Money – Warren's space

My Travels to Kosovo

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

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

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

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

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

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

Econ 101: Moving money abroad

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

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

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

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

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

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

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

Whither Libra?

Every other day, it seems, we witness the launch of a new crypto (digital) currency. Each combines a medium of exchange (a currency) and a means of payment (a technical process of delivering the currency—of making a payment with it). While many of us have watched the ups and downs of bitcoin and its imitators with amusement, none of us (hopefully) take it seriously as a currency. Bitcoin is a speculative vehicle for gambling. Processing bitcoin payments is too slow, and its value is too volatile to succeed as a medium of exchange or as a means of payment. Only about 1% of bitcoin transactions are actual payments. Many new means of payment do not involve a new currency. Thus, debit and credit cards, checks, wire transfers, PayPal, Popmoney, Zelle, etc., are means of payment of US dollars, or Euros or other sovereign currencies.

Unlike the bitcoins of the world, Libra is a currency and means of payment that is designed to ensure that its tokens will have a stable value. The legacy members of Facebook, Visa, Uber, and other partners in the Libra Association promise the possibility of rapid adoption. Libra’s value will be fixed to that of a basket of major currencies, its supply will be regulated by market demand at that fixed price (issued via currency board rules), and it will be fully backed by assets of the same value ensuring that holders of Libra can redeem them for the same value at any time.

Suddenly potential regulators are on high alert such as witnessed in the recent Congressional testimony of David Marcus, head of Facebook’s Calibra, to Congress. By whom and how should Libra be regulated? Obviously, it will need to comply with Anti Money Laundering (AML/CFT) requirements and whatever else each jurisdiction in which its participants reside (holders of “accounts” with Libra or of its tokens) require of money service providers. Banks take deposits and lend, so Libra would not be a bank. While its tokens might be treated as deposits, it will not lend (its purchases of government debt and other securities with the money paid to buy Libra are investments not loans). In this short note I will explain why Libra—the coin/token/currency—is not a claim on a mutual fund and thus should not be regulated in the US by the Securities and Exchange Commission. I will not, however, examine its claim to be a more efficient means of payment.

The nature of Libra’s claim of stability rests on how its value is determined. Its value is to be fixed to the market value of a basket of currencies yet to be determined. But how does that work exactly? The world already has an internationally determined and managed unit of account, the Special Drawing Right (SDR) of the International Monetary Fund. Rather than introduce yet another, competitive unit the case for Libra to fix to the SDR is so overwhelming that I will illustrate the difference between a currency basket as a unit of account and as an investment portfolio with the SDR. The composition of the SDR’s valuation basket is established by international agreement following a well-specified and transparent process. Fixing the value of a Libra to that of the SDR would remove any risk of its value being manipulated by Facebook or other Libra shareholders. That would strengthen the status of the Libra but also contribute to enhancing the IMF’s SDR as a supplement or substitute for the dollar in international reserves, as called for in the IMF’s Articles of Agreement.

The SDR’s value is determined by a basket of five currencies (the dollar, euro, pound sterling, yen and renminbi). The IMF computes the dollar value of one SDR (and thus the value in every other currency) daily on the basis of the market exchange rate of each of the five currencies in the valuation basket into dollars. The dollar values of each currency are added up to determine the dollar value of the basket. By fixing the value of one Libra to one SDR it sets the price at which Libra can be purchased and the currency value that would be returned if Libra were redeemed.

This might seem similar to, but is in fact very different than, the value of one Libra being determined by the value of the portfolio of investments that back it. The “Reserve” backing Libra would consist of SDR denominated assets (e.g., SDR bonds) or assets in each of the five basket currencies in the same proportion as in the SDRs valuation basket. Thus, it would bear no exchange rate risk. However, the investment would have other risks, specifically interest rate and default risks. To the extent that some of the Reserve’s investments are relatively long term (say ten-year Treasury bonds), changes in market interest rates would change the current market value of these investments. While Reserve investments would presumable be made only in the safest assets and would be limited to relatively short-term instruments, the risk of default or loss in value would not be zero. So, if one Libra is a claim on its share of the Reserve, its value could differ from the daily dollar value of the SDR valuation basket.

Libra wishes to include the unbanked in its market, thus opening financial and payment services to this broad group now unable to enjoy them. If Libra’s value is fixed to the value of its Reserve, and thus regulated by the SEC (in the US), consumer protection investment regulations would likely exclude the very people Libra is most interested in serving. Thus, Libra should fix its value to that of a unit of account and not to the value of its Reserve.

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/

FreedomFest in Las Vegas

Dear Friends,

Are you attending FreedomFest this year? It claims to be the world’s largest gathering of free minds. At this year’s gathering from July 13 – 16 at Planet Hollywood in Las Vegas I will be debating John Tamny, editor of Real Clear Politics and author of the new book, “Who Needs the Fed?” on Friday morning, July 15. In addition, I will be on a panel discussing the new documentary, “The Moneychangers” on Saturday afternoon July 16.

You can use code SALEM (all upper case) to get $100 off the registration fee. Go to “register now” at www.freedomfest.com, or call toll-free 1-855-850-3733, ext 202.

Here are some highlights:

Gary Johnson to Address FreedomFest

Now FreedomFest is pleased to announce that Gary Johnson, the former governor of New Mexico and the new presidential candidate for the Libertarian Party, will address FreedomFest at 4 pm Pacific Time, July 15, 2016, in the Celebrity Ballroom at Planet Hollywood, Las Vegas.

Johnson recently polled 10% support in two national polls. Many pundits consider him a legitimate third party candidate since Ross Perot ran for president in 1992. As David French wrote for National Review: “Good news, disgruntled Americans: As you ponder whether to vote for one of the two most-disliked, dishonest, and morally corrupt politicians ever to run for president — Donald Trump and Hillary Clinton — you just might have a third option. His name is Gary Johnson.”

Why FreedomFest?

Steve Forbes, chairman of Forbes Inc., said it best: “FreedomFest is where the best ideas and policies are flushed out. I attend all 3 days and wouldn’t miss it for the world.”

What’s FreedomFest all about? Everything! Philosophy, history, science & technology, healthy living, politics and your money, and much much more. It’s a Renaissance gathering in the entertainment capital of the world.

It’s organized by Mark and Jo Ann Skousen. Mark Skousen is a financial economist, author, and university professor who has taught at Columbia Business School and now Chapman University. Jo Ann Skousen teaches English literature at Chapman University and Mercy College, and is the director of the Anthem Film Festival.

Once a year in July all the freedom lovers of the world gather in Las Vegas for FreedomFest, what the Washington Post calls “the greatest libertarian show on earth.” Steve Forbes and John Mackey, CEO of Whole Foods Market, are co-ambassadors and attend all 3 days. Last July over 2,500 people showed up to learn, network and celebrate liberty–including Donald Trump, Senator Marco Rubio, Steve Wynn, Peter Thiel, and Glenn Beck. Steve Moore even debated Paul Krugman, the Nobel Prize economist and columnist at the New York Times. Want a summary? Watch the 5-minute video at www.freedomfest.com/videos).

Who’s coming this year? This year’s keynote speakers include Senators Rand Paul and Ben Sasse (who will debate Trump as the Republican candidate), radio hosts Larry Elder and Michael Medved, Judge Andrew Napolitano, TV host Kennedy from Fox Business, Charles Koch’s right-hand man Richard Fink, authors George Gilder and Steve Moore, and the former heavy weight champion of the world, George Foreman, and boxing promoter extraordinaire Don King.

In fact, they are holding a special reception with George Foreman, where attendees will get a chance to meet him, get an photograph taken with him, and have him sign a copy of his book, “Knockout Entrepreneur.” (He sold his grill business for $138 million.)

This year’s big debate will be “Capitalism vs. Socialism: Free to Choose or Free to Lose?” between John Mackey, co-founder and co-CEO of Whole Foods Market, and John Roemer, Yale professor at the top Marxist/socialist in the country (supporter of Senator Bernie Sanders). The debate is set for Thursday morning, July 14, in the Celebrity Ballroom, Planet Hollywood.

Other features: Watch the mock trial as we put “Global Warming on Trial” (C-SPAN coverage)…. Grover Norquist (CNN considers him “the most powerful man in Washington”) will hold his famous “Wednesday Meeting” at FreedomFest….a special session by the “Women of Liberty”….a debate on voting with actor/activist Ed Asner and political commentator John Fund….a 3-day investment conference with Peter Schiff, Alex Green, Mark Skousen, and Keith Fitz-Gerald….a debate between Dinesh D’Souza and Michael Shermer (Scientific American) on the Bible….and win $25,000 in prizes in the Pitch Tank organized by Shark Tank’s Kevin Harrington. Join all the freedom organizations and think tanks – Cato, Heritage, Reason, Students for Liberty, Americans for Prosperity, etc. They are all there in a gigantic exhibit hall, the “Trade Show for Liberty.”

Plus the ever-popular Anthem film festival, run by Jo Ann Skousen. This year one of the films will be shown by the producer of “Schindler’s List.”

Oscar Goodman, former mayor of Las Vegas, calls it an “intellectual feast” in Las Vegas – one of a kind!

FreedomFest will take place July 13-16, at Planet Hollywood, Las Vegas. For more details, go to www.freedomfest.com.

The Future of Bitcoin Exchanges

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

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

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

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

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

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

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

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

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

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

Cryptocurrencies – The Bitcoin Phenomena

Revised February 14, 2014

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

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

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

Background

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

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

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

The value of a bitcoin

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

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

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

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

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

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

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

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

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

The future of bitcoin

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

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

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

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

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

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

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

Appendix – What are bitcoins?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Future of Money

I solicited 12 articles on very diverse aspects of the future of money for the current issue of the Cayman Financial Review (I am a member of the Editorial Board). http://www.compasscayman.com/cfr/

I wrote two of the articles myself and I hope that you enjoy them:

http://www.compasscayman.com/cfr/2012/01/11/The-future-of-money—What-is-it-/

http://www.compasscayman.com/cfr/2012/01/11/The-Technology-of-Money/

Cayman Financial Review on the Future of Money

The first quarter 2012 issue of the Cayman Financial Review, of which I am an editorial board member, devotes a number of articles to The Future of Money. Here is my lead off article on that subject: http://www.compasscayman.com/cfr/2012/01/11/The-future-of-money—What-is-it-/

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