the worm that turned
12-07-2009, 10:57 PM
Although wikipedia is not something that I would always take as fact, there are some interesting pieces to read, such as the following:
The ability to exchange a note for some other kind of value is called "convertibility". For example a US silver certificate was "payable in silver on demand" from the treasury until 1965. If a note is payable on demand for a fixed unit, it is said to be fully convertible to that unit. Limited convertibility occurs when there are restrictions in the time, place, manner or amount of exchange.
A common misconception is that a bank note that is physically inconvertible is necessarily unbacked. Most of the confusion centers around the failure to distinguish between two types of convertibility:
1. Physical convertibility, where a unit of currency can be exchanged at the issuing bank for a given physical amount of something, and
2. Financial convertibility, where a unit of currency can be exchanged at the issuing bank for a unit's worth of the bank's assets.
The importance of financial convertibility can be seen by imagining that people in a community one day find themselves with more paper currency than they wish to hold — for example, when the main shopping season has ended. If the paper currency is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted paper currency to the bank in exchange for silver, but the bank could head off this demand for silver by selling some of its own bonds to the public in exchange for its own paper currency. For example, if the community has 100 units of unwanted paper money, and if people intend to redeem the unwanted 100 units for silver at the bank, the bank could simply sell 100 units worth of bonds or other assets in exchange for 100 units of its own paper currency. This will soak up the unwanted paper and head off people's desire to redeem the 100 units for silver.
Thus, by conducting this type of open market operation — selling bonds when there is excess currency and buying bonds when there is too little — the bank can maintain the value of the paper currency at one ounce of silver without ever redeeming any paper currency for silver. In fact, this is essentially what all modern central banks do, and the fact that their currencies might be physically inconvertible is made irrelevant by the maintenance of financial convertibility. Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued. Thus, it is an illusion that any physically inconvertible currency is necessarily also unbacked.
Although this is probably one of the weakest/lamest explanation of how the banks can continue to maintain the currency in each country, the statement "Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued" is interesting!
I would like to know what the "sufficient assets" are and how if money is created out of money (fractional reserve banking) this could even be true! Any thoughts?
The ability to exchange a note for some other kind of value is called "convertibility". For example a US silver certificate was "payable in silver on demand" from the treasury until 1965. If a note is payable on demand for a fixed unit, it is said to be fully convertible to that unit. Limited convertibility occurs when there are restrictions in the time, place, manner or amount of exchange.
A common misconception is that a bank note that is physically inconvertible is necessarily unbacked. Most of the confusion centers around the failure to distinguish between two types of convertibility:
1. Physical convertibility, where a unit of currency can be exchanged at the issuing bank for a given physical amount of something, and
2. Financial convertibility, where a unit of currency can be exchanged at the issuing bank for a unit's worth of the bank's assets.
The importance of financial convertibility can be seen by imagining that people in a community one day find themselves with more paper currency than they wish to hold — for example, when the main shopping season has ended. If the paper currency is physically convertible (for one ounce of silver, let us suppose), people will return the unwanted paper currency to the bank in exchange for silver, but the bank could head off this demand for silver by selling some of its own bonds to the public in exchange for its own paper currency. For example, if the community has 100 units of unwanted paper money, and if people intend to redeem the unwanted 100 units for silver at the bank, the bank could simply sell 100 units worth of bonds or other assets in exchange for 100 units of its own paper currency. This will soak up the unwanted paper and head off people's desire to redeem the 100 units for silver.
Thus, by conducting this type of open market operation — selling bonds when there is excess currency and buying bonds when there is too little — the bank can maintain the value of the paper currency at one ounce of silver without ever redeeming any paper currency for silver. In fact, this is essentially what all modern central banks do, and the fact that their currencies might be physically inconvertible is made irrelevant by the maintenance of financial convertibility. Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued. Thus, it is an illusion that any physically inconvertible currency is necessarily also unbacked.
Although this is probably one of the weakest/lamest explanation of how the banks can continue to maintain the currency in each country, the statement "Note that financial convertibility cannot be maintained unless the bank has sufficient assets to back the currency it has issued" is interesting!
I would like to know what the "sufficient assets" are and how if money is created out of money (fractional reserve banking) this could even be true! Any thoughts?