Saturday, June 4, 2011

New Monetary Economics

My perspective on monetary economics was strongly influenced by Robert Greenfield and Leland Yeager's "A Laissez-Fair Approach to Monetary Stability."     In that paper, they described what they called the "BFH payments system."

Tyler Cowen recently claimed that the "New Monetary Economics" is alive and well.    He said:
The standard view is that Fischer Black, Bob Hall, Neil Wallace, and Eugene Fama wrote a few creative papers on monetary theory in the 1980s (for Black the 70s), but that the embedded monetary scenarios were “too weird” and the line of research did not prove fruitful.  Even in “free banking” circles the “New Monetary Economics,” as it was called for a while (NME), wasn’t always taken very seriously.
The connection between Greenfield and Yeager and the New Monetary Economics is that BFH is short for Black-Fama-Hall.   What might better be called the Greenfield-Yeager payments system was inspired by ideas that had been introduced by Fischer Black, Bob Hall, and Eugene Fama.

At first pass, Greenfield and Yeager's proposal was for the "dollar" to be defined in terms of a broad bundle of goods and services and for the medium of exchange to be a system of competing money market mutual funds.    As they, and others (including me) explored this system, the centrality of checkable money market funds shifted to the background while the role of "indirectly convertibility" came to be seen as central.   Checks (or other dollar-denominated monetary instruments, would be redeemable in gold or some other settlement medium, equal in market value to the market value of the bundle that defines the dollar.

Despite the shift away from any focus on market pricing for mutual fund shares early on, it remains true that much of the inspiration for the scheme involved thinking about a monetary order without any hand-to-hand currency.    To me, one important legacy of the "New Monetary Economics" is a shift away from seeing zero-nominal-interest hand-to-hand currency as the core concept of money to a view that sees it as a possibly useful appendage to the monetary order.   Money pays interest, well, except for hand-to-hand currency, where that exists.   The opportunity cost of holding money is the difference between the interest rate earned on money and other assets.   Of course, if there is no nominal interest rate paid on currency, it is a little different.  (One error of the "New Monetary Economics" was to assume that if none of the peculiar characteristics of zero-interest hand-to-hand currency exists, then the resulting payments system is no longer a monetary order.)

Another element of the "New Monetary Economics" that has influenced me is the notion that in equilibrium, anyway, it is the medium of account that determines the price level.    And further, if the actual price level is  different from whatever clears the market for the medium of account, then there are going to be serious macroeconomic difficulties.      For example, if gold serves as the medium of account, then the dollar price level depends on the supply and demand for gold.   To the degree that there is a demand for gold for coins or reserves, then that impacts the price level much like demands for dental work or jewelry.    Various sorts of financial instruments must adjust in price or quantity to equilibrate the supplies or demands for them.

Of course, the gold standard is long past, but this approach leads to a focus on the supply and demand for the monetary base.   That is what defines the dollar and serves as medium of account.    All the variety of other sorts of financial instruments that play monetary roles must adjust in price or quantity to equate supply and demand.     But once one accepts this perspective, there is no particular reason to assume that the demand for the monetary base is proportional to nominal expenditure on final goods and services.   Why shouldn't there be substitutions between base money and other sorts of financial instruments that provide similar services?

Finally, it was concerns with the operations of indirect convertibility that lead me (and others) to shift towards index futures convertibility.     Because targeting the growth path of money expenditures on output has advantages over targeting some measure of the price level (say the price of a broad bundle of goods and services,) the new monetary economics lead me to "quasi-monetarism."

HT to Kurt Schuler at Free Banking.

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