Category Archives: sections

Meta-category for grouping categories on the nav menu.

Who are the big carbon emitters?

Earlier this week, @pureandapplied brought to my attention the emissions data that has been published by the Department of Climate Change in Australia. Their report comprises data for the 2008-09 reporting year provided to the Greenhouse and Energy Data Officer by corporations whose greenhouse gas emissions exceeded 125 kilotonnes*. A few corporations are missing from the list for a number of reasons, including failure to provide their data in time for the report’s publication (a sorry excuse indeed). Nevertheless, the data makes for some interesting reading. As @pureandapplied remarked, for example, Qantas was responsible for more emissions than Shell: those air points are producing a lot of CO2-equivalent emissions!

The data is reported in two categories, “Scope 1” and “Scope 2” emissions. The definitions of the two scopes are as follows:

Scope 1 emissions are the release of greenhouse gases into the atmosphere because of activities at a facility that is controlled by the corporation. An example of this would be gases emitted by burning coal to generate electricity at an electricity production facility (i.e. a power station).

Scope 2 emissions in relation to a facility, are the release of greenhouse gases emitted at a second facility because of the electricity, heating, cooling or steam that is consumed at the facility. An example of this would be greenhouse gases emitted to generate electricity, which is then transmitted to a car factory and used there to power the car factory’s lighting. The greenhouse gas emissions are part of the factory’s scope 2 emissions. It is important to recognise that scope 2 emissions from one facility are part of the scope 1 emissions from another facility.

The report is very careful to note that these two scopes should be used warily. In fact, it warns that the two figures “should not be used individually, or added together” to estimate liabilities under any emissions abatement scheme. That is a red rag to a Mule, so I will indeed look at them individually and added together. The chart below shows the top 25 emitters in the Scope 1 category.

Top 25 Scope 1 Emitters

It should come as no surprise that the big Scope 1 emitters are primarily power generators, although there are a number of mining companies in there, along with Qantas thanks to its burning of jet fuel. Scope 2 tells a somewhat different story.

Top 25 Scope 2 Emitters

Here “poles and wires” make an appearance: Transgrid and the like, move energy from place to place that has been generated elsewhere. So, the Scope 1 emissions are counted by the generator, but the tranmission company wears the Scope 2 emissions. Woolworths manages an impressive fifth place, perhaps thanks to the lights in all of their supermarkets? Wesfarmers, the owners of the Coles supermarket chain, rank higher still.

Finally, here are the top 25 emitters by the combined total of Scope 1 and Scope 2 emissions. Not surprisingly, the generators dominate once more.

Top 25 Scope 1+2 Emitters

Also included in the data is the total amount of energy consumed by each corporation. It is in these numbers that I stumbled upon something of a puzzle. Envestra produced a reasonably sizeable 627,161 tonnes of Scope 2 CO2-equivalent, but had one of the lowest levels of total energy consumption at only 193 GJ. What have they been up to? Guesses are welcome!

* Also included are those corporations holding a reporting transfer certificate.

Mule Stable demo video

5 Replies

Last weekend, the Mule Stable* was launched as a forum for discussions that may tie in to topics here on the Stubborn Mule, and then again may not. A number of discussion groups have already been set up there, including groups on modern monetary theory (aka chartalism), economics, and politics.

For anyone already familiar with the twitter social network, finding your way around the Stable will be breeze. But for those less familiar with the conventions, here is an introductory video showing you how to get started on the Stable. Keep an eye out for more videos explaining more advance tips and tricks you can use at the Stable, and don’t forget to sign up and join in!

If you are finding this video a bit too small, there is a larger screen version.

* Thanks again to the StatusNet developers responsible for the software that powers the Stable.

Junk Charts #3 – US Business Lending

10 Replies

Today’s “Chart of the Day” from Business Insider’s Clusterstock blog presents an alarming picture of the US economy viewed through the prism of bank business lending. The chart, which I have reproduced below, shows a precipitous collapse in lending*, described in dramatic language as “falling like a knife”. There is no doubt that the US economy remains in very poor health, but should we be getting as excited as Clusterstock?

Annual Change in US Commercial and Industrial Loans

Closer examination of the chart reveals that it is in fact quite misleading.

For a start, it makes the very common mistake of plotting a long series of data without adjusting for the fact that over time the value of the dollar has declined through inflation and the US economy has grown. As a result, more recent movements in the data take on an exaggerated scale.

Also, the chart shows annual changes without providing any sense of the base level of lending. Not only that, while attention is drawn to the US $300 billion annual decline in lending, the increase of close to US $300 billion just over a year earlier is ignored, when in fact the two largely offset one another. Certainly lending has declined, but rather than taking us into historically unprecedented territory, as the Clusterstock chart suggests, it actually means loan volumes are back to where they were in late 2007.

Both shortcomings are addressed in the chart below, which shows the history of loan volumes themselves rather than annual changes and overlays a series scaled by the gross domestic product (GDP) of the US to represent lending in “2010 equivalent” dollars.

US Commercial and Industrial Loans

Changes in lending do provide a useful reading of an economy’s health. But, it is important to be careful when using annual changes to read its current state. The change from January 2009 to January 2010 is affected just as much by what happened a year ago as by what happened last month. Since monthly data is available, we can in fact look at changes over a shorter period. The charts below show monthly changes, which are probably a little too volatile, and quarterly changes which are probably the best compromise. Since these charts extend only over a five year period, it is not as important to adjust for changes in the value of the dollar and the size of the economy.

Monthly Changes in US Commercial and Industrial Loans

Quarterly Changes in US Commercial and Industrial Loans

Both of these charts reveal an economy that certainly remains unhealthy and lending volumes are still declining. However, the declines of the last couple of years evidently reflect an unwinding of the enormous increases of a few years earlier. So rather than fretting that lending is “falling like a knife”, we can take some comfort from the fact that the rate of decline is diminishing from the worst point of the third quarter of 2009. The moral of the story is that charts can mislead as easily as words and should always be treated with caution.

* The data is sourced from the St Louis Fed “FRED” economic database.

Blame Greece’s Debt Crisis on the Euro

11 Replies

The shadow finance minister, Barnaby Joyce, has been waxing hysterical of late about Australia’s “unsustainable” public debt. This is not a new line to take in Australian politics. Last year when the then leader of the opposition, Malcolm Turnbull, began attacking the government’s stimulus package, I argued in “Park the Debt Truck” that there was very little reason to be worried about Australia’s public debt.

This phobia of government debt is not unique to Australia. In the US, national debt is one of the primary bug-bears of the “Tea Party movement” that emerged in 2009. Widespread concern about government borrowing is helped along by the sort of simplistic fear-mongering evident in the so-called “debt clock” (and yes, I am aggrieved to say, there is an Australian version of the debt clock).

The catalyst for the current focus on sovereign debt is the crisis faced by Greece. Stimulus spending to combat the economic fall-out of the global financial crisis has led to significant growth in government debt around the world, prompting fears that Spain, Portugal, Ireland or even the United Kingdom or the United States will be the “next Greece”. This week, Business Insider published what it dubbed “the real list of countries on the verge of sovereign default”. Sourcing its information from a Credit Suisse paper via the FT Alphaville blog, they rank United States government debt as riskier than Estonian debt. That alone should raise eyebrows and suggests that Credit Suisse needs to join Barnaby Joyce in some remedial lessons in economics.

The basis of Credit Suisse’s sovereign risk ranking is mysterious. It supposedly takes into account, amongst other things, the market pricing of credit default swaps (CDS). However, they are clearly not listening too closely to the market, otherwise Argentina would be at the top of their list and the United States at the bottom (the chart below shows the actual Credit Suisse ranking). Of course, the market is not always right: just look at the tech bubble or the US housing bubble. Indeed, I know of one person working in the markets who refers to sovereign credit default swaps as a device for “taking money from stupid people and giving it to smart people”, so perhaps Credit Suisse are right not to put too much weight on these prices.

Credit Suisse Sovereign Risk Ranking*

It would appear that Credit Suisse is primarily concerned about the amount of public debt each country has (although if this was the sole criterion, Italy would rank above Greece).

Many who fret about the risk of government debt appeal to an analogy with a household budget. Just as you and I should not live beyond our means and put more on the credit card than we can afford to repay, so the government should not spend more than it earns in the form of tax. This analogy is simple and compelling. However, just as H. L. Mencken once wrote, “For every problem, there is one solution which is simple, neat and wrong,” this analogy is simple neat and wrong. The circumstances of the government are fundamentally different from yours or mine.

In “How Money Works” I explained the difference between money which derives its value from being convertible to something else, such as gold or US dollars, and “fiat money” for which there is no convertibility commitment. As I wrote in that post,

However, in a country with fiat money, the central bank makes no convertibility commitments…It has monopoly power in the creation of currency. So, the government simply cannot run out of money.

The United States, United Kingdom and Australia are all examples of countries with fiat money with floating exchange rates. None of these countries can ever be forced into default. Contrary to the alarmists, none of these countries are reliant on China (or anywhere else) for their money. Here is a simple thought experiment: when China “lends” the US government money by buying Treasury bonds, where does that money come from to buy the bonds? From US dollar mines by the Yangtzee river? No. All of the money comes from China taking US dollars as payment for their exports. So China is “lending” the US government money that was all created in the United States in the first place. While any of these countries could decide for political reasons not to repay their debt, that is extremely unlikely in current circumstances. So the United States, United Kingdom and Australia and indeed many other countries with fiat money and free-floating exchange rates should all be considered to pose an extremely remote risk of sovereign default.

But what about Greece? Unfortunately for the Greek government, ever since they joined the European monetary union and adopted the euro as their currency, they lost the power to create their own money. While the US government cannot run out of dollars, the Greek government certainly can run out of euros. To make matters worse, they are subject to the tight controls of the Growth and Stability Pact as part of the Maastricht Treaty which severely restricts their ability to use the sorts of stimulus measures Australia, the United States and others have turned to in the face of economic downturn. In fact, their national debt levels are already well over the Pact maximum of 60% of their gross domestic product.

Like the other members of the monetary union, Greece is effectively operating on a gold standard only substituting euros for gold. In A Tract on Monetary Reform, John Maynard Keynes referred to the gold standard as a “barbarous relic” and the European Union is now learning how right he was. They adopted a common currency with an eye on the benefits of streamlining commerce between member countries, but without understanding the implications for times of economic crisis. The Union is now in a bind: do they allow Greece to fail, only to see Portugal, Spain and others tumble in its wake? Or do they ignore the rules of the Pact and bail Greece out, a course of action which would doubtless leave Ireland feeling that their fiscal austerity measures were an unnecessary hardship? In all likelihood, they will find a way to dress up a rescue package with all sorts of tough language and pretend that the union is as strong as ever. The fact remains, that the euro is the real reason Greece finds itself facing a debt crisis.

But what of Estonia being less risky than the United States? The Estonian kroon is pegged to the euro, so despite not yet being part of the European currency union, Estonia has chosen to give up sovereign control of its currency. As long it goes down this path, Estonian government debt has to be considered a far riskier proposition than US government debt. Clearly Credit Suisse’s sovereign risk analyst does not understand this. Little wonder it is lost on Barnaby Joyce.

* India, which ranks between Egypt and Italy, is not shown in the chart because no CDS data is provided. The “CDS spread” represents the annual cost of buying protection against an event of default. This cost is measured in basis points (1 basis point = 1/100th of a percentage point). For example, in the chart above, the CDS Spread for Australia is reported as 50 basis points (i.e. 0.5%). This means that to buy protection against default on $100 million of Australian government bonds would cost $500,000 each year. A typical credit default swap runs for five years.

The Mule on Mortgages

No hiding the cost of emissions reduction

6 Replies

In today’s Sydney Morning Herald, Ross Gittins has an opinion piece entitled Mealy-mouthed pollies see voters as a bunch of suckers. In it he argues that politicians are not to be believed when they start talking about taxes: they are more interested in playing issues for their electoral effect than actually saying what they believe about a tax. After all, if Labor really believed all their arguments against the goods and services tax (GST) back in the days of Kim Beazley‘s 2001 “Rollback” campaign, wouldn’t you expect to hear something from the current Labor government about the GST?

Perhaps this goes some way to explain why no politician in Australia is brave enough to enunciate the unavoidable fact that if, as a nation, we want to reduce carbon emissions, there will be a cost.

This is true regardless of whether your scheme of choice be Labor’s proposed emissions trading scheme (ETS), a carbon tax or the latest offering from the coalition, an emissions reduction fund. The reason is simple. The bulk of Australia’s power generation is sourced from coal-burning power-stations and this is because coal is cheaper than any other source, including natural gas, solar, wind or geothermal. Achieving a meaningful reduction in Australia’s carbon emissions will require a gradual phasing out of coal-burning power stations, replacing those reaching the end of their life with generators using more expensive alternative sources. Ultimately someone, somewhere must bear this cost if the shift is to occur.

Some would argue that “the big polluters have to pay”. That is easier said than done: these polluters would want to preserve their profit margins and so in practice any additional costs imposed on power generators and other industrial polluters would be passed directly on to their customers anyway.

Others would prefer to rely on people opting to reduce their own emissions. One avenue for this currently open to Australians is provided by the GreenPower program. Established by Commonwealth Government in 1997, GreenPower allows energy retailers to provide their customers with an accredited “green” option. This allows households and businesses to buy some or all of their power from lower emission generation sources. Needless to say, these options cost more than the standard offering. According to the 2008 GreenPower audit, 947,268 customers were using a GreenPower product, representing around 10% of Australian households. While this may appear at first glance to be an impressive take-up in 10 years, digging into the figures a little deeper gives a different picture. For many of the retailers, close to 90% of the retail customers have elected to buy the cheapest GreenPower product which only sources 10% of the householder’s power from alternative sources. For businesses the number using the 10% option is even higher. So, relying on customer choice alone, the GreenPower program has only resulted in a shift to lower emission sources of about 1 or 2%.

Both emission trading schemes and carbon taxes aim to provide a far bigger shift by closing the price gap between cheap but carbon-intensive power sources and the more expensive alternatives. Economically the key difference between a tax and a trading scheme is that the cost of carbon imposed by a tax is fixed by the government, while the price imposed by a trading scheme would vary with supply and demand.

Most economists are attracted to trading schemes, pointing out that the problem with a tax aimed at reducing emissions is that you do not know how high to set the tax to get a desired reduction in emissions. While government can progressively tweak the tax to get to the target, it still requires significant guesswork. In contrast, under a trading scheme, the emissions target can be set in advance and then an appropriate number of “emissions permits” are issued (at which point, some environmentalists get queasy at the thought of providing business with the right to pollute, but that is an emotional distraction). These permits can be bought and sold, so any polluters unable to reduce their emissions to the level of the number of permits they have can purchase additional permits from others who can achieve greater reductions. In the process, the price should automatically adjust (thanks to the famous–or infamous–invisible hand of markets) to a level that achieves the desired reduction target. Any emissions not backed by permits are subject to punitive financial penalties set at a sufficiently high level to make the purchase of permits preferable.

For carbon taxes the price is known in advance, but the amount of reduction achieved is unknown. For a trading scheme, the reduction is known in advance, but the price is not.

That is the theory at least. In practice, both approaches have enormous practical complexities, not least the challenges of monitoring compliance. Furthermore, the trading scheme proposed by the Labor government, known as the Carbon Pollution Reduction Scheme (CPRS), is not quite as pure a trading model as economists would like since it comes with a price cap. This means that, while the market is allowed to determine the price of carbon, the price cannot trade above a pre-determined level. Under the proposal, the cap would be set at $40 per ton of carbon for the first few years. This means that if the market price of emissions was in fact higher than $40 per ton, the CPRS scheme would in fact operate more like a fixed-price carbon tax.

As for the coalition’s reduction fund, it resembles a carbon tax approach to some extent in that it does not impose a particular emissions target. But the key difference between the reduction fund and either a carbon tax or a trading scheme is that it would be up to the government to determine the most promising approaches to reducing emissions and offering financial inducements to pursue these approaches. So it involves the government “picking winners”, to use a phrase favoured by free-market enthusiasts who consider markets far more efficient than governments at making decisions about allocation of scarce resources and, presumably, the best approach to dealing with climate change. To see the Labor government advocating a market solution and the Liberal/National Party coalition advocating a government-led approach is perhaps the most peculiar aspect of the current climate change debate.

While there are many reasonable discussions that could be had about the relative merits of all of these schemes, sadly the debate driven by the politicians is far more likely to be which scheme is or is not a “great big new tax”. The fact that a trading scheme is not a carbon tax does not somehow mean than taxpayers and other consumers will not end up paying for the emissions reductions. Equally, the money in a reduction fund has to come from somewhere and, since the scheme is being advocated by a party with a deep-rooted fear of government deficits, it is safe to say that it will come from increased taxes, reduced public spending elsewhere or a combination of the two. Again, someone will pay.

The last Federal election and opinion polls held before and since then all suggest that, recent visits by Lord Monckton notwithstanding, the majority of Australians want something to be done about reducing our country’s emissions. Is it too much to ask of our politicians to stop shouting “It’s a tax!”, “No it’s not a tax, yours is!”? I hope it is not, but in the process, everyone else has to accept the fact that reducing our emissions will come at a cost and do not believe any politician who tries to claim otherwise.

Carly’s Law

6 Replies

Fifteen-year-old South Australian Carly Ryan was murdered in 2007. The 50-year-old man found guilty of her murder had used fabricated online identities to attempt to seduce the girl and, when she ultimately rejected his advances, he used another identity to lure her to a beach-side town where he bashed and drowned her.

Independent South Australian senator Nick Xenophon now intends to introduce a private member’s bill which would make it an offence for an adult to misrepresent their age online for the purpose of meeting minors. Carly’s mother, who plans to establish a foundation to promote awareness of the risks children face online, has said she supports the bill.

The story of Carly Ryan is terrible. Just hearing the story triggers a shiver of disgust and horror and those who are parents themselves may well be worrying about the risks posed to their own children by shadowy online stalkers. Politicians are human too and react the same way. Indeed Nick Xenophon’s reaction follows a common pattern that has emerged around the world in recent decades.

The pattern starts with a terrible crime committed against a child. This is followed by extensive and sometimes lurid media coverage. A politician will then call for new laws to “prevent this happening to others”. It would be a brave politician who would argue against such a law and thereby risk appearing insensitive to the plight of the victim and the grief of their distraught family. So they do not oppose it and new laws are passed. The pattern is clearest in the United States. The archetypal example is Megan’s Law. In 1994 seven-year-old Megan Kanka was raped and murdered by a repeat sexual offender. Her name has since been attached to laws introduced across the country requiring a public register of sex offenders. Other examples fitting the pattern include Jessica’s Law in Florida which imposes a minimum 25-year sentence on sex offenders. Nick Xenophon’s “Carly’s Law” could well be another in this sequence.

But, how effective are laws like this in curbing the criminal behaviour they are targeting? Continue reading →

Left, Right and Climate Change

23 Replies

In the wake of the singularly unproductive COP15 Climate Change conference in Copenhagen, I have been reflecting on the polarisation of views on climate change along political lines. Whether or not human activity is leading to climate change is a question of scientific fact: it is either happening or it is not. So knowing someone’s politics should not help to predict their attitudes towards climate change, and yet it does.

It is not conclusive of course. Most people do believe that climate change is occurring and this includes people of a full range of political views. But, climate change skeptics seem to sit overwhelmingly on the right side of the political spectrum, while those most concerned about the effects of climate change are largely left of centre. Why is this?

Some would offer conspiracy theories to explain the dichotomy. The Australian Liberal senator Nick Minchin is an outspoken critic of climate change and in November last year he claimed that the left has been intentionally stirring up fears about global warming. While his comments elicited a storm of angry responses, including from his then party leader, Malcolm Turnbull, these views are widely held among skeptics. Indeed the controversy about climate change within the Liberal Party and its coalition partner the National Party was an important contributing factor to the downfall of Turnbull from his leadership position a few weeks later. For another conspiratorial slant, Ian Plimer regularly argues that academics are pushing the idea of climate change simply to help boost their research grant money.

Continue reading →

Banks, Central Banks and Money

7 Replies

One misconception about the mechanics of money that I mentioned in my last post is the idea that banks can hoard their reserves at the central bank* rather than lending them out.

Here I will explain why this idea simply does not make sense, but no more casinos and gaming chips. No more senior croupiers and casino cashiers. I will dispense with the metaphor and instead stick to a more prosaic explanation, looking at interactions between banks and central banks.

All banks have their own accounts with the central bank. Often these are called “reserve accounts”, although in Australia they are called “exchange settlement accounts” (ESAs). As the Australian terminology suggests, the primary function of these accounts is to facilitate settlement of transactions that take place between banks. To keep it simple here, I will stick to the terminology of “reserve accounts”.

To see how this works, imagine I make a $100 purchase from a shop on my credit card. If the shop banks with the same bank as I do, all that happens is that our bank increases the balance of my credit card by $100 and also increases the balance in the shop’s bank account by $100. With a couple of simple accounting entries and no movement of any physical currency, the transaction is complete. In fact, as was discussed in the casino money post, this simultaneous $100 loan advance to me and $100 deposit raising for the shop has effectively “created” an additional $100 of money in the economy that was not there before.

Continue reading →

How Money Works

31 Replies

Over the last couple of years as the global financial crisis unfolded, a subject I have spent a lot of time thinking about is the nature of money. I have been planning a blog post on the topic and the time has finally come.

The catalyst for finally writing this post was attending last week’s 16th national conference on unemployment at the University of Newcastle, hosted by the Centre of Full Employment and Equity (CofFEE). I found myself there because the centre’s director, Professor Bill Mitchell, is the author of billy blog, which I read regularly. Bill’s research and advocacy in the area of unemployment and underemployment is firmly rooted in a detailed understanding of how money works in a modern economy (hence the appeal for me) and the implications these mechanics have for government spending policy. This theme also underpinned many of the talks at the conference and the program included a panel discussion on the subject of “Modern Monetary Theory”. The panel comprised Bill Mitchell, Randy Wray and Warren Mosler, all strong advocates of what is sometimes referred to as “chartalism”. Along with another billy blog regular, Ramanan, I was invited to participate by providing a brief wrap-up at the end of the discussion.

But how hard can it really be to understand how money works? You earn it and you spend it or save it. Or, as the textbooks would have it, money serves as both a medium of exchange and a store of wealth. Is there anything more to say?

In fact there is. Most people and, indeed, many economists have not given very much thought to the mechanics of money and this leads to a number of misconceptions, all of which have made frequent appearances in the press and in political debate around the world over the course of the financial crisis. One example is the suggestion that the UK government could run out of money, an idea given further credence by the decision of rating agency Standard & Poor’s to put the UK’s rating on “negative outlook”. Even Barack Obama seems to be saying that the US is running out of money. The fact is, governments in many developed countries simply cannot run out of money. China could (but it is very unlikely) and so could member states of the European Monetary Union, but the US, UK, Japan and Australia could not. I will explain why here. In later posts I will continue the theme of the mechanics of money and will look at other misconceptions such as the idea that banks can “hoard” their reserves at central banks or that government deficits inexorably lead to high interest rates (the short answer to this one is: look at Japan).

In this post I will start with the basics of how money works and cover the following points:

how lending can “create” money
the limits to money creation
the difference between “fiat” money and money that is convertible on demand

A useful parallel to money in a real economy can be found in gaming chips in a casino. So, imagine a fairly standard sort of casino. You walk in, James Bond-style, hand over a thousand dollars to the cashier and get a pile of chips in return. The chips are marked with various denominations and total one thousand. This is an old-fashioned sort of casino: every game is played on a green felt table, there is not a poker machine in sight and, of course, you need your chips to play. To make your stay easy, you can also use your chips to buy drinks and snacks. When you have finished your evening’s play, you can redeem any chips you have not gambled away for cash.

There might be hundreds of thousands of dollars worth of chips circulating around the casino, but so far behind every chip is a corresponding amount of money sitting in the cashier’s safe. If we call this money the casino’s “reserves”, then the chip supply in circulation around the tables is equal to the casino’s dollar reserves. Of course, there might be a few cases of chips in the croupier’s office and even a chip-pressing machine in the basement, but these chips are not yet in circulation. They are just waiting to be handed over to the next patron who walks in the door with a full wallet. Under this regime, every gambler can be completely certain that they will be able to redeem their winnings at the end of the night.

While your thousand dollar stake might seem like a lot, there are a few high-rollers who frequent the place who like to play with much larger sums. Rather than producing chips with very high denominations, this casino has introduced convenient “smart chip cards”. High rollers can pay the cashier as much money as they like and the cashier will add it to the virtual chip balance on their smart cards. At every gaming table, the croupier has a card reader which can be used to debit the balance on the card in return for actual chips. This means that the total chip supply in circulation is the sum of actual chips and virtual chip balances on the smart cards. But still, this chip supply is matched by money in the cashier’s safe.

Now suppose you are a trusted regular at the casino and one night you turn up short of cash. No problem, the casino is happy to advance you your thousand dollars in return for a quickly scribbled IOU with your signature. Your credit is good. You take your $1,000-worth of chips and walk to the Blackjack table. But now something has changed. The total chip supply in the casino is $1,000 higher than the money in the cashier’s safe. In theory this could be a problem. You could immediately lose the $1,000 in chips and walk out. Then if everyone in the casino wanted to redeem their chips, there would not be enough money to go around. But, it isn’t likely to be a problem in practice. The casino operates 24 hours a day and so there are always far more than $1,000 in chips in circulation. On top of that, the house takes a decent cut on the tables, so it would not take very long for the casino to win back over $1,000-worth of chips and then $1,000 can be held back from the profits that the cashier regularly sends up to the manager’s office. In fact, the credit seems so safe, the casino decides to offer credit more widely. While they are at it, they introduce a few other innovations, like offering lucky door prizes in chips, which also adds to the supply of chips in circulation without a corresponding increase in money in the cashier’s safe.

These loans that the casino has introduced give it the ability to “create” an additional supply of chips. But not all lending creates new chips. If instead of borrowing from the house, you had offered your IOU to a high-rolling friend you would still get your $1,000 in chips for the evening, but you got them from your friend so the chip supply does not change.

The new lending arrangements are working well, but the system is limited by the fact that the cashier does not know all of the patrons very well, and is naturally being very cautious about who to lend chips to. To manage this bottleneck, the casino decides to allow senior croupiers to provide loans to gamblers they know well as long as they take responsibility for the credit-worthiness of the borrower. So now getting credit is simply a matter of providing an IOU to the senior croupier who knows you best and he or she will charge up your smart chip card. If you need actual chips, that is not a problem either as the senior croupier has a stash under the table borrowed from the cashier. Of course, the croupier is taking a bit of a risk providing you with this advance since the house expects him or her to make good any amounts you do not repay. So to make it worth their while, you give the croupier a few chips for their trouble each time you need an advance. This works so well that the cashier no longer offers loans directly to anyone other than the senior croupiers.

As successful as the new arrangements are, the casino does have to be very careful about putting strict limits on the number of chips that the senior croupiers can create through lending. Otherwise, the day may come when there are simply too many chips and not enough money in the safe and a successful gambler may walk up to the cashier to cash in their chips only to find that the cashier does not have enough money in the safe. Word will spread and everyone will want their money back, but the casino will be unable to oblige. It would be bankrupt. So while there may be no limit to the number of chips that the casino could physically manufacture (and of course it has complete control of smart chip card balances), there is a constraint on the number it can put into circulation. This constraint is a direct consequence of the fact that chips are redeemable for cash.

The analogy to the real economy should be clear here. The cashier operates like a central bank and government treasury combined. The senior croupiers are the banks. Chips are money and smart chip card balances correspond to bank account balances. In the same way that senior croupier lending effectively creates new chips, so bank lending adds to the money supply in an economy. But what is the analogy to the money in the cashier’s safe? While central banks around the world do maintain reserves of gold and foreign currencies (think of all the US dollars that the central bank of China has), for many countries the analogy breaks down in one important respect.

The casino made a commitment to redeem your chips for cash. Some central banks do make similar commitments. In the days of the gold standard, central banks in Australia, the US, the UK and elsewhere would exchange currency for gold. Of course there were times, as in war, when this convertibility was suspended, but in those days having something backing money was seen as just as important as having money backing chips in a casino. The gold standard system was abandoned after the second world war and instead, under the Bretton Woods system, domestic currencies could be exchanged at the central bank for a fixed number of US dollars. This system collapsed in turn in the 1970s. Today, some countries such as China do maintain currencies pegged to the US dollar (or some other currency) and so still make a commitment of convertibility. However, most countries have adopted so-called “fiat” money. The word fiat is Latin for “let it be” and fiat money does not derive its value from any form of backing. It is declared to be money, and so it is. Many people still assume that Australian dollars are in fact backed by something, but if you tried to take a $10 note to the Reserve Bank of Australia, you would be lucky to get two $5 notes in return. You could certainly not be assured of getting any particular amount of gold or US dollars.

Some people find the entire concept of fiat money deeply disturbing and pine for a return to the “real” money days of the gold standard. But fiat money is in fact an extremely powerful innovation. In the casino analogy, the cashier must always be careful about how many chips are put into circulation to avoid the crisis of being unable to convert chips back to cash. However, in a country with fiat money, the central bank makes no convertibility commitments, so this risk simply does not exist. It has monopoly power in the creation of currency. So, the government simply cannot run out of money. There may be very good reasons for a government to curb its spending. For example, it may not want to add too much to demand in the economy because it is concerned about inflation. But running out of money is not one of those reasons, whatever the president of the United States may think.

I will leave it there for now, as this post is long enough already. But, stay tuned for more on the macroeconomic implications of a modern fiat money system.