Tag: inflation

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/

 

 

A Modest Proposal—Helicopter Money and Pension Reform

It is possible to fix the bankrupt Social Security System and the Federal Reserve’s failure to achieve its inflation target painlessly. Yes, really.

The Fed has failed to raise inflation to its 2% target because over regulated banks can’t find over regulated firms wanting to borrow and invest. As a result, the increases in the Fed’s base money from its Quantitative Easing and other efforts to stimulate the economy has piled up as bank excess reserve deposits at the Federal Reserve Banks.[1] If the Fed pushes too hard (e.g., by lowering the interest it pays on these bank reserves, potentially even to negative levels) it feeds asset price bubbles (stock and housing prices), which do great damage when they burst.[2] If the Fed just printed more money and sprinkled it around to the general public—what Milton Friedman called helicopter money—there is no doubt that the public would spend more and drive up prices.

Leaving aside whether it is really a good idea to create a steady 2% rate of inflation, there is an easy way of doing it that would also facilitate badly needed reform of the government’s retirement system. Contrary to the myth that our Social Security pensions reflect what we paid in (saved) to the system, Social Security pension payments are now fully pay as you go. This means that the revenue from payroll taxes approximately matches the outflow for current pensions, i.e. nothing is being saved for the future. As our population continues to age and the number of retired pensioners increases relative to the shrinking number of workers paying into the system, the modest amounts that have been accumulated in the Social Security “Trust Fund” will be drawn down to zero in about 15 years at which time the government will not be able to meet existing promises.[3]

The following proposal combines helicopter money sufficient to bring the inflation rate to its target with badly needed reform of our government pension system. Under this proposal all individuals will receive a minimum government guaranteed pension for life whether they paid in anything or not. This might be implemented as part of a Friedman like negative income tax and other badly needed tax reforms,[4] or stand alone. Before retirement, individuals who are working but with incomes below the poverty level (to be politically established) will not pay a wage tax as they do now. The subsequent pensions of such people will be paid with helicopter money (the Federal Reserve will print the money to buy government bonds sufficient to finance these expenditures). All workers with incomes above the poverty level will be required (as they are now) to set aside the amount of income needed to finance their minimum guaranteed pension on a fully funded basis. They are free to save more if they would like a higher pension. The funds set aside must be invested in government licensed and approved private pension funds chosen by each worker rather than in the almost fictitious Social Security Trust Fund.

This would establish the three pillars of good pension policy proposed by the World Bank in 1998: a means tested minimum pension financed by the government’s general revenue, a mandatory minimum pension paid for and privately invested by all working individuals, and additional, optional, supplemental retirement saving privately invested. Such a model was first adopted in Chile over 35 years ago with great success. Central and Eastern European countries have adopted similar models as part of their transition from centrally planned to market based economies. Financing income subsidies to the poor from general revenues (via printing money), and a user fee approach to mandatory saving (mandatory saving matched to the actuarial value of the pension received), conforms more closely to the principles of good tax policy.[5] The alternative sometimes proposed of raising the income cap on the payroll tax is closer to general revenue financing (if the government guaranteed minimum is only paid to the poor), but leaves out non-wage income and thus fails the good tax criteria.

As new workers would be truly saving for retirement, their savings would not be available to finance those currently retired, as is now the case with our pay as you go system. Thus transitional arrangements will be needed (for several decades) to deal with existing unfunded promises. If the promises remain unchanged, the money to pay for them will have to come from somewhere (higher taxes or reduced defense or other expenditures). Usually, in such cases the government spreads the burden around (burden sharing). Two simple and sensible changes to the current promises would absorb the greater part of the shortfall. The first is to adjust the pensionable retirement age to the fact that the average person lives much longer than when the current retirement ages were fixed. People are living longer and can (and most would like to and do) work longer. The other is to change the index to people’s pensions from a wage index (which generally increases pensions in real terms over time) to the cost of living (CPI), which would preserve their real value against any inflation over time.

For today, this means that the wage tax on the poor would be abolished and paid for with new Fed money that would thus be put in the hands of those who would spend it, increasing employment (though we are really at full employment now) and/or wages and prices. It would both raise inflation a bit and launch a genuine, long over due pension reform.

[1] “US Monetary Policy–QE3” Cayman Financial Review, January 2013

[2] “The D E Fs of the Financial Markets Crisis” CATO Institute, September 26, 2008.

[3] https://wcoats.wordpress.com/2008/08/28/saving-social-security/

[4] http://www.compasscayman.com/cfr/2009/07/07/US-federal-tax-policy/

[5] http://www.compasscayman.com/cfr/2013/07/12/The-principles-of-tax-reform/

Economics Lesson: Is deflation bad?

Fortunately the key insights about inflation or deflation are fairly intuitive and easy to understand. Stable prices—i.e., zero inflation—is best, fully anticipated inflation (or deflation) is second best, and inflation/deflation surprises are bad. If you would like a bit more detail, read on.

Inflation refers to the rate at which the value of money (average prices usually measure by a consumer price index—CPI) changes over time. Zero inflation, constant purchasing power of a currency over time in its local market (e.g. the value of the US dollar in the US), is best because all of the other factors impacting the supply and demand for individual goods that potentially change their prices relative to other goods and services can be expressed in terms of a constant unit account, a constant measuring rod. This makes comparing prices stated in that unit of account, especially over time, much easier. Imagine if the length or weight of something had to be expressed in units of weights and measure that themselves were always changing. Economic resources are better allocated to the satisfaction of public demand when the relative scarcity of each good and service can be clearly discerned. Decisions about the allocation of resources (whether to build a new factory to produce a new product or more of an old one and/or to hire more workers, etc.) are necessarily forward looking. The entrepreneurs’ question is what will people pay for something next year and the year after and what will it cost to produce it and how does this compare with producing something else. This is more difficult to do when the forecast of prices need to mix in the changing value of the currency in which they are stated.

However, a decent second best is a rate of inflation (positive or negative) that is steady and predictable. The inflation target of 2 percent chosen by many central banks, if reliably achieved, provides an example. If the inflation rate is fully and correctly anticipated, whether positive or negative, all other relative prices, including interest rates and wage contracts, can and will take the anticipated rate into account when setting prices in contracts for the future (e.g., a wage contract). If borrowers and lenders are willing to contract for a loan for five years at 3% per year with zero inflation in the value of the money borrowed and repaid, they would both be willing to undertake the same loan at 5% if they both expected inflation of 2% per year over those five years. If that expectation were rather uncertain, a suitable risk premium would need to be added to the interest rate. If everyone expected with certainty a 2% deflation over the same period, the loan would carry a 1% nominal rate. In both of these examples, the so-called real rate of interest—the rate adjusted for inflation—would be 3%. Thus, modest deflation does no harm if everyone fully and correctly anticipates it.

As an aside for the more advanced students, Milton Friedman explained why a fully anticipated, mild deflation was actually good because it would reduce or eliminate the opportunity cost of holding money and thus encourage people to hold larger cash balances on average without any cost to themselves or society. The money we hold in our wallets or nightstands or in our checking accounts at the bank is like any other inventory of goods that shop keepers keep on their shelves. Without an adequate inventory of what they sell, they would occasionally run out and miss some potential sales. But it cost money to hold an inventory of something. The cost can be measured by the interest you could have earned investing the money you spent to acquire the inventory (called “opportunity cost” by economists), plus any storage costs. Deflation reduces the opportunity cost of holding money by generating a real return from holding it (it is worth more in the future).

Unanticipated inflation, however, is bad because contracts written in dollar terms (so called “nominal” terms) will turn out to have a different real value than was expected. Normally a voluntary contract benefits both parties to it; it is win win. But when the inflation outcome was not anticipated, it will produce unexpected winners and losers. Debtors benefit from unanticipated inflation and creditors lose. More to the point in our current, over indebted environment, a deflation that was not anticipated when the money was borrowed, will increase the real value of the money that must be repaid. Lenders will benefit from the unexpected windfall only if borrowers actually repay their loans. But the unexpected increase in the real value of the debt being repaid may result in a larger number of defaults. So central banks are trying to avoid deflation, or more accurately are trying to achieve their inflation targets (generally 2%) in order to avoid making the economy’s excessive indebtedness even worse.

The above discussion concerns the value of a currency in its own country. But given the very extensive commerce across borders and the fact that most countries use their own currencies, cross border payments require exchanging one currency for the other. If the exchange rates of all currencies were fixed and never changed, the above analysis would apply globally as well. However, the exchange rates of many currencies, such as the USD/Euro rate, vary continuously and sometimes very significantly. The USD/Euro rate has fallen (i.e., the dollar has appreciated) 30% in the last 12 months (on April 9, 2015). This represents an enormous and very disruptive shock to the value of US trade with Europe, increasing the cost of our exports and reducing the cost of imports from Europe by very large, unpredicted amounts. Following the collapse of the gold standard, which fixed the exchange rates of most currencies, in the early 1970s, a costly financial market of insurance against exchange rate movements has developed. The total daily value of FX related transactions (spot, forwards, swaps, options) are estimated at around 4 trillion US dollars. Yes, that is daily and yes, that is trillions. These added costs of international trade would be eliminated if all or most countries returned to credibly fixed exchange rates or better still one globally used currency. The enormous gains in the standard of living from this trade could be extended even further.

The world is now “blessed” with a variety of monetary policy regimes. All of them aim in one way or another to deliver stable value for their currency either domestically or relative to another currency. The major industrial countries generally target inflation domestically and allow the exchange rates of their currency to float against other currencies. Many smaller countries fix or target the exchange rate of their currency to the US dollar or the Euro or the IMF’s Special Drawing Rights (SDR) thus causing the domestic values of their currencies to reflect the inflation rates of the currency to which they are fixed.

Two major reforms would establish a global monetary system with stable money (zero inflation). The first would be to change the IMF’s international reserve asset, the SDR, from a currency whose value is determined by a basket of key currencies (the USD, Euro, UK pound, and Japanese Yen) and allocated on the basis of political decisions, to a currency whose value is determined by a basket of real goods that is issued on the basis of market demand in accordance with currency board rules. These reforms are explained in more detail in earlier articles such as https://wcoats.wordpress.com/2010/01/21/the-u-s-dollar-and-the-sdr-as-international-reserve-currencies/ and https://wcoats.wordpress.com/2013/07/31/a-hard-anchor-for-the-dollar/. The above reforms in the SDR would include an international agreement to replace the US dollar and Euro in international pricing and payments with the reformed SDR, which I call the Real SDR.  http://works.bepress.com/warren_coats/25/

The second reform would follow naturally given the greater stability of the Real SDR. Countries would fix the exchange rate of their national currencies to the Real SDR or replace them all together with the Real SDR (the equivalent of dollarization). If all or most countries did this, the world would enjoy the benefits described above of a global currency with a completely predictable and stable value relative to a “typical household consumption basket” across the globe. It is worth fighting for.

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”.