmer. That would be “money” creation, and is the province of banks, not commercial businesses.

    3) The economist accepts MDan’s point in Comment #11 that shrinking a bank’s constrained balance sheet can be a good thing — if lending is being constrained by a shortage of bank capital. HOWEVER, this argument (applied to the story) has two problems. First, as stated in the previous paragraphs, these participants are not banks. And secondly, in a tight credit environment, once you lose your counterparty credit, you may have a hard time re-establishing it. So, the elimination of credit that is occurring here could actually be viewed as a net negative to the participants — if they are unable to re-establish their credit.

  19. September 7, 2009 at 11:45 am

    Fakename is disappointed that she came to this discussion so late, when the right and wrong answers (which are often both at the same time) had already been advanced. Now it would be cheating for her to espouse a viewpoint. She still wants to know whether or not the prize consists of a dubious 100-Euro bill, or a dubious 100-dollar bill.

  20. September 7, 2009 at 9:35 pm

    Rocky just shipped George his prize of dubious monetary value. If MDan will privately send ( rocky at rockyhumbert.com ) his snail mail address, he too will receive his justly earned swag. Fakename: “if you don’t do the crime, you don’t get the time.”

  21. ld
    September 7, 2009 at 10:02 pm

    Rocky – My humble points below:
    1) Many Americans would have no clue what this whole conversation was all about yet it impacts our lives with forces so real. I cannot help but feel terrible for those of us earning a fixed pay each year accounted in the unit of measure subject fluctuation due to so many factors one of which happens to be this complex concept of “quantitative easing” (words created to obfuscate the subject matter by making it more technical than necessary). Creation of money ex nihilo is incomprehensible to those having to work like slaves every days for their daily bread.
    2) The example did not account for the Patriot Act impact and the Russian having to prove that his bill was earned through legitimate means. A gold dealer asking for identification due to the Patriot Act seems to be a breach of basic rights to privacy in the name of security. Did the article mention if all these folks ended up on some FBI watch list due to their transactions?
    3) This reminded me of http://en.wikipedia.org/wiki/Parable_of_the_broken_window
    4) “A well regulated [credit] system being necessary to the security of a free State, the right of the People to keep and bear [debt] shall not be infringed.” Think about this one as it’s the bedrock of the modern financial system. I struggle to understand how a free representative democracy like ours would allow itself to be mortgaged to oblivion… but then again it takes something [in our case dollars created ex nihilo] [even in a barter system] to suck down the natural resources of the rest of the world.
    5) The money supply does not increase no matter what the central, commercial, or any bank does unless Samuel Joseph Wurzelbacher [or any other Joe] [no Joe mentioned in the article] feels compelled to and is able to borrow more. The reserves can be plenty big but the money doesn’t multiply until the average Joe jumps in. This is how people put their signature on the dotted line of the central bank policy [social contract].
    6) I cannot believe the story failed to mention that money creation and quantitative easing are necessary for the hotelier, the good time girl, the butcher and the average Joe to live happy lives the way things are today.
    7) Rocky continues to amaze/amuse with his perfect posts and comments.

  22. September 8, 2009 at 8:05 am

    LD: Thank you for your thoughtful and interesting comments. Especially, thank you for any and all complements (item #7).

    Your item #1 is a subtle reminder that policy-makers should heed asset-price changes (including currency prices), or markets will set the agenda in a most forceful way. Rocky’s suspicion is that gold prices may be sending an early warning signal on this dangerous point….

  23. MDan
    September 12, 2009 at 8:41 am

    Rocky, I sent you an e-mail but it probably got filtered out by your spam filter. Can you please just use the e-mail adress I used in the comment form?

  24. September 12, 2009 at 9:35 am

    MDan: Rocky just sent you an email…

  25. allocator
    September 14, 2009 at 5:14 pm

    I just received my prize of dubious monetary value, and, as advertised, it was over and above dubious, beyond the call. 🙂

    My thanks to you Mr. Humbert.

    Cheers,
    George

  26. September 14, 2009 at 5:19 pm

    George:
    As Eddie Murphy (aka Special Agent Orange) would say, “Please keep the prize hush,hush super secret.” Otherwise you might have to declare the prize as income on your tax return. 😉

    You gotta admit that it is indeed a “Unique” prize of dubious monetary value, though!

  27. September 14, 2009 at 5:23 pm

    Isn’t the saying supposed to be “beyond the pale”?

  28. September 14, 2009 at 5:24 pm

    Fakename: Not for lagers. Only for stout. (He’s Canadian, after all.)

  29. September 14, 2009 at 5:34 pm

    Well that explains it.

  1. September 7, 2009 at 2:15 pm
  2. September 10, 2009 at 9:33 pm
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