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Tally Sticks

One of the greatest sources of confusion, when it comes to discussing economics, is the failure to understand the nature of money.

Money is defined as a thing that is used as a unit of account, a store of value, and a medium of exchange. The problem with the definition is that it’s overly broad: a bicycle and a train are both means of transportation, but you might still want to know the difference.

Over the course of history, all kinds of things have been used as money: gold, silver, copper, shells, feathers, paper, cows, and women. All these things share an important attribute: they exist in the real world.

There is another kind of money, however, which doesn’t share that attribute. An early example is the use of tally sticks in England. A tally stick was a stick with a series of lines marked on it. The lines represented a sum of money. The stick was broken in half, lengthwise, and one half went to each party in the transaction. One half was made shorter than the other, and that half – the short end of the stick – went to the debtor. The long end – also called the “stock” – went to the creditor.Image

When the government wanted to buy something – say, wheat from a landowner – it might issue a tally stick to the seller. When tax time came around, it would accept the tally stick as payment for taxes. The system continued for about 700 years. (When the tally sticks were finally burned, in 1834, they started a fire which burned down Parliment.)

In addition to its value as a tax credit, the sticks had value as currency as well. They could be used to purchase things in the marketplace. Because some people needed them to pay their taxes, others were willing to accept them as well.

What’s interesting about the tally sticks is that they illuminate some things about the modern financial system that are otherwise obscure. For example:

  • Taxes don’t fund spending. The reverse is true: spending funds tax payments. Without the government having first spent the tally sticks into the marketplace, no one could use them to pay their taxes.
  • The government can’t “run out” of money. In theory, it could run out of sticks. But since money is now recorded electronically, even that’s not an issue.
  • Government spending is constrained by inflation. If the government creates far more tally sticks than what it collects as payment for taxes, the value of the sticks will fall. Taxes are important not because they fund government, but because they prevent inflation.
  • Government has no actual need of tax payments for its own benefit. When Parliament got tired of storing its tally sticks, it burned them. If you show up at a tax office in California with stacks of hundred-dollar bills, the IRS official may send them on to Washington. Or he may toss them in the shredder.
  • Government debt is the record of private sector savings. If the government spends one million in tally stick marks, and collects half of as much in taxes, the net increase in tally sticks accumulated by the public is the same as the deficit of the government – .5 million.
  • If the public wishes to save tally sticks, the government must net-spend tally sticks into the marketplace, so that the public can save them. The same thing applies to foreigners – if foreigners, including foreign governments – wish to be net savers, we must be net spenders in order to accommodate them.
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Is Economics Science?

Steven Williamson writes that economics is science.

Historically, “science” has a broad meaning. Something like: a rigorous school of thought; or the application of logic, in a systematic way, to a particular subject. Accordingly, philosophy was a kind of science.

More recently, science has come to mean the application of the scientific method. A scientist makes a hypothesis, conducts tests, and then determines whether the results of the tests are consistent with the hypothesis.

Philosophy is not a science, according to this view, because philosophers don’t put things in test tubes, or run experiments on them.

Neither is economics.

Williamson writes that economics “looks like science”.

This isn’t an accident – I would argue. “Science” has come to mean something like “objective”. The prestige associated with doing science is far higher than that of doing philosophy – which has come to mean something like “some guy’s opinion.” Money follows prestige, and the money flowing to people doing science eclipses anything a philosopher is likely to see.

Economists, therefore, try to look like they’re doing science.

The flaw in the project – the fly in the ointment, so to speak – is economists’ failure to do the one thing that would make economics look most scientific: their failure to make falsifiable predictions about the future.

The Trade Deficit, Again

The Chinese central bank, like all central banks, can create money, in its own currency, at will.

Suppose the PBC creates a billion units of its own currency, and uses it to purchase US currency on the open market, at market rates.

When a country purchases fx, three things happen. One is that the country – China in this example – accumulates dollar denominated deposits at a US bank – in this case, the Fed. Another is that one or more foreigners – in this case, Americans – obtain yuan-denominated deposits in China.

The other thing that happens is that the value of yuan falls relative to the value of the dollar. (China’s purchases increase the demand for dollars while decreasing their supply; while simultaneously increasing the supply of yuan.)

The net result is that Americans hold a billion newly-created yuan. These Americans (or more likely, American companies) can do one of two things with the newly-created yuan. They can do nothing, or they can purchase things from China.

Assuming they choose to use the yuan, their purchases create a trade deficit, as the newly created yuan flows back to China, and Chinese goods flow to the US.

The trade deficit, if or when the American companies use all of the yuan, will exactly equal the billion yuan the Chinese central bank created in the first place.

The conventional wisdom is that America borrows dollars from China in order to finance a trade deficit.

But what if the truth is that China is financing a trade surplus, by printing Chinese money?

Where Do Trade Deficits Come From?

The impression that you get from the press is that the reason for the US trade deficit is low wages in foreign countries – or, conversely, Americans who get paid too much. The general idea is that Americans are in competition with foreigners who make $0.10 per hour, and that unless they can compete at that level, they’re expendable.

But I wonder if the press has got it exactly backward.

Suppose, hypothetically, there was a foreign country (“China”) with a central bank. That bank, like all central banks, could purchase assets “for free”. If those assets were the currency of another country, say, the US dollar, and if the central bank 1.) kept the dollars, and 2.) purchased them on the open market, what result would there be?

One result would be a depreciation of the currency (“the yuan”) of the buyer – since the dollars are removed from the market, but the yuan is not. Another would be an increased demand for Chinese products from abroad (what else, ultimately, is the yuan good for, but for buying things from China?) A third would be an increase in the ownership of dollars by China (or, better yet, US Treasuries, which at least draw interest). A fourth would (likely) be a current account surplus – assuming at least some of the yuan made its way back to China (and China can always sell more yuan, if needs to, to ensure that happens). Finally, as long as not all the returning yuan is used to purchase Chinese investments, China has more or less guaranteed itself a trade surplus.

What if, in other words, the trade deficit is simply a product of Chinese purchases of US dollars?

Economics: The Economics of Being Wrong

Earlier I posted a chart from Federal Reserve’s research site showing (non) relationship between monetary base and inflation. Afterwards I happened to come across a Wall Street Journal piece by Arthur Laffer: Get Ready for Inflation and Higher Interest Rates.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs — such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid — are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

Since then, the Fed’s added another $1 trillion+ in monetary base.

Yet still no inflation.

It’s rare for economic conditions to clearly and unambiguously test economic theories. But this is one of those times.

What are the consequences – if any – when a theory is wrong?