Category Archives: Monetary Theory

Sound Money

What is “sound money?” The simple answer: a monetary system that best promotes coordination between market agents. Every economist advocates “sound money;” the disagreement is over what exactly constitutes a good monetary system. This is where the issue becomes much more difficult, because we enter the realm of monetary institutions. But, there are some who want you to believe that the problem is much simpler than it actually is. Some of these people are the same who advocate a return to a commodity money (e.g. gold, silver,…).

Will a return to commodity money end the business cycle? Would it end inflation? We can point to the period of U.S. history between, roughly, 1879–1893, and try to answer in the affirmative. After all, that was a period of strong growth and slight deflation (although, there were recurring banking crises). On the other hand, we could just as easily look at just about every other period of history and answer ‘no.’ The European “price revolution” (~1500–1650), for example, is thought to be caused by the large inflow of New World gold and silver. Likewise, it was common for monarchs to debase their currency, whether via clipping, or by replacing valuable content with less valuable metals. So, no, reverting back to commodities will not necessarily make our monetary system any more stable.

What makes, say, gold attractive as money, anyways? It has certain physical characteristics: it is physically scarce (relatively costly to produce), it is durable, and it is divisible, amongst other possible traits. Why do these characteristics matter? Because they help determine the rules that constrain the monetary system.

Suppose we are looking at two isolated societies, each with their own monetary standards. These systems are exactly the same, except for what they are using as money: one uses gold, the other bushels of wheat. We expect the former to outlive the latter. Why? First, wheat is relatively easy to grow, so it does not have that same production constraint as gold — the value of wheat, as money, is easy to drive towards zero. Two, wheat is not as durable. It can be stored, and modern storage methods have allowed us to keep it around for longer, but it doesn’t have the same durability as gold. If the value of wheat is low enough, it would also take a lot of it to buy certain products. These are all factors that determine the rules of the game, or monetary institutions.

What really makes one monetary system better than another, then, are the institutions that constrain it. This should re-frame the terms of the debate, because now we know that what really matters are these rules. And, we can’t just look at some rules over others; we have to consider these institutions in their totality, and how they interact. For example, if the currency is in some way controlled by an extractive government, even if this currency is gold, we can expect a sub-optimal monetary system. Yes, even with commodity money, certain institutions can ruin the game, so to speak.

Another bad rule that could fit with a gold standard — or commodity money, more generally — is full reserve banking. Forcing banks to keep gold in their vaults that they would otherwise somehow get rid of is sub-optimal; that society is forgoing a better use of that gold. Similarly, by constraining a banking system’s ability to expand their liabilities when the demand for money increases, we forgo the opportunity of inter-mediating between a certain group of savers and a certain group of spenders (whether investors or through consumer credit). Finally, a banking system that cannot respond to changes in the demand for money will cause macroeconomic instability.

Despite all the benefits to using certain commodities as money, these benefits alone do not guarantee that they will be “sound money.” You also need good man-made institutions, or additional rules that constrain the monetary system. These rules evolve over time, and in different directions.

One direction is central banking. The Federal Reserve arose to re-write some of the rules that constrain the banking system. Primarily, it serves as the most important clearinghouse, with the ability to expand and contract its liabilities to service its member banks. During times of crisis, a central bank also acts a lender of last resort — a role private clearinghouses also fulfilled. Those who believe that, without a central bank, an economy can be stuck in monetary disequilibrium for long periods of time also advocate for central banking, because it allows for an elastic money supply even in the worst macroeconomic conditions. Of course, central banks — and their rules — evolve over time. One example of this is the general preference for independent central banks, because this weakens the ability of the few to manipulate the money supply at the expense of the many.

Another direction is “free banking,” which refers to financial institutions that arise through a decentralized process of change. This is not all theory; we have seen episodes that come fairly close to completely free banking. This monetary system is still regulated — it is still constrained by rules —, but these rules arise through a decentralized process. Competing systems might have competing rules, and good rules replace bad rules through, for instance, profit and loss. More concretely, if clearinghouses develop sets of rules that they enforce over member banks, separate clearinghouses and their bank networks will compete against each other. Good rules promote a healthier industry, which usually means greater gains, at least over some period of time (a bank that commits fraud might make a high profit at first, but they will certainly lose customers as people catch on). Bad rules promote losses, creating an incentive to replace bad with good.

What’s important here is that what improves the monetary system are rules. Some of these are innate to the type of money being used. But, these institutions might not be strong enough as the market becomes more complex, money is inter-mediated, the pricing process becomes more complicated, et cetera. This is why man-made monetary institutions are ubiquitous: they are experiments to improve monetary systems. In other words, the quest for  “sound money” is really a process of developing sound monetary institutions.

Where does this leave commodity money? Many free bankers do advocate commodity money, along with inside money of a form dictated by the market — classically, we usually think of paper money when we think of “inside money,” but it could just as well be “e-money.” But, we should be open to the idea that maybe commodity money is no longer optimal, because of the other institutions that regulate the monetary system. It could very well be that a modern banking system would prefer alternative safe assets as “outside money,” and that gold is antiquated. In any case, when answering “what is sound money,” gold, or silver, or commodity money are not right answers — what matters are institutions, and monetary rules have developed since the 19th century, so returning to a 19th century monetary system is retrogressive.

Mises Defines Deflation

Many Austrians like to define inflation as “an increase in the money supply,” and for the most part ignore the demand for money. But, how did Mises define deflation?

Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the braoder sense) for cash holdings. This may be properly called deflation.

Human Action (Mises Institute: Auburn, 1998), p. 566.

Babysitting Co-Op Crises and Money

David Gordon discusses Krugman’s use of the babysitting co-op story as an explanation for Keynesian stimulus policies. In his post, Gordon mentions Tim Harford’s critique of Krugman’s pedagogical model. Harford’s criticism teaches us an important message, but I want to distinguish between what it tells us and what it doesn’t.

Some of you who have never read Krugman (2009; 2012), or the original Sweeney and Sweeney (1977) article (ungated), might have no idea about what Gordon, Harford, and I are going on about. The story involves the Capitol Hill Babysitting Cooperative (CHBC), which is an organization that provides babysitting services in a very specific way. Basically, new members are given a certain amount of scrip, worth 20 hours of babysitting; these members are asked to return all 20 hours when they decide to end their membership. This scrip is used as money, where those who demand the service pay those who supply it in scrip. To earn more, then, — for future babysitting services, or to repay your debt to the CHBC —, a member has to supply babysitting services.

On average, members thought that they should hold more scrip before demanding services. Those who increased their demand for scrip would work the jobs they could. But, the increase in demand called for more scrip than existed, causing a shortage. Members, on average, rather babysit than go out, but when nobody goes out there is no demand for babysitting services. Since the price of scrip is fixed, a falling “price level” can’t clear the market for babysitting. If the scrip were allowed to appreciate in value, it would take less scrip to fulfill the average person’s demand for babysitting hour IOUs, and excess notes would be exchanged to those who want them, in return for babysitting services. The solution, instead, is to increase the supply of money, or, in this case, scrip.

Harford, however, tells us that in the real story, the monetarist solution eventually led to an oversupply of scrip. This is confirmed by Wikipedia. The CHBC supplied too much new scrip, members sought to spend excess scrip on babysitting, but since now the average member wanted to go out, there was a shortage of babysitters (rather than a surplus, as was the case originally). One way to interpret this is to reject the babysitting co-op story altogether. I don’t think this is the right approach; rather, the whole story teaches us a lesson on monopolized management of the money supply, but it leaves Krugman’s actual point largely unscathed.

Suppose, for the sake of argument only, that the CHBC knows exactly how much scrip to introduce into its babysitting economy. Assume that it distributes this new scrip at random, so that some will have excess holdings. Those with more scrip than they want will spend it, demanding babysitter services. This allows those with inadequate scrip balances to offer their services and earn babysitting money in return — it allows mutually beneficial trade to take place, whereas originally a rigid price disallowed them (which is why we say that demand shortages lead to output gaps). Thus, the monetary solution is the right one.

The CHBC story does warn of the problems of an issuer that is not disciplined by the market — rather, the issuer and the market(s) it helps coordinate are disciplined once the damage has been done. We want a competitive scrip market, where those who over- or under-issue are disciplined (through reflux or foregone profit, respectively) before the market breaks down, coordinating the supply and demand of scrip (money). Moving from the analogy to the real world, this is why competitive free banking is preferable to central banking.

Central banks are not very good at responding to money shortages and judging excess supply, causing volatility and distortions. A competitive private banking system, however, can achieve better results, because individual banks’ constraints on issuing money are much tighter — excess notes circulate back to the issuer, putting pressure on their assets, and interest on deposits limits their ability to attract them (to the margin where it becomes unprofitable). When the demand for money rises and velocity falls, the pressure on banks’ assets falls and they can issue notes. When the demand for money falls, or after an issue of excess notes, the pressure on their assets rises and they are forced to reduce the number of outstanding liabilities. These pressures are much more muted in the current system, where there are no competing notes (and customers can’t discriminate between them), and the ultimate issuer is the central bank.

The CHBC story illustrates the problem of monetary disequilibrium very well. It also shows why monopolizing the currency system can be so damaging to the economy. Unfortunately, most probably only appreciate one of the two lessons, but never both.

Bitcoin’s Demand Problem

Cathy Reisenwitz responds to an article on bitcoin’s “image problem.” The article she responds to pretty much argues that bitcoin users are a bunch of misogynistic nerds, and that people outside that narrow community see that as a reason not to invest in that asset. The fact that bitcoin is largely unregulated (and the bitcoin community’s aversion to regulation) is also used as a reason for mistrust that outsiders have in the asset, and why they might decide to not buy into it. I like Reisenwitz’ response; I particularly like this line from her piece, “…illegal narcotics make up about half a percent of bitcoin transactions” (strong proof that there’s more to bitcoin than black markets).

In any case, Reisenwitz’ article got me thinking about bitcoin and its scope for growth. I say growth, and what I have in mind are the opportunities for the demand for bitcoin to grow — for the number of people who hold it for transaction purposes to increase. I think, right now, these opportunities are limited, largely because the reasons to demand bitcoin are still relatively narrow. Allow me to explain what I mean.

Before I proceed, I should clarify that I am not opposed to bitcoin, nor do I have a specific interest in discrediting it. In fact, I support bitcoin and I see it as a natural consequence of government’s attempt to monopolize currency. Throughout history, we have seen people try to get around these legislated constraints. When note issue was restricted, banks focused on their deposit service. When interest on demand deposits was made illegal, the market responded with assets like mutual funds and eurodollars. Markets tend towards competition — not perfect competition, but still competition —, and that is what we are seeing in currency markets with bitcoin and other digital currencies. Will bitcoin succeed or fail? Who cares? The uncertainty of’s future doesn’t bring anybody to emphasize their opposition to its existence. Entrepreneurial projects sometimes fail and other times they succeed. But, this trial-and-error process is what allows our society to progress, for new ideas to implemented and tested, and for the good ideas to be rewarded.

Let’s come back to this article’s point.

Why is bitcoin demanded? There are probably various reasons. There is a significantly large libertarian community which distrusts government and any service provided by government, including the U.S. dollar. For years after the financial crisis, there was also a (most likely misguided) fear of runaway inflation. For libertarians with these preferences, especially if they have a service or goods they can provide in exchange, it’s sensible to be interested in a growing financial community which promotes the use of bitcoin for exchange. As the demand for bitcoin grows, it’s also reasonable to expect speculation. Many investors are going to put their money in bitcoin, because they expect its price to appreciate over some period of time — and the great thing is that bitcoin is relatively liquid.

According to Cato, 15 percent of Americans are libertarian (the Washington Post claims 22 percent). What induces the ~75 percent of other Americans (and other non-libertarians throughout the world) to demand bitcoin? The fact that there even many libertarians who haven’t invested in bitcoin is a strong signal that bitcoin is not necessarily a strong competitor to the U.S. dollar. Consumers differentiate between products, and right now the supermajority of people still prefer to hold U.S. dollars and other fiat currencies before bitcoin. This poses a serious limitation to the demand for bitcoin, and especially its demand for transactions. Increases in demand for transactions creates a network effect, because it increases the liquidity premium attached to bitcoin, but without other benefits the use of bitcoin might be restricted to people with certain ideological preferences.

Reisenwitz actually goes into some of the additional benefits to bitcoin,

  • Smart property: I don’t know much about this, but Reisenwitz describes it as a credit market, where credit can be extended to the worst off (who don’t have access to credit from firms with stricter requirements).
  • Remittances: She argues that remittances are easier and cheaper through bitcoin. I can’t verify, but if that’s true it’s a big advantage. Remittances are a big deal. According to the CBO, outward flow of remittances in the U.S., in 2009, totaled $48 billion. As the economy picks up, this flow will grow.
  • Charity: innovative and effective charity programs might induce people to give through bitcoin, rather than through traditional means.

I wonder, though, if a strong demand for bitcoin will arise if sophisticated bitcoin-using financial markets develop. Bitcoin is an asset — a commodity, if you will —, like gold. If it becomes money (or if it already is), it will be as “outside money.” The supply if bitcoin is relatively inelastic. It’s growth function is asymptotic, to mimic the physical scarcity of other highly liquid commodities. If the value of the asset is stable, or the risk of loss in value is low enough, financial firms can use it as capital and they will borrow it from bitcoin holders through deposits. The firm will most likely pay interest on these deposits (if it’s legal), to compete with other firms who are seeking the same means and ends.

These are demand deposits and they are liabilities to the firm. The latter can issue notes in exchange, or the depositor can spend all or part of the deposit through some other system, such as a debit card. These would all be bitcoin-substitutes. But, if these services are competitive enough, it creates a proxy demand, in a sense, for bitcoin. Customers who are interested in the firm’s notes or their debit cards will demand them and, in turn, there is a derived demand for bitcoin.

This brings me to a more important point. Right now, when we think digital commodities (or currencies, if you prefer — I don’t want to debate on what is money) we think bitcoin, dogecoin, et cetera. When we think about where the industry is going, we think about competing brands. We should also be thinking about spontaneous orders, and how these competing brands will lead to competition in more sophisticated financial markets, using digital currencies as assets. If these services are superior to those provided by firms who still use “traditional” assets — and the legislated rules that constrain how these assets are used —, the demand for bitcoin (and digital currencies in general) will grow.

The question is, will digital currencies become a sufficiently stable asset for these purposes? What I mean by stable is not necessarily constant value, but where the expected path of changes corresponds to the mean expectation. And, if they do, will they be competitive enough to offer a product superior over those already existing? The “answer” to these questions is: we will have to wait and see. But, while there is clearly a lot of exciting scope for growth, there are also serious obstacles that digital currencies have to topple if they plan on becoming widely used transaction assets.

The Entrepreneur’s Role in the Emergence of Money

Think of what a pre-monetary economy must have been like. With no commodity generally used as money, trading was costly and time-consuming. In those circumstances, some alert people realized that they could benefit by holding greater stocks of the most marketable commodities than they had immediate use for. Thus they would accept highly marketable commodities in exchange even when they really wanted something else, because marketable commodities could be exchanged quickly on reasonable terms for what they did want. Extra stocks of highly marketable goods increased the chances of acquiring desired goods on favorable terms. (ed. Emphasis mine.)

— David Glasner, Free Banking and Monetary Reform (New York: Cambridge University Press, 1989), p. 6.

One guess of mine is that there arose a type of merchant who coordinated suppliers and consumers by accepting a broader range of assets (goods) and assuming the risk of a lack of double coincidence of wants. They would hedge this risk by accumulating stocks of multiple types of relatively liquid assets, which began to narrow over time, as some goods became more liquid than others. Finally, intermediate exchange would converge on a single asset: money.

Friedman and the Demand for Money

Milton Friedman argued that the demand for money is stable. But, he didn’t mean that the demand for money is constant, or that it fluctuates around a stable mean; rather, he posited a stable demand function, meaning a stable relationship between income, the price level, relative rates of return, and the demand for money,

The quantity theorist accepts the empirical hypothesis that the demand for money is highly stable — more stable than functions like the consumption function that are offered as alternative key relations. This hypothesis needs to be hedged on both sides. On the one side, the quantity theorist need not, and generally does not, mean that the real quantity of money demanded per unit of output, or the velocity of circulation of money, is to be regarded as numerically constant over time; he does not, for example, regard it as a contradiction to the stability of the demand for money that the velocity of circulation of money rises drastically during hyperinflations. For the stability he expects is in the functional relation between the quantity of money demanded and the variables that determine it… On the other side, the quantity theorist must sharply limit and be prepared to specify explicitly, the variables that it is empirically important to include in the function. For to expand the number of variables regarded as significant is to empty the hypothesis of its empirical content; there is indeed little if any difference between asserting that the demand for money is highly unstable and asserting that it as a perfectly stable function of an indefinitely large number of variables.

— Milton Friedman, “The Quantity Theory of Money: A Restatement,” in R.W. Clower, Monetary Theory (Middlesex: Penguin, 1973), pp. 108–109.

When economists argue that Friedman was wrong, and that the demand for money is not stable, what they mean is that the same function that fits the data between, say, 1940–50 cannot predict the demand for money between, say, 1980–90.

Money as a Capital Good

I remember, in response to a Hans-Hermann Hoppe article, Walter Block was wondering whether he and William Barnett were wrong to classify money as a capital good, rather than in its own category of general medium of exchange.

For what it’s worth, Milton Friedman is on his side,

To the ultimate wealth-owning units in the economy, money is one kind of asset, one way of holding wealth. To the productive enterprise, money is a capital good, a source of productive services that is combined with other productive services to yield the products that the enterprise sells. Thus the theory of the demand for money is a special topic in the theory of capital; as such, it has the rather unusual feature of combining a piece from each side of the capital market, the supply of capital, and the demand for capital.

— Milton Friedman, “The Quantity Theory of Money: A Restatement,” in R.W. Clower (ed.), Monetary Theory (Middlesex: Penguin, 1973 [1969]), p. 95.

Yeager on Why Money Disequilibrium is Unique

A longer-than-usual excerpt,

Exceptions hinging on excess demands for non-currently produced goods other than money are not inconceivable but would be economically unrealistic. In the General Theory, Keynes remarks that a deficiency of demand for current output might be matched by an excess demand for assets having three “essential properties:” (a) their supply from private producers responds slightly if at all to an increase in demand for them; (b) a tendency to rise in value will only to a slight extent enlist substitutes to help meet a strengthened demand for them; (c) their liquidity advantages are large relative to the costs of holding them. Another point that Keynes notes by implication belongs explicitly on the list: (d) their values are “sticky” and do not adjust readily to remove a disequilibrium.

Money is the most obvious asset having these properties. Keynes asks, however, whether a deficiency of demand for current output might be matched by an excess demand for other things instead, perhaps land or mortgages, Other writers have asked, similarly, about other securities, works of art and jewelry.

My answer is no. Such things might be in excess demand along with but not instead of money. Money itself would also be in excess demand. One reason is that all other exchangeable things trade against money in markets of their own and at their own prices expressed in money. (This is rue even of claims against financial intermediaries if their interest rates count as corresponding, inversely, to prices.) An excess demand for a good or a security tends to remove itself through a change in price or yield. If, however, interest rates should resist declining below the floor level explained by Keynes and Hicks, people would no longer prefer additional interest-bearing assets to additional money, and any further shift of demand from currently produced goods and services to financial assets would be an increase in the excess demand for actual money in particular. (If stickiness or arbitrary controls should keep prices and yields of financial assets from adjusting and clearing the market, the situation would be essentially the same as in the case of price rigidity of other assets…). The monetary interpretation of deficient demand for current output thus does not depends on any precise dividing line between money and assets; if money broadly defined is in excess demand, money narrowly defined must be in excess demand also. Unlike other things, money has no single definite price of its own that can adjust to clear a market of its own; instead, its market value is a reciprocal average of the prices of all other things. This “price” tends to b sticky for reasons almost inherent in the very concept of money.

— L.B. Yeager, “The Medium of Exchange,” in R.W. Clower (ed.), Monetary Theory (Middlesex: Penguin, 1973 [1969]), pp. 51–53.

Market Power and Price Rigidity: Spanish Football

Five months ago, I laid out the beginnings of an explanation for price rigidity, based on the concept of imperfect competition. One of these days, I’ll think through the idea a bit more, build a model, and see if there’s actually anything there. For the time being, some superficial evidence will have to do.

My theory posits a situation where an uneven distribution of the demand shortage can change the distribution of market power, under the assumption of product differentiation,

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.

Or, assume an uneven distribution of market power (still an imperfectly monopolistic market). Further, suppose there is a recession and a subsequent demand shortage. My theory is that firms with greater market power — who are in a better position to weather the decline in receipts — can keep input prices relatively high, where firms less able to survive the recession are forced to pay input prices above what would be the case in a perfectly competitive market.

Do European football markets offer some evidence for this theory? Consider Spain’s La Liga, where you have two clubs who are dominating European football (Real Madrid and Barcelona) and 18 which are struggling domestically. Despite the generally poor financial state of Spanish football, Real Madrid and Barcelona can essentially buy whatever players they want at higher prices than any competitor (e.g. €57 million for Neymar; €91 million for Bale; €94 million for Cristiano Ronaldo;  €35 for Illarramendi; €30 million for Isco; …the list goes on and on). Together with other European clubs with relatively high market power, such as Bayern Munich, Manchester United, Paris Saint Germain, Chelsea, Manchester City, et cetera, they raise the price of quality players. They raise the price level, so to speak.

Let’s generalize and say that a club’s value marginal product is a function of the quality of its players. The other 18 Spanish football teams, who are struggling financially because they are affected more by the demand shortage than R.M. and Barça, now face a higher price level than what would be the case if market power were more evenly distributed. This makes buying quality players very difficult. With reduced incomes, they can’t afford these players at existing prices. They opt for lower quality substitutes (although, youth academies can also occasionally produce youths of high quality), and the average quality of input falls. This is the same thing as saying that their output, and therefore real income, declines.

Clubs with typically tight budget constraints typically turn to youths (~18–22 years old). A club with a mean quality that allows it to place somewhere within the top 10 by the end of the season might have 1–3 truly high quality youths (with the average probably closer to 1). If they have a high debt burden, with falling real incomes, they can earn a good return by selling their youths to clubs of high market power. Real Sociedad sold Illarramendi for €35 million to Real Madrid; Málaga sold Isco to Real Madrid for €30 million; Sevilla sold Geoffrey Kondogbia for €20 million; Atlético Madrid has had to raise the buy-out clauses for their youth players, in case they can’t match their wealthy competitors’ wage offers. The result is that clubs find it difficult to retain the talent they produce at home. In other words, clubs with higher market power can offer their less well off, debt-constrained competitors a price that compensates them for foregoing the opportunity to use (and develop) their youths and sell them at a future date.

Generalizing, the process of buying youth-academy products from debt-constrained clubs is analogous to high market power firms buying their low market power rivals’ best inputs. Say that an input produces a continuous stream of output over some period of time. In this case, firms with high market power can pay a current price that makes it worthwhile for debt-constrained clubs to forgo the alternative of earning the continuous flow of revenue. They also have to compensate the seller for forgoing the expected future value of the player. This type of horizontal exchange of inputs is probably not relevant for most goods, but it does seem relevant for the one good that we typically think of suffering from price rigidity: labor.

But, an unequal distribution of market power can apply to many industries, and this may mean that these markets are prone to price levels that force smaller firms to cut output, because they can no longer afford to buy as many inputs (or they have to substitute with lower quality inputs).

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.