Economics – Page 23 – Warren's space

Minimum Wages

Saving people money so they can live better

Walmart helps people around the world save money and live better — anytime and anywhere — in retail stores, online and through their mobile devices. Each week, more than 245 million customers and members visit our nearly 11,000 stores under 71 banners in 27 countries and e-commerce websites in 10 countries. With fiscal year 2014 sales of approximately $473 billion, Walmart employs 2.2 million associates worldwide.

The above words are taken from the first page of Walmart’s website. Some have claimed that Walmart achieves this great feat by exploiting its workers. What might that mean?

A number of the gulf countries have workforces that are predominantly foreign. Qatar is the world’s wealthiest country on a per capital basis. In a recent article The Guardian reported that: “the Guardian visited a group of more than 60 workers from south Asian countries in a workers’ camp in the desert 25km west of Doha. They have had their passports taken from them, in breach of Qatar’s labour laws, which prevents them from leaving the country, and many of them have not been paid for several months. Most paid hundreds of pounds to agents in their home countries simply for the right to get a job in Qatar. Among them lives Ujjwal Thapa, 25, who left Nepal last autumn…. He has not been paid for several months despite working for 11 hours a day, six days a week, on building sites for an Indian contractor.

“Another worker was conned over the wage he would earn. His immigration document, stamped by the Nepalese government before his departure from Kathmandu, shows he had agreed to work as a foreman on a basic salary of £410 a month. But the contract signed with the employer on arrival was for £150 [US$ 240] a month to work as a carpenter “ “Qatar promises change-unpaid migrant workers”

Labor practices in Qatar are truly exploitive even though workers came voluntarily. Walmart has been accused of paying poverty level wages: “Walmart’s average sale Associate makes $8.81 per hour, according to IBISWorld, an independent market research group. This translates to annual pay of $15,576, based upon Walmart’s full-time status of 34 hours per week.” Should they pay more?

If the number of workers they now employ, about 2 million, were not willing to work for the wages offered, Walmart would have to pay more, but would almost certainly choose to get by with fewer workers. The demand curve for labor (wages on the vertical axis and number of workers on the horizontal axis) is downward slopping—lower wages brings larger demand. If a minimum wage law required them to increase their minimum wage to say $10.10 dollars an hour as proposed by President Obama, Walmart would hire fewer people. Some people working at the current minimum of $7.25 would enjoy an increase and some would become unemployed. Not only would the quality of Walmart service drop a bit with fewer employees helping customers but the customers would have to pay a bit more as higher wages were passed through to higher prices paid by customers. The Congressional Budget Office estimates raising the federal minimum wage to $10.10 an hour would eliminate 500,000 to 1,000,000 jobs. On the other hand, if customer demand for Walmart services increased and Walmart found it profitable increase its staff, it would have to pay more to attract them even without a minimum wage law.

It is obvious that if some one offers their services cheaply enough you will use more them than otherwise. If you could hire the neighbor kid for a dollar an hour to weed the garden and clean up the garage you might do so when you wouldn’t for $10.00 per hour. If he or she doesn’t want to do the work for a dollar an hour or has a better offer somewhere else, you might do it yourself. The supply curve for labor is upward sloping—fewer people are willing to work at lower wages. The intersection of the supply and demand for labor is the wage at which everyone wanting to work has a job.

But of course not every worker is the same as every other worker. You are happy (or at least willing) to pay the plumber $30 per hour because of his greater skills. In fact very few people earn the minimum wage or less and thus most workers will be unaffected by its prospective increase. Some jobs are exempt from the minimum wage to prevent closing off some services altogether (home companions for the elderly, newspaper delivery people, babysitters, disabled workers, etc.). Failing to win the economically obvious case for eliminating minimum wage laws all together, some have argued for sparing teenagers at least from its damaging effects. Young people just entering the job market from high school must learn skills on the job. They begin with very low productivity and employers are not willing to hire them at the same wage paid to more experienced (older) workers.In 2013, 16-19 year olds had an unemployment rate of more than 20 percent in the U.S. when total unemployment averaged 7.4%. “Minimum wage hike means more sub-minimum workers”

So why does President Obama (and George W Bush before him) want to raise the minimum wage? It seems to exploit the public’s ignorance of economics, with the feel good prospect that the government can make us richer by legislating it. The public is not really that dumb. It is frankly difficult for me to understand. Marc Linder argued for minimum wages, not because he believed that people could be made wealthier with magic wands, but because he believed that some (very low wage) jobs should not exist at all because they were beneath man’s dignity. He assumed (or advocated) that those unable to work as a result would be cared for by the state. At least I think that is what he is saying (he is a lawyer, not an economist). The abstract to his book: The Minimum Wage as Industrial Policy: A Forgotten Role, says: “In the welter of arguments being debated in connection with amending minimum wage legislation, the protagonists have lost sight of the original intent of such state intervention. That purpose was to help — exclusively — those workers whose wage formation process was subject to “market failure” by forcing their employers to internalize the minimum social costs of maintaining a worker, which they had succeeded in shifting onto the worker or society.

“Although the minimum wage was obviously also designed to create micro-welfare effects, its primary function lay in removing labor costs from competition, increasing productivity macro-economically by driving “parasitic” firms out of business and concentrating production in the most competent firms, and steering capital-labor relations.” “Marc Linder” I have no idea what that means, but the evidence is overwhelming that minimum wage laws harm the least advantaged if they set minimum wages high enough to make any difference.

Liberal societies vs top down (centrally planned) societies

Michelle Obama is absolutely correct to criticize food served in many school cafeterias as contributing to an epidemic of obesity. I grew up knowing that white bread, especially enriched white bread, was bad for me. My mother, who like all mothers loved her children and wanted them to be healthy, had read every word of Adelle Davis three times over. Moreover, compared to whole wheat and multigrain breads, white bread has no taste. So why are some kids today—fat kids no doubt—throwing whole wheat bread and fruit in the trash? “Michelle Obama’s school lunch agenda faces backlash from some school nutrition officials” WP/2014/05/29/

I believe it is ignorance, which the First Lady wishes to help overcome, and rebellion. The ignorance is a bad thing to be over come, and the rebellion, if that is what it is, is fundamentally a good thing—resistance to being dictated to from above. If loving mothers and their children understood the importance of nutritious food to their well-being, do we really believe they would throw it in the trash? These are children we are talking about, who must be taught everything they know. If on the other hand, the government and school administrators simply try to impose healthier food on them, they will resent having their candy taken away from them and will rebel.

This all speaks directly to a frequent theme of mine—the sanctity of the individual vs. the power of the state. If the government thinks it knows better than Johnny and Betty what is good for them to eat, what should it do? The top down, central planning mentality calls for better food standards imposed on schools. After all, pizzas etc. are cheaper and easier to prepare as well as more fun to eat and the government shouldn’t allow these shortsighted considerations to dominate. Respect for individuals, even children, suggests a very different approach. It suggests improved education (the same arguments I have made against the war on drugs). If mothers, and through them their children, understood better what food was good for them and the implications of eating or not eating healthier food, most would choose it. The companies that make it are interested in selling their products and if there is demand for healthier food, then that is what they will make money producing.

Ukraine Monetary Regime Options

On March 12^th I participated in the Emergency Economic Summit for Ukraine in Kyiv. The summit was organized by Tom Palmer (Atlas Foundation) and Dalibor Rohac (Cato Institute) and several Ukrainian free market think tanks. My charge was to evaluate monetary policy regime options. The following paper prepared for this meeting and published in the current issue of the Cayman Financial Review, presents my assessment. If, like most people, you are not interested in monetary policy issues, you should skip this paper: http://www.compasscayman.com/cfr/2014/04/07/The-future-of-Ukraine-%E2%80%93-and-the-role-of-sound-money/

Keep it limited and keep it simple

The first and second rules of good government

The price of liberty is eternal vigilance. We can never remind ourselves of this fact too often. As I have written many times, government by its very nature is a slippery slope. We need government and we need good and efficient government for a number of things that only governments can provide. But it is in the very nature of government that it naturally expands its scope and power unless prevented from doing so – over and over again. It is also in its very nature that it is relatively inefficient and slow moving because of the need for cumbersome checks and balances. Private enterprises are disciplined by the market (their need to profitably satisfy consumers). Governments are more difficult to monitor and keep honest. But we need them so some (hopefully limited and enumerated things) are properly assigned to government.

Government is especially difficult to keep in check the more it intrudes into activities in and of the private sector. This is a good reason for resisting such extensions in the first place. The repeated cycles of corrupting our tax code with special breaks for special groups provides but one example of the danger. After pretty much cleaning up the income tax in 1986, special interest favors gradually crept back in until now it is again a total mess. Economists continue to debate the best approach to taxation (see my summary: The-principles-of-tax-reform in the Cayman Financial Review July 2013), but they are generally agreed that a broad tax base with low or flat marginal rates is the most neutral (least distorting of the economy), efficient, and fair way to raise the money to pay for what the government does. In short, special tax brakes for specially groups are generally bad (watch a few episodes of the Netflex series House of Cards to get a feel for the problem).

I was brought back to this topic by a recent Washington Post article on proposals by Senator Ron Wyden, the new Chairman of the Senate Finance Committee to restore all kinds of special favors to the tax code, basically ignoring the recent, laudable efforts of the House Ways and Means Committee, lead by Representative David Camp, to remove them and clean up our scandalous income tax law. “Senator to revive array of tax breaks”/2014/03/26/. Once a favor (tax break or subsidy) is extended to a special interest group it has a much stronger interest in defending it than the rest of us (the general tax payers) have in fighting it to take it away.

A few of Wydern’s proposals tell you all you need to know (once again, think House of Cards): “Sen. Ron Wyden (D-Ore.) plans Monday to unveil a proposal to temporarily extend the breaks, which include such popular policies as a credit for corporate research and development, an incentive for commuters who use mass transit and a special deduction for sales tax in states such as Florida and Texas, which do not tax income.

“Democratic aides said Wyden plans to ask the committee to vote separately on some of the more controversial provisions. For instance, senators will be asked whether to revive a much-maligned break to promote development at NASCAR racetracks, as well as a credit for the purchase of electric motorcycles and golf carts that barely survived a 2012 effort to weed out special-interest provisions.

“However, Democratic aides expect the entire list of temporary tax policies — known as “tax extenders” — to emerge intact from the committee, adding nearly $50 billion to this year’s budget deficit.”

President Putin’s welcome to Crimea

Anyone interested in current events in Ukraine should read Russian President Putin’s address to the Russian people on March 18, 2014 welcoming Crimea back into Russia: “Putin’s speech on Crimea”. It is very clever in playing to the insecurities of the Russian people while also speaking to the international community. Putin says many things we can hardly disagree with along with (and often packed in) some amazing lies and some embarrassing truths.

Here is one example of the former: “I would like to reiterate that I understand those who came out on Maidan with peaceful slogans against corruption, inefficient state management and poverty. The right to peaceful protest, democratic procedures and elections exist for the sole purpose of replacing the authorities that do not satisfy the people. However, those who stood behind the latest events in Ukraine had a different agenda: they were preparing yet another government takeover; they wanted to seize power and would stop short of nothing. They resorted to terror, murder and riots. Nationalists, neo-Nazis, Russophobes and anti-Semites executed this coup. They continue to set the tone in Ukraine to this day.” Perhaps Putin’s virtual shut down of a free press in Russia has kept the Russian people from knowing of his suppression of political opposition there. Or perhaps he thought that the recent release from prison of Mikhail Khodorkovsky (after over ten years of political incarceration) and Pussy Riot demonstrated that the “right to peaceful protest” was alive and well in Putin’s Russia. His statement that the murder of over 100 Maidan demonstrators was at their own hand is just a bald faced lie.

Examples of embarrassing truths include President Obama’s pledge not to bomb Libya. Quoting Stephen Cohen, a professor emeritus at New York University and Princeton University, on the Charlie Rose show: “The United States said to Russia, support of the United Nations’ [authorization of] a no-fly zone over Libya so that Gaddafi can’t take his planes up and attack the insurgents. Russia said, so it’s just a no-fly zone? You’re not going to bomb Gaddafi? [But] we did and it led to his assassination. From that moment on, Putin never trusted anything that came out of the White House.”

I had intended to start the previous paragraph with the often repeated claim that, to quote former U.S. defense secretary Robert McNamara, ‘‘the United States pledged never to expand NATO eastward if Moscow would agree to the unification of Germany.’’ According to this view, ‘‘the Clinton administration reneged on that commitment when it decided to expand NATO to Eastern Europe.’’ Quoted in Mark Kramer: TWQ article on Germany and NATO. Recently available documentary evidence cited by Kramer clearly refutes this “myth.”

I want to share an account of a famous meeting I attended in Tashkent on May 20-21, 1992. The account was written by me many years ago but never shared until now. It presents the truth of another mini lie in Putin’s speech contained in the following passage:

“The USSR fell apart. Things developed so swiftly that few people realized how truly dramatic those events and their consequences would be. Many people both in Russia and in Ukraine, as well as in other republics hoped that the Commonwealth of Independent States that was created at the time would become the new common form of statehood. They were told that there would be a single currency, a single economic space, joint armed forces; however, all this remained empty promises, while the big country was gone.” The following account reveals just how committed Russia was to “a single currency” for the newly independent Former Soviet Republics.

Tashkent, May 20 1992

A. Background: Monetary Babylon

The sudden formation of 15 central banks out of Gosbank in the Former Soviet Union created a strange and ultimately unsustainable situation. One monetary system suddenly had 15 suppliers of “rubles.” The ruble banknotes supplied by the new Central Bank of Russia (they were initially the USSR ruble notes that had already been printed by the Central Bank of the USSR) were issued in their respective areas by each of the 15 FSU central banks. In addition, ruble deposits with banks where used in payments throughout the entire FSU region using the settlement accounts each bank maintained with its newly independent central bank. When payment orders from FSU republics outside Russia began piling up at the Central Bank of Russia in Moscow, we were forced to start sorting out what was wrong with the “system.”

Initially the payment system continued to function as it had previously under Gosbank. The system was decentralized. All that was needed under that system was to verify that the sender (payer) had sufficient funds in its account with its bank. As there was only one bank in the Soviet system, Gosbank, there was no issue of the sender’s bank having enough money in its “settlement” account. All deposit transfer payments were in effect “on us” (i.e., intrabank transfers). Thus a valid payment order could be and was safely accepted at which ever branch or office of Gosbank it was delivered to (the one closest to the recipient of the payment). However, with the introduction of a two tiered banking system several years earlier, the adequacy of a depositor’s bank’s settlement account with the central bank potentially became important.

In early 1992 we were confused by the system being described to us. It was very difficult for us to understand how it really worked. Our counterparts who were explaining the system to us, either didn’t really understand the system either or understood it in terms of its functioning in monobank days. On top of this, the system we were trying to understand was being described to us in Russian and then being translated into English for us by interpreters with no real knowledge of the subject they were interpreting.

Under the old, inherited system, a payment order was sent directly from the central bank branch office used by the sender to the central bank branch office used by the receiver. We were concerned with the potential for credit creation by overdrafts that seemed to be automatically generated when payment orders were accepted wherever they landed without being able to verify the sending bank’s settlement balance with its respective central bank. Bruce Summers of the Federal Reserve Bank of Richmond, complained that each of the fifteen central banks created out of Gosbank needed to centralize the information on account balances if they were to avoid accepting payment orders that might result in overdrafts. Furthermore, something was needed to ensure that net payments among the fifteen central banks did not result in unauthorized overdrafts.

In a series of quick steps, the Central Bank of Russia centralized all incoming payment orders from FSU payers outside of Russia in its Regional Branches and ultimately in Moscow. Furthermore, payment orders that had earlier been sent directly from the Gosbank office servicing the payer to the Gosbank office serving the payee, were now redirected to the new central bank of the republic of the payer, which forwarded it to Moscow (if the payee was somewhere in Russia). Quite aside from whether the bank of the payer had sufficient settlement funds, the sheer volume of payment orders now directed to Moscow overwhelmed the CBR staff there. The time for processing cross border ruble payments was measured in months.

In addition, no one seemed to know the terms under which the CBR supplied its ruble bank notes to the new FSU central banks. Under the inherited system, banknotes were shipped from the mints to the regional branches and offices of Gosbank as needed. They were issued to enterprises against debits to the enterprises’ account balances with the central bank or as credits to the enterprises. The rest was just internal bookkeeping. This arrangement continued for a while until the new FSU central banks began to realize that they were no longer part of the new central Central Bank of Russia and would need to pay for the banknotes of the CBR.

I remember being told by bewildered staff of the National Bank of Kazakhstan and National Bank of Kyrgyzstan that of course the CBR would continue sending banknotes when needed because they always had. And why should they “charge” for them as they had never charged for them before. And indeed, the CBR did continue to send their banknotes for a while and no one knew what the terms for providing them was or might be. This was new territory for everyone and no one seemed to understand exactly where the system was going or how it should work.

As almost all of the new republics had a balance of payments deficit with Russia, the settlement accounts of their new central banks with the CBR in Moscow were always over drawn. The CBR periodically extended credits to these FSU central banks in order to put the overdraft credits on a more explicit basis. But in fact, as the whole process was not really understood and the CBR’s policy not yet really established, the terms of these credits were often unspecified for many months after the fact. Russia seemed to use the undefined terms for political leverage. More politically cooperative Republics negotiated better terms than others.

Resolving the settlement problem was further complicated by the fact that the system was not designed to produce up-to-date account balances. I remember when our accounting expert, Alan Vedren Lacohm from the Bank of France, reported to me that the central bank did not seem to know the current balances of the deposits banks held with it. As hard as it was for him to believe or understand, the central bank seemed to maintain separate debit and credit accounts that were only compared and balanced once a year. An enterprise could issue payment orders against its account on the basis of a central plan authorization. It didn’t matter if it had enough money in its combined debit and credit accounts, and in fact no one really knew whether it had a positive balance or not. This astounding fact mystified us because we were seeing it from the prospective of the systems familiar to us designed for market economies. When we came to understand that the Soviet system, obviously designed to serve a centrally planned economy, was really a budget tracking tool, we suddenly understood its logic. None-the-less, it would not work for a market economy. (Alan later married my assistant after they met on my second mission to Kazakhstan and Kyrgyzstan)

When a bank did not have sufficient balances in its settlement account at the central bank, the central bank could extend it credit to permit payment settlement to proceed. However, such credit did not help when “rubles” were being transferred from Kazakhstan (for example) to Russia. The National Bank of Kazakhstan could not extend credit to its own account with the CBR. The system was designed to work with one central bank and it continued to operate throughout the ruble area as if it still had one central bank when it in fact had 15. The fact that the CBR more or less automatically extended credit to the other FSU central banks and supplied them with what ever ruble bank notes they needed (a very soft budget—balance of payments—constraint), encouraged the FSU central banks to create ruble credit at an ever increasing rate.

B. A Blue print for monetary union

The emerging system was not viable. The USSR had been one economic and monetary space. With its break up, the ruble continued to circulate and to be used for payment through out the entire area. In the case of bank notes, a ruble was a ruble (until new versions were introduced later in the year and in 1993). But in the case of deposit rubles, 15 central banks now issued them. And they continued to be transferred from one account to another as if they were one currency in one system. As we more fully appreciated later, the ruble area of 1992 consisted of one cash ruble and 15 different non cash rubles. Each central bank was issuing its own ruble credits. A ruble claim on the National Bank of Kazakhstan was not the same as a ruble claim on the CBR even though they had the same name.

If an FSU central bank was going to create credit as it saw fit, it would need to introduce its own currency (bank notes as well as central bank account money). If an FSU republic wished to continue using the “traditional” ruble, it’s monetary policy would need to be subordinated to or coordinated with that of the CBR and any other central banks that remained a part of the ruble system. We developed a set of rules for central bank cooperation within a ruble area that we thought would be needed to make the system coherent and stable and invited the governors of all 15 FSU central banks to a meeting to discuss them. The meeting took place in Tashkent on May 20 and 21 following a heads of state meeting there as part of the Russian effort to organize the Commonwealth of Independent States (CIS).

This meeting was preceded by building tensions between the CBR and most of the other FSU central banks as they raced to out do one another in creating ruble credit and as payment orders piled up in Moscow. The situation was further complicated by conflicting signals from Moscow. Depending on who was speaking on any given day, Russia seemed to support the introduction by the FSU republics of their own currencies (thus leaving the ruble area) or the surrender of monetary autonomy to the CBR. Either of these Russian positions was coherent. Our own proposal was meant to provide coherence and central, but collective, control of monetary policy (along the lines of the subsequent ECB), without full surrender to the CBR (These can be found in IMF [Occasional Paper 51]). The Russian terms for staying in the ruble area were cleaner, but because they required complete subservience to the CBR, we felt they would drive out (into their own currencies) even those countries that wanted to stay in a ruble area.

After helping to develop the guidelines to be discussed, I attended the meeting. Other IMF staff attending where Malcomb Knight (later the Sr. Deputy Governor of the Bank of Canada and the General Manager and CEO of the BIS), John Oling-Smee (head of the IMF’s newly established European II Department consisting of the FSU countries), Ernesto Hernadus Catan and Ishan Kapur (both from the IMF’s European I Department). Most of us met in Geneva in order to take a charter flight on May 19. We stopped in Moscow on the way to pick up Ernesto. May 19, 1992 happened to be my 50^th birthday. We celebrated on the plane with a bottle of Dom Perignon. It was a memorable birthday.

We were met at the airport in Tashkent by the Deputy Prime Minister. A caravan of three Chaikas and several police cars took us to the compound in which we would stay and our meeting would be held. It was 10:00 pm when we arrived and a formal welcoming dinner had regrettably been planned that required our attendance.

Following the dinner, sometime after midnight, I slept moderately well, despite my excitement, because I was so tired. We had no idea what the current Russian position on use of the Russian ruble would be. It had been changing back and forth in the work up to these meetings almost daily. Clearly views within the Russian hierarchy were divided. Relations between Russian and most of the FSU republics had grown increasingly tense. No one trusted anyone. I had found trying to understand the existing monetary arrangements and working out principles that could make it work intellectually very challenging and interesting. I was filled with excitement and anticipation to hear the reactions of the delegates.

The meeting on the 20^th was opened by the Prime Minister, Abdulhashim Mutalov, and the Governor of the State Bank of Uzbekistan. The substantive part of the meeting, which was attended by the Governors of most of the FSU central banks and the Deputy Governors of the rest, was led by John [Odling-Smee]. After a general introduction of the purpose of the guidelines, we proceeded through the sixteen points one after the other. Questions were raised by one chair or another to clarify some of the points. The general suspicion that the IMF would take the Russian position gradually melted (this was helped by the fact that we had fielded technical assistance missions to all of the FSU central banks by then and established the beginnings of relationships of trust). Very few political statements were made and everyone kept glancing at the Russian chair trying to read their position. The Russian Chair, headed by Governor Georgy Matyukhin, said nothing at all that day. It seemed that Russia was not going to challenge our proposal, which was enthusiastically supported by all of the other central banks. At the conclusion of the day it was agreed that a communiqué signed by each of the fifteen governments would be prepared that would set out the sixteen points.

Following the long day’s meetings, we were taken in a long police escorted motorcade to a lake on the outskirts of Tashkent for a celebratory banquet. Our banquet tables were on a large wooden pontoon floating at the edge of the lake. By that time I knew the routine (toasts from each governor, lots of food and lots of vodka). Between the 15 central bank representatives, Uzbek/Tashkent government representatives, and our group, there were a guaranteed minimum of 18 toasts. And indeed, we exceed the minimum. My routine of minimal sips was again subverted by yet another Russian woman sitting across the table. Nothing but “bottoms up” was acceptable. The spirit of the group was exuberant. Each toast became more friendly and gushier than the one before it. Governor’s who were barely willing to speak to each other in the morning had become the best of friends—brothers (“comrades” was no longer a forbidden term).

We arrived back at our compound around midnight. Galinda, our translator from Washington went to work translating the draft communiqué into Russian. John had asked me to be ready to respond the next morning to any questions about inter-enterprise arrears. I started down the hall to my room to brush up on my potential presentation and the First Deputy Governor of the State Bank of Kazakhstan (Mr. Tadjeokof) grabbed me and insisted that I join him in his room for another drink. I had met him two months earlier in Alma Ata (now called Almaty) during my first mission to Kazakhstan. He wished, it seemed, to thank me for our technical assistance and to explain how much they needed lots more. Mr. Tadjiokof did not speak English and I do not speak Russian (or Kazakh), but we proceeded to speak to each other and to lift our glasses of Vodka and toast whatever warm words had been said.

I had assumed that Mr. Tadjiokof had wanted company for another drink, but he persisted in efforts to communicate. It was only possible to go on as if we understood each other for a limited time. I was soon forced to seek help from one of our interpreters. Galinda agreed to suspend her translations of the draft communiqué to interpret for us. Several toasts late, I had second thoughts about the seriousness of Mr. Tajiokof’s communications, which remained focused on his gratitude for our assistance. Galinda was complaining that she needed to return to her work on the communiqué. I was beginning to lose patience and focus. As Galinda left, I spotted Ernesto in the hall. He had been taking Russian lessons and agreed to practice on Mr. Tadjiokof. It was 3:00 am and I stagger off to my bed.

I awoke a few hours later still fully dressed where I had fallen on the bed. I had one of the worst hangovers I can remember. I had serious doubts that I could clearly explain the interrelationships between inter-enterprise arrears and monetary policy. I wanted to sleep for a few more days. But the meeting resumed. No one raised the issue of inter-enterprise arrears thank God. The Russians remained silent. The text of the communiqué was agreed on and the Uzbek hosts agreed to obtain the signatures of the fifteen FSU republics.

The communiqué was never issued nor heard of again. The Russian’s had quietly killed it. In the end, Russia required each FSU republic to choose subordination to the CBT or to introduce their own currency. All but Tajikistan chose the latter. Within several months the Baltic states introduced their own currency and one year later Kyrgyzstan became the first FSU country beyond the Baltics to introduce its own currency. Most of the rest followed before the end of 1993 and the ruble crisis came to an end. Inflation in 1992 is thought to have been several thousand percent dropping to 875% in 1993 and 307% in 1994.

*****************

The quiet disappearance of the central bank cooperation communiqué is reminiscent of the mysterious disappearance of President Yanukovych on February 22, 2014, one day after signing an EU brokered truce with opposition leaders following two days of the worst violence between demonstrators and police in 70 years in which almost 100 were killed. According to witnesses in the room, Yanukovych only agreed to sign the agreement after being instructed to do so by President Putin in a phone call during the meeting. The agreement has not been heard of since. Though Yanukovych was removed from office by an overwhelming vote of the Ukrainian Parliament on February 22, Putin and Yanukovych called it a coup.

The Future of Bitcoin Exchanges

A major selling point for Bitcoin is its ability to transfer money directly between two entities (peer-to-peer) without the need for a trusted third-party such as a bank. Virtually all electronic payments today require (ultimately at least) the transfer of the ownership of deposits with banks. The settlement of such payments between banks takes the form of transfers of bank balances with the central bank. Peer to peer transfers have cost advantages (if the costs of preventing double use are less than those of the services of the trusted third parties) and confidentiality advantages (though a ledger record of every transfer of bitcoins is publically available). The difference between Bitcoin and bitcoin and other features of the system are explained in my earlier blog: “Cryptocurrencies: The bitcoin phenomena”.

As with bank deposits or mobile phone deposits, Bitcoin must also provide some means for paying cash in to the Bitcoin system and of getting it out. Banks have teller windows or ATM machines. Bitcoin now also has a few ATM machines and organized gathering places for individuals wanting to buy or sell bitcoin to meet. But the overwhelming convenience of buying and selling them through an exchange has resulted in most in and out transactions taking place through exchanges.

One of the oldest and largest of these exchanges, Mt. Gox in Japan, recently declared bankruptcy as the result of misplacing or otherwise losing about 850,000 bit coin (valued at about $470 million at March 1 prices). Mt. Gox had bitcoins in its care (as a pure exchange it would only have its own bitcoin capital for trading purposes) because it was also a depository or wallet. Apparently the software for individuals dealing in bitcoins is not particularly user-friendly. As a result, many have chosen to deposit their bitcoins with trusted third parties to hold and transfer on their behalf. As these depositories do not lend or invest these bitcoins, they are not required to be licensed as banks. 750,000 of Mt. Gox’s missing bitcoins belonged to (i.e. were owed to) such depositors. It is still unclear whether Mt. Gox’s bitcoins were stolen or misused by Mt. Gox. “Hackers allegedly stole 400 million in bitcoins-here’s how to catch them” WP 2/28/2014.

This seemingly devastating development has not yet killed interest in bitcoin. While the price quoted by Mt. Gox (which tracked closely the price index published by Coindesk until February 8) fell from $1,236.90 on December 5, 2013 to $130.95 when it closed on February 28, the Coindesk index for all exchanges has “stabilized” in the neighborhood of $600. A debate has broken out among bitcoin supporters over whether exchanges and depositories should be regulated in order to strengthen public trust in them and what sort of regulation would be helpful.

Jeremy Liew, a leading bitcoin investor at Lightspeed Venture Partners, stated that:

“I think a regulatory solution would do more to increase ordinary consumer confidence in Bitcoin and its institutions than one that is purely market driven or industry led. I am well aware of all the challenges that regulatory solutions have, but if Bitcoin is to become a mass market product, then it will require measures to lift confidence from those who will not understand a technology solution that their BTC is safe. I advocated against new BTC specific regulation at Lawsky’s hearings last month, but I now think that some sort of regulation covering customer funds security may make sense if there is going to be a BitLicence.”

Reliance on trusted third parties, such as exchanges and depositories, requires trust in their honesty and competence. The question for bitcoin and other cryptocurrencies is how such trust can be best developed. Bank and financial service industry regulators care about the safety and soundness of banks and the financial sector. Unfortunately, however, much of the regulatory concern with cryptocurrencies has to do with Anti Money Laundering and the Combating of the Financing of Terrorism (AML/CFT), a well-meaning but almost totally wasteful effort to fight crime by making it harder to spend the proceeds of crime by monitoring the use and users of money. See “Report Global Surveillance of Dirty Money” 1.30.2014 for a very critical evaluation. Regulatory bodies also have a disadvantage in promoting the safety and soundness of regulated entities deriving from the natural timidity and caution of bureaucrats.

While licensing exchanges and depositories and requiring public disclosure of their beneficial owners and of their financial conditions and activities (audited financial statements) should contribute to public trust, self regulation benefits from a stronger profit incentive to get it right. The Bitcoin Foundation exists to promote bitcoin and thus has a strong incentive to ensure that exchanges and depositories’ behavior contributes to the health and profitability of the industry. It has the right incentive to find the rules that best contribute to public trust at the least cost of compliance. Certification by the Foundation that individual exchanges and depositories comply with their standards should contribute more to public trust than would oversight by a government regulatory body.

The P2P technology reflected in or inspired by Bitcoin may evolve in unforeseen ways if allowed. It might, who knows, transform payments as we now know them (I am referring to Bitcoin—the means of payment—not bitcoin the currency, for which I see no future). “Our Flawed Financial System is Reflected in Bitcoin” March 2, 2014, FT. Unnecessary or overly restrictive regulations could prevent that. If the internet and the World Wide Web, whose potential few of us imagined twenty years ago had been regulated beyond addressing and messaging protocols, we might be stuck with something like the French Minitel, an ahead of its time State designed and run digital forerunner of the WWW. Not able to keep up with the exploding features of the Web, Minitel was retired in 2012.

Tax treatment will also be important. Payment transactions (as opposed to investments) are not generally taxed. Thus it is encouraging that the UK has just ruled that bitcoin trades will not be taxed. “Britain to scrap VAT on Bitcoin trades” FT 3/3/2014 . My assessment remains that bitcoin will not succeed as a private money, but that Bitcoin and Bitcoin like means of payment have exciting promise to further improve and lower the cost of making payments and transferring money. We would be wise to allow any such potential to develop.

Teachers of the Poor

The raging debate about income inequality has focused on the growing demand for well-trained workers and the declining quality of American education. The mismatch is contributing to rising incomes for the well-educated and stagnant incomes for the poorly educated. Improving the education of the poor is thus a sensible and promising target for improving the incomes of the poor.

Thus the case getting underway in California attacking teacher tenure as a source of poor teachers being assigned to the poorest schools is timely and important. Teacher tenure goes on trial in Los Angeles courtroom/2014/01/26/

The issue of the unionization of public sector workers more generally is contentious. In the private sector unions can balance the market power of employers and are restrained in their demands by their impact on an employer’s bottom line. If excessive wages make a company uncompetitive and it losses market share or goes out of business, the jobs go with it. In fact, a constructive relationship between unions and their employers can potentially improve wages and the bottom line.

Public sector workers, on the other hand, are not constrained by the government’s bottom line (tax payers). Charles Lane provides a good discussion of this issue in today’s Washington Post: Public Sector Unions Interfere with the Public Interest/2014/01/27/. Unionized or not, public sector workers have long been protected from political interference by the Civil Service system. These protections were established in order to reduce the role of political favoritism in public sector hiring and promotion. However, the trade-off was the creation of a system in which promotion had much more to do with years of service than performance and in which it was difficult to fire anyone thus sheltering mediocre workers.

These trade offs are not easily resolved. If government supervisors can evaluate performance and reward it appropriately, they can also be easier prey for political interference. If they can’t, the worst performing employees rise to the top over time just as fast as the best performing and we get the civil service that we know and love. The plaintiffs in the California case “are nine students who say they were trapped in classrooms with “grossly ineffective teachers” who could not be fired because of the job protection laws.” (W.Post)

The solution, of course, is to leave as much in the private sector as possible. Private schools, including government funded but privately run charter schools systematically produce better results than public schools, especially for the poor.

In an interesting footnote, the plaintiffs legal team includesformer U.S. solicitor general Ted Olson and Theodore Boutrous, who most recently paired to win a U.S. Supreme Court decision that struck down California’s prohibition against same-sex marriage. Olson and Boutrous had famously represented opposing sides before the Supreme Court in Bush v. Gore, which halted the Florida vote recount and resulted in Bush capturing the presidency. Olson’s wife Barbara died on September 11, 2001 when American Airlines flight 77 crashed into the Pentagon.

Cryptocurrencies – The Bitcoin Phenomena

Revised February 14, 2014

Bitcoins are digital fiat currency passed directly between two people without the need for a trusted third party, such as a bank.[1] In this respect they resemble banknotes. Bitcoin with a small “b” is a privately created and issued medium of exchange, the value of which is the subject of this note. Bitcoin with a capital “B” is a public ledger that records all transfers, hence changes of ownership, of bitcoin. Thus Bitcoin is the means of payment of bitcoin. Unfortunately the two, bitcoin and Bitcoin (the medium of exchange and the means of payment) are often mixed carelessly in discussions of bitcoin. This note is primarily about bitcoin—the medium of exchange—rather than Bitcoin—the means of delivering them.

While a growing number of digital competitors[2] claim to overcome one or more of bitcoin’s (and Bitcoin’s) technical weaknesses, bitcoin is the frontrunner among cryptocurrencies with the most developed supporting infrastructure. It is the very nature of money that its usefulness depends on how widely it is accepted (so called network externalities) and thus the dominant currency tends to suppress potential competitors and is itself hard to displace. Thus while bitcoin is likely to continue to dominate over its cryptocurrency rivals, the key question is whether it is likely to seriously challenge national currencies such as the U.S. dollar or the Euro.

Though Bitcoin’s digital and peer-to-peer (P2P) nature poses serious technical issues for bitcoin, a key question for its future is whether it will ever achieve a stable value, the most important quality of a successful currency. In this note I will review the factors that determine the value of a currency and how they might apply to the long run value of bitcoin and thus its prospects of ever achieving a stable value. With regard to the protocols and algorithms underlying big B Bitcoin, many have claimed potentially dramatic improvements in how payments are made, and titles of all sorts more generally are maintained and transferred.

Background

The difference between cash (physical banknotes and coins) and other means of payment such as checks, wire transfers, Visa, and Paypal, is that the payment of cash is made directly between the parties to the payment, i.e. peer-to-peer. All other means of payment involve trusted third parties, such as banks, credit companies, and exchanges, that keep records of the ownership of money and its transfer from one party to another. These alternatives describe means of payment, not what is being paid, i.e., not money. These various means of payment can be used to make payments in any money desired. Wire transfers of bank balances can make a payment in whatever currency the bank balance is in—U.S. dollars, Euros, Renminbi, gold, or what ever. This distinction between means of payment and money is very important.

Money by its nature combines the functions of a medium of exchange (the thing paid), a store of value (the inventory of that medium held pending payment), and a unit of account (the unit in which things are priced). [3] All combine to promote money’s raison d’être—reducing the cost of exchange.

While a medium of exchange can potentially be anything acceptable to the payee (barter), and almost any durable good can store value (uncooked rice), the unit of account function of money stands out as its most central and critical quality. As such, the value of that unit—the value of the money—what it can buy—is basic to its usefulness. Like standards of weights and measures, the nominal value of money is almost universally established by governments,[4] while its real value is determined by markets. The various means of payment of that money—can be and generally are privately developed and provided (Visa, Paypal, bank checks, etc).

The value of a bitcoin

Bitcoin (small “b”) is a privately produced fiat money in every respect. So how is its value determined? Like everything else, its value is determined by the interplay of supply and demand.

The behavior of bitcoin’s supply is its strong point. New bitcoins are minted by a publicly visible formula at a decreasing rate until its supply approaches 21 million units in 2040. There are currently about 12.3 million bitcoin in existence. Currently an additional 25 bitcoins are minted every ten minutes and they are issued to miners for verifying that bitcoin used in transactions are not counterfeit. Their price is not fixed to anything and they are not redeemable for anything. They can be exchanged for dollars or other national currencies for whatever buyers are willing to pay and sellers are willing to accept.

Thus the story of the determination of the value of bitcoins is on the demand side. Such a system is the opposite of the gold standard or my real SDR currency board system[5] in which the value of the monetary unit is fixed and the supply adjusts to the market demand at that price. Bitcoin is a system with centralized control (via a rule) of the supply of money and decentralized (market based) determination of its value, while the gold standard was a system of centralized determination of the value of money and decentralized, market based determination of its supply.

Who demands bitcoins and what factors influence that demand? Money of any kind is demanded and held in order to have some available when we want to make a payment or to buy something. Money holdings also reflect the lack of synchronization of the timing of receipts of money, such as for wages, and its expenditure. An inventory of ready cash (and or bank account balances or credit) is needed in order to make payments. The bigger each person’s inventory of money is, the easier it is to make any payment that is needed or desired. However, as with any other inventory, there is a cost to maintaining it. A very large amount of empirical evidence supports the theoretical expectation that the more expensive it is to hold cash between its receipt and expenditure, the less people will hold. When the interest rate opportunity cost of holding money is high, cash holdings, like all other inventories, will be reduced. When inflation is higher (a tax on holding cash), cash holdings will be lower. When the cost of holding money in one or the other of these ways is more uncertain, e.g., because of fluctuations in its value, cash holdings will be lower as well.

The value of a bitcoin, or any other money, is measured by what it can buy. This has two dimensions, a) how widely it is accepted in payment; and b) how much it can buy where it is accepted? Thus the best measure of the value of a bitcoin in the second sense is its exchange rate with the U.S. dollar as the dollar is widely accepted and its purchasing power is quite stable (though any other good or basket of goods could be used as well). Bitcoin’s value is famously highly unstable and unpredictable (and it is still not accepted in very many places).

Over the three months between November 1, 2013 and February 1, 2014 its price (exchange rate) on the Mt. Gox exchange has ranged from around $200 USD per bitcoin to $1,200 and is currently (February 14) around $425 per bitcoin ($220 on Feb 16). These reflect huge bitcoin inflations and deflations. The price on the Mt. Gox exchange plunged from the mid $900s last week to the low $400s this week after it announced the suspension of withdrawals as a result of a bug in the bitcoin software (a claim denied but some). Coindesk has removed Mt. Gox from its bitcoin price index until this problem is resolved, which in mid day Feb 14 was $659 dollars per bitcoin.

As a result of such volatility, virtually nothing is priced in bitcoin, even things that can be purchased with them. Many who pay with bitcoin and most merchants that accept them never actually hold them for more than a few minutes. A toy selling for $100 can be purchased with bitcoin with minimal inflation or deflation risk in the following way. The buyer of the toy pays dollars to a seller of the bitcoin equivalent of $100 via an exchange such as Mt. Gox in Japan and instantly transfers them to the merchant selling the toy. After a few minutes delay while “miners” verify that the bitcoin being transferred (first to the buyer of the toy and then to its seller) are genuine and not electronic copies (i.e. counterfeit), the merchant sells them through an exchange for dollars. Thus the buyer pays dollars and the seller receives dollars but with bitcoin transferred between them. The risk of exchange rate movements is thus minimized. Trusted third party transaction processors like bitpay[6] or coinbase[7] absorb the exchange rate risk over the up to ten minute verification periods. While such trusted third parties provide badly needed support for bitcoin transactions, they undermine the alleged uniqueness of direct peer-to-peer payments.

The above practice is needed to reduce the risks to merchants of “accepting” (fleetingly) volatile bitcoins and thus promises to promote the broadening of their usability. So far the use of bitcoin is a negligible fraction of total payments but not trivial and is growing. However, the fact that few bitcoin transactors actually hold them, and the fact that all bitcoins in existence must be held by someone, implies that the demand to hold bitcoin today comes almost totally from speculators. As long as speculators think the value of bitcoins will continue to increase they will be willing to continue to hold or add to the stock they now hold. This will maintain or increase their value. The moment speculators lose such optimism or decide to cash out while they are ahead, the price of bitcoins will fall and bitcoin prices have experienced a lot of both. The dollar price of bitcoin has skyrocked to unbelievable levels (over $1,200) but it could just as easily fall to zero.

For the value of bitcoins to stabilize, the transaction demand for them (the demand to hold modest inventories of them in order to make payments with them) will need to increase to the point that it crowds out or at least dominates the speculative demand for them. This is not impossible, but in my view is very unlikely.

The future of bitcoin

The use of bitcoin at this point is driven more by ideology than economics. Its promoters like the fact that bitcoins’ supply and value are not controlled by any government and that transactors can be anonymous (or at least Pseudonymous). But there is no compelling reason for anyone to replace the dollar as the American economy’s unit of account with bitcoin, which has been wildly more volatile than the dollar. If goods and services are not priced in bitcoin, however, it will always suffer from the added cost of exchanges between bitcoin and the dollar or other national currencies at the time of a payment.

Bitcoin enthusiasts point to its current low cost of transfer when making payments as a source of its attractiveness and thus its future demand. However, this claim is subject to two challenges. The first is that the means of payment used by bitcoin (i.e. Bitcoin) is equally usable for any other medium of exchange. The entire payment infrastructure that has been developed and continues to develop for bitcoin could be used to make payments with U.S. dollars or other currencies if in fact it provided a superior means of payment. This is the model used by rival cryptocurrency Ripple. Two simple modifications could replace bitcoin with U.S. dollars in the existing Bitcoin system. Rather than being fixed by a rule, the number of dollars in the bitcoin like system would be whatever people paid for, dollar for dollar, and existing Bitcoin exchanges would accept and hold traditional dollars (currency or deposits) in exchange for the same quantity of digital dollars to be used via the Bitcoin system.

The systems of mobile phone payments in local currencies that are growing rapidly around the world are similar in many respects but require the central accounting records of a trusted third party. These systems are driving down the costs of making payments and are instantaneous (faster than bitcoin, which must first authenticate that the bitcoin are genuine). A P2P system has inherent technical challenges and is likely to always be slower than systems relying on trusted third parties.

The use of M-Pesa in Kenya to make small payments of Kenyan Shilling and remittances from abroad has grown at a spectacular rate. Over 70% of Kenya’s adult population used the system by the end of 2012. Based on the record keeping of a trusted third party, M-Pesa payments are simpler and quicker than bitcoin payments. Such new technologies are also driving down the costs of making payments. Cash in and out when buying or selling M-Pesa is almost all in cash requiring street vendors or physical windows rather than virtual exchanges with all digital payments as with bitcoin.[8] However, should bitcoin be used in Kenya it would also need physical cash in – cash out facilities, which would increase its costs relative to those in more advanced economies.

The cost of M-Pesa or Bitcoin type payments should be less than credit payments such as Visa, or Master card because users must pay for the currency in advance of its use and because credit payments can be reversed with charge backs. Each has its advantages and disadvantages and there is room for both

The second challenge to bitcoin’s claims as a superior, lower cost means of payment is that its business model will ultimately require the introduction of fees (some already exist for trusted third party services now being provided). The miners, who perform the service of authenticating bitcoins used in every transaction, are currently remunerated on the basis of the first to complete the authentication of a payment block (public ledger of transactions) earning newly minted bit coin. Over time as the number of bitcoin minted declines to zero and the number of transactions to authenticate increases (should that happen) the remuneration to miners will fall and will need to be supplemented with fees to ensure that the authentication service continues to be provided. Aside from providing its own medium of exchange, Bitcoin is one among many means of payment. Competition and further technical innovations promise to lower the cost of making payments in any currency and it is difficult to see any particular advantage for Bitcoin and considerable disadvantages in this regard.

If a well-defined transactions demand for bitcoin does not emerge to sustain its value, and it is difficult to see why it would, its value will remain at the mercy of the whims of speculators. My expectation is that it will never achieve importance and that it is likely to vanish all together, giving way to more robust means of payment of more stable mediums of exchange. However, it deserves the chance to compete.

Appendix – What are bitcoins?

Bitcoins are digital monetary units created according to a well-specified rule, which will gradually increase their total supply to 21 million sometime beyond 2033. Newly minted bitcoins are paid out to “miners” who perform the services of vetting the authenticity of each bitcoin being transferred from one address to another. This is a critical service to prevent the multiple use of the same bitcoin (double spending problem) given the ease of making electronic copies of what are digital codes to begin with.

Bitcoin may be purchased from those who have them at a mutually agreed price. Such transactions may be conducted face to face or via exchanges established for this purpose. A significant infrastructure has been and is being developed to facilitate these exchanges between bitcoin and national currencies, thus introducing an important role for trusted third parties.

The digital records of the receipt and transfer of bitcoins are maintained in thousands of copies of Block Chains (public ledgers) on the internet. The approach uses public key and private key encryption much like email, where our email addresses are public for everyone to see but our passwords are (hopefully) known only to us. If I receive an email from your address I can be confident it came from you if you keep your password secret. Apps have been developed for bitcoin users to separate their transactions from all others. These “wallets”, make the process more user friendly. If the record of a bitcoin users private key (password) is lost because the hard drive crashes (without back up) or is lost or stolen, the bitcoins held by that user are lost to him/her without recourse. For this purpose and to further simplify the transaction and exchange process, trusted third parties provide on-line wallet and related services. Though at least one on-line wallet service has absconded with the bitcoin deposited there (rather like hacking your email by discovering your password and changing it to something you don’t know).

The ultimate purpose of bitcoin is for making payments for the purchase of goods and services or the discharge of debts. They may be used to make a payment to anyone (person or merchant) willing to accept them anywhere in the world. Given the extreme volatility of their value, a number of trusted third parties have been established to take the exchange rate risk by guaranteeing the exchange rate at which bitcoins can be acquired and resold as close to simultaneously as the authentication process permits (usually no more than ten minutes). Thus a merchant selling goods priced in dollars can accept the bitcoin equivalent (at the moment of the settlement) and resell them for dollars without holding them more than a few minutes.

Bitcoin payments are final, i.e. cannot be reversed without the agreement of the recipient to send them back. They are currently cheaper than most existing means of payment. Information on ownership and transfers is decentralized with many copies of the history of all transaction publically available to anyone. They are somewhat slower than some other means of payment (the average time to authenticate and thus complete a transaction is currency around 9 minutes) but much faster than most bank transfers. The authentication of transaction may become problematic as the number of them increases and the remuneration of miners is reduced.

In my judgment, the use of Bitcoin for making payments and transferring titles and records of all sorts offers much more promise for future efficiencies than do bitcoin or any other private media of exchange.

An easy to read guide to most aspects of using bitcoin can be found at: http://www.coindesk.com/information/. A more detailed and outstanding guide is also provided by Jerry Brito and Andrea Castillo at the Mercatus Center, George Mason University: http://mercatus.org/publication/bitcoin-primer-policymakers

[1] http://bitcoin.org/en/

[2] https://en.bitcoin.it/wiki/List_of_alternative_cryptocurrencies

[3] For a fuller discussion, see my article on the Future of Money in the 2012 Winter issue of the Cayman Financial Review http://www.compasscayman.com/cfr/2012/01/11/The-future-of-money—What-is-it-/

[4] See Section 8 of the Constitution of the United States.

[5] Real SDR Currency Board, Central Banking Journal XXII.2 (2011), also available at http://works.bepress.com/warren_coats/25)

[6] https://bitpay.com/faq

[7] https://coinbase.com/about

[8] Warren Coats, “The Technology of Money” Cayman Financial Review, January 18, 2012.

A Hard Anchor for the Dollar

For the last three years with zero interest rates and “quantitative easing” the Federal Reserve has been pushing on a string. It has been trying to stimulate an economy that suffers from problems that are not basically monetary. In the process it is distorting the limping economic recovery and potentially reflating housing and other asset bubbles. The Federal Reserve has jeopardized its revered independence by undertaking quasi-fiscal operations (buying long-term government debt and MBS to push down longer term interest rates in those markets while paying banks interest on their deposits at the Fed to keep them from lending the proceeds). The result has been an explosion of the Fed’s balance sheet (base money—the Fed’s monetary liabilities—jumped from around $800 billion in mid 2008 to over $3,200 billion in July 2013) while the money supply only grew modestly (over the same period M2 increased from about $8,000 billion to about $10,700 billion- about the same increase as over the five year earlier period from mid 2003 to mid 2008).

There is growing sentiment that our fiat currency system should be replaced with a hard anchor, such as the gold or silver standards in place in much of the world over the two centuries preceding gold’s abandonment by the United States in 1971. In order to avoid the weaknesses of the earlier gold standard, which contributed to its ultimate abandonment, three key elements of its operation should be modified. These are: a) the conditions under which currency fixed to a hard anchor is issued and redeemed; b) what the currency is sold or redeemed for; and c) what the anchor is.

Monetary Policy

During the earlier gold standard, the value of one U.S. dollar was fixed at $19.39 per ounce of fine gold from 1792 to 1934 and $35.00 per ounce from 1934 to 1971 when Nixon ended the U.S. commitment to buy and sell gold at its official price because the U.S. no longer had enough gold to honor its commitment. None-the-less, the official price was raised to $38.00 per ounce in 1971 and to $42.22 in 1972 before President Ford abolished controls on and freed the price of gold in 1974.

Under a strict gold standard, operated under currency board rules, the central bank would issue its currency whenever anyone bought it for gold at the official price of gold and would redeem it at the same price. In fact, however, the Fed engaged in active monetary policy, buying and selling (or lending) its currency for U.S. treasury bills and other assets when it thought appropriate. Thus rather than being fully backed by gold, the Fed’s monetary liabilities (base money) were partially backed by other assets. Moreover the fractional reserve banking system allowed banks to create deposit money, which was also not backed by gold. The market’s ability to redeem dollars for gold kept the market value of gold and hence the dollar close to the official value. Because the Fed could offset the monetary contraction resulting from redeeming dollars, this link was broken and in 1971 President Nixon closed the “gold window” altogether for lack of gold.

A reformed monetary system should be required to adhere strictly to currency board rules. The Federal Reserve should oversee the interbank payment and settlement systems and provide the amount of dollars demanded by the market by passively buying and selling them at the dollar’s officially fixed price for its anchor (gold, in a gold standard system) in response to market demand. Banks should be denied their current privilege to create deposit money by replacing the fractional reserve system with a 100% reserve requirement (a subject for another time).

Indirect redeemability

Historically, gold and silver standards required that the monetary authority buy and sell its currency for actual gold or silver. These precious metals had to be stored and guarded at considerable cost. More importantly, taking large amounts of gold and/or silver off the market distorted their price by creating an artificial demand for them. Under a restored gold standard the relative price of gold would rise over time due to its limited supply, and the increasing cost of discovery and extraction. The fix dollar price of gold would mean that the dollar prices of everything else would have to fall (perpetual deflation). While the predictability of the value of money is one of its most important qualities, stability of its value (approximately zero inflation) is also desirable.

This shortcoming of the traditional gold standard can be easily overcome via indirect redeemability. The market’s regulation of the money supply in line with the official price of money in terms of its anchor does not require transacting in the actual anchor goods or commodities. As long as an asset of equal market value is exchanged by the monetary authority when issuing or redeeming its currency, the market will have an arbitrage profit incentive to keep the supply of money appropriate for its official value. In a future, hard anchor monetary system, the Federal Reserve could issue and redeem its currency for U.S. treasury bills rather than gold or other anchor goods and services. The difference between that and current open market operations by the Fed is that such transactions would be fully at the initiative of the market rather than of the central bank. The storage cost of such assets would be negligible and in fact would generate interest income for the Fed.

The Anchor

The final weakness of the gold standard was that the relative price of the anchor, based on a single commodity, varied relative to the goods and services (and wages) purchase by the public. In short, though the purchasing power of the gold dollar was highly stable historically over long periods of time, gold did not provide a stable anchor over shorter periods relevant to most business decisions.

Expanding the anchor from one commodity to 10 to 30 goods and services carefully chosen for their collective stability relative to the goods and services people actually buy (e.g. the CPI index) would be an important improvement over anchoring the dollar to just one commodity (gold). There have been many such proposals in the past, but the high transaction and storage costs of dealing with all of the goods in the valuation basket doomed them. Replacing such transactions with the indirect convertibility described above eliminates this objection.

A Proposal

The United States could easily amend its monetary policy to incorporate the above features – a government defined value of the dollar as called for in Article 1 Section 8 of the U.S. Constitution and a market determined supply of dollars. First Congress would adopt a valuation basket of 10 to 30 goods and services chosen to give the dollar the most stable value possible in terms of an average family’s consumption (i.e. the Consumer Price Index). The basket would consist of fixed amounts of each of these goods and would define the value of one dollar. As with the gold standard, if the value of the goods in the basket were more in the market than one dollar, anyone could buy them more cheaply by redeeming dollars at the fed for an equivalent value of U.S. treasury bills (indirect redeemability). The resulting contraction of the money supply would reduce prices in the market until a dollar’s value in the market was the same as its official valuation basket value. The money supply would grow with its demand (as the economy grows) in the same way (selling t-bills to the fed for additional dollars). The Federal Reserve would be restricted to passive currency board rules. All active purchases and sales of t-bills by the fed (traditional open market operations) or lending to banks would be forbidden. During a two year transition period the fed would be allowed to lend to banks against good collateral in order to allow banks time to adjust their operations and balance sheets to the new rules.

A global anchor

The gold standard was an international system for regulating the supply of money in each country and between countries and provided a single world currency (fixed exchange rates). This led to a flourishing of trade between countries. This was a highly desirable feature for liberal market economies.

The United States could adopt the hard anchor currency board system described above on its own and others might follow by fixing their currencies to the dollar as in the past. The amendments to the historic gold standard system proposed above would significantly tighten the rules under which it would operate and strengthen the prospects of its survival.

However, there would be significant benefits to developing such a standard internationally as outlined in my Real SDR Currency Board proposal (http://works.bepress.com/warren_coats/25/). One way or the other, replacing the widely fluctuating exchange rates between the dollar and other currencies would be a significant boon to world trade and world prosperity. Replacing the U.S. dollar as the world’s reserve currency with an international unit would have additional benefits for the smooth functioning of the global trading and payments system.

Printing Money

Isn’t that just printing money? Here is a quick, and hopefully simple, primer on what central banks do.

Central banks print money. They are responsible for issuing a country’s legal tender (banknotes and bank deposits with the central bank) and regulating its value. Most of what we call money is actually privately produced (deposits at commercial banks, credit and debit cards, paypal, etc.) but tied to the money printed by each country’s central bank by the public’s demand that it be redeemable for the central bank’s money. There are a few exceptions to this demand by the market, such as bitcoin (see: the-rise-of-the-bitcoin-virtual-gold-or-cyber-bubble), but they shall ever remain unimportant fads. There is never a question about whether central banks print monetary or not. It is their responsibility to do so. This is as true for a pure gold standard or other fixed exchange rate monetary regimes, as for the variety of fiat money regimes (from monetary targets to inflation targets to flying by the seat of their pants day-to-day).

The important and proper question about a central bank’s behavior is what guides its decisions about when and how much money to print. A secondary question is what does it buy when it issues money (there are no helicopters that drop it from the sky)?

The gold standard: Under a gold standard the central bank buys gold with the money it prints and is legally bound to buy that money back with gold at the same price whenever anyone holding its money wants to redeem it. While this is still printing money, the supply is determined by the preferences of the market (each and every one of us) to hold and use that money. Such central banks have no monetary “policy” in the usual sense. They passively supply whatever amount of money the public demands.

Fiat money: If the central bank issues money with no obligation to redeem it for anything in particular nor at a particular price, its value is determined in the market by its supply and demand. The amount supplied by the central bank relative to the market’s demand for it will determine is value (the price level). Monetary policy consists of the decisions made by central banks that determine the amount of the money they supply and manner in which they supply it.

The public’s demand for money reflects its convenience for making payments, its expected value when exchanged for goods and services, and the opportunity cost of holding it (inventory costs, i.e., the interest rate that could have been earned on holding wealth in other forms). Rapidly changing payment technology (debit/credit cards, Paypal, e-money, etc.) has a profound impact on this demand. There is a vast academic literature on this subject. Unlike any other good or service money’s value derives solely from what it can be exchanged for or more specifically from the economy it brings to exchange/trade. Fiat currency is always useable and thus “redeemable” for the payment of taxes and other obligations to the government that issued it. These obligations are denominated (valued) in the same units as the currency. These guaranteed uses of fiat money anchor its demand and thus value in the same way that the demand for gold for jewelry and other non-monetary uses anchors its value. Bitcoin has no alternative use and thus has no anchor to its value.

Central banks have learned the value of establishing clear rules for issuing money, such as targeting the rate at which the money supply (by one definition or another) grows, or targeting nominal income, or inflation. These rules guide how much money they “print.” They also influence the public’s demand for money by informing its expectations of the central banks actions. The policy regime adopted—rule—determines the behavior of the money supply and thus its value (or visa versa). The supply of bitcoin also follows a well-defined rule, but its demand is unanchored. The fact that the central bank is printing money is irrelevant by itself.

A secondary consideration is what it is that the central bank buys with the money it prints. Under a gold standard it buys gold. Under a fiat money standard central banks generally buy government securities because these securities are generally of unquestioned safety and in most countries have the deepest and most liquid secondary markets. Central banks also traditionally adhere to a “bills only” policy, i.e., they buy short-term government security, in order not to interfere with the market’s determination of the term structure of interest rates, i.e. the relationship of interest rates on securities with longer maturities relative to those with shorter maturities. In a free market, rates on longer maturities are determined by the expected value of overnight rates over the period in question plus a risk premium for the uncertainty over the behavior of overnight rates.

Whatever the ultimate or intermediate targets of monetary policy, most central banks in recent decades have pursued them by targeting a short-term interest rate, their so-called “operating target.” The Federal Reserve targets the overnight interbank rate, the so-called “federal funds rate,” as its approach to targeting the money supply, nominal income, or inflation. Given all other market factors, a particular fed funds rate target will result from and result in a particular rate of growth in the money supply.

Because most money and related means of payment are privately produced by banks or is ultimately settled through banks, and because banks only keep a small amount of the money produced by their central banks for which bank deposits are redeemable (the so-called “fractional reserve banking system”), central banks have also been given the role of insuring that banks have sufficient liquidity to function smoothly. They are mandated to lend to solvent but illiquid banks when banks need to convert loans into cash to accommodate deposit withdrawals (the so-called “lender of last resort” function).

As more and more central banks successfully adopted the techniques of inflation targeting and most of the rest fixed the exchange rate of their currencies to an inflation targeting currencies such as the U.S. dollar or the Euro, the world entered a long period dubbed “the great moderation.” However, the long period of very low interest rates following the bursting of the “dot com” bubble produced the housing price bubble in many locations in the U.S. and Europe. Its collapse in 2007-8 plunged much of the Western world into the long, Great Contraction.

Monetary Policy Plus (MP+): In the last few years the Federal Reserve, the European Central Bank (ECB) and other central banks have undertaken many non-traditional actions in an effort to help lift their respective economies out of recession. In the early days of the serious liquidity crunch following the collapse of Lehman Brothers in September 2008, the Fed, ECB, Bank of England and a few other central banks very successfully pumped needed liquidity into their financial systems by expanding the number of counterparties they would lend to, increasing the eligible collateral, and entering into currency swap arrangements to supply dollar liquidity to foreign banks.

However, after unblocking the flow of funds between banks and other financial firms, the Fed’s concern shifted to fighting deflation, then to reviving economic activity. After driving its operating target to almost zero, the Fed continued increasing monetary growth beyond the rate resulting from a zero fed funds target and dubbed it quantitative easing. However, the channels through which monetary policy is traditionally transmitted to the economy (interest rate, credit, asset price, portfolio/wealth effects, exchange rate channels) seemed ineffective. Thus, the Fed began to purchase non-traditional, financial instruments, such as Mortgage Backed Securities (MBSs) and longer-term government securities, in an effort to keep mortgage interest rates low and to encourage the flow of funds into the mortgage market and stimulating investment more generally. These quasi-fiscal policy measures do not square easily with the Fed’s legal mandates of price stability and employment.

With the Fed’s third program of quantitative easing it is now pushing on a string (QE3: http://works.bepress.com/warren_coats/28/). It is attempting to stimulate an economy that lacks a clear policy environment that would encourage more investment rather than one suffering from inadequate liquidity. While market measures of inflation expectations remain very low, long periods of very low interest rates influence the capitalized value of income streams. A given monthly mortgage payment will purchase a more expensive house when interest rates are lower. What people and firms invest in is distorted toward more capital-intensive projects than are economically efficient and justified at normal rates of interest. Pension funds and other endowments lose income that must be made up somehow (often by moving into riskier investments). Asset price bubbles emerge. On top of these economic risks, the Fed’s need to unwind its huge portfolio of securities (purchased by printing money) when the economy recovers more fully is becoming more and more challenging.

Moreover, the policies of one central bank can affect the exchange rate of its currency if its policies are not coordinated with those of other central banks. This can either improve or worsen the balance of payments between countries (balance of imports and exports). The very wide swings over the last decade in the exchange rate of the US dollar with the Euro, for example, cannot be justified by economic fundamentals and is very disruptive to trade and international capital movements. Recent monetary policy initiatives by the Bank of Japan raise such concerns.

In short, the problem is not that the Fed and other central banks are printing money. The problem is the amount they print and their conceit that they can do more to help the real economy than they really can, thus adding to the market’s uncertainty over the economic, policy, and financial environment in which their decisions to spend and invest must be made. The solution is to reestablish a hard anchor for monetary policy that allows the supply of money to be market determined (as proposed in my: Real SDR Currency Board, paper).

The fantasy of a purely private money that would overcome the weaknesses of government money, remains for the foreseeable future a utopian fantasy: “The Future of Money”. But those of you who enjoy fantasy, might enjoy the following story by Neal Stephenson: “The Great Simoleon Caper”.

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