Thanks for comments. As you may have noticed, I kept the blog shorter this week so that we could focus on a smaller range of topics. That seems to have helped—the comments this week are also well-focused. I think I can hit the main concerns by addressing three topics.

  1. Relation between the sovereign currency and the medium of exchange: We first introduced the money of account: the Dollar in the US and the Pound in the UK. This is a unit of account, a measuring unit like the “inch”, “foot” and “yard”. It does not exist even as an electronic entry; not even a bloodhound could sniff it out. It is representational, something only a human could imagine. Next we introduced the concept of “money things”—denominated in the money of account. (Similarly, our unit used to measure length cannot be sniffed by dog, but it does have physical things that can be sniffed and measured: the inch worm is an inch in length, my foot is a foot—more or less, and the football field is 100 times the distance from Henry the first’s nose to thumb. Probably more, actually, as we know those kings exaggerated the size of their anatomical features, like rap stars today.) This can include paper, notes, and electronic entries. We’ll say a lot more about the nature of those things that get measured by the money of account. This week we introduced the sovereign currency—the national money of account adopted by a sovereign government. While a money of account could—in theory—be created and adopted by private entities, the sovereign currency is adopted by the sovereign government; and the sovereign currency is usually at least the primary money of account if not the only money of account used within a sovereign nation.

    The word “currency” is frequently used to designate not only the money of account adopted by sovereign government, but also to designate a money thing issued by the sovereign government and denominated in the money of account. In the US it is the coin issued by the Treasury and the note issued by the Fed. In other words, we use the term “Dollar” to indicate both the sovereign currency (money of account) and the money thing (paper note or coin) issued by the US government. We have not yet got to the “medium of exchange”. Most textbooks begin with the medium of exchange (Crusoe and Friday look about for handy sea shells to function as convenient media of exchange). I reject that story and purposely wait to introduce the concept. But to jump ahead a bit, yes the “money thing” currency issued by government generally functions as a medium of exchange. Other privately issued money things also frequently function as media of exchange. That is a function of money things, and really does not help us to understand much about the nature of money. When you walk into a relatively new diner or any other “mom and pop” firm, there usually is a frame hanging on the wall, with a Dollar bill and some sort of statement like “the first dollar we ever earned”. Here, money functions as a memento—reflecting the pride of the owner of the establishment. Two decades ago, there were lots of stories of Wall Street traders using hundred Dollar bills functioning as cocaine delivery devices. I don’t think it is useful to put undue emphasis on the various functions of money. Let us at least first try to understand its nature.

  2. That leads us to the question about “bank money”. Again, we will get into this in detail in coming weeks. However, to break the suspense, banks (and other institutions as well as individuals) can issue IOUs denominated in the money of account. We do not call these “currency”. They are not issued by sovereign government. They are “money things”. Yes, some are more “special” than others: the IOU of the Bank of America (a private bank—not Uncle Sam’s bank) is more “special” than the IOU that you issue. Yes, it can function as a medium of exchange. The reasons for the “specialness” will be examined later. But an obvious one is that to some degree Uncle Sam stands behind BofA—for example, he guarantees demand deposits (your checking account).

    So, yes I do understand the worry that Uncle Sam has essentially licensed BofA to “counterfeit” Dollars—if the bank goes bust, Uncle Sam will pay out nice new Dollar bills to depositors. This raises many issues of concern, and some of those are directly relevant to the global financial crisis we are going through—in which Uncle Sam has effectively done just that. But for right now, that really would take us too far afield. Please be patient.

  3. Currencies and balances. Recall that we have discussed (briefly) unsold inventories. Suppose it is the end of the year 1974 and we are Ford motor company and we produce 1000 Ford Pintos (remember those—the ones with exploding gas tanks?) that we cannot sell. Unsold inventory gets counted as investment. Ford carries the inventory at its market price—let us say, the average price of Pintos that it actually did sell in 1974. Assume it cannot sell them in 1975, either (deep recession, bad publicity about the tanks, and so on). How to value them? All things equal, Ford would prefer not to book a loss of value—it carries them at original value, otherwise, the value of its inventory declines impacting 1975 profits and net worth. Now in 2011 it is still carrying those Pintos in inventory. You see the problem. We have to assign a dollar value to them.

    Now let’s address the problem of dual currencies. Suppose Ford produces cars in America but sells them in America and Japan. It imports all the electronic components from Japan. It can keep two sets of books—one for Dollars and one for Yen. It has income and outgo in each currency. Clearly it could run a deficit in one and a surplus in the other (or surpluses in both, or deficits in both, etc—you get the picture). All other firms, households, and levels of government can do the same in Dollars and Yen. Adding up all the sectors, we get to our three balances in each of the currencies. But Ford’s shareholders do not want to know that it has a surplus in Dollars of 1 billion and a deficit in Yen of 1 trillion—it wants the overall balance for Ford’s income. Just as we have to convert Pintos to Dollars, we have to convert those Yen to Dollars. We need an exchange rate. Yen and Dollars float—changing every day in relative value. It is going to make a huge difference what exchange rate we use.

    So, yes I am sympathetic to “Tobinesque’s” comments. The cleanest way is to keep the accounts separate and there will be sectoral balances in each currency that do balance. But, yes, a government as well as a firm needs a budget in one currency (generally it is going to be the domestic currency) and so if income and outgo occur in more than one, exchange rates must be used to get everything into that currency of denomination. This is true even if the government/firm/household actually has bank accounts denominated in the foreign currency. This complicates matters because now the sectoral balances will not balance (exactly) unless everyone uses the same exchange rate all the time—which would happen if we pegged.

    This issue has come up before—there are variations in estimates of the three balances. One reader pointed out that one of the graphs I used showing—say—the private deficit during the Clinton years differed a bit from a later one I showed here on the MMP. The reason was due to updated data and different sources (the older one came from Wynne Godley and the later one from Scott Fullwiler). As they say, economics is not an exact science!

    More seriously, you should not think that aggregate economic data like GDP or the CPI (consumer price index), or the sectoral balance are measured precisely. These are estimates, using data that is constructed. What is important is consistency. I know this always shocks students the first time they hear it. But the CPI does not come from heaven. It is constructed, it is revised, and it is subject to great debate among wonky people with thick glasses. And believe it or not, it does matter exactly how these data are constructed. But do not get misled by that. Certainly at the level of logic, the three balances do balance. If we could measure things exactly, they would balance in practice. Knowing that they should balance, the statistician who puts them together ensures they do balance—by construction. This is not easy; a “statistical discrepancy” is added to ensure they do—and if you need a big one of those, that is not good. And, yes, dealing with valuing those inventories is a big headache—I can remember when Wynne Godley used to fret over that, and I didn’t understand why. Now I do.