Category Archives: Monetary Theory

The Error of Latin American Market Reform

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Left Behind (Edwards)In the story of Latin American economic reform, then, one variable more than any other plays a crucial role. It is not inflation, wages, or economic growth; it is not privatization or the extent of openness and globalization; it is not even foreign debt. The key variable is the exchange rate, or the value of the local currency — the peso, the bolivar, the quetzal, the real, or the córdoba — in relation to the United States dollar. Repeated mistakes in exchange-rate policy will be singled out as the most important cause behind the region’s economic travails, the waning support for modernizing reforms, and the eventual revival of populism during the twenty-first century.

— Sebastian Edwards, Left Behind: Latin America and the False Promise of Populism (Chicago: University of Chicago Press, 2010), p. 142.

The problem that Edwards brings to our attention is the seeming inability for a fixed exchange rate regime to coexist in a country with independent monetary policy. In a floating exchange rate regime, a fall in the value of a currency will also manifest itself in the exchange rate — the currency becomes cheaper relative to others. If the price of local currency is fixed, however, internal inflation will cause it to become overvalued relative to foreign currencies. This discourages export-oriented growth.

But, the currency and debt crises that struck Latin America in the mid- and late 1990s was more than just a price fixing problem. Latin American assets (except for debt denominated in foreign currency) also required currency exchange to take place, and so the artificially overvalued local currency should also impact capital flows (or, at least, the kind of assets held). But, inflationary environments tend to correlate with — and/or cause, I think — asset price booms, so holding these assets becomes attractive. Most Latin American countries were running large trade deficits, meaning they have capital account surpluses. In my opinion fixed exchange rates in an inflationary environment is part of the problem, but not the whole story.

Institutions, Gold, and Banking

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Originally, I was going to write a post on the recent volatility of gold prices and what this means for gold standard advocates. Pondering the subject, I became more interested in what this means for free banking advocates, specifically those who think that gold (or similar commodity monies) would be the primary backing asset. Since paper notes are circulated in place of gold, the relative scarcity of gold is no longer an advantage in constraining the money supply. From here, it’s not a big jump to come to the conclusion that gold loses some of its purpose. If what matters is limiting fiduciary expansion, the choice of backing assets broadens, because the bank only needs a capital reserve to make good the liabilities that its circulating banknotes represent. Many people, incorrectly, assume that it’s the “backing” that decides the sustainability of a currency. It’s not, what give sustainability are the institutions of banking.

To see my particular angle of approach, let’s quickly look at this hypothetical history of banking in hypothetical Ruritania. After some time, gold emerges as the principal medium of exchange, and people begin depositing their gold coins at specialized businesses, or money warehouses. Not only is this for safety, but these warehouses also preform the function of financial intermediaries, settling debts on net and in bulk. In place of actual gold coin, people trade with redeemable warehouse receipts. At first, any lending by part of these warehouses comes from their own retained earnings, and not the deposits of their customers. Over time, though, these firms begin loaning their customers’ deposits, as they realize that some fraction of total liabilities aren’t redeemed at any given point in time. This system slowly becomes more sophisticated, as standards are developed and new types of promissory notes are introduced Ruritanian banks eventually begin circulating the banknotes we’re most familiar with — imagine U.S. dollars redeemable for gold at your local bank branch. Gold is relegated to a reserve asset used to settle interbank clearings (when bank A goes to bank B with a large stack of B’s notes and redeems them).

Bank notes, or inside money, are circulating in place of gold coin, meaning they essentially become just as good as the commodity money they’re substituting for. To keep things simple, let’s assume that all notes trade at par (a $1 bill is worth the full amount of the assets it represents). It’s the circulation of these notes that forms part of the process of competitive price formation, so any change in the quantity of bank notes will affect prices. In this banking system, changes in the quantity of bank notes are bound to occur. The substitution of inside money for gold is essentially an act of abandoning a relatively rigid money for a much more elastic one. If banks wanted to, they could print an unlimited number of bank notes — well, until Ruritania ran out of trees (or until the saw and paper mills decided to stop working because hyperinflation had caused the pricing process to break down). This seemingly presents a dilemma.

The main argument against central banking is precisely that this state of affairs makes it too easy for a monopoly to exploit the elasticity of the currency. But, free banking doesn’t suffer from the same problem. To paraphrase Douglass North, free banking is a case of being able to conquer ourselves once we conquered nature — we gradually make the uncertain more certain. As competition in banking increases, rival bank notes (assumed to be imperfect substitutes) will circulate in competition with each other. Banks will accept rival notes to accommodate their customers, but will then take them to rival banks for redemption. This makes for a relatively fast feedback mechanism for each bank to gauge the health of its balance sheet. An increase in the number of returning notes will force a bank to constrain loans, perhaps borrowing in the short-term to temporarily shore up its assets (waiting for loans to be repaid). Even a competitive banking system of this type is bound to suffer periodic instability, but the institutions also get more complex over time. For example, specialized banks, or clearinghouses, may arise that deal solely with the inter-bank clearing process. Ultimately, these can act as central banks of sorts, loaning to banks in times of temporary distress. Banks would have to conform to certain standards to be eligible for aid.

Usually, when we think of a commodity standard we consider one of its qualities to be the physical scarcity of the commodity, like gold. But, in reality, society decided that the relative inelasticity of gold was too costly, so it adopted the more elastic system of inside money circulation. But, in doing so it abandoned one of the most important safeguards against inflation. What took their place were certain institutions, such as competitive banking. What this means to gold standard advocates is that they should stop advocating the gold standard and instead ask for competitive banking. Any gold standard that’s left unconstrained will eventually evolve into the more modern system of money substitute. The natural qualities of gold are therefore irrelevant. What matters are the institutions developed to not only take the place of these qualities, but to do the job in a superior way. Even a full reserve banking system has to develop institutions to constrain the elasticity of inside money.

One final point. In our hypothetical world of free banking, gold is relegated to the task of paying net debts through the inter-bank clearing process. Why couldn’t alternative assets take the place of gold? A bank could transfer ownership of another asset, such as a securitized loan portfolio. One thing that decides the quality of an asset, though, is its information sensitivity. An asset that varies in value is going to be more information sensitive, because the counterparty is going to have to track changes in price. For example, a $1,000 securitized loan portfolio with a 90 percent repayment probability may, at first, be valued at $900 by the counterparty (.9 × $1,000). As it turns out, this asset is volatile, with default probability fluctuating between 10 and 30 percent. If a bank is is using volatile assets as a capital reserve, then there will be a relatively greater likelihood that this bank is going to be unable to make good of all short-term liabilities (if the value of its “backing assets” falls). The banknotes of these banks are going to be circulating at less than par. Competitive pressures are going to force them out of business, and customers are going to choose more stable currencies. Another consideration is liquidity. Counterparties, or rival banks, are hardly going to want to be repaid in relatively illiquid assets. The advantage of gold as a backing asset is that it’s relatively information insensitive (if the money supply is constrained enough) and it’s relatively liquid. But, there are a broad range of assets, and new assets are likely to be developed over time, so we can’t discount the possibility of other assets being mixed with, or replacing, gold.

As I write above, it seems to me that what I argue here is true whether you advocate for a free fractional reserve or full reserve banking system. If inside money is circulating in place of outside money, what matters is constraining the supply of inside money. Banks can still choose amongst different backing assets, but even full reservists are interested in constraining money supply volatility. Ultimately, the end goals of the two approaches aren’t too different. Fractional reservists look to competition as a means of developing means of restricting excess money creation. Full reservists look to legal constraints, or some simply claim that a competitive banking system would be forced to full reserves because of instabilities allegedly inherent in fractional reserve banking. Whatever the case, what matters are the institutions, not gold.

Regressions

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Human Action (Mises)Now the extent of that part of the demand for a medium of exchange which is displayed on account of its service as a medium of exchange depends on its value in exchange. This fact raises difficulties which many economists considered insoluble so that they abstained from following farther along this line of reasoning. It is illogical, they said, to explain the purchasing power of money by reference o the demand for money, and the demand for money by reference to its purchasing power.

The difficulty is, however, merely apparent. The purchasing power which we explain by referring to the extent of specific demand is not the same purchasing power the height of which determines this specific demand. The problem is to conceive the determination of the purchasing power of the immediate future, of the impending moment. For the solution of this problem we refer to the purchasing power of the immediate past, of the moment just passed. These are two distinct magnitudes.

— Ludwig von Mises, Human Action (Auburn: Ludwig von Mises Institute, 1998), pp. 405–406.

Many people interpret Mises’ regression theorem as claiming that all money must have some value as a non-monetary commodity. This is only true for the first currencies. It’s possible for a new currency, such as bitcoin, to be first introduced as a substitute to an already circulating currency (e.g. the U.S. dollar), therefore basing its purchasing power on that of the dollar (by setting an exchange rate and basing prices on U.S. dollar prices [or Euro, et cetera, prices]). From there, bitcoin can go its own direction and become a competitor, rather than a substitute. An accurate reading of Mises — at least, in my opinion — suggests that bitcoin doesn’t violate the regression theorem any more than the occurrence of fiat money does (which first arose as a substitute to outside money and then went its own direction).

Where initial substitution isn’t possible, a potential currency must have some use value. As a commodity is more widely traded, its purchasing power can be partially decided by this use value. That is, as the first monies spontaneously emerge, money prices will have to initially be based on the value these commodities carry as producers’ or consumers’ goods, and then a liquidity premium is added as the commodity circulates more widely. These are currencies that can’t base their purchasing power on already existent currencies, by initially acting as substitutes.

If you’re still having trouble explaining bitcoin, think of the U.S. dollar, backed by whatever assets the Federal Reserve owns. From where did the U.S. dollar derive its value? Some say from taxes. The problem is that taxes are monetary transactions, and it represents the U.S.’ demand for money. But, for the U.S. government to know how much it should tax, it needs to have some basis to calculate its demand for money — without money prices it can’t do this. Instead, the U.S. dollar — say, after 1971 — based its purchasing power on the already existent dollar when it was still redeemable, which in turn continued to base its value on prices of the recent past. We can trace this back to the national banking era, where the U.S dollar was first introduced as an alternative substitute for outside money. Bitcoin has essentially the same history, except that it’s a step beyond fiat money, in that it originally used (if it still doesn’t) fiat money as a means of estimating its initial purchasing power.

The vehement rejections of bitcoin based on the regression theorem are all misreadings of the latter. Of course, this doesn’t mean the bitcoin is preferable to alternatives as a general means of exchange. I’ll continue to use the U.S. dollar for the foreseeable future, because it’s less volatile and less sensitive to speculation. But, the regression thereom is not an adequate basis for a critique of bitcoin.

Chartalism Reversed

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Jon Matonis, in his “The Monetary Future” blog, writes,

While some call Bitcoin an “existential threat to the state,” local governments could soon embrace the digital currency and payment system as a practical alternative to credit and debit cards.

This is interesting, because chartalism holds it’s the state which creates money and gives it liquidity by demanding it through taxation. Recently, I suggested that this seems to be an inefficient means of taxation, since it requires the government to distribute the means of payment before anybody can pay taxes. It turns out that there’s reason I’m right: the government may soon start accepting bitcoin as a means of payment (for certain things). If the chartalists were right, I’d think that the dollar would outcompete the bitcoin just by virtue of it being the only currency currently accepted as a means of paying taxes. Instead, the government may start accepting bitcoin, out of virtue of the liquidity it has already gained.

Costs of Money

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In a passing comment on bitcoin, Krugman takes on the procedure of bitcoin creation, invoking Adam Smith to argue that the costs of money production ought to be minimized, because they represent a waste of resources. Thus, it makes sense to use paper currencies instead.

First, I’m not sure what Krugman thinks “mining” consists of, with regards to bitcoin. It’s as if he thinks bitcoin creators decided to include “mining” just for the sake of making the currency more expensive to produce than it needed to be. The point was to limit the creation of new bitcoin, and to make it relatively predictable. I think Krugman, of all people, sees the benefits of predictability, given the importance of expectations in inflation. If the mining of bitcoin were costless, the only limit on bitcoin creation would be time and the speed of the miners. Who would use a currency like this?

Second, I find the “cost of production” argument against gold to be so dull. It’s not that it’s a silly argument, because — and this isn’t sarcasm — economists like Paul Krugman, Milton Friedman, and, apparently, Adam Smith don’t believe in silly arguments. So, I don’t mean “dull” in the sense of “stupid,” just incredibly unconvincing. Economists know that costs shouldn’t be cut for the sake of cutting costs. Sometimes, cutting costs in production can lead to an even greater cost, if it leads to falling benefits. Rather, something is superior to its alternatives when its net benefits are higher. Sometimes increasing costs can lead to such great increases in benefits that the firm is better off with higher costs of production!

Suppose we wanted to buy a car. There are two options: a Toyota Corolla and a Toyota Camry. The first costs $15,000 and the second costs $25,000. Apparently, the unambiguous answer is the Corolla, because it requires less “real resources” to build. But, is this really true? Assume, just for the sake of simplicity, that we can put a price on the benefits of each car. What if the Corolla and the Camry each have a benefit of $18,000 and $30,000, respectively? The net benefits are $3,000 and $5,000. The Camry is clearly the superior choice.

My point is that the cost advantages of paper over metallic currency doesn’t really say much with regards to which is a more optimal form of money. The benefits of each also matter, and it’s the net of these two that matters the most. If the ratio of the benefits of gold to those of paper is greater than the ratio of the costs of gold to those of paper, then gold is preferable to paper. The only reason not to consider the benefits is because you’re convinced that paper has the most or the same, and I’m sure Krugman is convinced — as I am, with certain qualifications (gold is a good information insensitive asset). But, proponents of circulating metallic currency aren’t convinced, so an argument that looks only at comparative costs isn’t persuasive. In other words, you have to realize that different forms of money are all different products and, in a concrete sense, incomparable. Not all monies confer the same benefits.

Also, using “real resources” to produce money isn’t something bad. Producing the computer I’m using to type this post requires the consumption of “real resources,” but that doesn’t mean we should stop producing laptops. Resources are combined in production when the resulting output is of even greater value. Money, in any case, is just as much of a “real resource” as any other economic good, it’s just of different character than the rest. If “real resources” are consumed to produce the money the market demands it’s because money is valued more than what these “real resources” are valued independently. They could, of course, be used somewhere else, but they’re not, precisely because their use as inputs for money carries the lowest opportunity cost.

I am a proponent of paper currency, but one of my arguments in favor of a paper currency is not that gold requires the use of “real resources” for its production. I believe that a competitive monetary system, where banks would most likely issue private banknotes, would be relatively stable and would allow for a relatively efficient use of private savings (relative to a full reserve gold standard and fiat money). Banks can use all kinds of backing assets to make good of the liability of their inside money. But, not all assets are made the same. If the asset’s price is volatile it is information sensitive, where speculation has significant payoffs. Financial instruments like bonds, packaged debt, and other things subject to uncertainty and risk are the kind of assets likely to be information sensitive. Something like gold, on the other hand, may have an advantage in sensitivity to risk and uncertainty. During the national banking era in the United States, the value of gold was relatively stable, and in fact tended to slightly increase over time between 1879–1893. If this type of banking and currency system were the best option (just humor me), the costs would be worth the benefits.

Maybe people who buy bitcoins to actually use them as money are really using poor judgment in choosing the currency with the higher opportunity cost. But, it’s going to take more than the cost argument to prove this to be true. And, if it turns out that bitcoin really is a better product than fiat money — as improbable as this is —, then it turns out that bitcoin users aren’t using poor judgment at all.

Update: Above, I wrote,

Banks can use all kinds of backing assets to make good of the liability of their inside money.

Sounds incredibly close to the real bills doctrine, doesn’t it?

Bitcoin’s Information Sensitivity

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Gary Gorton uses the term “information sensitivity” a lot in his writing on debt. See, for example, his most recent book, Misunderstanding Financial Crises (alternatively, here is a free working paper that discusses these issues in the context of the 2007–09 financial crisis). The term is applied to things like money substitutes, which can be seen as claims on assets. Money is supposed to convey a certain set of knowledge, and the more complete this set is the better money is at being a general medium of exchange. When a currency is informative sensitive it means that the set of knowledge is incomplete and it pays to search for this knowledge. It also means that there’s a degree of uncertainty with regards to the value of the currency.

Suppose we lived in an era of free banking, where each bank is free to issue its own currency. One bank decides to build a capital reserve based on government bonds. These reserve assets help the bank guarantee that they will always be able to pay their short-term liabilities. Let’s assume that the only relevant information is the quality of the assets held by the bank. If there is no doubt, or if it doesn’t pay to constantly keep up with fluctuations in the quality of the assets (let’s say because their quality is stable), then the bank’s currency will be information insensitive. However, one day the government finds itself unable to afford its debt, and so it defaults. The quality of the bank’s assets is questioned and the currency suddenly becomes information sensitive. Its value as a currency will be put into doubt, because it’s not clear that the bank will be able to make good of what the currency represents — a liability for the bank.

The situation with bitcoin is somewhat different, because bitcoin — as far as I know, I could be wrong — is not a liability for anybody. Bitcoin resembles outside (base, high-powered, et cetera) money. I’ve only looked into bitcoin recently, so this will strike most people as obvious, but something I’ve noticed is that different websites post different exchange rates. My one time co-blogger Mattheus tells me this is because these websites don’t have the computing power to consider all trades simultaneously. This creates opportunities for arbitrage.

There’s some impulse to emphasize how these exchange rate asymmetries opens the door for speculation, but speculation itself is a good thing. It’s arbitrage that leads to the equalization of prices. If a currency is open to speculation, though, it oftentimes means it’s not a very good currency. For example, yesterday I saw one website that had posted the exchange rate at $60:฿1 and another one had it at 130:1. To a vendor, this creates uncertainty as to what the value of bitcoin actually is. This lowers demand for it, making it more difficult for bitcoin holders to buy other goods. In other words, it lowers bitcoin’s liquidity. This puts its desirability as anything other than a possible way of making large profits (or, alternatively, large losses) into question.

Whether or not this information sensitivity is all that important, I don’t really know. I’m not a bitcoin hater, so this isn’t me coming up with any reason to put it into doubt. I’m just raising a concern that may possibly have some importance.

Digital Discrimination

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Patrik Korda writes,

While bitcoins are designed so that they cannot be hyperinflated in name, they certainly can be hyperinflated in substance. Already, there are numerous knockoffs such as litecoin, namecoin, and freicoin in place.

I don’t have a bone to pick in the bitcoin debate, but I thought this an interesting objection. One of the major assumptions in the theory of free banking is that different brands of inside money are imperfect substitutes, which means that people will practice note brand discrimination. Maybe this bitcoin experience will provide some empirical evidence. If “litecoin,” “namecoin,” et cetera are seen as alternatives to bitcoin, as opposed to supplements, then this should help stabilize some of these currencies through competition (of course, even — or maybe especially — firms in a competitive setting are subject to failure).

Is bitcoin in a bubble? I don’t think anybody really knows. You have to be able to distinguish between rising exchange values as a result of bitcoin gaining liquidity (through wider use) and “phantom profits.” If bitcoin is experiencing the latter, this is how I see it unfolding. Bitcoin is competing with the dollar, and as long as people are skeptical of the dollar they will discriminate in favor of bitcoin. When the economic situation improves and the dollar is seen to be mostly stable, there is the potential for people to begin discriminating in the other direction. Bitcoin will lose value to the extent that people prefer to hold dollars, and as bitcoin loses liquidity more and more people will prefer dollars, because the dollar gains relative liquidity.

A movement back to the dollar is possible, but I don’t know why people spend so much time arguing one way or the other. With bitcoin, it’s probably best to wait and see. As I read through more bitcoin material, though, I get the feeling that bitcoin, or at least the concept of a purely digital currency, is here to stay. This doesn’t mean that superior digital currencies to bitcoin won’t come into existence, but I’d consider this a success story.