James Buchanan argues that the financial crisis and Great Recession show that there is a need for "The Constitutionalization of Money." I agree with the constitutional approach and believe that a clear mandate for stability is the key element of the monetary constitution. But I reject any constitutional interventions in the banking business--particularly, any mandates for any level of bank reserves, much less 100 percent reserve requirements.
James Buchanan is the leader of the Virginia School of Economics. His training was from "Old Chicago," but after being exposed to Knut Wicksell's approach to public finance, he began to integrate the economics and politics of taxes and spending. Starting at the Thomas Jefferson Center for Political Economy at the University of Virginia in the sixties, he moved to Virginia Tech and began the Center for the Study of Public Choice. And then in the eighties, he moved the Center to George Mason.
I began my undergraduate studies at George Mason, before Buchanan. I moved to Virginia Tech and completed my undergraduate and began my graduate studies. And then, when Buchanan and much of the economics faculty left for George Mason, I became a G.M.U. student. I received my Ph.D. from George Mason in 1987. If I count myself as part of the "Virginia School." My approach to monetary "policy" is constitutional.
Buchanan argues that the monetary authority should be independent of the political branches, but it should be given a constitutional mandate to focus solely on providing money of stable value. The natural interpretation would be a stable price level, presumably measured by a price index.
For many years, I also advocated a stable price level, however, I have been persuaded that a stable growth path of nominal expenditure provides a superior macroeconomic environment for microeconomic coordination. It provides a stable background that is consistent with a stable price level on average. In particular, such a rule would be inconsistent with irresponsible money creation aimed at funding government spending or worse, an effort to inflate away public or private debts.
However, productivity shocks would cause opposite changes in the price level that would persist as long as the shocks. For example, if the supply of oil should fall, so that its price rises and quantity falls, the arithmetical consequence is a higher price level. Having the monetary authority generate a shortage of money so that all the other prices in the economy are deflated enough to return the price level to target is needlessly disruptive. If the supply of oil remains low, then the price of oil and the price level would remain high. If the supply of oil recovers, then the price of oil would fall, and the price level would return back to its initial level.
There is no danger that this will result in persistent inflation. Or rather, persistent inflation would only occur if the supplies of all goods and services persistently fell, and if that is happening, inflation would be the least our problems. And while such a disaster could could be realized by falling nominal incomes and stable prices, it is unclear that higher prices of goods and services are a less appropriate signal of the reduced availability all of goods and services.
Similarly, suppose there is a an exceptionally good wheat harvest. With nominal expenditure targeting, the price of wheat falls, and the price level falls a bit. Rather than having the monetary authority generate monetary disequilibrium so that all the other prices in the economy are bid up a bit so that the price index returns to target, the price level is low for the year with the good harvest. Presumably, when the supply of wheat returns to normal during the next season, the price level rises back to its previous level.
Buchanan suggests that the financial crisis was caused by fractional reserve banking and argues that fractional reserve banking is no longer justified. With a gold standard, gold for monetary purposes must be produced--dug out of the ground. Further, gold must be diverted from industrial purposes, such as jewelry, to be used for monetary purposes. Fractional reserve banking provides the benefit of freeing up resources that would be used to dig up gold to instead produce other goods and services. And more of the gold that has or will produced can be used for industrial purposes.
Since a pure fiat currency can be produced at no cost, there is no reason to economize on its use by fractional reserve banking. Because fractional reserve banking can result in undesirable fluctuations in the quantity of money, Buchanan argues that 100 percent reserve requirements form the best legal environment for the market system.
I disagree with this argument. If the monetary constitution requires a stable price level or stable growth in nominal expenditure, then the monetary authority must stand ready to reduce the monetary base. Money creation is not simply a source of government revenue, but rather a way of borrowing money.
If zero-interest, tangible, hand-to-hand currency is taken to the model of fiat currency, then it is natural to see the government as borrowing at a zero nominal interest rate. As long as the demand for base money is growing, then the government can borrow progressively more at a zero nominal interest rate. But, if the demand for money should fall, keeping the price level stable or nominal income on a stable growth path will require that the government "repay" part of that zero-interest debt. The government doesn't have to reduce its total debt, of course. It can instead issue interest bearing debt in place of the zero-interest currency.
From this perspective, forbidding fractional reserve banking is a way of compelling people to lend more money to the government at a favorable interest rate--zero, in the usual case. Is providing government with a greater opportunity to borrow at a zero interest rate desirable? Or will the result be that the government will borrow too much because it fails to take into account the opportunity cost of this use of people's saving?
Printing currency costs nothing, but the government goods and services purchased with the money have opportunity costs--the private goods and services that could have been produced.
Doesn't the illusion of free money interfere with a sound fiscal constitution where voters compare the benefits of government spending programs to the cost of the private goods sacrificed? Isn't one of the most important element of the fiscal constitution clearly visible tax shares so that voters can make sensible fiscal choices?
If freedom of contract is allowed, then the government faces competition for this source of funds. Banks can issue interest bearing monetary liabilities. Further, paying explicit interest on money reduces the private opportunity cost of holding money. Those holding money can obtain all the liquidity services the private sector is willing to provide, paying only the cost of providing that service--the difference the interest rates banks are willing to pay on money and the interest rates on nonmonetary assets that banks can hold.
With mandated 100 percent reserves, depositors must pay storage costs, and will restrict their holdings of deposit accounts to the point where the implicit liquidity yield at the margin is no less than the difference between the storage cost of currency and the yields on nonmonetary assets. As might be expected, giving government a monopoly on the creation of monetary services results in inefficiency. The real demand for money is too low. Too few monetary services are produced.
Buchanan points to the Great Depression as an example where a shift from deposit money created by banks to base money currency resulted in a decrease in the total quantity of money. The resulting decrease in nominal expenditure resulted in a deep and persistent decrease in real output and employment.
However, if the constitutional requirement is that the purchasing power of money is to be stabilized, (or nominal expenditure is to be kept growing at a stable rate,) the quantity of money must be adjusted to accommodate changes in the demand to hold money.
A ban on fractional reserve banking makes the quantity of money equal to the quantity of base money. Changes in the demand for money and changes in the demand for base money are the same. Maintaining monetary stability requires changes in the quantity of base money to match changes in the demand for money.
With fractional reserve banking, the demand for base money can change even though there is no change in the demand for money. So a ban on fractional reserve banking prevents some changes in the demand for base money, but not all. If the goal is money with a stable purchasing power rather than just a stable quantity of money, then the quantity of base money must change to accommodate changes in the demand to hold base money. Fractional reserve banking simply creates a few additional ways by which the demand for base money can change.
As a practical matter, if counting some financial instrument as money imposes draconian regulations on its creation, such as 100 percent reserves, then those regulations will create a constant incentive to develop liquid financial instruments that don't meet the legal definition of money. For example, if checking accounts count as money and require 100 percent reserves, and savings accounts don't count as money and require no reserves, then there will be a strong motivation to minimize checkable deposits. Banks will create and depositors will hold savings accounts to avoid the reserve requirements. When the banks develop sweep accounts, so that funds in checking accounts are automatically swept into savings accounts each night, what happens? Regulators must be constantly vigilant to impose this regulatory scheme.
While imposing a 100 percent reserve requirement on everything that counts as money will keep worries about the financial health of the issuing institutions from causing a change the quantity of money as officially defined, all this does is shift the instability to the demand for this official measure of money. For example, worry about bank asset portfolios funded by savings accounts that don't count as money will result in a shift out of savings accounts into checking accounts. The result is an increase in the demand for money. The official quantity of money would be unchanged, but the regulatory scheme, combined with worries about the issuing institutions, has created instability in the demand to hold money.
Of course, savings accounts could be counted as money and subject to 100 percent reserve requirements as well. But then there are money market mutual funds. Do they count as money? Do they require 100 percent reserves of base money? Or can they hold interest bearing government debt? What about Certificates of Deposit? What about 30 day commercial paper? What about overnight repurchase agreements?
One important element of the financial crisis was that investment banks were funding portfolios of mortgage backed securities with short term commercial paper and repurchase agreements. Some of the commercial paper was overnight as were the repurchase agreements. None of these investment banks could give their creditors direct access to the payments system. The commercial paper, even overnight commercial paper, wasn't checkable. Some of the commercial paper was sold to money market mutual funds. While those mutual funds were sometimes checkable, the mutual funds didn't have direct access to the payments system. The mutual funds held transactions accounts at commercial banks to clear the checks of their customers.
When the creditors of the investment banks began to worry about their portfolios of mortgage backed securities, they quit rolling over their commercial paper and repurchase agreements. Since the investment banks needed to borrow new money to pay off all of the commercial paper and repurchase agreements coming due every day, they faced what was equivalent to a bank run. Those who had been holding the commercial paper or repurchase agreements didn't demand base money. There was no run to fiat currency. Instead, they purchased Treasury bills and accumulated funds in FDIC insured bank deposits. Through a variety of direct and indirect channels, the result was a large increase in the demand for money, and a very large increase in the demand for base money by banks.
It is not at all clear that requiring 100 percent reserves for all of the transactions accounts of all the depository institutions would have made much difference. Hoping that some scheme regulation will stabilize the financial system so that there will never be a sharp increases in the demand for base money is unrealistic. Making sure that the quantity of base money adjusts to accommodate changes in the demand to hold base money is the more sensible approach.
That the financial crisis led to the Great Recession does provide a reason for fundamental change. The Fed's approach of gradual and judicious changes in the overnight interbank interest rate aimed at reducing the output gap and raising the core CPI 2 percent from its current value has failed. A constitutional commitment to a stable monetary environment is the right approach. Futile efforts to create a stable monetary environment through reserve requirements would be a mistake.