Category Archives: Monetary Theory

No Mainstream Consensus

Other collections of readings on money, like standard textbooks on money and banking, convey a false impression of the authority of received doctrine. In truth, contemporary monetary theory is among the least-settled branches of economic analysis and no serious student of modern economics can afford to be ignorant of this fact — or of the reasons for it.

— R.W. Clower (ed.), Monetary Theory (Middlesex: Penguin, 1973 [1969]), p. 7.

Cryptocurrencies, Destined to Inflation?

Yesterday on Facebook, someone asked an interesting question on cryptocurrencies and inflation. One of the attributes that, to some degree or another, makes gold currency stable is that gold is in strict supply. It’s costly to mine, and there is a limit to how much there is available to mine. Monies that don’t have a similar constraint have to establish alternative institutions, such as the inter-bank clearing mechanism in George Selgin’s theory of free banking. Cryptocurrencies don’t have the same physical scarcity as gold — a new firm (which I will use as a catch-all term for individuals, groups, hackers, coders, whatever…) can introduce a new algorithm, and with it a new cryptocurrency —, and sophisticated institutional constraints have not yet arisen. Does this mean that cryptocurrencies are destined to an inflationary demise?

Different currencies are imperfect substitutes to each others. There is some degree of brand discrimination, in that people oftentimes prefer one over another. Different cryptocurrencies are different goods, and the marginal value of one is not the same as the marginal value of another. The broad implication is that the overall supply of all types of cryptocurrency does not determine the marginal value of the individual brands. These are determined by their own supply and demand schedules, even if these curves are inter-related. For example, suppose that the “GoogleCoin” firm issues an excess supply of its currency, dramatically reducing the value of the marginal “GoogleCoin.” If we hold all else equal, this doesn’t mean bitcoin’s marginal value will fall with “GoogleCoin’s.” In fact, individuals may want to reduce their “GoogleCoin” balances and increase their bitcoin holdings, implying an increase in demand for the latter (and a corresponding increase in its marginal value).

The same idea holds true with modern currencies. Hyperinflation in Zimbabwe does not cause, all else equal, similar effects on the U.S. dollar or the euro. The marginal value of the two latter currencies are determined by their own supply and demand schedules. In fact, the hyperinflation of the Zimbabwe dollar shifted the demand curve for currencies like the South African rand to the right, because individuals were looking for a more stable currency. We can conceive of a situation where several paper monies are quickly loosing value, because of, say, hyperinflation, while another paper currency elsewhere — benefiting from effective institutional constraints — remains relatively strong and stable.

What matters for a currency to be stable is that there are limits to how many units can be issued. Bitcoin’s approach to this issue is to include an asymptote to its money supply function. I’m sure other cryptocurrencies are similar. If cryptocurrency markets get more complicated, more sophisticated institutions might be necessary to help ensure monetary stability, but for the time being these kind of built-in limits to supply essentially mimic the relevant natural attribute of gold: physical scarcity.

Throughout this discussion, I’ve assumed that there are established cryptocurrency monies. Currently, this assumption may not hold. I don’t generally follow the cryptodebate, but I believe it’s contested that bitcoin is really money. The guidelines to what is money and what isn’t are somewhat ambiguous, because the overarching quality of money is its liquidity. But, there is a continuous range of liquidity (or, borrowing from J.P. Koning, moneyness) that a set of assets can lie on. Money is generally considered the most liquid asset, but different currencies can certainly have different degrees of liquidity (the Rothbard dollar may be accepted over a larger geographic area than the Mises peso).

The supply of money is always determined by the demand for money. When something is already money, supply can create its own demand. Without strong institutional constraints — something that creates a quick process of reflux —, an excess supply of money raises the price level and may induce individuals to increase their desired cash balances. But, new cryptocurrencies are not automatically money. They have to earn that liquidity by being widely accepted as a unit of exchange. Their moneyness depends on the demand for its liquidity. The implication is that any new brands that are money candidates cannot be supplied in excess, because changes in their supply are determined by changes in the demand for them as money. If bitcoin were already a widely traded general medium of exchange, and if there were no constraints on its supply, an excess supply of them may create its own demand, but there are built-in constraints to its supply. Further, since bitcoin is in a relatively competitive environment, dramatic changes to its marginal value may drive individuals to get rid of their bitcoin and increase their holdings of alternative currencies.

If existing cryptocurrencies are unstable, it’s not necessarily because of a lack of constraint on their supply. The majority of, if not all, cryptocurrencies are not money, they’re just non-money assets (valued for whatever reason). They are volatile assets, because the source of their demand is volatile. And, they are just as prone to bubble behavior as any other financial asset: false profits leads to malinvestment, and all of that.

If cryptocurrencies do catch on and they begin to be valued for their liquidity (that is, as money), I don’t see any obvious reason for instability. This may change as the financial system adapts to these cryptocurrencies — depending on the institutions that develop along with it —, but the built-in rules that limit the supply of different brands of cryptocurrency mimic the physical scarcity of gold.

Paper Doesn’t Require “Intrinsic Value”

Over at ZeroHedge, Tyler Durden writes on the gold standard,

Before 1974, U.S. dollars were backed by gold. This meant that the federal government could not print more money than it could redeem for gold. While this constrained the federal government, it also provided citizens with a relatively stable purchasing power for goods and services. Today’s paper currency has no intrinsic value.

I think “intrinsic value” here has a different meaning from how an economist define “intrinsic value.” Gold is valued for other ends — jewelry, industrial uses, electronics, et cetera —, but this fact confuses people into thinking that gold has “intrinsic value.” But, the source of value for gold as money is the same as the value ascribed to paper monies. Money is valued as a general medium of exchange, meaning for its liquidity (money is the most liquid asset). Corollaries to this main function, money is also a medium of account and, potentially, a store of value.

I’m not making this point just to stress the subjectivity of value (the value of something is imputed from the ends that good is a means toward). Well, in a way I am, because my main point is that “paper currency has no intrinsic value” is a bad argument against paper money. In terms of sources of value, paper and gold are no different. So, if paper currency has no intrinsic value, neither does gold.

This doesn’t mean paper is preferable to gold. (I wouldn’t say that gold is preferable to paper, either. A competitive, free banking system would probably use both; although, maybe there are better assets than gold.) The reason it’s often assumed that a gold standard would lead to a relatively stable price level is because gold is rare, which makes it relatively scarce compared to potential alternative monies (e.g. shells, cows, bushels of wheat, Rai stones, et cetera). But, gold standards can be politically manipulated, and they have been — the inter-war and the post-war gold standards were not the same monetary system that existed during the 19th century. The best “standard” we can have isn’t a particular material from which to produce our money, but a competitive, free banking system.

“Printing Wealth:” A Bad Allegory

Behind the talk is the notion that monetary spending makes the economic world go round. It does not. Increasing the money supply does not magically increase the quantity of land, labor, or capital goods available for production. Creating money out of thin air does not produce more consumer goods, and there is the rub. We cannot eat money. We cannot wear money. We cannot live in money. Even the Beatles knew that money can’t buy you love.

— Shawn Ritenour, “Money Can’t Buy You Economic Prosperity,” Mises Daily 26 April 2011.

The line “you can’t print wealth into existence” is commonly used, and apart from being a criticism of monetary policy it stems from the, correct, belief that only capital goods are productive and only consumer goods can actually satisfy our ends. Money is an intermediary, a lubricant, that makes indirect exchange easier by providing a highly liquid medium of exchange; money is accepted by almost everybody, carburetors, your labor hours, and apples aren’t.

But, it isn’t a good criticism of monetary policy, whether public or private. While others have addressed the mistake before, they do so by embracing the allegory (e.g. Timothy Lee and Paul Krugman). While the substance of their responses are absolutely right, accepting that “you can print wealth into existence under certain conditions” is misleading. I peddled the same critique even three years ago, and I wouldn’t have seen the merit of the reply. Someone who is focused on the real sources of productivity isn’t going to be swayed to the idea that, in the right environment, printing money creates wealth. It takes away from what the real point is: a shortage of money can price productive goods out of the market.

In an equilibrium economy with quantity of money M, prices will reflect opportunity costs and there will be neither a shortage or excess of money. Suppose there is some “shock” (i.e. malinvestment, animal spirits,…), and you — along with most other members of your economy — decide to increase the amount of money you hold (leave unspent). Maybe you do this because the shock makes your future options and standard of living unclear, or uncertain. This event is called an increase in the demand for money, and it implies that the value of money increases. Prices reflect relative valuations, so if the value of money rises, the relative value of other things must fall: prices must fall. If prices don’t fall, the smaller amount of money that people are willing to exchange is going to buy a smaller amount of goods.

Few serious economists actually posit a direct relationship between “printing money” and creating wealth. But, if prices don’t fall after an increase in the demand for money, the volume of trade will collapse: there will be productive goods that were once traded, but no longer are. If less factors of production are being purchased, less output is being produced: our standard of living falls. The point behind increasing the quantity supplied of money isn’t to create wealth, but to sustain the volume of exchange that allows for an economy producing at its maximum output.

This doesn’t mean all monetary policy is good. There are different ideas for equilibrating the demand for and supply of money. Policies which target inflation expectations are meant to induce people to reduce their cash holdings; inflation is a reduction in the value of the marginal dollar, and if you expect your money holdings to fall in value you have a greater incentive to exchange that money for goods (the relative value of those goods increase). NGDP targeting seems more ad hoc: anything goes, as long as that NGDP target is hit. But, individual policies, or “transmission mechanisms,” come with costs and benefits of their own. No policy is created equal, and it doesn’t make sense to me to not scrutinize between them.

But, if there is a collapse in the volume of trade caused by a shortage of money, it’s a sensible option to increase the quantity supplied of money, especially if prices — whether all or only some (i.e. labor) — are sticky. Money is not directly productive, but it’s a lubricant by which we can move productive resources around and utilize them to increase (or maintain) our standard of living.

Contra Galbraith on Inflationary Finance

James K. Galbraith has written a strange piece for the New York Times, where he muses on the debt ceiling. He argues that the necessity for government to borrow money is an “anachronism,” product of the gold standard. In answering why the government doesn’t just create new money, he claims that “to do so would expose the “public debt” as a fiction, and the debt ceiling as a sham” — as if the constraint on debt monetization is nonsensical or ideological. Galbraith, however, gets his history wrong, and as a result gets the answer to his question wrong. Governments have tried to get around borrowing constraints throughout history, and the reason we toughen these constraints is exactly because unconstrained governments have misused the power to debase their currency.

Prior to the 20th century, it was often that governments attempted to avoid their financial constraints. The Roman Empire, for example, frequently underwent currency debasement to pay for growing bureaucratic and military expenses (Bartlett [1994]). The Spanish Empire also relied on seigniorage for financing (Motomura [1994]), on top of the new silver and gold it imported from its colonies — this lead to the “European price revolution,” as the value of money fell sharply. Governments don’t need paper money to spend without borrowing. In the era of metallic currencies, all government had to do was lower the content of the precious metal in the coin — replacing it with a less valuable substitute (e.g. copper) —, and encourage acceptance at par.

Contra Galbraith, there were (and remain — after all, economic laws are immutable) economic constraints on seigniorage. By lowering the value of money, and redistributing resources away from non-government market participants, significant and sustained currency debasement leads to the deterioration of exchange. It is no accident that, ultimately, the most successful imperial government that emerged from the pre-modern milieu was England, which made use of a growing finance industry to borrow larger sums of money than rival governments could. English society had learned from a multitude of previous experiences that currency debasement is not a permanent solution to financial constraints, and that over the long run inflationary expenditure is more harmful than anything else.

It could be argued that modern, democratic governments have constraints of other types that would limit the extent of seigniorage. Perhaps, but it wasn’t too long ago that modern governments resorted to the printing press to get around financial constraints. This led to the great inflations and hyperinflations that followed the First World War. Similar to pre-modern experiences, this public finance technique led to the deterioration of European markets, and ultimately the only viable solution was to place a ceiling on public budgets. Now, I do think that we learned “too much” from this experience, making monetary policy more rigid than it really needs to be: case-in-point, the Great Depression. But, there is a big difference between constrained, but flexible-enough monetary policy, and unconstrained inflationary fiscal expenditure.

Increasing the quantity supplied of money is not always a bad thing. When there is a demand shortage increasing the quantity supplied of money is oftentimes a superior alternative to waiting for the price level to fall, because many individual prices do not always fall to their market-clearing level. Maybe what we need today is more money (although, given that the price level has been rising I’m skeptical of the idea that a demand shortage is currently the most important deterrent to economic recovery). But, lifting the constraints on public finance is not a solution. Maybe the current administration, and even many administrations to follow, can be trusted, but political institutions can deteriorate, especially when government is under financial pressure. The reason we don’t voluntarily dismantle them voluntarily is because the risk of gratuitous inflationary public finance is very real, and it has been something governments have resorted to since the beginning of governed civilization.

A Theory of Price Rigidity

On Facebook, someone raised a discussion on the impact of technology on sticky prices. The reasoning is that new technology that increases the amount of information being considered by price-setting agents, and/or delivers the relevant information at a faster rate, will help reduce the amount of time it takes for prices to adjust. If I understand the argument correctly, it mostly boils down to reducing the frictions attached to price arbitrage. If what we mean by sticky prices are non-equilibrium prices, or even the amount of trial-and-error necessary for prices to approach their equilibrium values, then this argument makes sense. But, I’m not convinced that this is the price stickiness that matters. At least, this is how I approach the price friction problem when it comes to, what we can broadly refer to, price level adjustments.

I can’t really offer a formal model. What this means is that my argument might be somewhat confusing, because it’s not exactly crystal clear to me, and I haven’t had the time to formalize it and think it through (see “Intuition and Math“). My main intention is, actually, to help me think through the problem and, if anybody is interested, discussing it. If you want to skip the introductory paragraphs, that make up a good chunk of this post — to introduce the reader to the problem —, skip the next four paragraphs (to the paragraph beginning with, “My intuition is…”).

To clarify what I mean by price friction within the context of price level adjustments, think about the issue in terms of changes in the demand for money. If the aggregate demand for money rises, the price level will fall. This is so, because if there is an increase in the demand for money its value will rise — we demand more, because the benefits accrued from holding it increase. This implies the value of money relative to other goods, all else being equal, will increase — everything else, in terms of money, will be worth less. In a frictionless world, when the demand for money rises all other prices will adjust to reflect the new relative valuations, and peoples’ real cash balances (the real value of their money) will increase (again, because other goods, in terms of money, have become cheaper) — this is what some economists call the “Pigou effect.”

However, if prices are sticky, we have to consider what happens if prices don’t adjust. This is essentially the consideration that drives monetary (dis)equilibrium theory (see “Theory of Monetary Gluts“). If prices don’t adjust when increasing their cash balances a shortage of money results, which can also be referred to as a general glut. To see why this is, assume the quantity of money is fixed. If the demand for money rises, people will hold on to their dollars instead of spending them. The amount of money being substituted for goods falls, and some subset of non-monetary goods will be essentially priced out of the market. Consequently, most economists — at least, those who believe sticky prices are empirically relevant — advocate increasing the quantity supplied of money, maintaining the price level.

The next question is, why would prices be sticky? Like I said, I’ve only taken a superficial look at the literature. But, the explanations I have read have never been too persuasive. For example, Leland Yeager, in “The Significance of Monetary Equilibrium,” contextualizes it almost as a game, where no firm wants to lower their prices first. But, the firm, in these cases, really only has three choices: (1) it can produce an excess amount of widgets; (2) it can reduce the amount of widgets it produces; or (3) it can reduce the price of its widgets. Inaction essentially implies that the firm will take a loss, so it doesn’t make sense to me that a firm hold out, and suffer excessive losses, out of the expectation of foregone benefits. The case, to me, seems the exact opposite: waiting carries a higher opportunity cost.

In “A Sticky-Price Manifesto,” Greg Mankiw and Larry Ball discuss some theories of price stickiness. One theory is the menu cost theory. Menu costs are the costs associated with price changes. The name comes from the costs of printing new menus to advertise the new, lower prices. Specifically, then, if the costs of the price adjustment are higher than the losses associated with maintaining the existing set of prices, firms will opt for the latter choice. They also propose a theory that is essentially the same as Yeager’s. But they frame it as an externality, in that a firm can hold-out from reducing its prices in the hope that other firms will reduce theirs instead — even explained this way, the real demand for the hold-out firm’s product will not shift outward once real cash balances adjust, rather firms with the cheaper product will sell more than the hold-out.

My intuition is that none of these explanations are really satisfactory. Rather than seeing it as a “frictions” problem, or a problem that should be assuaged over time, what if price rigidity is of a much more permanent nature? This would be similar in conclusion to Keynes’ own theory of “wage rigidity” — where the real wage can’t fall, because a decline in real wages will cause a decline in prices, maintaining real wages —, since the prediction is a permanent unemployment equilibrium. Rather than focus on wages, however, I assume that the fall in demand will impact firms asymmetrically, such that one firm will be much more impacted than others.

Suppose an industry with n firms is impacted by a fall in demand, caused by a rise in the demand for money. To make the model clearer, let’s take it to the extreme and assume that only one firm suffers the demand shortfall, such that n–1 firms can continue to sell the same quantity of output at the same price. Further, suppose that the distribution of inputs to firms is symmetric, implying that the higher the value of n is, the less the one firm can influence the price of inputs (i.e. if all firms reduce their demand for inputs, the price of inputs will fall). The result is that the one firm has to reduce its output, and the inputs that otherwise would have been purchased are now idle.

If this only happens to one industry, out of many, it might not seem significant. But, what if this is characteristic of many, or most, industries? The assumptions seem reasonable. In most sectors there are firms of different sizes, and changes in demand will impact firms differently. If the affected firm can’t influence the price of inputs, they’ll be forced to reduce output. This is what the theory of monetary (dis)equilibrium predicts. For output to be restored, the price level has to fall, or the quantity supplied of money has to increase.

The problem is not sector specific, even if only some out of many are affected by the demand shortage. Unless the prices of idle inputs falls to zero — at the extreme —, output will fall. We may be inclined to argue that if the demand for a firm’s output falls, it must be that that output is no longer valued (even though other firms can charge the original price and earn a profit). Since there is a shortage of money, however, there is no way that demand can be transferred. It’s not as if widget x has been substituted for widget y. The only reason widget x isn’t being purchased is because it has been priced out of the market. This continues to be true for whatever alternative kind of widgets could be produced with that idle part of the capital stock.

In my framework, the problem of price rigidity is a coordination failure. It assumes that money is non-neutral, and therefore changes in the demand for money will impact firms asymmetrically. At the extreme, a firm with no power to impact input prices (the inputs it demands) will have to cut output, because the alternative choice — a price reduction — isn’t possible (if the price of the input stays fixed and the price of the output falls, the profit margin will fall, and in this case we assume it turns negative). As a result, there is a permanent unemployment equilibrium. This theory loses relevance the more symmetric the demand shortfall is and/or the greater the market power of a particular firm. But, it’s distinct from information problems, where the problem is inadequate arbitrage (something that could be solved with better technology). That is, it’s not so much about “frictions” as much as it is about a failure of the pricing process (that has a potential private solution in the form of a flexible private banking system).

Rothbard Strikes Back

Speaking of “daft” definitions of inflation,

The process of issuing pseudo warehouse receipts or, more exactly, the process of issuing money beyond any increase in the stock of specie, may be called inflation.

— Murray N. Rothbard, Man, Economy, and State (Auburn: Mises Institute, 2004), pp. 990 (HT Ben Rizzo).

Why does the “stock of specie” get special treatment? What if banks could use a 3D printer to print gold? Does that mean we’ll forgo all the problems Austrians would suspect of if I replaced “gold” with “fiat?”

This is the kind of stuff that Keynes had in mind when he wrote that passage on digging holes in the ground to find bags of money. He was criticizing the naïve belief that gold is, for some unexplained reason, different in nature from all other monies, because producing gold (for monetary purposes) is thought to be productive but the same doesn’t go for non-specie money. The truth is that gold is like any other money, and an increase in its supply will have the same effects, given the same conditions.

It gets worse. I suspect Rothbard had an intention, which was to stress his opposition to fractional reserve banking. He knows that one of specie’s strengths is its limited physical supply and that because of this the supply of gold is relatively stable. This reminds of George Orwell, except this time it’s Rothbard using the vague language to push an agenda. The debate over whether the Austrian definition of inflation is different and more/less useful, in my opinion, is not only a debate over a non-existent difference, but fails to address actual changes in the definition, such as this one, that clearly suffer from a narrow vision.