Category: Money

Should the State mandate or advise?

It depends of course. But in America, which was established to empower each individual to make their own decisions, the state should only regulate those individual activities that might harm others such as violating property rights. This attitude presumes that each of us cares more about our wellbeing than does anyone else and know better how to achieve it taking account of our differences in tastes, interests, and risk preferences. It has resulted in a society of more prosperous and happier members.

This can be contrasted with the view that the average person is not intelligent enough or self-motivated enough to maximize their potential and needs to be guided by smarter, wiser people.

A society in which each individual enjoys the maximum freedom of choice hardly means that the government has little or no role in our wellbeing. In addition to providing public safety, shared institutional and physical infrastructure development, and the adjudication and enforcement of contracts (the rule of law), government can contribute to the provision of the knowledge to help inform the individual choices we each make. I want to review two very different areas of government involvement that have reflected the above conflicting attitudes of the government’s best role—monetary policy and public health policy.

Section 8 of the US Constitution gives the federal government the power “To coin Money, regulate the Value thereof,…” Our twelve Federal Reserve Banks and the Board of Governors of the Federal Reserve System carry out that mandate via a system of market determined prices of goods and services and an inflation target of 2%. While I would prefer a monetary policy in which currency was issued or redeemed at a fix price for a hard anchor (traditionally gold) in response to market demand (currency board rules), the Fed has behaved very well within its inflation targeting regime over the past two years (after keeping its policy interest rate too low until two years ago).

A successful inflation targeting policy requires keeping inflation expectations anchored to the target (2% in the US) so that economic wage and price decisions are made in light of that expectation. But todays’ policy actions are only fully felt over the next year or two (what Milton Friedman called “long and variable lags” in the effects of policy). Federal Reserve policy is implemented largely by setting the rate at which it supplies the money it creates to the market. If it sets that rate below the so called neutral rate, it must supply money to keep the rate low. If it sets the Fed Funds (and related) rate above the neutral rate, it must absorb money from the market to keep the rate high. Setting its policy interest rate is the lever by which it controls the rate at which the money supply grows. Each Federal Reserve President and Governor must evaluate all available information about economic activity most likely over the next one to two years and determine in like of that what monetary growth is most likely to result in 2 percent inflation over that period. If market participants believe that the Fed’s choice is most likely to result in achieving the stated target in the future, their wage and price decisions will anticipate that inflation and thus bring it about.

It should be obvious that if Fed officials are honest it attempting to achieve their target and explain as fully as they themselves understand the prospects to the public and the public has confidence in the Fed’s commitment, this is the best that can be done. In fact, the Fed deserves high marks for such transparency in our uncertain and evolving world. Each person and firm make their own forward looking decisions in light of their best guesses of future conditions. The Fed’s guidance is the best and most the Fed can do to bring or keep inflation on target.  

When governments don’t trust “the people” to make their own decisions (they are not smart enough or are two lazy or whatever), they must mandate the “proper” behavior. Consider our approach to the public’s health during the Covid pandemic. Whether government should offer advice and provide information on what is known about a disease such as Covid-19 is complicated by the fact that we should not be free to expose others to communicable diseases. In the case of Covid the government’s understanding of its nature and best protection grew and evolved over time. But the US public heath agencies lost credibility from the beginning by telling well intentioned lies.

“In early March 2020, Dr. Fauci said ‘there’s no reason to be walking around with a mask.’ In the same interview he said people could wear masks if they liked, but they wouldn’t get perfect protection, and it would further pinch what at the time was a short supply of masks for doctors and nurses.” PolitiFact | Marco Rubio says Anthony Fauci lied about masks. Fauci didn’t.

But more to my point, CDC officials thought that their shut down and isolation mandates would be more effective than allowing individuals to determine how best to protect themselves and others. The subsequent evidence suggested that they were wrong. Any benefits were outweighed by very substantial costs. Read the following articles and studies for examples.

Scott Atlas on Lies

“I explore the association between the severity of lockdown policies in the first half of 2020 and mortality rates. Using two indices from the Blavatnik Centre’s COVID-19 policy measures and comparing weekly mortality rates from 24 European countries in the first halves of 2017–2020, addressing policy endogeneity in two different ways, and taking timing into account, I find no clear association between lockdown policies and mortality development.” https://academic.oup.com/cesifo/article/67/3/318/6199605?login=false  

“The most restrictive nonpharmaceutical interventions (NPIs) for controlling the spread of COVID-19 are mandatory stay-at-home and business closures. The most restrictive nonpharmaceutical interventions (NPIs) for controlling the spread of COVID-19 are mandatory stay-at-home and business closures. Given the consequences of these policies, it is important to assess their effects. We evaluate the effects on epidemic case growth of more restrictive NPIs (mrNPIs), above and beyond those of less-restrictive NPIs (lrNPIs)….

“After subtracting the epidemic and lrNPI effects, we find no clear, significant beneficial effect of mrNPIs on case growth in any country…. While small benefits cannot be excluded, we do not find significant benefits on case growth of more restrictive NPIs. Similar reductions in case growth may be achievable with less-restrictive interventions.”  January 2021 study

Worrying About Mandates and Lockdowns as Delta Variant Hits Unvaccinated Californians

FedNow

The Federal Reserve has launched FedNow, which executes instant payments 24/7. What does that mean? When I led IMF technical assistance missions to the former Soviet Union (Kazakhstan, Kyrgyzstan, and Moldova) and to post conflict countries (Afghanistan, Bosnia and Herzegovina, Iraq, Kosovo, Serbia), the payment experts on my teams referred to the Clearing and Settlement of payments. I never fully understood what that meant. “Federal Reserve FedNow Payments”

The key to understanding the meaning of “clearing and settlement” is to understand the deference between the authorization to make a payment and actually debiting and crediting bank accounts to execute the payment. When I pay from my bank account to yours, mine is debited and yours is credited. My bank executes the debt and credit if your account is also at my bank. If not, my bank debits my account and “sends” the money to you at your bank via an intermediary (usually the central bank) at which both my bank and yours have accounts that can be debited and credited. When my account has been debited and your credited, the payment has been “settled.”

The clearing part of clearing and settlement has to do with communicating the authorization to our banks to execute the debit and credit. It refers to the messaging systems that authorize the actual settlement of a payment. This is what FedNow is about (as is the well-known SWIFT messaging system for authorizing cross border payments). It will replace paper checks or electronic payments such as Venmo, Zelle, PayPal, etc. that now authorize our banks to debit our accounts and credit the accounts (somewhere) of the payees.  “Econ-101-Retail Central Bank Digital Currency-CBDC”

I haven’t mentioned what it is that is being paid. If it is from my bank account, it is US dollars (ultimately a claim on the Federal Reserve Banks of the U.S.). Every currency (dollars, Euros, bitcoin) has its system of clearing and settlement.  And of course, there are markets for exchanging one currency for another (FX markets).

FedNow is a messaging system that authorizes settlement in seconds 24/7 that replaces (or supplements) systems that now can take days.

My Travels to Kosovo

Post-World War II Yugoslavia consisted of the federation of Bosnia and Herzegovina, Croatia, Macedonia, Montenegro, Serbia, and Slovenia. Though its residents were predominantly Albanian, Kosovo was a province of Serbia. During part of its post-WWII history, Kosovo was relatively autonomous within Serbia, while part of the time it was ruled directly by Serbia. Frictions between Albanian and Serbian Kosovars escalated in the 1990s into armed conflict, which ended only with the North Atlantic Treaty Organization’s (NATO) bombing of Serbian Army forces in Kosovo and Serbia proper from March 24 to June 10, 1999.

Following the June 10 end to the fighting, the United Nations Mission in Kosovo (UNMIK) took over the governance of a ruined Kosovo. Among the normal needs to be restored most urgently (food, water, electricity, etc.), was the ability to pay for things. Kosovo’s banks were closed, and its financial and monetary connection with Belgrade and the rest of the world was not functioning. There was an urgent need to revive Kosovo’s ability to make payments while also determining what sort of financial systems to build for a future, more integrated with the rest of Europe.

If only by using it, Kosovars themselves had answered what currency they wished to use—the German mark (DM). But arrangements were urgently needed for how to acquire and maintain DM banknotes and coins (I remember well the tattered currencies in post-war Bosnia and Iraq), and to adjust the procedures of banks and other money handlers to the use and safekeeping of DM, rather than the Serbian dinars previously supplied by the National Bank of Serbia.

The International Monetary Fund (IMF) joined with the United Nations, the World Bank, the United States Agency for International Development (USAID), and other international organizations to provide the needed emergency humanitarian assistance and to help in the rebuilding of a potentially transformed economy. I led the IMF missions to address the money and banking aspects of this effort. The revival and/or restructuring of Kosovo’s monetary capacities needed to be achieved in days and weeks rather than months and years. This was a tall order.

My latest book documents our work to revive and transform Kosovo’s monetary system and some of the challenges and adventures we encountered in the process. Most of us only see the public face of our payment systems (currency, ATM machines, credit cards). In recounting our experiences in restoring and transforming Kosovo’s payment system, I will endeavor to pull back the curtain a bit to expose what is behind and generally out of sight.

If this interests you, you can buy the paperback or kindle versions here. https://www.amazon.com/s?k=Warren+Coats&i=stripbooks&crid=10ON15E99H8X6&sprefix=warren+coats%2Cstripbooks%2C63&ref=nb_sb_noss_1  This will also give you the opportunity to rate the book. I hope that you will enjoy it.

The Dollar (again)

Any country selling its goods abroad could price and collect payment for them in its own currency. Foreign purchasers would have to buy the sellers currency in the foreign exchange market (a whole nether story) in order to make such payments.

To communicate with each other they could also learn each other’s language. To communicate with everyone in their own language would require learning 7,000 languages. The economy of everyone adding English as a second language to their own is self-evident.

Rather than each trader dealing with several hundred currencies, there is huge economy in everyone dealing in one intermediary (so called vehicle) currency for pricing and payments of their cross-border transactions. But what currency?

When an exporter gives up pricing its products in the currency it pays its workers, it takes on a valuation risk. The choice of its invoicing currency and currency of payment needs to be attractive to potential buyers and of minimal risk to itself. The currency needs to have a relatively stable value for a large number of goods. The U.S. economy is large, and its goods are priced in dollars, which has a relatively good track record of price stability.

But to pay for imports with someone else’s currency the importer must have some of it. He must either take the risk of buying it in the foreign exchange market at whatever its current exchange rate might be or keeping some in reserve. Keeping a reserve of the international pricing and payment currency requires having safe assets with stable values in that currency, with deep and liquid markets in which they can be bought and sold. Currently the US dollar wins hands down. The Empire and the Dollar – Warren’s space (wcoats.blog)

The militarization of the dollar to serve U.S. foreign policy objectives increases the risk to others of holding and using dollars. How much that potentially undermines the dollar’s reserve currency status depends on how broadly the foreign policy objectives of the U.S. are shared and how well alternative currencies measure up to the value and market advantages of the dollar.

Protecting bank deposits

Following the collapse of Silicon Valley Bank last week there has been considerable discussion about whether and how the regulatory regime might be strengthened (or actually more effectively implemented) to prevent such collapses (yet again) in the future. Raising deposit insurance coverage to 100% of all deposits is being suggested (and was provided ad hoc to SVB and Signature Bank this week). Econ 101: SVB and bank runs – Warren’s space (wcoats.blog)

Insuring all deposits and adopting the Chicago Plan represent two very different approaches to removing all risk of loss to depositors and thus any incentive to run from a bank. In the search for regulatory or market checks on excessive bank risk taking or poor management, the expectation that depositors would carefully monitor the behavior and condition of their banks was never realistic. Thus, removing any financial incentive for such due diligence by raising deposit insurance to cover all deposits would have little to no impact on bank behavior. Such scrutiny by bank shareholders and managers is much more realist and thus important. US bank bankruptcy procedures do not spare shareholders, who in the case of SVB have lost everything. However, more might be done to impose losses on managers of insolvent banks.

Following the bankruptcy of SVB considerable attention has rightly focused on the speed with which facts or rumors of a bank’s weakening financial condition can spread over the Internet. What might have taken weeks as depositors began to line up outside their banks to withdraw their deposits while the funds lasted, now takes minutes, dramatically accelerating the speed with which a bank must try to liquidate enough of its assets to fund the withdrawals.

Full deposit insurance and the Chicago Plan of 100% reserve banking (deposits at the central bank, which are always safe and instantly available) eliminate any incentive for bank runs. But the difference between them deserves more attention. The full deposit insurance approach puts the cost of bailing out the depositors of a failed bank on the rest of the banking system (on the “good” banks) who finance the insurance fund.  The cost of the Chicago Plan, if indeed it is a cost at all rather than a benefit, is the need for banks to fund their credit operations with equity or long-term debt, rather than with potentially volatile deposits. We should move to the Chicago Plan and fully separate money from credit.

                            ,

Econ 101: SVB and bank runs

What is a bank run and how can we prevent them? A bank run, as I am sure you all know, is a rush by depositors to withdraw their deposits for fear that the bank will not have the money to give them. But there is a lot to unpack there in order to understand what is going on and how runs might be prevented.

It is important to understand the difference between debt and equity—between lending a specific amount of money with specific terms and investing an amount of money in exchange for a share of the earnings (or losses) of the recipient. When you buy shares in a company, it has no obligation to return your money. If you no longer want to invest in that company, you can sell your shares to someone else or the company might, at its discretion, buy them back. Its failure to “return” your money cannot be the cause of a company’s bankruptcy (take over by creditors to collect what the company is no longer able to return).

The deposits that we make in our banks are a special case of debt finance of whatever the banks do with our money. As we know, they lend much of it to people and companies for one thing or another and invest some in hopefully safe assets like Treasury bills and keep a tiny bit on hand for when you need cash. But the deposit contract says that you have the right to withdraw (or pay to someone else) any or all of it whenever you want to. Thus, banks must keep sufficient liquid assets in order to satisfy such withdrawals by selling them in the market when you demand your money back. The Federal Reserve, our lender of last resort, also has facilities for lending to banks needing cash against the collateral of bank assets.

The difference between illiquidity and insolvency is critical as well. A bank is solvent when the value of its assets match or exceed the value of its liabilities (such as your deposits). But having sufficient good assets doesn’t mean that that bank can always honor your deposit withdrawal demand. That is a question of liquidity. Does the bank have enough of its assets backing your deposit in forms that it can pay out immediately (cash in its vault, deposits at the Federal Reserve that it can transfer to another bank or use to buy cash, or assets it can quickly sell such as t-bills, or credit lines with other banks or the Fed, etc.)?  “The difference between bank liquidity and capital” Thus, even a solvent bank (positive capital) might fail to honor your withdrawal demand if it doesn’t have sufficient liquid assets. “The big bailout-what next?”

Usually, a bank becomes insolvent when more of its loan assets default than the bank has capital to cover such losses. But as we will see in the case of Silicon Valley Bank, insolvency can also result from a decline in the current market value of a “good” asset.  When depositors suspect that their bank might be insolvent, they will withdraw their money while they still can. This tends to use up the bank’s liquid assets compounding the risk of default. As the word spreads the classical bank run takes off (electronically these days rather than long lines outside the bank as in the old days).

The SVB, which specialized in financial services to start-ups and technology companies, enjoyed a huge increase in its deposits over the last four years, increasing from $49 billion in 2018 to $189.2 billion in 2021 dropping back to $175.4 billion at the end of 2022. It invested most of those deposits in “safe” long term government and similar debt. While the default risk for these assets was negligible, the risk of a loss in current market value if market interest rates increased was high. No one will pay the face value of a 3% ten-year bond while current market rates for the same maturity are 4%. The rapid increase in interest rates as the Federal Reserve reversed money growth to fight inflation tanked the current market value of a large share of SVB’s assets making it impossible for it to come up with the cash depositors might demand if they “ran”. That is how runs work. On March 10 SVB was put into receivership.

The original sin of modern banking is financing long term loans/investments with money (demand and savings deposits). Islamic banking, what uses equity investing, is wiser in this regard. During the Savings and Loan crisis in the U.S. in the 1980s and early 90s (financing mortgages with deposits) more than 1000 S&Ls failed when interest rates increased. But in fact, the U.S. bank regulation regime has some good features. While bank risk taking is subject to many, often costly, regulations, the ultimate check on risk taking comes from the knowledge of bank owners that they will lose their entire stake if their bank becomes insolvent. The Federal Deposit Insurance Corporation (FDIC), which oversees America’s deposit insurance scheme, has developed effective bank bankruptcy and resolution procedures that allow it to take over and resolve insolvent banks with barely a ripple. A favorite tool is the so-called purchase and assumption transaction by which a healthy bank buys the assess of the insolvent one and assumes its liabilities (deposits), usually over a weekend. Thousands of insolvent banks have been resolved by the FDIC in the last fifty years.  See “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” by Warren Coats and Arno Liuksilo “Warren Coats-17”

Most bank depositors pay no attention to the financial condition of their bank because their deposits are insured against losses, which until last week had been raised to $250,000. But the government has now implicitly extended such insurance to all deposits via accounting and other tricks, thus removing any remaining check on bank risk taking from all depositors. On Monday, President Biden announced that no depositors in SVB (and Signature Bank of New York) would lose any of their deposits.  Following the banking crisis of 2008, the Dodd-Frank law further strengthened financial sector regulations. The most important and helpful provisions of this 2,300 page law provided for significant increases and strengthening of bank capital requirements.  

The overuse of debt rather than equity financing is a more general weakness in our economy. The IRS should stop subsidizing it. Interest on borrowing is deductible from taxable income while dividends on equity financing are not. While increasing bank capital makes them less run prone, a simpler and easer to regulate approach is to remove the cause of runs all together by eliminating any risk that your bank can’t honor its obligation to return your money on demand. Another few thousand pages of laws and regulations might catch the last mistakes (though it is hard to see why regulators didn’t address the obvious duration risks taken by SVB), but there is an easier, less costly solution. Bank failures result from the mistakes of banks (their owners and managers) and the failure of depositors to more carefully evaluate the soundness of the bank in which they deposit their money. But depositors have little competence to evaluate bank soundness, and why should they be expected to?

Money (bank deposits) should be fully separated from credit. Deposits should not finance loans. Those financing investments should share in its risks (and rewards) via equity financing. “More than decade ago Professor Kotlikoff and [John Goodman] proposed “limited purpose banking” in The New Republic and in Investment News. The idea is that credit market institutions should be intermediaries between savers and investors and should not themselves use depositors’ money to make risky investments.”

When we deposit money in banks for safekeeping and making payments there should never be any doubt about the bank’s ability to return it on demand and thus no reason to “run” on the bank to protect our deposits. This is the essence of the Chicago Plan which would replace so call fractional reserve banking with 100% reserves (deposits at the central bank). When my bank deposit is backed totally by my bank’s deposits at the Fed, I would know with certainty that they were 100% safe and instantly available.  The “Chicago Plan” and New Deal Banking Reform | Levy Economics Institute (levyinstitute.org) Narrow banking schemes have a similar motivation. “A proposal for the feds balance sheet”

The difference between Bitcoin and FTX

Bitcoin is a digital currency (cryptocurrency) that can be paid to another bitcoin user willing to accept it via a blockchain account.  It is backed by nothing and promises nothing. Its US dollar value has fallen from $65,496 on November 14, 2021, to $15,630 on November 21, 2022.

“FTX Exchange was a leading centralized cryptocurrency exchange specializing in derivatives and leveraged products. Founded in 2018, FTX offered a range of trading products, including derivatives, options, volatility products, and leveraged tokens. It also provided spot markets in more than 300 cryptocurrency trading pairs such as BTC/USDT, ETH/USDT, XRP/USDT, and its native token FTT/USDT.12 In early November 2022, the exchange and the companies in its orbit began a steep fall from grace….  According to its bankruptcy filing, FTX, which was once valued at $32 billion and has $8 billion of liabilities it can’t pay, may have as many as 1 million creditors…. On November 16, a class-action lawsuit was filed in a Florida federal court, alleging that Sam Bankman-Fried created a fraudulent cryptocurrency scheme designed to take advantage of unsophisticated investors from across the country. ” “FTX exchange”

The difference between Bitcoin and FTX is that Bitcoin is a digital coin/token that some believe might achieve wide adoption as money and thus a stable demand that could stabilize its price. In my opinion, this is HIGHLY unlikely. I explained this potential eight years ago: “Cryptocurrencies the bitcoin phenomena”   “The future of bitcoin exchanges”  But most people buying Bitcoin are gambling that they can sell it for a higher price than they paid for it (first cousins to slot machine addicts).

On the other hand, FTX and its related products and services promised real things and to play by known rules (contracts). On November 11, FTX and its affiliated firms were put into bankruptcy. Billions of dollars where missing? Founder Sam Bankman-Fried (SBF) claims that he was just careless. It appears more likely that he was a lying fraudster. “An attorney also said the firm had been run as a ‘personal fiefdom’ of Bankman-Fried with $300 million spent on real estate such as homes and vacation properties for senior staff.” “Crypto lender genesis says no plans to file bankruptcy imminently”  Presumably to promote himself as a good guy and to win influential friends, SBF also contributed millions to charities and politicians. 

Most crypto product and service providers want regulations that will give potential investors and customers more confidence in their products but that will not stifle the potential creativity of a dynamic industry.  Hopefully congress will get on with it — carefully. “Crypto bill criticized”

“Sam Bankman-Fried, the founder of the FTX exchange and Alameda Research, a cryptocurrency trading platform, seemed to confuse his bank and his companies. According to John Ray, the new CEO in charge of the restructuring of his empire which went bankrupt on November 11, Bankman-Fried received a personal loan of $1 billion from Alameda. He is not alone: ​​the firm, which is a kind of cryptocurrency hedge fund, has also lent $543 million in personal loan to Nishad Singh, an associate of Bankman-Friend, and $55 million to Ryan Salame, the co-CEO of FTX Digital Markets, one of FTX’s affiliates.  

“’Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,’ Ray wrote. ‘From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.’”  “Bankman-Fried received 1bn in personal loan from his company”

“Bankman-Fried’s net worth peaked at $26 billion.[11] In October 2022, he had an estimated net worth of $10.5 billion.[12] However, on November 8, 2022, amid FTX’s solvency crisis, his net worth was estimated to have dropped 94% in a day to $991.5 million, according to the Bloomberg Billionaires Index, the largest one-day drop in the index’s history.[13][10] By November 11, 2022, the Bloomberg Billionaires Index considered Bankman-Fried to have no material wealth.[14]”  “Sam Bankman-Fried”

I assume that jail is next, perhaps in the cell previously used by Bernie Madoff.

If you subscribe to The Economist you can read fascinating details here: “The failure of ftx and Sam Bankman-Fried will leave deep scars”

Econ 101: The Value of Money

During a discussion of Bitcoin with friends, it became clear to me that it might be helpful if I explained some fundamentals of how the value of money is determined. Like most everything else, money’s value is ultimately determined by its supply and demand.

Demand for money reflects the public’s need to keep an inventory of it in order to use it for making payments.  Bitcoin are generally held as a speculative asset rather than for payments as almost no one will accept them in payment. “Cryptocurrencies-the bitcoin phenomena”

The supply of money is determined by those who created it, generally central banks. Generally central banks issue their currency, thus increasing its supply, by lending it (generally to banks) or by buying assets, generally their government’s debt.  When anyone holding that currency no longer wants it and has the right to redeem it, the central bank takes it back in exchange for the asset it purchased in the first place, thus reducing the money supply.  Under the gold standard, currency was redeemed for gold.  The rules governing a central bank’s issuing and redeeming its currency defines the nature of its monetary regime.  That is the topic of this econ 101 lesson.

As none of us has ever redeemed our currency, it is understandable that my friends confused spending their money with redeeming it.  Spending it transfers it to someone else without changing its supply, while redeeming it reduces its supply.  Cryptocurrencies add a new category to our discussion of money.  As noted by “a billionaire hedge-fund manager… cryptocurrencies are a ‘limited supply of nothing.’”  “Crypto skeptics growing”

As discussed further below, the supply of Bitcoin increases slowly and steadily over time as determined by an unchangeable formula and Bitcoin cannot be redeemed for anything.  The U.S. dollar and virtually every other national currency in the world grow at more erratic rates as determined by their issuing central banks.  So what makes the value of the dollar relatively stable over long periods of time?  The fall in its value by about 8% over the last month is nothing compared to bitcoin’s fall of 23% over the same period and over 50% over the last half year.  Over the past 15 years the dollar’s value has declined less than 2% each year.  Unlike Bitcoin, dollars are widely accepted for payments that are denominated in dollars, including our taxes, and thus held (demanded) to make such payments.  Almost no Bitcoins are held to make payments as almost no one will accept them for payments.  But I want to focus on a currency’s supply.

There are fundamentally three broad approaches to determining the supply of a currency.  Historically, the supply of most currencies were determined by fixing their price to what they could be redeemed for, such as gold or silver. I have called such a system for regulating money’s supply, a hard anchor. “Real SDR Currency Board”  The value of a currency can be fixed (the price set) to something real such as gold or a basket of goods.  A country with a strict gold standard, which the U.S. never really had, issues its currency (dollars) whenever anyone wants to pay the fixed gold price for more of them.  If the dollar price of gold in the market rises above its official price, there would be an arbitrage profit from buying gold from the central bank at its lower official price.  Such gold could be resold in the market at the higher price.  But the key point is that this mechanism (what I call currency board rules) of redeeming currency reduces its supply and thus reduces prices in this currency in the market (deflation).  Several of the monetary systems I helped establish, work in this way (Bulgaria and Bosnia and Herzegovina). “One Currency for Bosnia”

The most common system of monetary control today is for the central bank to determine its currency’s supply by buying or selling it in the market (the Federal Reserve can buy treasury bills, etc. to increase the supply of dollars).  Most central banks today adjust their money supplies in an effort to achieve an inflation target (a much more complicated subject). “Czech National Bank: Inflation Targeting in Transition Economies”  Generally they do so by setting an intermediate target for a short-term interest at which market participants (banks) can borrow from the central bank.  Such fiat currencies, such as the U.S. dollar, are not redeemable but are widely accepted in payment for goods, services and debts.

This brings us to Bitcoin.  The supply of Bitcoin is determined by a formula that predetermines its gradual growth to 21 million by 2140.  There are currently about 19 million in existence.  The supply is increased by giving them to successful miners for verifying the legitimacy of each transaction (another complicated subject).  Thus, the issuer (the formula) received services (protection against double spending the same coin) but no assets such as gold or treasury bills for creating and issuing new Bitcoins.  Once created, an issued bitcoin can never be redeemed (i.e. the outstanding supply can never be reduced).  When you spend or give away your Bitcoins you are circulating them to other holders, not redeeming them.

When my imaginary aunt Sally discusses Bitcoin and cryptocurrencies more generally, she tends to mix up the marvelous new payment technologies for paying my dollars all over the world with private money such as Bitcoin and Tether.  She also doesn’t seem to quite understand that most money has always been privately produced including the U.S. dollars that we spend in various ways (occasionally even by handing over cash).  “A shift in monetary regimes”

But these distinctions are critical when considering what role the government should play in our monetary system.  The truly amazing technical progress we have experienced and the dramatic increase in the standard of living of the average person it has delivered over the last century was made possible by a government that provided a general framework in which we, the consuming beneficiaries of this progress, could make informed choices.  Our government, wisely, generally did not make such decisions for use.

With that in mind consider “a letter addressed to Senate Majority Leader Charles E. Schumer (D-N.Y.), Senate Minority Leader Mitch McConnell (R-Ky.), House Speaker Nancy Pelosi (D-Calif.) and other congressional leaders, [from 26 influential technology personalities that] outlined what it described as potentially grave dangers of cryptocurrencies.” They are absolutely correct to expose and condemn the technical and economic weaknesses of blockchain technology—the distributed ledger with which Bitcoin claims to avoid the need for trusted third parties to record and document payment transaction (as happens on a centralized ledger when you pay from your bank deposit). 

But the fact that foolish people invest in Bitcoin and other cryptocurrencies does not justify our government prohibiting and restricting them from doing so.  The government requires the banks in which we put our money to publish properly audited financial statements of the assets backing our deposits and to set minimum capital requirements to protect against the possible loss of bank asset value (e.g., loan defaults).  Cryptocurrencies claiming redeemability at a stable value (so called stable coins) should similarly be required to disclose the rules by which they operate and the composition and value of the assets backing their digital coins.  In short, government regulations should help us decide what we want to buy and/or hold without restricting the ability of fintech pioneers to explore and innovate products to offer.

Overly restrictive regulations create incentives for incumbents to create barriers to competition.  Large and intrusive governments tend toward corruption.  The Federal Reserve System seems quite aware of these risks as it cautiously explores whether to compete with the private sector in developing a central bank digital currency.  “Econ 101-Central  Bank digital currency-CBDC”

So when considering the government’s role in money and payments be sure to clearly distinguish money from payment technology and limit government to setting the rules of the game that maximize the ability of private consumers to make wise choices. But perhaps the biggest policy decision of all is how the government should determine/regulate the supply of its currency, most of which is privately created.  I support a currency whose value is fixed to something real (a hard anchor) and whose supply is determined by the market via currency board rules.  “A libertarian money”  

Econ 101: Retail Central Bank Digital Currency (CBDC)

The history of money is long and fascinating. Even the currency most frequently used in the United States has a rich history. Money makes possible the specialization and trade upon which our great wealth depends. Through its long history of development and evolution, money has serviced two key functions. It provides the standard unit for pricing traded goods and services so that their values can be meaningfully compared (it’s the unit of account) and it is the common asset in which payments are made (it’s the medium of exchange or payment).

Medium of Payment–Money

When you hire the neighborhood boy to mow your lawn, you probably first agree on a price (the number of dollars) This is the unit of account function of money, which is indispensable for the functioning of markets.  You could agree to trade with the neighborhood boy a nice lunch with lemonade in exchange for his mowing your lawn. But paying him $15 in Federal Reserve Notes has the advantage that he can exchange it for your lunch, or he can buy his lunch at Wendy’s or anything else of his choice.

Obviously, markets can’t really function if each item or service is priced in a different money unit (dollars, Euro, rubles, bitcoin, etc.). The Continental Congress of the United States authorized the issuance of a new currency, the US dollar, on July 6, 1785. Following the ratification of the Constitution of the United States, the new Congress established the United States dollar as the official currency of the United States in the Coinage Act of 1792. The Act also established the United States Mint, which produced and circulated coins with a fix amount of gold or silver (later only gold). “History of the United States dollar”  

As the result of the changing relative price of silver for gold, the bimetal gold/silver standard was replaced with the single metal standard of gold. The dollar was redefined in 1900 as “twenty-five and eight-tenths grains of gold nine-tenths fine,… and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard.” Fast forwarding through WWI and WWII and the creation of the Bretton Woods Institutions and the failure of the US to adhere to the requirements of the gold standard, the US “closed its gold window” and proceeded with varying degrees of success to manage the supply of its currency so as to preserve its purchasing power.

Over this long history many private actors (banks) created dollars. There are in fact thousands of private producers of dollars (Chase dollars, B of A dollars, etc.) Glossing over the details, it was a one currency system–the US dollar–because each bank’s currency could be redeemed for gold at  fix price or, after the creation of our central bank in 1913, for a deposit at a Federal Reserve Bank. This is obvious when you pay with Federal Reserve Notes, which are direct obligations of our central bank. Originally each note was identified by the Federal Reserve Bank that issued it–there were twelve of them–but even that distinction has been eliminated. Few people even noticed the difference. But most of our dollar money supply (M1: Federal Reserve Notes in circulation plus demand deposits at banks) is privately produced by banks and exists in digital form as accounting records with each of our banks.

Means of Payment

Our money–US dollars (or Euros or bitcoin)–is quite distinct from the various ways in which you can pay it–payment technologies. Cash payments–the transfer of Federal Reserve Notes from me to you–are hand delivered. But most payments are made by digitally transferring an amount of dollars from my bank account to yours. Such digital payments have the obvious advantage of enabling you to pay someone across town, across the country or even across the world (if they accept your currency) plus the safety of keeping your money in the bank pending such payments.  It’s not recommended that you send cash in the mail. The key insight is to understand how my dollar balance in my bank gets to your account at your bank and why your bank is willing to accept it. The quick answer is that your bank will not generally accept a claim on my bank but will record my payment because it receives an increase in its deposits at a Federal Reserve Bank of that amount.

In the old days I wrote a check that authorized my bank (after the check was deposited by you at your bank, which sent it to my bank) to debit my balance with the indicated amount and to transfer that amount from its balance at the Fed to your bank’s account at the Fed. SWIFT performs this payment instruction/authorization function for cross border payments (i.e., those involving two central banks). Today I issue this instruction directly to my bank electronically on the internet or my smart phone. The “dollars” are one currency no matter who creates and issues them because whoever receives them can redeem them for balances at the central bank (or in the old days for gold).

Visa, Master Card and American Express credit cards provide payments on my behalf by lending me the money before I actually make the payment from my bank account to the credit provider at the end of the month. The loan to me involved in such payments, increases the cost of this type of payment.

The execution of the interbank portion of my payments have become increasingly efficient over time but can still take several days because the Federal Reserve Banks do not operate in the evening or on weekends. When our central bank launches FedNow next year it will allow the continuous processing of payments between banks 24/7.

The front end of the payment process, i.e., my initiation of a payment to you, for example, has also benefited from software improvements. Unlike bitcoin, Ethereum, or Ripple, which are currencies, Zelle, Venmo, PayPal, etc. are payment technologies rather than money. They are means for paying US dollars (or other currencies) from me to you. Venmo, for example can be thought of as the payment service part of a bank. It can hold money for you and can transfer it to others (who must also have a Venmo account) but Venmo cannot make loans with your money. Thus, people without bank accounts can use Venmo as if it were a bank account.

The Federal Reserve and other central banks are investigating whether they should also provide the service to the public of paying dollars with so called Central Bank Digital Currency (CBDC). The Federal Reserve defines a CBDC “as a digital liability of the Federal Reserve that is widely available to the general public.” “Money and payments–Fed report”  CBDCs would be a direct claim on the central bank like Federal Reserve notes (cash) but would be held and transferred digitally like your bank deposits. If the Fed goes forward with introducing CBDCs, they would almost certainly be what are called retail CBDCs. Rather than opening accounts at the Fed directly, we would each do so through a bank. We would sign up with and deal with a bank to hold the Fed’s CBDCs. The Fed has no existing capacity to deal directly with each of us in the way that our banks do. The balance of this note will explore how such CBDC would compare with, say, Venmo balances and payments and whether they are worth the trouble.

All digital money is recorded on electronic ledgers, either distributed as with a block chain used by bitcoin, or centrally maintained as with our bank accounts. As block chains are slow and expensive to verify, they would not be used for CBDCs. Just in case you didn’t know, when you walk into your bank and deposit cash, they don’t put it in the value for you. They record the value of the cash you delivered in our account with the bank, and they return the cash to the Fed for a credit to your bank’s Fed account or invest or lend it to someone else (after having converted it into a balance in their Fed account). It is both useful and interesting (to us economists at least) to walk through how my deposit at my bank is transferred to you (your account at your bank).

Taking Venmo as the example of existing digital payment technology, your deposit of dollars to your Venmo account would be digitally transferred from your bank account to your account on Venmo’s ledger. Your bank would transfer the same amount to Venmo’s deposit account with its bank (in the name of PayPal, which owns Venmo) in the usual interbank transfer manner. All (double entry) financial ledgers have a liability side (your deposit with the bank — what the bank owes you) and an asset side (the cash you deposited or the balance in your bank’s fed account for the money you had transferred to it). The ledger shows what the bank owes (liabilities) and the assets it holds with which to pay out what it owes (assets).

All digital money, whether your bank deposit or Venmo or bitcoin, must provide for an on ramp into and off ramp out of the digital system, i.e., for the process of paying cash in to acquire the digital money and of drawing it out as cash. Interestingly, Kenya has had a version of Venmo payments for several decades already. Kenya’s M-Pesa The ownership and use of cell phones (not necessarily smart phones) is very widespread in Kenya, while bank accounts are far more limited. Thus, people paid for phone airtime by the hour by paying cash to street venders selling such service. This became the on ramp for the unbanked to fund their M-Pesa mobile money accounts.

If you have money in your Venmo account (a positive balance), you can issue a payment instruction via your Venmo wallet directly to the friend you are paying. You can also instruct Venmo to take that the money simultaneously from your bank account. You can do all of this on your smart phone while waiting for your drink at a local bar. If your friend doesn’t have a Venmo account, Venmo will instruct her on how to set up one in order to receive your payment. If you give Venmo a day or two to complete the payment, it is free. If you want it delivered immediately (within a few minutes) there is a small fee. When the payment is complete, your balance at Venmo (or your bank) will have been reduced by the amount of the payment and your friend’s balance with Venmo will have been increased by the same amount. She can leave the money there or move it to her bank account (on her cell phone) if she has one. The money will “exist” as an accounting record somewhere. These “dollars” are accepted from wherever they come (from whoever produced them) because they are claims on, or are converted into deposits at, a Federal Reserve Bank.

How would this compare with a payment with central bank digital currency (CBDC)? While the Federal Reserve has not indicated the details of a possible CBDC, it would probably work something like this. I would ask my bank to sell me CBDCs by debiting my checking account by the indicated amount. These would be added to (credited to) my CBDC account at my bank.  My bank would transfer that amount from its general account at its Federal Reserve Bank to a segregated CBDC account at the Fed. My cell phone wallet would record (by accessing my CBDC account at my bank) this amount, and my bank would back it 100% with its CBDC account at the Fed.

Why does this matter? It matters because if my bank fails (goes into bankruptcy), the amount in the bank’s CBDC reserves at the Fed would be excluded from the bankruptcy process. They are exclusively and fully available to back my CBDC holdings. When I pay CBDC to my friend, her bank will receive them without regard for the condition of my bank.

Some of you will recognize this as the equivalent of the so-called Chicago Plan. The Chicago Plan required banks to back all checking account deposits 100% with central bank reserves. Our bank deposits today are largely backed by bank loans and investments plus a small deposit with the central bank. Such CBDC deposits would be totally free of default risk. While all CBDCs would exist on the books of the Federal Reserve, ownership by individuals would be reflected on the books of their respective banks and in their CBDC wallets.

Like the Chicago Plan, CBDCs have the potential to reduce the money multiplier (the ratio of broad money to base money–the Federal Reserve’s monetary liabilities). A shift from demand deposits to CBDC deposits at banks would reduce the funds available to banks for lending by increasing the reserves they must hold at the Fed. This could be easily compensated for by increasing base money (Federal Reserve monetary liabilities). Sudden shifts to the safer CBDCs in reaction to financial shocks, like traditional bank runs, would require central bank intervention. The Fed has also indicated that it would want any digital replacement of its currency notes to provide as much user privacy as possible (like cash) consistent with “affording the transparency necessary to deter criminal activity.”

How would this compare with a Venmo payment. From our perspective (the perspective of the payer and payee) a Venmo or CBDC payment would be executed in the same or very similar way. The difference is that the CBDC balances would be totally risk free (being relatively direct claims on the central bank) while the Venmo balances would be exposed to the risk of the failure of the bank in which Venmo keeps its assets that back our Venmo balances. It is not obvious that this is a big enough difference to make it worth undertaking.

Econ 101: Moving money abroad

The Washington Post published an article this morning titled “THREE DOZEN TYCOONS MET PUTIN ON INVASION DAY. MOST HAD MOVED MONEY ABROAD.”“Offshore Putin Russia Oligarchs Pandora” It said things like “many of them had been moving their wealth out of the country for years,” and “The money often ends up offshore.” While where income is claimed is important for tax purposes, which is another interesting and complicated story, the abandon with which this story discusses moving wealth around drives us economists up the wall.

Wealth can be physical (factories, stores, etc.) or human (the knowledge or skills of people).  Financial wealth, such as money, is a claim on physical or human wealth. People can move abroad, and many skilled Russian’s are doing so. Moving physical capital abroad is more difficult if even possible. A yacht built in Russia can be sailed off to another country, but not a shopping mall. What this and similar articles generally mean by moving wealth abroad, is, as the headline states, moving money abroad. This is often done to minimize taxation, which is usually based on where income is recorded. “The corporate income tax” That is an interesting subject of its own but not my focus today.

How do people “move money abroad?” Money is rarely moved in suitcases anymore, and a bag full of rubles can’t be spent abroad in most places anyway.  So, let’s take a deeper look at what is really happening when Russian tycoons (or anyone else) “move money abroad.”

The easiest example is when Russian exporters are paid in foreign currency (generally US dollars). If the exporter has a dollar account in a bank abroad (in a US bank to keep it simple) the payment for his export can be deposited directly there by a debit to Shell Oil’s bank account and a credit to the Russian exporter’s US bank account via the normal interbank transfer process. He can hold it there or buy US treasures or other US financial assets. His money is moved abroad by moving (selling) his goods abroad and keeping the payment abroad. This helps explain why Russia is insisting that German and other buyers of its oil must pay in rubles.

To pay for oil or any other Russian export with rubles the foreign buyers must first buy rubles in the foreign exchange market. The increased demand for rubles increases its exchange rate (or keeps it from falling as Russian importers sell rubles for dollars to pay for imports). Russia has made the process of paying dollars then buying rubles simple and almost automatic, but critically the Russian exporter receives ruble. Normally Russian exporters would convert dollar payments into ruble with which to pay for their workers and local suppliers, etc. But by keeping the dollar payment abroad, they have effectively “moved money abroad” by shipping goods (and services) abroad.

If a tycoon’s income/wealth is local (in rubles), and he wants to move it abroad, he can’t just write a check (or SWIFT payment order) to deposit X amount of money in his account with the Bank of America. The funds in his local bank, which will be in rubles, will need to be exchanged for dollars in the foreign exchange market. He (his bank) will deposit his ruble in the ruble account of the seller of the dollars and will receive those dollars in his Bank of America account in the U.S. If the supply of dollars to the foreign exchange market are not being supplied as the result of Russian exports, the increased demand for dollars will depreciate the ruble (increase the ruble price of a dollar). With a balance of imports and exports the ruble/dollar exchange rate should be stable. But a net increase in the movement of money abroad would depreciate the ruble. In short, underlying the movement of money abroad, there is a net movement of goods (exports minus imports) abroad.

If there was a sudden increase in money being moved abroad from Russia (often called capital flight) the ruble’s exchange rate would depreciate and the cost of imports would thereby increase.