Sunday, July 10, 2011

New Blog: Uneasy Money

David Glasner has started blogging at Uneasy Money.    David has advocated free banking combined with index futures convertibility.   Rather than proposing to use index futures on the prices of goods and services or else nominal GDP, he proposes using a wage index.

While I am not very familiar with wage indexes, the proposal has some advantages over GDP targeting.    For example, suppose wages are targeted to grow with labor productivity.   If labor's share of income should fall relative to capital, then the trend of money wages would remain unchanged.   Nominal income would grow more rapidly, nominal capital incomes would grow more rapidly, and the price level would rise to a higher growth path.   The inflation in final goods prices would slow the growth in real wages, and reduce them to a lower growth path.

The disadvantage is that because wages are sticky, monetary disequilibrium could impact output and even employment while having little impact on the growth path of wages.   With index futures convertibility, those speculating in futures in a way that corrects the disruption would profit little, while those who were taking positions on the futures in a way that exacerbates the problem would suffer little loss.

With nominal GDP targeting, when monetary disequilibrium impacts both real output and flexible prices, the errors show up in what is being targeted.   Those trading the futures that drive the quantity of money will obtain profits or suffer losses more consistent with the benefits or costs their actions are creating for the economy.

In a recent post, Glasner discussed the Pigou effect, Keynes, Sumner, and Krugman.    With the Pigou effect, a lower price level raises real wealth, reduces the supply of saving, and raises the natural interest rate.   If the natural rate is negative, and the market rate is at zero, then equilibrium returns when the price level is low enough for real wealth to be high enough that saving is low enough that the natural interest rate rises back to the market rate.    (This only works with outside money.  With inside money, a lower price level just transfers wealth from debtor to creditor.   Of course, in a  gold standard world, there is outside money.)

Glasner wonders how different economics would have been if Pigou had instead suggested that the inflation rate rate increase enough so that the real market rate fall enough to match the perhaps negative natural interest rate.   I am not sure whose "effect" this is, but if the price level falls below its expected value in the long run, then the expected inflation rate will reduce the real market rate, perhaps making it sufficiently negative to equal the natural rate.

If the monetary system has no anchor for the price level, for example, due to inflation targeting, this doesn't work.   To the degree people project past deflation into the future, moving to a lower price level ends up having perverse and perhaps catastrophic consequences.    With a gold standard, the price level is anchored, more or less.

The flavor of Glasner's comment, however, is more consistent with a policy aimed at causing more rapid inflation from the current price level--shifting the price level to a steeper growth path.    The price level doesn't need to fall.   Prices begin to rise more rapidly, and the real market rate falls to the perhaps negative natural interest rate.    (In the context of an economy that already has suffered a large deflation, this could just be reflating the price level  to some past level.   He is discussing Keynes and Pigou.)

For those of us favoring a rules-based monetary regime, whether targeting a growth path for wages, prices, or nominal GDP, the anchor for the price level means that deflation can be brought to a halt as long as people have confidence that the regime will eventually bring the price level back to the explicit or implicit target.    This is especially true if the problem is that experience of deflation causes people to expect more deflation so that a zero nominal interest rate becomes a positive real interest rate greater than the natural interest rate.

But suppose the problem isn't expected deflation.   If the price level falls to a lower level, expectations are that it will stay there or perhaps rise back to a normal level.   No, suppose the problem is that the natural interest rate is negative.

If the problem is just self-fulfilling expectations--high saving and low investment because of poor economic performance is projected into the future--then the same process should work.   As the real market interest rate falls to the negative natural interest rate, the economy recovers, and so, there is little reason to expect poor economic performance in the future.   The natural interest rate rises again.

But suppose the problem is more persistent.   Suppose the natural interest rate is negative, even when economic performance is good.   People want to save a lot, and the investment opportunities, even in the context of full employment, appear somewhat poor on the margin.

With a rule-based monetary order, having the experts adjust the inflation rate to clear markets seems counterproductive.   It would be possible to make the rule inflationary, so that a zero nominal interest rate will imply a sufficiently negative real rate that it could never be below the natural rate.     I favor price level stability, and so would like to avoid a rule mandating a rising price level because something might happen.

In that situation, if the of the nominal market interest rate needed to equal the natural interest rate is negative, either because of expectations of deflation or a negative real natural interest rate, then the "problem" is that the issue of hand-to-hand currency becomes unprofitable.

What does it mean that the issue of hand-to-hand currency is unprofitable?   The nominal interest rates on the assets purchased by the issuer of the hand-to-hand currency is not sufficiently greater than zero to cover the cost of intermediation.

In the context of free banking, the answer is simple.   Don't make zero-nominal-interest hand-to-hand currency central to the monetary order.  Base everything on interest bearing deposits, and make the issue of currency a minor convenience.   And, if no bank wants to issue it, then that convenience will not be available.

Do we set a permanently higher inflation rate so that we can be assured that hand-to-hand currency can always be issued at a profit?   Or, do we deflate all prices and incomes so that the real value of hand-to-hand currency adjusts to a given quantity?   Perhaps it is just better to avoid having an entire economy held hostage to hand-to-hand currency.     If the issue of hand-to-hand currency becomes unprofitable, then let those who would use it find alternatives.


  1. Bill, Thanks for your detailed comments on my blog. There is so much material here that I don't even know where to begin. So for the time being, at least, I will have to defer any detailed comments. My only immediate comment is that if nominal interest rates are close to zero, the costs of intermediation may make issuing bank deposits unprofitable, too, unless banks impose very steep service charges on depositors, so I am not sure that the dichotomy between creating deposits and currency is as stark as you suggest.

  2. I usually call the situation of "steep service charges" as "negative nominal interest rates."

    Or, more exactly, the interest rate on deposits is the interest rate on earning assets (bonds in the simple scheme) less the cost of providing intermediation services. When interest rats on earning assets fall (like the yield on T-bills or even the interest rate paid on reserve balances at the central bank) the interest rate on deposits fall as well. They can turn negative.

    Of course, if the interest rate on deposits turn more negative than the cost of storing currency, then under current conditions, the banks suffer a currency drain. If there is no hand-to-hand currency, this isn't an issue. Deposit yields turn negative.

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