Thursday, April 4, 2013

Two Framings for Fiat Currency

Scott Sumner has been giving a series of lessons on basic monetary theory.    He discusses a commodity standard and then a fiat currency.   In my view, there are two framings of a fiat currency.    Both have elements of truth and provide some insight.   I see Sumner as constantly leaning too far in the direction of what I call the paper gold framing.    The alternative framing is the credit money framing.

With a gold standard, gold is mined from the ground, and the mining industry spends the new money it creates.  A competitive mining industry would have little direct concern with the impact of its mining on the relative price of gold.   As long as its purchasing power is high enough to make mining the gold profitable, then it will be mined and spent.

Gold has a variety of uses, both monetary and nonmonetary.   If one is doing monetary analysis, it is convenient to ignore the nonmonetary uses.     The quantity of money, determined by the profit seeking efforts of the mining industry, and the demand to hold gold, determines the relative price of gold, and so the price level in terms of gold.

The paper gold framing treats paper money issued by the government like it is gold.   The government's money printing operation replaces the gold miners.   The government prints money into existence and spends it.   This ties directly to government finance.   It could reduce ordinary taxes, fund extra government programs, or pay down government debt, understood as interest bearing government bonds.  

The paper gold framing naturally leads to worries that the government will print money and spend it with no more concern for its purchasing power than does the gold mining industry.   Since the cost of printing currency is very low, it would be profitable to print currency until its purchasing power is very low.

The paper currency has approximately zero use for anything other than money.   The quantity of paper money created by the government and the demand to hold it determine its purchasing power and the price level in terms of paper money.  

The paper gold framing is especially useful to understand an irresponsible government that simply prints money as needed to finance its expenditures.     It also fits quite well in a scenario where this source of government funds is limited by quantity.   The government is permitted to print money and spend it, but it can print only a limited amount of currency per year.   A fixed percent increase provides a "ceteris paribus" constant inflation result.

Of course, if the demand to hold money is subject to large fluctuations, then rule fixing the growth rate of currency printed by government will result in fluctuations in spending on output, short run fluctuations in production and employment, and long run fluctuations in the price level.   This suggests that limiting government money creation by a quantitative rule is undesirable.

Suppose that the rule instead mandates that the quantity of money be adjusted to keep the price level or nominal GDP constant or growing at a stable rate.   Now, rather than money simply being printed and spent by the government at either an uncontrolled and unconstrained rate or a limited, more responsible rate, the quantity of money must sometimes decrease.  

Gold miners don't collect gold and destroy it for any reason, much less in order to make sure that its relative price doesn't fall.    If paper money is somehow controlled to stabilize something other than its own quantity, then it is no longer like paper gold.

The credit money framing instead treats paper money as a debt instrument.   Initially, it was a promise to pay commodity money on demand.  This promise was made by private banks, often under conditions of imperfect competition.   Usually banks offered deposit accounts and allowed payments "on the books," well before banknotes were discovered.   Rarely, and almost entirely due to government requirements, did banks operate on a 100% reserve basis.     The money issued by banks was a promise to pay, not a claim to commodity money being stored.

With the credit money framing, tangible hand-to-hand currency is fundamentally identical to money in deposit accounts.   What years ago were entries on the books of banks are now entries in their computers.   A bank deposit denominated as one dollar has a value of one dollar for the same reason that the paper money issued by a bank would have a value of a dollar.   The issuing bank must stand ready to pay them off on demand.   And, of course, both are used to make payments.  

There is, of course, a difference between banknotes and deposits.   It is technically easier to pay interest on deposits than on banknotes.    Historically, banks did not pay interest on most banknotes, which made them a source of profit to the individual bank.   A competitive system of traditional banks, offering banknotes and interest bearing deposits, while making specialized bank loans, will compete away these profits.   In effect, this would make the profits from issuing bank notes essential to compensate for what would otherwise be "excessively" high interest on deposits, "excessively" low interest on loans, or perhaps excessive operating costs--"excessive" numbers of bank tellers.

A monopoly issuer of banknotes can capture these profits.   Long ago, governments granted that monopoly privilege to a single bank.  And that is the actual reason for the existence of central banks.   They can profit from borrowing at a zero nominal interest rate by issuing banknotes.   With a monopoly on this business, they face no direct competition.  

Why did the government's provide this benefit to a particular bank?   In exchange for being able to obtain loans at a low interest rate.     When the national debt was high, particularly when it was growing due to war-time deficits, the central bank would do its patriotic duty and lend to the government at below market interest rates.   

In the modern era, central banks have been nationalized.   The Federal Reserve, for example, receives market interest rates on the government debt it holds, covers its operating costs, pays a modest fixed dividend to the member banks that nominally own it, and then give the remainder back to the Treasury.      The Treasury claims the residual profit that is generated by the ability of the Federal Reserve to borrow at a zero nominal interest rate.

Competitive note-issuing banks were able to largely out compete coin-issuing government mints and they were also able to operate with very slim commodity money reserves.   To keep commodity money in circulation, governments prohibited the issue of small banknotes.   To encourage banks to hold commodity money reserves, governments banned the option clause.   And most obviously, governments mandated minimum reserve requirements.  

With a central bank monopolizing note issue, the remaining deposit banks replace commodity money coins with banknotes issued by the central bank as vault cash and find it convenient to keep some reserves on deposit with the central bank.    The deposit banking system has no need for more than minimal commodity money reserves.

Oddly enough, it is possible for a central bank to also operate with minimal gold reserves.   Even if households and firms use commodity money coins, then central bank can provide them to commercial banks as they need them, with the central bank purchasing them from the mint.   The central bank can pay the mint by crediting its deposit account and the mint can pay for bullion by writing a check against the central bank.

The primary constraint on a developed central bank or competitive banking system imposed by a commodity standard is that the market price of bullion cannot rise so high that it becomes profitable to do round trip arbitrage.   For example, to redeem money for gold and sell it, and then redeem the money received for more gold.

For both a central bank in a gold standard world, or any individual competing bank, the "solution" to excess demand for gold bullion is to sell short term securities.  The key effect of "open market sales" is to contract the quantity of money and raise short term interest rates.    This tends to reduce the demands for all goods and services, including gold bullion.   And so, the credit money issued by central bank and the banking system that is denominated in terms of some commodity-defined unit of account roughly purchases the amount of the commodity that defines the unit of account.

In such a monetary order, the unit of account, such as the dollar, is defined in terms of some commodity, such as gold.   The media of exchange, including paper money, are denominated in terms of the unit of account.   The banking system, including the central bank, keeps the market price of the commodity equal to the defined price by some system of redeemability, though often indirect.   For example, a dollar-denominated deposit at a commercial bank is redeemable for paper currency issued by the central bank which is redeemable in foreign exchange.   By open market operations or manipulating its discount rate, the central bank makes sure that the market price of gold remains pegged at its defined price.

Given such a system, it becomes untenable to treat the nonmonetary uses of the commodity as just a slight distraction.   The media of exchange are made up of a variety of debt instruments.    The medium of account, such of gold, has a supply depending on the mining industry and a demand that in the limit would be solely for "industrial" purposes, such as jewelry.

With a credit money system, it is possible to change the medium of account without changing the unit of account.   For example, it would be possible to switch from gold to silver or silver to gold.   All that would change is that rather than adjusting the quantity of money to keep the market price of gold at the defined price, the banking system would begin adjusting the quantity of money to keep the market price of silver at its defined price.

More interesting would be more complicated standards.  For example, a symmetalic standard combines two metals, like both silver and gold.   Coins could be minted out of electrum, the alloy of silver and gold, but there is no need for commodity money coins.   Central bank or private bank deposits could be redeemed with a fixed amount of gold bullion along with a fixed amount of silver bullion.

Now, if the banking system, with or without a central bank, is obligated to redeem banknotes and deposits with both a fixed amount of gold and a fixed amount of silver, these monetary instruments remain debt instruments.    Further, there is no need for direct redeemability.   For example, suppose that central bank redeems its money with both a fixed amount of foreign exchange drawn on a country on the gold standard and a fixed amount of foreign exchange drawn on a country on the silver standard. 

Rather than worry too much about symmetalism, consider a true multiple standard, with the unit of account defined as fixed amount of pig iron plus a fixed amount of wheat plus a fixed amount of aluminum, and so on.   Suppose a central bank promises redeemability not in the actual commodities, but in foreign exchange sufficient to purchase all of those items.   A paper dollar or dollar deposit is redeemable in the number of Euros sufficient to purchase a fixed amount of pig iron plus the amount of Euros necessary to purchase a fixed amount of wheat plus the amount needed to purchase a fixed amount of aluminum and so on.  

Whether or not such a system would be better or worse than simple commodity standard, it is clear that the paper money and deposits remain debt instruments.   The actual operation of such a system would require monetary system, either competing banks or a central bank, to use ordinary open market operations to adjust the quantity of money so that the sum of the market prices of the items in the bundle add up to the defined price of the bundle.

Finally, suppose that rather than using some system of direct or indirect redeemability to compel a central bank, to undertake the needed open market operations to keep the market price of the bundle at the defined price, some alternative motivational scheme is used.    Further, rather than using open market operations to keep the market price of a bundle goods at the defined price, instead, a price index calculated using that same bundle of goods and open market operations are used to keep the price index at 100.

What is the best way to frame such a monetary order?   In my view, paper money issued by a central bank committed to a stable price level is better framed as credit money.    With a modern, nationalized central bank, the tangible paper currency is a type of government debt.   It just pays zero nominal interest.   It is nothing like paper gold.

Now, suppose that the rule is instead to to keep nominal GDP growing at a slow steady rate, so that the price level remains at 100 on average.    Which  is better?  The paper gold framing or the credit money framing?   If the demand for money of any sort, whether hand-to-hand currency monopolized by a central bank, or an interest bearing checkable deposit issued by a commercial bank, should decrease, the quantity of that particular type of money must be decreased.   The issuer must pay back what has been borrowed.

In my view, it is best framed as credit money.    Of course, if the central bank is obligated to buy and sell index futures contracts on nominal GDP, the monetary regime has something similar to redeemability.    And, of course, if government-issued currency is replaced by private banknotes, then, the paper money is clearly debt instruments of some bank, and nothing like paper gold.


  1. Well, I read this post mangy times, even downloaded unit my Kindle and read it there in bed.

    I love the word "electrum," btw. New one for me.

    I enjoyed how you lead from the gold standard, to electrum, to multiple commodities as a backing for paper currency. I thought you might extend it to other items, such as hotel stays in a five-star etc.

    My complain is the one I always have, and that is the implied desirability of zero inflation. It strikes me that the "costs" of moderate inflation are nil in the practical world, but the benefits huge.

    There is such a thing as "money illusion" in the practical sense.

    Moreover, even if workers suffer no illusions, they lack the mechanisms to do much about eroding real wages. It is socially acceptable to cut workers wages by not giving out raises.

    Never underestimate the power of social convention. After all, people go to church etc, very uneconomic behavior. Oh sure, you can say "psychic income" but really it is social convention. Stores used to have to close on Sundays.

    Coming back to zero inflation, the case of Japan suggest it is terrible place to be. Who is going to take the risk of lending or buying real estate in zero inflation? Hoarding currency becomes practical, generating more deflation.

    On the other hand, inflation is the real estate investor's friend. If nothing else, a developer can wait, wait, wait until he gets bailed out by moderate inflation. Buying and developing property is tricky. So is property lending.

    Real estate is an illiquid investment, in a unique product, subject to unpredictable dangers, such as rezoning, new taxes, unforeseen property damage and expenses.

    I am not surprised that in Japan, in minor deflation, that property values fell by 80 percent over 20 years.

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