Tuesday, February 23, 2010

James Buchanan on Constitutional Monetary Reform

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.


  1. Good piece, Bill. I always learn something from your posts.

    I thought the point about 100% reserves not accommodating changes in the relationship between demands for money and base money was particularly good. Building inflexibility into the system when one is concerned about the ability of the system to absorb shocks seems like a bad idea.

    A couple of other points.

    One, the notion that fractional reserve banking is purely an artifact of the gold standard seems wrong to me. I have always thought of it as an economically efficient way to make use of idle money balances.

    Second, to equate fractional reserve banking and financial system instability seems an odd emphasis when the system is so clearly riddled with moral hazard. It is the moral hazard which is the source of the instability. You would know more than I about this but my understanding of the history of free banking is that it would suggest that fractional reserve banking and stability are compatible. It would also be pretty odd if a practice of longstanding, evolving from voluntary contracts and profit maximizing behavour, would turn out to be fundamentally unstable (and thus bad for both sides of the transaction). Doesn't sound right to me.

    Third, Canada is generally thought of as having one of the more stable banking systems and it has no reserve requirements at all.

    Fourth, the argument (from some Austrians) I have most frequently seen against fractional reserve banking (and its effect on the money multiplier) is that it permits loans in excess of real savings and contributes to malinvestments. (I am not sure whether I have characterized that argument properly). I have seen it written elsewhere that fractional reserve banking appears to have a positive effect on long term economic growth which seems to be related (although presumably in opposition) to the Austrian argument. It strikes me that 100% reserve banking would fail the test in the opposite direction, i.e., real savings would exceed loans created. What's your response to the Austrian argument?

  2. You write: "Money creation is not simply a source of government revenue, but rather a way of borrowing money." Do you mean that money creation is a *substitute for*--and *alternative to*--borrowing money? Money *created* is not literally money *borrowed*.

    Creating a dollar and then using it to buy something from someone has some similarity to borrowing a dollar from that person. But in acquiring the dollar, in the context of a regime of fiat currency, the seller does not really become a creditor of the government (of the monetary authority); the latter does not become his debtor, for it owes him nothing *further*. (In contrast, a banknote issued by a bank is a promise to pay the holder the stated amount of *government cash*.)

  3. The common view (which you obviously do not share) is that "runs"--on the banking system and on the "shadow banking" system--are a serious systemic danger. I wonder why those who take the common view would be willing to deal with institutions that are susceptible to runs. For example, if bank balances were not guaranteed by the government, wouldn't these people keep their transaction balances mainly in a short-maturity bond mutual fund rather than a (non-guaranteed) bank? They might have to take a slight haircut now and then, but they wouldn't face the danger that other depositors, having acquired advance information that the bank had become insolvent, would beat them to withdrawal, imposing on them a major haircut.

    But maybe this question wrongly presupposes that the risk of a run is easy to assess. The risk inherent in fractional reserve banking is obvious (and so traditional deposit insurance is quite unnecessary), but the risk in lending to Lehman Brothers, buying insurance from AIG, etc., must have been quite opaque. So the financial system will always be susceptible to runs, and we had better hope you are right, that this poses no serious systemic danger.

  4. Sorry, I first posted this comment to the wrong article.

    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?

    Presumably savings accounts would no longer exists but would be replaced by bond funds that fluctuate with the bond market and the strength of the bank's portfolio. The money market accounts would become short term government bond funds.

  5. Anonymous 1:

    If there is a constitutional monetary regime, and it something other than restrict the quantity of base money, then the monetary authority is obligated to reduce the quantity of base money if the demand for it falls. This makes it into a kind of debt.

    If you think of fiat money as something the government just spends and then its value depends on supply and demand, then this is not an issue. If the constitutional restriction is that the quantity of base money must grow at a certain rate (or perhaps remain frozen) then that particular rule implies no obligation to ever withdraw it from circulation.

    But other rules, and especially the interesting ones that require a stable purchasing power of money or a stable growth path for nominal expenditure, imply that the quantity of base money may need to decrease. In fact, without 100% reserve banking or some other draconian scheme of regulation, it is almost certain that the demand for the monetary base will decrease greatly as currency is replaced by electronic payments.

  6. Anonymous 2:

    Thank you for your comment.

    Deposit insurance was instituted in the U.S. during the Great Depression. Fractional reserve banking already existed at that time.

    In the U.S., there was no lender of last resort before 1913, and fractional reserve banking existed.

    In my view, much of the systematic risk associated with bank runs involves the sharp increase in the demand to hold base money. If the quantity of base money is fixed, then prices, including wages, must fall enough to raise the real quantity of base money to match the increase in demand. The way that happens is through a possibly sharp decrease in nominal expenditure. Because prices and wages are less than perfectly flexible, real output and income are depressed. While this is a terrible consequence, one troubling aspect is that falling real income adds to default risk. But even if prices and wages were perfectly flexible, the increase in the real burden of debt increases default risk. Default risk is relevant because it increases the chance that banks will become insolvent.

    Rather than making sure that the demand for base money never rises, I favor increasing the quantity of base money however much is necessary to prevent an excess demand for base money and the consequent decrease in nominal expenditure. Nominal expenditure targeting avoids these "systematic" adverse consequences of bank runs.

    Anyway, the usual private solution to bank runs was the option clause. Personally, I favor full privatization of hand-to-hand currency, and limiting the monetary base to reserve deposits.

  7. Ogden:

    Milton Friedman casts a long shadow, and I think Buchanan be inclined to go with the M2 measure of the money supply. That would mean saving accounts have 100% reserves. What is the minimum legal term to maturity for a CD and exactly how much penalty should be imposed for early withdrawal? Such issues become important when anything that counts as money must have 100% reserves.

  8. The biggest loophole in the 100% reserve banking is the credit card.

  9. "In the U.S., there was no lender of last resort before 1913 [and no federal deposit insurance before 1934], and fractional reserve banking existed." True but--to me--puzzling. Fractional reserve banking was always known to be inherently unstable, subject to runs. Eventually a superior alternative--the T-bill-only money market fund--was developed; why did it take so long (and why did it not happen until deposit insurance was in place, which deprived it of some of its *raison d'ĂȘtre*)? Of course, this development required a liquid market in short-term government debt, which (I presume) did not come into existence until some time in the 19th century, so fractional reserve banking was an appropriate institution for an earlier time. But why has it survived into our own time?

  10. Moldbug uses the term "maturity-transformation" for the problem instead of fractional reserve banking, it makes the debate much clearer.

    http://unqualified-reservations.blogspot.com/2010/maturity-transformationI like 02/maturity-transformation-cat-bag-out.html
    I think that some form of free banking is the best solution but i think that it might evolve away from maturity-transformation. The banks might guarantee some accounts and give instant access in return for being able to borrow money from depositors for lower interest but they would cover those with capital.

  11. Anonymous:

    Thank you for your comment.

    Money market mutual funds (T-bill only or not) developed because interest rates rose to high level, and banks were subject to ceilings on the interest rates they could pay.

    Obviously, the risks of fractional reserve banking are not that great to the individual depositor. I do think, however, that option clause, and then later, illegal suspensions of payment, reduced the effective instability.

    By the way, if you imagine a fixed quantity of base money, and a "banking system" made up T-bill only mutual funds, what exactly would a "liquid" market in T-bills mean? Suppose the demand for base money doubles? All the mutual funds, then, can sell their T-bills into the liquid market and obtain base money?

  12. Ogden:

    Thanks for your comment.

    The conventional view is that one of the benefits of financial intermediation is that the intermediaries create liquidity by borrowing shorter than they lend. This creates risk, which is born by the intermediaries stockholders in the first instance, but if the financial intermediary fails, then its creditors (like depositors) take a loss.

    It seems to me that Moldbug thinks he discovered the risk associated with this purported benefit.

    The creation of monetary instruments by banks takes the creation of liquidity to an extreme.

  13. David:

    Thank you for your comment.

    As for the Austrian theory, if you start with an equilibrium with 100 percent reserves, and fractional reserve banking is introduced, then the quantity of base money is held constant, then the price level rises. The process by which the price level adjusts could involve malivestment. It requires entrepreneurs to fail to understand what is happening. Once the new equilibrium is established, there is no particular reason to expect malinvestment from fractional reserves banking.

  14. (Regarding your reply to Anonymous 1, above:) Under the sort of monetary rule you favor, the monetary authority will sometimes be obliged to withdraw some amount of currency from circulation, but it will not be in debt to any particular holder of currency. We might say, its "debt" is to the currency-holding public as a collective whole; but that would be straining the notion of debt beyond its normal limits, which extend only to obligations that can be discharged by paying money. (My point is not substantive, merely verbal.)

  15. Anonymous (yet another one?):

    Thank you for your comment.

    I think the "normal limits" of the term "debt" break down when thinking about alternative monetary institutions. In particular, if there is no outside money then defining debt as a claim to outside money is insufficient.

  16. If the demand for base money suddenly doubled, I presume the demand for T-bills would also nearly double: most people whose demand to hold currency increased would also look more favorably on short-maturity government debt instruments. Money market funds facing redemptions might have to sell T-bills at a slight discount, but surely it would be no more than slight--the slighter the shorter the remaining time to maturity. (And an option clause would eliminate even the slight haircut.)

    As a matter of financial history, I can understand why Federal Deposit Insurance would have retarded the development of money market funds, but I don't understand why they had not already come into existence *before 1934*.

  17. Anonymous:

    So, your answer to how the system responds to a doubling of the demand for base money is that people would want to hold T-bills too.

    I suppose that is possible.

    But you fail to grasp the problem. People show up at the door of their money market mutual fund and ask to redeem funds in currency. Where do the funds get the currency?

    My point is that T-bills are not liquid in the face of a doubling of the demand for a fixed quantity of base money.

    Suppose people holding corporate bonds want to get rid of those bonds and buy T-bills at the same time. While this would surely cause the prices of corporate bonds to fall, it is hard to see how this would help the mutual funds scrambling for currency to pay off fund holders.

    Of course, the mutual funds can't fail. The mutual funds "break the buck" and people who want their money now take a loss. And those willing to wait presumably take no loss.

    Anyway, having "banks" organized as mutual funds holding what are highly liquid assets doesn't solve the problem caused by changes in the demand to hold the monetary base. The only solution is either changes in the price level or else changes in the nominal quantity of the monetary base.

  18. You wrote: "Money market mutual funds (T-bill only or not) developed because interest rates rose to high level, and banks were subject to ceilings on the interest rates they could pay." I accept this. My question is: why did it take this combination of regulatory failures to bring them into existence? They seem to me to be a superior--because run-proof--alternative to traditional fractional reserve banking. (If one has inside information about the financial condition of a bank, he doesn't need to worry about being left holding the bag in a run; but most depositors will not be in this position.)

    Further: "My point is that T-bills are not liquid in the face of a doubling of the demand for a fixed quantity of base money." This seems to assume that the demand for T-bills does not *nearly* double at the same time; but my claim is that, in any realistic scenario, it would do so.

  19. "The biggest loophole in the 100% reserve banking is the credit card."

    First, a change to public money would essentially end the concept of "reserve-based" banking of any kind.

    The government would create all money as real, permanent money.
    After the transition from bank-credit money, anything that would serve as money would need to remain real money.
    Credit regulations for any backroom 'card' based operations would require they NEED to be fully funded.
    With real money.
    Operations are simply the backing by a line of credit from front room to back room.
    All fully-backed.
    Credit card operations are no problem for debt-free money.

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