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”

A shift in monetary regimes?

By Warren Coats[1]

This Sunday, August 15, is the 50^th anniversary of President Richard Nixon’s closing of the gold window as part of the “Nixon Shock.” “Fifty years later Nixon’s August surprise still reverberates” He announced on that day that the U.S. Treasury would no longer redeem its dollars for gold at $35 an ounce. Over the subsequent few years, the world moved from national currencies whose values were anchored to the market value of gold, to currency values determined by central banks’ regulation of their supply relative to the market’s demand. The value of one currency for another floated in the foreign exchange market. Central banks have deployed various approaches to determining the supplies of their currencies and most have now settled on targeting an inflation rate (often 2% per year) in one way or another.

With the rapidly increasing interest in cryptocurrencies, some have asked whether we are on the brink of another monetary paradigm shift? Specifically, might the dollar be replaced as the dominant international reserve currency. To explore that question we need to understand how the existing monetary systems work and how the widespread use of cryptocurrencies might add to or change these systems.

In describing the existing and potential future monetary systems, we need to distinguish “money” from the “means of payment.” Money is the asset that people accept in payment of debts or for the purchase of goods and services. The U.S. dollar and the Euro are “money.” The means of payment refers to how money is delivered to the person being paid. Do you personally hand dollar bills and coins to the Starbucks cashier, write out a check (bank draft) and put it in the mail, or electronically transfer “money” from your bank account to an Amazon merchant via eWire, Zelle, Venmo, PayPal, or some other digital payment service? Or perhaps you purchase goods and services with borrowed money (Visa, MasterCard, American Express) that you pay back at the end of each month or over time. Or if you don’t have a bank account (a form of digital money) you might hand-deliver physical currency to a Hawala dealer or a MoneyGram or Western Union office to be electronically transferred to their office nearest to the person you are sending it to, potentially anywhere in the world. If you are paying in a currency that is different than the one the payee wishes to receive, your currency will be exchanged accordingly along the way in the foreign exchange market.

Discussions of cryptocurrencies include both the latest and evolving means of payment (digital payment technologies) as well as new, privately created moneys such as bitcoin, Ethereum, or Ripple. Private currencies vary enormously with regard to how their value is determined. By private currencies I do not mean privately created assets redeemable for legal tender, such as our bank accounts. When we speak, for example, of the U.S. dollar, we invariably include dollar balances in our bank accounts, dollar payments made via our Visa card, etc. These are all privately produced assets that are ultimately redeemable for Federal Reserve currency or deposits at a Federal Reserve Bank. They are credible claims on the legal tender of the United States. Most U.S. dollars are privately created.

The value of all money is determined by its supply and demand. The demand for money arises from its acceptability for payment of our obligations and the quantity of such obligations (generally closely related to our incomes). Within each country, its legal tender money (e.g., the U.S. dollar in the U.S.) must be accepted by payees. In particular, it must be accepted by the government in payment of taxes. Truly private currencies (those not redeemable for legal tender, of which there are over 11,000 at last count) have a serious challenge in this regard. Very few people or businesses will accept bitcoin, or any other such private cryptocurrency. As a result, the demand for such currencies for actual payments is very low. The demand for bitcoin, for example, is almost totally speculative–a form of gambling like the demand for lottery tickets. Such private currencies are more attractive in countries whose legal tender is rapidly inflating or has unstable value (e.g., Venezuela).

The acceptability of a currency in cross border payments raises special challenges. My currency is not likely to be the currency in general use in other countries. Someone in Mexico paying someone in Germany will generally have Mexican pesos and the recipient in Germany will want Euros. The pesos will need to be exchange for Euro in the foreign exchange market. It would be very costly for dealers in the FX market to maintain inventories of and transact in every bilateral combination of the world’s 200 or so currencies. It has proven more economical to exchange your currency for U.S. dollars and to exchange the U.S. dollars for the currency wanted by the payee. The dollar has become what is called a vehicle currency.

The economy of a so-called vehicle currency can be illustrated with languages. Two hundred and six countries are participating in the 2021 Olympic Games in Japan. To communicate with their Japanese hosts participants could all learn Japanese. It is unrealistic to expect the Japanese hosts to learn 205 foreign languages. But what about communicating with their fellow participants from the other 205 countries. For this purpose, English has become the default second language in which they all communicate. Unlike more isolated Americans, most Europeans speak several languages, but one of them is always English. English as the common language is the linguistic equivalent of the dollar as a vehicle currency.

The rest of the value of money story focuses on its supply. Bitcoin has the virtue of having a very well defined, programmatically determined gradual growth rate until its supply reaches 21 million in about 2040. The supply today (Aug 2021) is 18.77 million. See my earlier explanation: “Cryptocurrencies-the bitcoin phenomena” The other 11,000 plus cryptocurrencies each have their own rules for determining their supply, some explicit and some rather mysterious. The class of so called “stable coins” are linked to and often redeemable for a specific anchor, sometimes the U.S. dollar or some other currency. The credibility of these anchors varies.

The highly successful E-gold (from 1996-2006) is an example of a digital currency that had well-defined and strict backing and redemption for a commodity at a fixed price. “E-gold” The supply of such currencies is determined by market demand for it at its fixed price–what I have elsewhere called currency board rules. I describe how currency board rules work in my book about establishing the Central Bank of Bosnia and Herzegovina: “One currency for Bosnia-creating the Central Bank of Bosnia and Herzegovina”

The dominance of the U.S. dollar in cross border payments reflects far more than its use as a vehicle currency. Many globally traded commodities, such as oil, are priced in dollars and thus payments for such purchases are settled in dollars. Pricing a homogeneous commodity trading in the global market in a single currency makes that market more efficient (the same price for the same thing). Making cross border payments in dollars (or any other single currency) also avoids the costly need to exchange one for another in the FX market. The dollar is most often chosen because its value is relatively stable, and it has deep and liquid securities markets in which to hold dollars in reserve for use in cross border payments.

So, what are the chances that current cryptocurrency developments might precipitate a shift from the dollar to some other currency and means of payment. Several factors of U.S. policy have heightened interest by many countries in finding an alternative. Specifically, from my recent article in the Central Banking Journal on the IMF’s $650 billion SDR allocation:

“Cumbersome payment technology. Existing arrangements for cross-border payments via Swift are technically crude and outmoded.

The weaponization of the dollar. The US has abused the importance of its currency for cross-border payments to force compliance with its policy preferences that are not always shared by other countries, by threatening to block the use of the dollar.

The growing risk of the dollar’s value. The growing expectation of dollar inflation and the skyrocketing increase in the US fiscal deficit are increasing the risk of holding and dealing in dollars.” “The IMF’s 650bn SDR allocation and a future digital SDR”

Most central banks are upgrading their payment systems. But the Peoples Bank of the Republic of China (PBRC) is one of the most advanced in developing a central bank digital currency (CBDC), the e-CNY. However, it has little potential for displacing the dollar for several reasons. The Federal Reserve is also modernizing its payment technology, including exploring the design of its own CBDC, and can match China’s payment technology in the near future if necessary. More importantly, China’s capital controls, less developed Yuan financial markets, and less reliable rule of law make the Yuan an unattractive alternative to the dollar. These latter impediments do not apply to the Euro, however. “What will be impact of China’s state sponsored digital currency?”

Rather than looking for another national currency to replace the dollar, there are several advantages to using an international one. These include greater ease in making cross border payments and the reduced risk of political manipulation, or a national currency’s domestic mismanagement. Bitcoin, for example, can make payments anywhere in the world without being controlled by any one of them. The serious drawbacks of Bitcoin’s blockchain payment technology might be overcome with one or another overlaid technology. But to become a serious currency, bitcoin must be dramatically more widely accepted in payment than it is now. Widespread acceptance in payments could generate the demand to hold them for payments, which would tend to stabilize its very erratic value. This seems very unlikely. A digital gold-based currency, such as the earlier E-gold, would enjoy the advantage of an anchor that is well known and that has enjoyed a long history. However, gold’s value has been very unstable in recent years. Aluminum has enjoyed a very stable price and elastic supply and will be the anchor for Luminium Coin to be launched in the coming weeks: https://luminiumcoin.com/

But the world has already established the internationally issued and regulated currency meant to supplement if not replace the dollar, the Special Drawing Rights of the International Monetary Fund. The IMF has just approved a very large increase in its supply. “The IMF’s 650bn SDR allocation and a future digital SDR” The SDR’s value is determined by the market value of (currently) five major currencies in its valuation basket. While all five of these currencies have a relatively stable value, the value of the basket (portfolio) of these five is more stable still. The rules for determining the SDR’s value and supply, as well as its uses, are well established and transparent and governed by the IMF’s 190 member countries. In short, the SDR is truly international. However, it can only be used by IMF member countries and ten international financial institutions such as the World Bank and the Bank for International Settlements.

While the SDR has played a limited useful role in augmenting central bank foreign exchange reserves, it has failed to achieve a significant role as an international currency because of the failure of the private sector to invoice internationally traded goods and financial instruments (such as bonds) in SDRs and the absence of a private digital SDR for payments. If the IMF is serious about making the SDR an important international currency it should turn its attention to encouraging these private sector uses of the unit. “Free Banking in the Digital Age”

In the long run the IMF should issue its official SDR according to currency board rules and anchor its value to the market value of a small basket of commodities rather than key currencies: “A Real SDR Currency Board”

[1] Warren Coats retired from the International Monetary Fund in 2003 where he led technical assistance missions to the central banks of more than twenty countries (including Afghanistan, Bosnia, Egypt, Iraq, Kazakhstan, Kenya, Kyrgyzstan, Serbia, South Sudan, Turkey, and Zimbabwe). He was a member of the Board of the Cayman Islands Monetary Authority from 2003-10. He is a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise. He has a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago.

Econ 101: Currency Manipulation

Currency manipulation refers to a country’s interfering with the market’s determination of the exchange rate of its currency in order to favor its exports over its imports. In a world in which people and firms trade and invest across borders, i.e. our world, anything a country does (monetary policy, fiscal policy, industrial policy, trade policy) will potentially affect the exchange rate of its currency for other currencies (real and/or nominal exchange rates). This makes it difficult to define what currency manipulation might mean, but it generally refers to a government’s intervention in the foreign exchange market by buying dollars or other foreign currencies thus depreciating its own currency’s exchange rate. This makes its exports cheaper to foreign buyers and its imports more expensive domestically resulting in a trade surplus (or smaller deficit). While a country’s persistent intervention to buy foreign currencies is clear evidence of currency manipulation, many countries with floating exchange rates intervene temporarily in either direction to prevent excessive volatility of their exchange rates without longer-run interference in the market’s determination of their exchange rate. https://www.youtube.com/watch?v=wE7UkXk_VCo

Any country whose currency is held abroad also must have a current account deficit sufficient to supply the amount of its currency demanded abroad. The US dollar is the world’s primary reserve currency and has experienced current account and trade deficits for that reason. In the first six years of this century (2000-2006) many central banks acted to increase their foreign exchange reserves (largely USD) pushing the US current account deficit from $400 billion per year to $800 billion. https://nationalinterest.org/feature/who-pays-uncle-sams-deficits-26417

When President Trump criticized Federal Reserve Board Chairman Powell for not cutting interest rates enough on July 31, was he trying to depreciate the dollar (currency manipulation) in order to boost American exports, or more generally trying to boost American economic output (to counteract the economic damage he is inflicting with his many trade wars) going into the 2020 Presidential elections? https://wcoats.blog/2019/07/30/is-trump-killing-his-own-re-election/ And can these two be separated?

In the following I compare policy reactions to shocks under three types of exchange rate/monetary policy regimes with an eye on the currency manipulation question. The broad categories of shocks are a) a globally shared recession and b) a single country shock to imports or exports such as from an oil price shock or tariffs, or from changes in capital inflows or out flows such as from a change in the political environment. The three policy regimes are: 1) freely floating exchange rates with no restrictions on capital flows, 2) an adjustable exchange rate peg, and 3) a gold standard with currency board rules. Regimes 1 and 3 are the opposite ends of the range of policy regime options.

If, for example, the US experiences an increase in its inflation rate above its 2 percent target (as could happen but for Trump’s trade wars) and raises its policy interest rate in order to tighten money and constrain the inflation, the exchange rate and market reactions will depend on its policy regime, which for the US is floating exchange rates with an inflation target. Similarly, but in the opposite direction, an oil exporting country experiencing a loss of export revenue from a fall in oil prices might cut its policy interest rate in order to increase domestic investment and make up for the loss of domestic demand. Or in the example currently in our face of Trump’s trade war with China, the imposition by the U.S. of tariffs on China’s imports might lead China to cut its policy interest rates or otherwise make up for the loss of aggregate demand from a reduced trade surplus (or increased trade deficit as China’s current account is currently more or less balanced).

Floating exchange rates

For a synchronized global recession (pretty much what we had in 2008)—all countries will want to lower their monetary policy interest rates in order to stimulate their domestic output. If one country gets out ahead of the others by lowering its interest rates more, its exchange rates will depreciate relative to the others (from capital outflows seeking higher yields abroad) and its stimulus to its output will come partly from an increased trade surplus, thus at the expense of other countries experiencing a trade deficit.

In the US example of tightening its monetary policy, the increase in US interest rates will attract foreign capital, which will appreciate the dollar’s exchange rates producing or increasing a trade deficit. This would increase aggregate demand in the foreign trade surplus countries. To illustrate with the recent easing of monetary policy in the US, the one quarter percent cut in the Federal Reserve’s policy rate on July 31 tends to precipitate a capital outflow as investors chase the relatively higher returns abroad. The increased sale of dollars for other currencies in order to shift investments abroad will depreciate the dollar. A depreciated dollar makes US exports cheaper and imports more expensive thus producing the trade surplus that makes the capital outflow possible, and which adds to domestic aggregate demand. If other countries respond by lowering their own interest rates more, or by direct intervention in the foreign exchange market, to prevent the loss of domestic demand in their own economies, they can set off a vicious cycle. Such situations have been referred to as competitive devaluations. To avoid the fruitless damage of competitive devaluations, countries need to synchronizing policy interest rate cuts in order to avoid exchange rate and trade balance effects.

Similarly, the oil exporter reacting to an oil price decrease induced trade deficit by cutting its monetary policy interest rate will depreciate its exchange rate. This will increase the prices and reduce the purchases of imports while increasing the domestic revenue from its reduced exports thus reducing its trade deficit and increasing (restoring) domestic aggregate demand. This would be appropriate exchange rate and aggregate demand management, not currency manipulation.

What would be the impact on the Chinese exchange rate from the imposition of tariffs by the U.S. on China’s exports to the U.S.? In the absence of any policy response by China, American imports from China would fall as American consumers faced the higher prices from the tariffs. China’s exports and export revenue would fall increasing its trade deficit (or reducing its surplus). The supply of dollars relative to yuan in the foreign exchange market would fall, depreciating the yuan until the trade balance is restored. This is what happened on August 5, 2019, though I do not know whether this was a purely market determined rate or whether China intervened in the FX market. Thus, it is not possible to conclude whether China was manipulating its exchange rate. Sadly this did not keep the US Treasury from labeling as currency manipulation the modest depreciation of the yuan from 6.90 yuan per dollar on Aug 1 to 7.05 on Aug 5.

Pegged exchange rates

With pegged or managed exchange rates the country that cuts its interest rates more than others must intervene in the foreign exchange market in order to maintain its exchange rate peg. There will be no trade balance effect if the monetary increase from the intervention is sterilized (an offsetting sale of domestic securities by the central bank to reabsorb the base money created by the initial FX intervention), but the ability of the rate cutting central bank to continue such intervention is limited by the size of its foreign exchange reserves. The US does not peg its exchange rates and maintains minimal FX reserves. Unsterilized intervention will increase the money supply and prices until the real exchange rate has depreciated enough to restore a balance of payments equilibrium (a trade surplus sufficient to enable the desired capital outflow).

China pegged its exchange rate at about 8.3 yuan per dollar for the decade from 1995-2005. In the last few years of that period China’s negligible trade surplus began to grow. Rather than allow its exchange rate to appreciate in response to market forces, China began to intervene and by 2005, when it abandoned its peg, its modest foreign exchange reserves had risen to around half a trillion USD. The ability of surplus countries to intervene and accumulate reserves without limit reflects the asymmetry of adjustment pressures between deficit and surplus countries noted by Keynes. Over the next nine years China allowed its exchange rate to appreciate to almost 6 yuan per dollar but in order to resist more dramatic appreciation it intervened massively, accumulating almost 4 trillion USD in FX reserves by early 2014. Domestic inflation also contributed to the badly needed real appreciation during this period. Since then China has reversed its interventions to prevent more rapid depreciation of the yuan from market forces, running its FX reserves from 4 trillion down to 3 trillion in 2017 thus keeping its depreciation under 7 yuan per dollar. Since then China’s FX reserves have grown very modestly to about 3.12 trillion USD and while appreciating temporary through mid 2018 its exchange rate remained just under 7 yuan per dollar through Aug 2, 2019. From a high of almost 10% of its GDP in 2007, China’s current account surplus has fallen to 0.4% by the end of 2018.

Hard anchor with currency board rules

Regime (3)—gold standard with currency board rules—is the most interesting because it reflects the market reaction when no monetary policy and thus no currency manipulation is possible. Market interest rates fully reflect market conditions with no input from the central bank. A global recession will result in a fall in market interest rates everywhere as aggregate demand falls below supply. This fall cushions the fall in demand by encouraging investment and facilitates the adjustments in the economy needed for recovery. Interest rates will not necessarily fall by the same amount in all countries and thus the emergence of interest rate differentials could precipitate capital flow. This contributes to global income because it encourages capital to flow to where its return is highest.

A capital outflow from the US to other countries under the classical gold standard would reduce the money supply in the US. For an American to invest abroad in this (gold standard like) regime, she must sell dollars for the foreign currency. Ultimately the Fed must transfer the ownership of gold (or whatever the reserve assets are) to the central bank issuing the currency being purchased (the Hume specie flow mechanism). The reduced money supply will lower prices in the US and thus depreciate the real exchange rate despite the fixed nominal rate. This will increase exports and decrease imports producing the trade surplus needed to finance the capital outflows. In the case of a currency outflow because of a trade deficit, the same specie flow mechanism would also lower prices in the US and thus depreciate the real exchange rate restoring trade balance (with underlying capital flows).

Regime (3) with currency board rules would operate a bit differently. If, for example, China and the U.S. have the same hard anchor (e.g., gold or a basket of commodities or the SDR) and abide by currency board rules, the exchange rate for their respective currencies is fixed. They are effectively in a single currency area and the supply of money will be determined by the public via currency board rules. Cross boarder financial relationships between individuals and firms (and countries) would be determined and evolve in the same ways they do within countries. Capital flows would eventually equilibrate (risk adjusted) interest rates globally.

Taking again the example of a US tax (tariff) on its imports from China, the resulting trade deficit in China (or reduced surplus) precipitates a capital outflow (reduced inflow) from the US to finance it. This tends to shift ownership of Chinese assets to the US. Under a classical gold standard (or other hard anchor) the money supply in China would fall and increase in the US. However, with currency board rules the US and Chinese publics’ will restore whatever level of money they demand at the fixed official price of its anchor (e.g. gold). Any tendency for the dollar price of the anchor in the US to increase would create an arbitrage opportunity that would prevent the increase in the money supply. With different market and central bank prices for the anchor (Gold), the anchor could be purchased at the lower official price at the central bank thus reducing base money and resold in the market at the higher price thus restoring the money supply to its desired level. Currency board rules break the Hume specie flow mechanism.

Conclusion

In floating or managed exchange rate regimes, it is hard to say whether monetary policy induced changes in interest rates are motivated by exchange rate objectives–i.e., are currency manipulation. For globally firmly fixed exchange rates with currency board rules, currency manipulation is not possible, adding to the benefits of such a system. There is no evidence that China has been guilty of currency manipulation for the last four to five years through August 2. It does not seem likely that they are guilty now but we must await more evidence of whether the PBRC has intervened in currency markets since then.

Returning to Currencies with Hard Anchors

Why did the gold standard ultimately fail? What system would overcome those weaknesses? See my: Adam Smith Institute Blog

Review of John Tamny’s attack on Jack Kemp Foundation article

By Dr. Warren Coats

Dr. Coats is retired from the International Monetary Fund, where he was Assistant Director of the Monetary and Capital Markets Department.

In an article titled, “When the Ideas of Thinkers and Great Statesmen Are Perverted,” John Tamny offers what he calls “a semi-brief response” to a Wall Street Journal op-ed by Sean Rushton from the Jack Kemp Foundation, “Monetary reform would rebalance trade.”

Mr. Tamny wastes no time in launching his attack with the following: “Worse were the myriad factual inaccuracies, including a Bretton Woods monetary agreement that took place after World War II. Except that it took place in 1944.” This is his only valid criticism in his not so brief discussion. As we all know, the Bretton Woods conference was in anticipation of the end of WWII and did not actually take place “after” the war. Devastating, right?

Mr. Tamny launches his more substantive critic by noting that, “To be clear, all trade balances. Always.” Whether that balance is healthy or not, however, depends on its composition. Mr. Rushton’s article is about that composition. He discusses the implications of the fact that one of the ways in which we pay for what we import is by exporting U.S. dollars. The others are exporting U.S. debt (largely government) and the ownership of American firms and other private assets. Many countries wish to hold our dollars (it is the primary international reserve asset held by central banks) because so much of world trade is priced in and paid for with USDs.

Given all the many factors that determine what we import and export, the global demand for USD as a reserve asset makes our trade deficits larger than they would otherwise be in order to supply (export) those dollars. Tamny correctly notes that “the U.S. has run ‘trade deficits’ for longer than it’s been the United States.” Obviously such deficits were not the result of the world’s demand for U.S. currency. “The U.S. always ran trade deficits precisely because it’s long been an attractive destination for investment.” In other words, other countries sold us more than they purchased in goods and services (our trade deficit) in order to earn the dollars to invest in the U.S.

But times have changed. Today, and since the U.S. left the gold standard in early 1970, most of the dollars earn abroad from our trade deficits (their surpluses) are invested in U.S. treasury securities. In short, dollars earn abroad via our trade deficits (in addition to accumulating dollars in foreign exchange reserves) are now largely invested in financing our government’s deficit spending. Even Mr. Tamny would not argue that this inflow of investment in the U.S. is contributing to our increased growth and productivity.

On the contrary, Tamny seems to be arguing exactly that. He says that: “we have a so-called “trade deficit” as a country precisely because the U.S. is a magnet for investors the world over. When we “export” shares in American companies that are routinely the most valuable in the world.” He seems to applaud selling our firms to foreigners when our government crowds out the domestic financing of our industries in order to finance our irresponsible government deficits.

Mr. Tamny is not content to label Mr. Rushton’s analysis false. He calls it “obnoxiously false” and “comically false.” Unfortunately these labels apply more accurately to Mr. Tamny.

Rushton claims and provides evidence that U.S. fiscal discipline weakened when Nixon closed the gold window. “No longer bound by fixed exchange rates and dollar convertibility, the U.S. government’s fiscal discipline broke down.” Obviously other political and demographic factors have also contributed to the alarming increases in U.S. deficits, but no longer needed to defend the dollars exchange rate removed an important constraint. To rebut Rushton’s claim and data, Tamny notes that our deficits were even higher during WWII. Truly. I am not making this up.

Turning to the dollar’s role as an international reserve asset, Mr. Tamny notes that Mr. Rushton “argues that thanks to ’high global demand,’ the ’dollar’s international position is always stronger and U.S. interest rates are lower than they would be otherwise.’” Added to all of the other factors influencing the composition of our external financial flows (our balance of payments), the world’s demand for dollars in their foreign exchange reserve holdings must increase their trade surplus (our trade deficits) or their investments in the U.S., either of which will appreciate the dollar’s exchange rate and lower interest rates in the U.S. relative to what they would other wise be. Mr. Tamny doesn’t get this. He says that Mr. Rushton “wants us to believe that a devaluation of the income streams paid out by the U.S. Treasury actually made them more attractive to investors.” I don’t really know what he means by that either.

Another of Mr. Tamny’s “obnoxiously and comically false,” or perhaps merely nonsensical statements is that: “if we ignore the obvious, that the sole purpose of production is to import as much as possible….” If he is relating production to imports, he presumably means producing for export. What we import must be paid for one way or another, i. e., by exports of goods and services, U.S. dollars for reserves, U.S. government debt, or ownership of U.S. firms.

I leave it to the reader to sort out what Mr. Tamny might mean by: “the path to a lower ’trade deficit’ is only possible if we’re willing to accept being much poorer.”

As a parting shot, Tamny mischaracterizes the views of the late Jack Kemp. Here’s what Kemp actually said, speaking in 1987:

“Why do we keep having these cycles? I believe it has to do with the burdens and privileges of the dollar’s unique international role. First, the extra demand for dollars puts a premium on their value that makes American exports less competitive. And on world markets, only a few cents means the difference between a sale and a loss. This increases our merchandise trade deficit.

“Second, the dollar’s role helps fuel Congress’s deficit spending. Foreign central banks buy U.S. Treasury securities to hold as reserves and to keep their currencies from rising—almost $100 billion in the last year and a half. This amounts to a special ‘line of credit’ that lets Congress spend resources that would otherwise be used to farm or manufacture for export. President Reagan used to say that to get Congress to spend less you have to reduce its allowance. Well, we may have reduced its allowance but we haven’t taken away its charge card. That’s one reason why every tax dollar is spent without cutting the deficit.

“Trying to compete in world markets under these conditions is like trying to run a race with a ball and chain around your ankle. We face a constant choice between giving in to pressure to let the dollar fall at the risk of inflation, or keeping interest rates high at the expense of a trade deficit and growing pressure for protectionism. This dilemma will continue until we stabilize the dollar, end the inflation/deflation cycle, and bring down interest rates with the right kind of monetary reform.”

###

Sound Money

Philadelphia Society Address on Oct 14, 2017

Introduction

Sound money is a necessary but not a sufficient condition for a healthy economy. How can we best achieve and maintain it?

For almost two hundred years the gold standard did a good job of producing sound money but its weaknesses ultimately led to its abandonment and exchange rates were allowed to float.

The movement in the 1980s to independent central banks with a stable price level mandate, such as an inflation target, delivered several decades of sound money—this was called the great moderation. But is came at the expense of increased exchange rate volatility and asset bubbles.

We need to return to a monetary regime with a hard anchor. But money fixed in price to a single commodity, such as gold, will not provide as stable a value as a price fixed to a larger basket of goods.

The discretion of the central bank to control the supply of money should be replaced with market determination of the money supply. To achieve this money should be issued under currency board rules. Specifically the public should be able to buy all of the currency they want at the currency’s official prices and redeem any of it they no longer want at the same price.

The Gold Standard

The essence of the gold standard was the obligation of the issuer of gold backed money to redeem it for gold at an officially fixed price. This limited the amount of money that could be issued. The United States set the price of fine gold at $19.49 per ounce in 1791 and raised it to $20.69 in 1834. The Gold Standard Act of 1900 lowered it slightly to $20.67. In 1934, Congress passed the Gold Reserve Act, which raised the price of gold to $35 an ounce and prohibited private ownership of gold in the United States. Lyndon Johnson’s guns and butter deficit spending over heated the U.S. economy, which raised doubts about the U.S.’s ability to honor its gold commitments. By late 1971 the U.S. no longer had enough gold to honor its redemption commitment, and President Richard Nixon suspended the U.S. commitment to buy and sell gold at its official price. Yet, an official price remained, and was raised to $38.00 per ounce in 1971 and to $42.22 in 1972. In 1974, President Ford abolished controls on and freed the price of gold, which rose to a high of $1,895 in September 2011 before falling back to $1,304 this morning (October 14, 2017). More importantly, as gold has never been very representative of prices in general, prices of goods and services on average in the U.S. rose 500% over the 45 years since Nixon closed the gold window.

Floating Exchange Rates and Inflation Targets

When Nixon closed the gold window he also imposed wage and price controls, which lasted for three years. The dollar no longer had a “hard” anchor. It was no longer redeemable for anything and new policies were needed to regulate its supply. Over this period the Fed implemented monetary policy via adjustments in the overnight interbank lending rate (the Fed funds rate) in light of, among other things, its objectives for the growth of monetary aggregates. When wage and price controls were finally lifted the CPI increased a staggering 12% in 1974.

In the face of the Fed’s persistent over shooting of its narrow and broad money target ranges and the entrenching of higher and higher inflation expectations in wage and price increases, Federal Reserve Board Chairman Paul Volcker led the Board and the Federal Open Market Committee (FOMC) on October 6, 1979 in a dramatic change in the Fed’s approach to implementing monetary policy by shifting to an intermediate, narrow money target, operationally implemented via a target for non-borrowed reserves. The new approach required the Fed to relax its Fed funds rate targets and it increased the band set by the FOMC for the Fed funds rate from 0.5% to 4%. However, the fed funds rate rose temporarily to over 22% and GDP fell by over 2% in 1982—actual and expected inflation were reversed and fell below 2.5% by 1983. The new approach had defeated inflation but it was not easy to implement and by the end of 1989 the Fed abandoned it for the more traditional fed funds rate targeting.

At about the same time radical innovations in the development of monetary policy rules were launched by the Reserve Bank of New Zealand, which came to be known as explicit inflation targeting. An inflation target provides a clear and explicit rule that permits flexible operational approaches to its achievement. Given Friedman’s long and variable lags in the effect of monetary policy on prices, setting monetary operational targets (almost always the equivalent of a fed funds rate) must be based on the best model assisted forecast of its consistency with the inflation target one to two years in the future. A longer target horizon provided more scope for smoothing any output gap (employment). Full transparency of the policy and the data and reasoning underlying policy settings is required to gain the benefits of the alignment of market inflation expectations with the policy target.

The RBNZ’s development and adoption of inflation targeting was an important development in the pursuit of rule based monetary policy with floating exchange rates that accommodated flexible implementation. It swept the world of central banking. While the Fed did not adopt explicit inflation targets until 2012, it clearly pursued an implicit inflation target long before that.

Monetary stability, defined as price level stability, improved significantly, but exchange rate volatility increased. The Great Moderation of the 1990s and early 2000s that resulted from more stable domestic prices was followed by the Great Recession. The Great Recession of December 2007 to June 2009 highlighted the failure of inflation targeting to take account of asset price bubbles and “inappropriate responses to supply shocks and terms-of trade shocks”.^[1]

What followed can only be described as a nightmare (largely because of the over leverage and other weaknesses in the U.S. financial system). After properly and successfully performing its function of a lender of last resort and thus preventing a liquidity-induced collapse of the banking system, the Fed went on to undertake ever more desperate measures to reflate the economy. These Quantitative Easings (QEs)—quasi-fiscal activities—have been widely discussed and have contributed little to economic recovery.^[2]

The conclusion from the above history is that monetary policy is being asked to deliver more than it is capable of delivering. Central banks are generally staffed by very capable people, but they can never know all that they need to know to keep the economy at full employment as employers and jobs keep changing. The quality of forecasting models has greatly improved in recent years, but they remain unreliable. The policy strategy and intentions of the Fed and other inflation targeting central banks have become admirably transparent, but given the uncertainty of its next policy actions, markets remain spooked by every new data release and speech by Fed officials. Yet inflation in the U.S. and Europe remain below the 2% targets of the Fed and of the ECB.

Despite the huge increase in the Fed’s balance sheet, which banks are largely holding as excess reserves at the Fed, monetary growth in the U.S. averaged only about 5.5 to 6% over the past four years or about the same as its long run average (for M2). My assessment of the slow pace and modest size of the economic recovery in the U.S. is that regulatory burdens have discouraged investment while many internet related investments continue to drive down costs of many economic activity (a sort of unrecorded productivity increase). Easy money is once again inflating asset prices (stocks and to a lesser extend again real estate). But who knows for sure?

The idea that central banks can micro-manage monetary conditions to smooth business cycles is a conceit. In my opinion, central banks have given their price stability mandates their best shot and failed. The successful, countercyclical management of the money supply with floating exchange rates is simply beyond the capacity of mortals.

Return to a Hard Anchor

The Fed should give up its management of the money supply and return to a system of money redeemable for something of fixed value – a so-called hard anchor for monetary policy. This means linking the value of money to something real and managing its supply consistent with that value (exchange rate). Such regimes do not magically overcome an economy’s many and continuous resource allocation and coordination challenges, but by providing a stable unit in which to value goods and services and to evaluate investment options, and sufficient liquidity with which to transact, such regimes facilitate the continuous adjustments private actors need to make for an economy to remain fully employed and to grow.

But fixed exchange rate regimes, including the gold standard in one of its forms or another, have historically had their problems as well. These problems generally reflected one or the other of two factors. The first was the failure of the monetary authorities to play by the rules of a hard anchor, which is to keep the supply of money at the level demanded by the public at money’s fixed value. The pressure to depart from the rules of fixed exchange rates generally came from fiscal imbalances or mistaken Keynesian notions of aggregate demand management. However, even when central banks aimed actively to match the supply of its currency to the market’s demand with stable prices it proved beyond their capacity to do so.

The second source of failure came from fixing the value of money to an inappropriate anchor. When the exchange rate of a currency is fixed to another currency or to a commodity whose value changes in ways that are inappropriate for the economy, domestic price adjustments can become difficult and disruptive. Fixing the exchange rate to a single commodity, as with the gold standard, transmitted changes in the relative price of gold to prices in general, which imposed costly adjustments on the public.

These historical weaknesses of monetary regimes with hard anchors can be overcome by choosing better anchors and by replacing central bank management of the money supply with market control via currency board rules.

Currency board rules give control of the money supply to the market—to the public. As an example, a strict gold standard operated under currency board rules would increase the money supply whenever the public wanted more and was willing to buy it with gold at the fixed gold price of a dollar. If the public found it held more money than it wanted it would redeem the excess for gold at the same price.

I led the IMF teams that established the Central Bank of Bosnia and Herzegovina with currency board rules, and it functions in exactly this way. It has no monetary policy other than issuing or redeeming its currency for Euro at a fixed exchange rate in passive response to market demand. It has worked very well. I was also involved in establishing currency board rules for the Central Bank of Bulgaria, which has also enjoyed stable money ever since.

The hard anchor should not be just one thing. The relative price of any individual good or commodity will vary relative to prices in general. Thus a small representative basket of goods should be chosen for the anchor. Earlier proposals for broader baskets suffered from the assumption that buying and redeeming the currency should be against all of the items in the basket. That would be cumbersome and storage and security would be costly. Currency board rules should provide for indirect redeemability, by which the currency would be purchased with or redeemed for designated AAA securities (e.g., U.S. Treasury bills) at their current market value.

Exchange Rate Volatility or a Global Currency

A major cost of the current system of floating exchange rates with inflation or other targets is the uncertainly and wide swings of exchange rates. Over the last decade the USD/Euro exchange rate varied over 40 percent. The classical gold standard was associated with a flourishing of foreign trade in part because the gold standard was a world currency, which there for eliminated exchange rate risk. There would be considerable benefit to world trade, economic efficiency, and growth if all or most countries adopted the same hard anchor for their currencies. The International Monetary Fund’s SDR already exists for this purpose but would need to be modified in several important ways in order to operate under currency board rules and to change its valuation basket from a basket of currencies to a basket of goods.

Conclusion

Experience with monetary regimes with floating exchange rates has been mixed. Almost all major currencies have become more stable in the last three decades but at the expense of increased exchange rate and asset price volatility. The United State, as well as most other countries, would benefit from a return to a monetary system with a hard anchor, but fixed to the value of a small basket of goods rather than to just one, and whose supply is determined by the public’s demand via issuing and redeeming it indirectly for a liquid asset of comparable value according to currency board rules. The benefits of such a system would be increased the more widely it was adopted. One of the virtues of the gold standard was that it was global.

Reference

Warren Coats, “Real SDR Currency Board”, Central Banking Journal XXII.2 (2011), also available at http://works.bepress.com/warren_coats/25

________________, “What’s Wrong with the International Monetary System and How to Fix it?” April 20, 2017. https://works.bepress.com/warren_coats/38/

Jeffrey Frankel. “The Death of Inflation Targeting”. Project Syndicate, May 16, 2012.

_____________________________________________

[1] Jeffrey Frankel. “The Death of Inflation Targeting”. Project Syndicate, May 16, 2012.

[2] See for example, Warren Coats, “US Monetary Policy–QE3” Cayman Financial Review January 2013.

Discussion of John Tamny’s: Who Needs the Fed?

John concludes that we do not need the Fed because the Fed has become irrelevant. He argues that the interest rate “set” by the Fed is not relevant for the rest of the economy and that the Fed’s influence on bank credit is unimportant because not much credit comes from banks anymore, and that in any event the Fed can’t really control money and credit. While I think that John and I agree on many of the basic propositions that he sets out in his book, I disagree with many of his specific statements and with all of the propositions in my opening two sentences above. To be blunt, John reveals a shocking lack of understanding of how the Fed and monetary policy more broadly work. The book has three Parts: Credit; Banking; and The Fed. I will set out my agreement with John on some important broad principles and then quote only a few of the many statements I disagree with.

For starters, John, Dan [Dan Mitchel, the moderator of this debate between John Tamny and myself at FreedomFest] and I all agree that it is what government spends that determines the resources it has taken from us and thus limiting that spending to the essentials is more important than cutting taxes. Of course how the government takes our incomes to finance its activities is also important. Some taxes are worse than others. On the other hand, it is surely not true that anything the government spends reduces the economy’s output. Government provided public safety, national security, and contract enforcement increase private economic output.

We agree that bailing out banks is bad for the health and efficiency of the banking sector.

We agree that failure of private sector firms that can’t make a profit and the market’s reallocation of those resources to better uses is good for economic efficiency and growth and rarely happens in government.

We agree that the market should determine the supply of money whose value is fixed to something tangible. But many of John’s statements suggest that he does not understand what the Feds does and what it is mandated to do. I will have a lot to say about this shortly.

Credit

The first of the books three parts is about Credit. When I get past some unusual usage of the word Credit to what I think is John’s fundamental point, I agree with him that those borrowing to invest in the real economy can only acquire and invest real resources. They cannot build factories, buy equipment, hire and organize workers with money created by the Fed, though a sound currency and efficient payment system lowers to the cost of connecting savers and investors. At the end of the day, real investment requires the saving and provision of real resources. This is what economists call the “neutrality of money, the idea that in the long run a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption.” [Wikipedia] Unfortunately, throughout his book John fails to distinguish between real and nominal magnitudes.

John states this in several ways: “The Fed can’t create credit” [p. 4] However, it is not helpful when John defines credit as real resources when he means wealth or capital. Quoting him again: “Never forget that credit is the resources created in the actual economy.” [p. 26] And again: “Credit is just the name for real economic resources.” [p. 87] But near the end of his book he reverts to a more traditional definition of credit as a loan: “Credit is access to real economic resources.” [p. 178] There is a big difference between saying that credit “is real resources” and saying that it is “access to real resources.”

John talks a lot about what it takes for firms to attract funding of their activities. He provides many interesting examples of shifting credit risks in the economy and the credit market’s response in shifting resources away from higher risks to more promising uses, but these examples have nothing to do with monetary policy or the Fed. The Fed is not a credit institution. It does not allocate credit in the economy. The Fed is a monetary institution, whose job is to provide our currency and regulate its market value. John does not seem to understand the difference.

Banking

“It will never be a lack of money that fells Amazon [or any other company]. Only a lousy strategy will take it down.” [page 98] I sort of agree, but John then mistakenly applies this thinking to banks, which have a legal and business obligation to back all of their deposit and other liabilities with assets of equal or greater value, i.e. they must have positive capital. They must be solvent. John is mistaken to say that: “Because banks never simply run out of money, lack of investor patience is what causes them to file for bankruptcy.” [page 98] While banks can borrow when they are short of funds (credit in the usual sense of the word) as long as lenders and depositor think they are solvent, deposit and interbank funding runs can occur when depositors think the bank is not solvent. Solvency means having positive capital. Bank capital is difficult to assess because many of its assets are loans and it is not possible to know for sure how may of these loans will be repaid in the future. The real world, practical challenge with banks is to determine when they become insolvent as promptly as possible to prevent their continued borrowing and deposit taking as their capital hole grows so that most depositors and other creditors can be repaid when the bank is liquidated. A bank that continues to operate when insolvent is a ponzi scheme.

John correctly attack’s Murray Rothbard’s claim that fractional reserve banking is fraudulent. When banks lend out some or most of what we deposit with them—so called fractional reserve banking—they are doing exactly what they say they will. There is nothing fraudulent about it. It does make banks vulnerable to runs, however, which is why central banks are empowered to be lenders of last resort. John focuses his discussion on whether banks hold enough reserves (liquid deposits with the central bank and cash in their vaults) for unexpected deposit withdrawals and notes that any credit worthy bank can borrow what ever it need for this purpose from other banks. He says little about bank capital, however, which is the basis of whether a bank is credit worthy in the first place. If the market suspects that the bank has little or no capital, it will not lend to the bank.

John’s rejection of the broadly accepted proposition that banks multiple the money created by the central bank into a much larger quantity of bank deposits is completely wrong, as is his implicit rejection of the Chicago Plan of 100% reserve requirements by saying that “Banks can’t pay to stare at or warehouse dollars—they would quickly go out of business or be acquired—so logically they lend them.” [page 87]. Of course they can. If they are providing a valuable safekeeping and payment function, they can charge for it. Who remembers to old days when banks levied a service charge on demand deposits? Rather than focus exclusively on reserve requirements John should focus on the role of capital requirements for protecting depositor money. Positive capital means that the value of a bank’s assets exceeds its deposit and other liabilities.

John’s attempt to disprove the money multiplier fails to reflect or understand the intermediary nature of banks. They sit between the savers and the investors; between depositors and borrowers. He illustrates his claim with four friends at a table, one with a $100 who lends 90 to the next friend who lends ten percent of that to the next one and so on mimicking the standard text book explanation of the creation of money by banks. The correct game would have the friend with the $100 depositing it with the imaginary banker in the center of the table. The banker then lends $90 to the next friend by recording a deposit liability to the second friend of $90. The two friends between them now have $190 in deposits with the bank, which now lends $81 to the third friend by creating a $81 deposit for the third friend, etc. The example reflects a 10% reserve requirement. For some reason John doesn’t get this very real world phenomenon. The creation of deposit money by banks is only inflationary if their growth exceeds the growth of the public’s demand for them. It is forgivable if Joe six pack doesn’t understand the money multiplier by banks, but it is shocking for someone writing about the subject to failure so completely to understand it.

Banks are one of many financial intermediaries lending other peoples’ money, but they are the foundation of the payment system. Capital protects depositors’ money from the occasional non-performing loan made with those deposits. Historically virtually every country in the world bailed out insolvent banks rather than let depositors lose money. This created terrible moral hazard as John notes. Deposit insurance has improved the picture and the US has closed thousand of banks without serious disruption, but not the biggest ones viewed as too big to fail.

My recommendation is to separate the payment from the lending functions of banks, requiring 100 % reserves on demand and savings deposits, and requiring equity (capital) to finance bank lending and its other investments. Thus deposits and the payment system would be risk free and require very little further regulation.[1] The intermediated lending would be all equity financed, like a mutual fund investment, and require very little further regulation as well, as its investors would have total skin in the game and could take whatever amount of risk they wanted as they would reap the rewards or suffer the losses. Losses of loans and investments would no longer threaten bank deposits and the payment system. There would no longer be a need for the Lender of Last Resort function of the Fed or other central banks. This is the Chicago Plan put forth during the great depression by such notable economists as Irving Fisher, Frank H. Knight, Lloyd W. Mints, Henry Schultz, Henry C. Simons, Garfield V. Cox, Aaron Director, Paul H. Douglas, and Albert G. Hart.

The Fed

Most central banks these days have the legal mandate to regulate the supply of their currencies so as to keep its value stable— the so-called price stability mandate. The Fed has a problematic “dual mandate” of maximizing employment and stabilizing prices, which I will not discuss further here. There are several basic approaches to fulfilling this price stability mandate, ranging from fixing the price of the dollar to gold at one end of the spectrum to targeting inflation with market determined, i.e. freely floating, exchange rates at the other end. The policy debate is or should be about which of the rules for managing the money supply would be best for the U.S.

John says that “Friedman was the modern father of monetarism, a theory of money that says the central bank should closely regulate its supply.” [p 136] Friedman said no such thing.

Monetarism says that, like every other good, the value of money is determined by its supply and demand. The demand for money comes from the public and has been empirically related to their incomes. The supply is determined by the central bank in accordance with the policy rule it adopts. The gold standard was one such rule. A fixed monetary growth rate rule, once advocated by Friedman, is another. Inflation targeting, now in vogue, is yet another.

John makes a number of statements that suggest that he understands none of this. He says that: “Production is the source of money.” [p 136] We can make sense out of this strange statement if we change it to say that production is the source of the demand for money. Given that demand, monetarism says that the price or value of money (its purchasing power) will be determined by its supply and its supply will depend on the policy rule the central bank follows. If the Fed creates more money than the public wants to hold, people will spend the extra money. But as John and I agree, spending such money doesn’t create the goods people want to buy. Thus a money supply that exceeds its demand will drive up the prices of goods and services. That is the monetarist story of inflation.

John goes on to say that: “Friedman viewed inflation solely as a money-supply phenomenon. Inflation was a function of too much money, as opposed to a decline in the value of money.” [p 136] I can’t make sense of this strange statement. The statement that “inflation was a function of too much money” is a statement about the cause of inflation. The final clause of John’s statement says that: “inflation was a function of…a decline in the value of money.” But inflation is a decline in the value of money by definition. So what does John mean? His effort to explain why these are difference seems to concern the allocation of money around the country. He says: “money migrates to where production is.” Yes it goes to where it is demanded. John confuses the markets role in allocating credit around the country with the Fed’s role in controlling the aggregate supply of money. It is shocking that someone who writes regularly on this subject fails completely to understand its basics. I cannot find any evidence that John understands the basics of monetary theory of the supply and demand for money and its price, i.e., its value.

Another indicator of John’s confusion comes from the first Part of the book when he compares the Fed’s lowering the fed funds rate to Nixon fixing gasoline prices below the market price. Fixing the price of gas lower than the market price reduces its supply and increases its demand and produced long lines at gas stations in the hope of tanking up before the station runs out. But the Fed does not fix the fed funds rate; it sets a target for it. The difference is profound. The Federal funds rate is determined in the market by banks. When the Fed reduces its target for the Fed funds rate it increases its supply of liquidity to banks so that supply and demand force the interbank rate down. John repeats this fundamental misunderstanding throughout the book. In order to emphasize the importance of the distinction between fixing the Fed funds rate and targeting it, let me in Donald Trump fashion, repeat the point. The Fed does not fix the Fed funds rate. It enters the market as a buyer or seller of t-bills in order to increase or reduce the supply of bank reserves in order to stimulate the market to move the rate to the Fed’s target value.

John repeatedly describes the folly of the Fed trying to increase the money supply in Baltimore or Cincinnati to stimulate growth there, as markets will attract it away to healthier areas that demand it. He repeatedly discusses money as if it is credit. The Fed does almost no lending and then only to banks temporarily short of liquidity. When the Fed wants to lower the Fed funds rate in the market, it buys U.S. treasury bills from the market. The transactions (so called open market transactions) take place in New York but the sellers of these t-bills to the Fed are scattered all over the country and the newly created money is deposited in the sellers banks all around the country. John failures to reflect a basic understanding of how monetary policy works.

John’s misunderstanding of how the Fed operations is further illustrated in his following statements: “The Federal Reserve… proceeded to borrow reserves from the banking system so that it could buy trillions worth of U.S. Treasuries and mortgage back securities…. The Fed has credit to allocate only insofar as it extracts it from the real economy.” [p 149] This is completely wrong. The Fed supplied reserves to the banking system by buying Treasuries with money it created. Understanding this is absolutely fundamental to understanding what central banks do. John documents over and over again that he does not understand these basics.

John and I are both skeptical of the Fed’s ability to managing its monetary policy (the fed funds rate and/or the money supply) so as to smooth out business fluctuations while maintaining a stable value of the dollar. We both think that keeping short-term rates near zero for so long has been a mistake. In the long run, monetary policy determines the price level and its rate of inflation, not full employment and real income. John and I agree that the health of the economy, or its lack of it, is much more the result of stifling regulations, not monetary policy.

These suggest that the Fed would do better to adopt a different policy strategy or rule. John suggests that we can do away with banks and the Fed altogether, but says almost nothing about their replacements. I favor a supply of money determined by market demand whose value is fixed to a basket of goods. The Fed would supply currency under currency board rules whenever people wanted it and paid its official price and could redeem it at its official price, i.e. the market value of its valuation basket, if they had too much of it. In the case of the gold standard the only good in the valuation basket was gold, whose price is not as stable as would be a basket of goods. This proposal is discussed in my Real SDR Currency Board and other articles. Unfortunately you will not find John’s proposal for determining the money supply in his book.

John’s arguments that we do not need the Fed because it has no (or only negligible) affect on market interest rates and credit and because the Fed and banks cannot create money, are wrong. While interbank interest rates (the Fed funds rate) are a tiny fraction of all interest rates, market arbitrage insures that all interest rates are related to each other given the unique risks and characteristics of individual borrowers and classes of borrowers and of the appetites for risk of lenders. The Fed can and does “print money” expanding the currency held by the public and bank reserve deposits with the Fed (so called base money) and banks can and do multiply this base money into a much larger supply of money (currency and bank deposits) by lending it. While in the long run these activities of the Fed and banks only affect the value of money (inflation) with no affect on the real economy, they can and do have important real economy affects for good or ill in the short run. The question we need to answer is what monetary policy rules should the Fed adopt and follow in order to best fulfill its price stability and full employment mandate.

[1] “Changing direction on bank regulation” Cayman Financial Review, April 2015

Postscript

A few Booboos

“Housing is not investment…. Housing is consumption” [p 113] Buying a house is an investment (it is a capital good). Living in or renting it is consumption.

“The Fed can’t create the credit that is economic resources” [p. 159] No but it can create money.

The Fed believes “that economic growth is the cause of inflation” [p. 159] Throughout John fails to distinguish real and nominal magnitudes (real exchange rate vs. nominal exchange rate; real interest rate vs. nominal interest rate; real income vs. Nominal income; real quantity of money vs. nominal quantity of money, etc.). Real economic growth with a constant money supply will cause deflation. Nominal economic growth when real income is constant is all inflation, etc.

“For those who still believe we need the Fed to keep a lid on the ‘money supply,’ what can’t be stressed enough is that our central bank cannot control that supply.” [p. 161] Not true.

References

Coats, Warren, 1982 “The SDR as a Means of Payment,” IMF Staff Papers, Vol. 29, No. 3 (September 1982) (reprinted in Spanish in Centro de Estudios Monetarios Latinoamericanos Boletin, Vol. XXIX, Numero 4, Julio–Agosto de 1983).

1983, “The SDR as a Means of Payment, Response to Colin, van den Boogaerde, and Kennen,” IMF Staff Papers, Vol. 30, No. 3 (September 1983).

2009, “Time for a New Global Currency?” New Global Studies: Vol. 3: Issue.1, Article 5. (2009).

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

2014, “Implementing a Real SDR Currency Board”

_____. Dongsheng Di, and Yuxaun Zhao, 2016, Why the World needs a Reserve Asset with a Hard Anchor, http://works.bepress.com/warren_coats/34/

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