In the latest installment in his series, “Understanding Money Mechanics,” Bob Murphy takes on Market Monetarism, and Scott Sumner’s case for having central banks practice NGDP level targeting in particular. A commentator there writes, “I hope George S. pipes up to defend MM! Seeing the other side can helps [sic] me to understand the theory better.”

Far be it from me to refuse such a request!

Murphy devotes much of his post to distinguishing Market Monetarism from both old-time Monetarism and Austrian monetary economics. Much of what I have to say also concerns those distinctions. I hope to persuade readers that Market Monetarism is more consistent with both old-fashioned Monetarism and Austrian economics than Murphy allows, and that, to the extent that it differs from versions of either, it does so in ways that improve upon them.

Velocity: The Elephant in the Room

Murphy’s essay begins with a generally accurate summary of the many points of resemblance between Sumner’s Market Monetarism and Monetarism of the old-fashioned Milton Friedman sort, from which Sumner draws much of his inspiration. Among other things Murphy notes, correctly, that both Sumner and Friedman reject the naive view that the level of nominal interest rates is a reliable indicator of the stance of monetary policy, with low rates serving as evidence that money is “easy,” and high ones suggesting that it’s “tight.”

Murphy’s summary falls short, however, when it comes to explaining the difference between Sumner’s framework and Friedman’s. He recognizes that Sumner’s “proposal to use a futures market in NGDP contracts to effectively automate Fed policy” supplies the “Market” aspect of Market Monetarism. And he of course understands that Sumner differs from Friedman in regarding the value of nominal GDP as a better indicator of the stance of monetary policy, and hence as a more fitting object of the Fed’s stabilization efforts, than any money-stock measure. But he never considers the rationale for this second, more crucial difference, and his failure to do this vitiates a substantial part of his critique.

That rationale couldn’t be simpler. It’s that the velocity of money—the ratio of nominal GDP to the money stock, which is an inverse measure of the intensity of people’s desire for “real” (that is, purchasing-power-adjusted) money balances—is unstable. There are times when people want to stock up on real balances, just as there are times when, for reasons good or bad, they want to stock up on toilet paper. And there are others when they’d rather not hold onto money at all, as happens when hyperinflation burns a hole in their pockets.

Friedman and other old-fashioned Monetarists long took the predictability of the velocity of money for granted, treating it as a stable function of a relatively small set of variables. But the merit of that procedure fell into doubt during the 1970s, and since then velocity has become notoriously unstable. Consider, for example, how the behavior of the M2 velocity has changed since 1960:

The story for M1 velocity is similar: although it was never constant, until the early 80s it seemed to grow at a modest, steady rate. But since then, its movements resemble those of a roller coaster:

So long as the velocity of money was itself stable, it made sense to suppose that some correspondingly stable money stock growth pattern would prevent monetary policy from becoming either too easy or too tight, and to regard any substantial deviation from the same pattern as evidence of over-tightening or its opposite. But when, by the 1980s, velocity had ceased to be stable, this was no longer so. From then on, whether changes in the level or growth rate of some money measure signified over- or under-tightening depended on whether they compensated for an opposite velocity change. In terms of the famous equation of exchange, MV = Py, what mattered wasn’t whether M grew at a modest and steady rate, but whether MV or, equivalently, Py, did so. Nominal GDP is, of course, a popular measure of Py. Nominal GDP targeting can thus be understood as nothing more than a velocity-compensated version of Friedman’s famous money growth rate rule.

Money Growth Measures Mislead

That the velocity of money ceased being stable has for some decades now been recognized by most self-described Monetarists, who stopped recommending constant money growth rate rules for that reason. Prominent early examples included Ben McCallum and John Taylor. So it’s only natural that Sumner and other “Market Monetarists” today would no longer treat the behavior of any money-stock measure as a guide to the stance of monetary policy. Nor of course would most non-Monetarists wish to treat it so.

Still, there are exceptions; and Murphy is one of them.[1] He writes as if it were still 1960, and as if the pace of money growth alone could be treated, as old-fashioned Monetarists once treated it, as a sufficient indicator of the tightness or looseness of monetary policy. Remarkably, the word “velocity” never even comes up in his essay.

Thus, of four “problems” Murphy has with Market Monetarism, the first consists of its alleged failure to recognize that “Monetary Growth Accelerated after the 2008 Crisis.” According to Murphy, that growth proves that Sumner and other Market Monetarists are wrong to think that money was tight during the recession and subsequent, slow recovery.

But as we’ve seen, Murphy’s claim makes sense only assuming that the velocity of money hasn’t decelerated enough to offset, or more than offset, the more rapid money growth he documents. And that assumption is clearly wrong, for otherwise the level and growth rate of nominal GDP themselves would not have declined! In short, Murphy faults Market Monetarists for failing to treat a stable money growth rate as the key to sound monetary policy, when the whole point of Market Monetarism is to improve upon that long outmoded perspective!

It gets worse. For Murphy also treats the rapid post-October 2008 growth of the monetary base as ipso facto evidence of easy monetary policy. That he does so makes one wonder, not only whether he appreciates the need to account for velocity changes, but whether he’s aware of the important changes to the Fed’s operating procedures that anticipated its resort to quantitative easing. In particular, he seems to overlook how, in October 2008, the Fed began paying interest on bank reserves with the deliberate aim of encouraging banks to hoard newly-created reserves that came their way, thereby severing the traditional link between base money growth and growth in broader money measures. Just how well this strategy worked isn’t evident from Murphy’s charts. I trust this one will make it so:

Despite the change just described, both the M2 and the M1 money stock did grow somewhat more rapidly after 2008 than they had beforehand. But owing to a concurrent decline in velocity, the increase fell short of what was needed to avoid lackluster growth of total spending on final goods, let alone make up for an initial, absolute spending drop. Here’s the relevant chart from M1. (The one for M2 tells the same story.)

Monetary Quackery

Murphy’s second complaint about Market Monetarism is that its NGDP criterion for judging the stance of monetary policy is “vacuous and (almost) non-falsifiable.” “Sumner argues that by definition,” he says, the 2008–9 decline in NGDP represented “a ‘tight’ central bank policy.” “The fundamental problem with this definition,” he adds, “is that it assumes Sumner’s conclusion.”

I confess that I can’t make much sense out of Murphy’s complaint. Yes, Sumner and other Market Monetarists regard the behavior of NGDP as a reliable indicator of the stance of monetary policy. Accordingly, when that value falls significantly below trend, they conclude that monetary policy is too tight; and when it rises above the same trend, they consider it too easy. It’s also true that, were there nothing more to Market Monetarism, it would indeed be “vacuous.” But that’s hardly the case: Market Monetarists’ treatment of NGDP as a reliable indicator of the stance of monetary policy isn’t a mere article of faith, as Murphy suggests. It’s a position they’ve arrived at on the basis of a substantial body of theory and evidence.

Much of that theory and evidence can be found in works by Market Monetarists themselves, including several by Sumner and David Beckworth that Murphy himself refers to. More can be found in various other works, including several I surveyed here not long ago. Being myself a Market Monetarist fellow traveler, and even a pioneer of sorts, I’ve contributed to its foundations myself, especially in my book Less than Zero, which argues for a particular stable-NGDP norm that would typically allow for modest, secular deflation.

In light of all these writings, it’s absurd for Murphy to portray Sumner’s case for treating NGDP as an indicator of the stance of monetary policy as a mere case of circular reasoning. Still, he tries, not by seriously considering the arguments and evidence to be found in the aforementioned writings, but by means of the following “medical analogy”:

Suppose a patient is suffering from fever, running a temperature of 103 degrees. One group of doctors recommends injecting the patient with substance M, in order to cure the fever. Yet another group of doctors argues that past injections of substance M are what made the patient sick in the first place.

Now, if they are to have any hope of resolving this dispute, how should the doctors measure the amount of substance M being injected into the patient? Most people would argue that the doctors should look at absolute physical measurements, involving the volume and/​or rate of injection. And so, for example, if they injected the patient with more M than had ever been administered to any patient in the history of that hospital, it would be odd if the patient’s chart read, “Received a very restrictive treatment of M.”

Indeed, imagine if the doctors who think that substance M is a helpful medicine wanted to define the M treatment in terms of the fever. That is, if after they had injected the patient with unprecedented amounts of M, whether the fever stayed the same or went up, the doctors were to declare, “We just made the patient sicker with our shift to restrict the M treatment.” This would be Orwellian and obviously would make it virtually impossible to figure out whether more or less M was what the patient needed.

Analogies are necessarily imperfect. But some are worse than that; and this one is just plain foolish, for all sorts of reasons.

The issue, first of all, is not how to define “M.” Market Monetarists define it the same way, or ways, as other economists do. They deny, however, that a fixed M regimen is always the right treatment for every possible condition. Some conditions call for more M, while others call for less.

To understand the Modern Monetarist perspective, consider a slightly different—but I dare say less labored—version of Murphy’s analogy. A doctor specializing in diabetes treats every patient who comes to his clinic with a fever to the same regimen of 100 units of insulin per day, without considering other symptoms or test results. Such a doctor would surely count as a quack, for not every patient with a fever (which can be a symptom of either hyper- or hypoglycemia, or of any number of other things) requires such a treatment: on the contrary, a hypoglycemic might well die from it. A responsible doctor, in contrast, would first determine a patient’s blood sugar level, and would only then decide how much insulin to give him, assuming he needs any. In this analogy, insulin is like money, a 100-unit regimen is like Friedman’s naive k‑percent money growth rule, and a patient’s blood sugar level is like an economy’s NGDP level: it depends both on preexisting insulin input and the patient’s particular insulin needs.

We thus return yet again to the subject of velocity. Like a naive Monetarist, our quack assumes that it’s constant. And Murphy sides unabashedly with the quack.

Austrian and Monetarist Busts

If the assumption that an economy always requires the same dose of monetary medicine is dangerously naive, the view that any dose of monetary medicine is harmful is downright puerile.

Yet that view is implicit in Murphy’s final criticism of Sumner, which is that his recommended solution to a collapse of NGDP, namely, a Fed-engineered boost to money growth, would “simply perpetuate the boom-bust cycle.”

Although I stopped calling myself an Austrian economist long ago, I’m pretty familiar with the Austrian business cycle theory to which Murphy’s complaint alludes. What’s more, I agree that it can help explain the boom-bust cycle of the last half of the 2000s. Still, I reject Murphy’s suggestion that a central bank following Sumner’s advice would be bound to trigger an Austrian-type cycle.

Why wouldn’t it? According to the Austrian theory, excessive money growth distorts relative prices, in part by leading to artificially low-interest rates, and this gives rise to booms. But the theory also holds that relative prices, and the rate of interest in particular, are bound to eventually return to their undistorted or “natural” levels, and that as they do, booms give way to busts. In other words, once the bust begins, the economy starts with a clean slate, so far as the efficient working of its price system is concerned: there’s absolutely no need for any contraction of either the money stock or total spending (money times velocity), or for deflation, to restore relative prices to their proper levels. The opposite view—that a bout of deflation somehow helps the economy to rid itself of prior malinvestment—was quite properly scorned by von Mises as akin to the view that one might make up for running over a neighbor’s cat by backing over it as well.

So what money growth rate—what dose of “money medicine”—does the economy require going forward? I agree with Murphy that the last thing the economy needs is another boom-generating dose. But monetary expansion is warranted so long as it only serves to maintain a stable and modest level of spending. Because it’s common for money’s velocity to decline, even drastically, during busts, that needed dose might be substantial.

Avoiding a Depression Double-Whammy

Monetarists, “Market” ones included, tend to downplay the importance of Austrian-style boom-bust cycles, while some Austrians dismiss the Monetarist theory that busts are caused by money shortages. This is a shame, because it often takes both theories, and then some, to explain any actual cycle. I’m pretty sure that’s so for both the 1927–33 and the 2005-10 cycles. In each of these episodes, a period of overly-loose money was followed by one in which money was too tight, adding the insult of deflation to the injury of malinvestment.

When I used to teach undergraduates about the Great Depression, I made this point using yet another (semi) medical analogy, after having first covered both the Austrian and the Monetarist explanations.

Suppose that a man has the bad habit of coming home very late, and badly hungover, every Friday night. His wife has had to put up with this for years. One Friday, he stumbles through their apartment door, and immediately starts to throw up. His wife has had enough: she wallops him with a frying pan. A neighbor, hearing the ruckus, runs in from across the hall, to find the man lying unconscious, in a pool of his own vomit. “What happened!?,” she asks.

Must the answer be either “he’s hungover” or “he’s been hit by a frying pan”? Can’t it be both?

Yes, it can. And the correct answer to the question, “What caused the Great Depression?,” I said to my students, is “both monetary excess in the late 20s, and a severe monetary shortage in the early 30s.

The correct answer to the question, what was ailing the economy in late 2008 and 2009, is likewise that it was suffering from both the after-effects of easy monetary policy between 2004 and 2007 and a money shortage afterward.

Hair of the Dog?

Murphy, however, argues that even monetary expansion aimed at preventing a collapse in NGDP is harmful, because it distorts relative prices, inviting another boom-bust cycle:

if the Austrians are correct, then if the Fed reacts to a downturn (which normally would go hand-in-hand with a fall in NGDP growth) with monetary expansion, then, besides the impact on aggregate nominal variables, this action will also distort relative prices. In particular, short-term interest rates will typically be pushed below their “natural” levels, giving the wrong signal to entrepreneurs and setting in motion another unsustainable boom.

This claim has now become commonplace among certain Austrians. Yet far from being sound, it shows a very poor understanding of basic monetary theory.

Suppose, for example, that I want to increase my money holdings. To do so, I just have to spend less on goods and on non-money assets. Then, provided the monetary system is working properly, my nominal money holdings can accumulate.

The rub is that, for any given stock of money, I can only increase my money holdings if others reduce theirs by the same amount. It follows that, if the overall demand for money goes up, either prices have to fall to make every unit of money worth more, so that we all can once again rest content with what we’ve got, or the total stock of money must increase. In the second case, the Fed generally has to help, either by supplying more currency and bank reserves, or by otherwise lowering interest rates to encourage more commercial bank lending and borrowing. Of course, the new money thus created doesn’t itself go to those who wish to increase their money holdings. But it doesn’t have to: the mere fact that it is created at all allows those persons to collectively gather to themselves the extra money they want, as they wouldn’t be able to do otherwise. Nor is there anything perverse about this. On the contrary: it’s just what one would wish to see in any system in which money consists of claims on financial intermediaries. Those who accumulate such claims—like me if I let my bank deposit grow—supply that many more savings to the banks that issue them; and in an ideal system those banks will in turn generate more claims. The Fed’s job is to see to it that this ideal is achieved, at least approximately.

It follows that some monetary expansion and the lowering of interest rates that may accompany it needn’t imply any “artificial” lowering of rates. Instead, it can reflect a genuine increase in savings. This doesn’t mean that interest rates always need to decline when the demand for money goes up, for people might choose to hold more money, not as an alternative to spending it on final goods and services, but as an alternative to other sorts of saving. Either way, monetary expansion isn’t like a “hair of the dog” remedy for a hangover. It’s more like making sure that the hangover isn’t compounded by dehydration. Money may resemble alcohol in being able to spur reckless behavior that eventually results in a painful reckoning, but it also resembles water in being absolutely essential to an economy’s health.

There is, by the way, nothing particularly un-Austrian about the arguments I’ve just made. Similar ones can be found in Hayek’s writings of the mid-1930s, and especially in his 1933 essay on “Saving,” reprinted as chapter five of Profits, Interest and Investment. They occur as well in chapter twelve of Fritz Machlup’s 1940 work, The Stock Market, Credit, and Capital Formation. The same ideas take up a large chunk of chapter four of The Theory of Free Banking, which I wrote while I was still a very Austrian grad student, and a similarly large chunk of Steve Horwitz’s Microfoundations of Macroeconomics.

The case of von Mises is more complicated. While certain passages of his appear to treat any growth in the quantity of “fiduciary” money as harmful, others suggest on the contrary that such growth can help to keep relative prices where they belong. Thus he observes, in The Theory of Money and Credit, that insofar as banks “increase and decrease their circulation pari passu with the variations in the demand for money… they make an essential contribution to stabilizing the inner objective exchange value of money.” As Jörg Guido Hülsmann explains, Mises regards “a stable inner objective exchange value of money” as a monetary policy ideal, albeit one that’s unobtainable in practice.

1920 and 2020

In fact, Murray Rothbard and those who cleave to his teachings, including Murphy, are the only Austrians—if not the only economists of any school—who deny that monetary expansion can be beneficial even when it matches corresponding growth in the demand for real money balances. Their dissidence has several roots, one of which is their belief that, instead of being rigid or “sticky,” prices are perfectly capable of quickly adjusting downward in response to such shortages. If prices respond quickly enough, people can always have all the real money balances they want, without delay, even if the money stock never grows.

Bob Murphy is nothing if not forthright when it comes to pleading this Rothbardian case, as he does in his essay’s closing paragraph. “The entire ‘sticky prices’ boogeyman,” he says,

is a red herring. During the 1920–21 depression, consumer prices collapsed more rapidly than in any twelve-month stretch during the Great Depression. Yet the 1920s were not a decade of economic stagnation. Blaming the worst economic crises in US history on “deflation” and “sticky prices” doesn’t fit the facts.

Let’s set aside the burning question of whether a herring of any color can qualify as a boogeyman. Instead, let’s just ask whether the 1920–21 episode really shows what Murphy thinks it shows, namely, that prices aren’t really sticky, so that there’s never anything to be gained from an expanding money stock.

The answer is that it shows no such thing. First of all, although prices fell relatively quickly during the 1920–21 recession, it was a recession nonetheless, and a serious one. It lasted a year and a half, which was longer than most post-WWI recessions, and it involved a substantial decline (6.9 percent) in output—the largest between the Panic of 1873 and the Great Depression. Unemployment rose sharply, to somewhere between 8.7 and 11.7 percent, depending on which statistics one consults, to roughly twice its level for the remainder of the decade. Although it’s true that the relatively rapid decline in prices prevented a still longer recession, it’s also obvious that they weren’t flexible enough to prevent a serious, albeit temporary, shortage of money with its inevitable counterpart: a glut of goods and labor.

Although the U.S. was on a gold standard when it entered the World War, a gold export embargo soon put that standard in abeyance, allowing both the U.S. money stock and U.S. prices to rise substantially. After the war, as the U.S. and other belligerent nations resumed gold payments, it was understood that prices would have to come down again. This supplies another reason for doubting the general relevance of the 1920–21 episode, for actual prices are more likely to keep up with their equilibrium counterparts, when equilibrium price changes, instead of coming as a surprise, are expected. The rapid downward adjustment of prices in 1920–21 was in this respect at least atypical, for in other episodes, including both the Great Depression and the slump that began in 2007, no one had been anticipating a major decline in prices or the rate of inflation.

Finally, although it should go without saying, things have changed since 1921, including the extent of price and wage stickiness. Indeed, they’d already changed substantially by the end of the 1930s—an era that witnessed numerous initiatives aimed at discouraging or prohibiting downward changes to prices and wage rates. These initiatives began with Hoover’s “high wages” campaign, by which he sought to convince businessmen to stick to paying high wage rates on the dubious grounds that doing so would allow workers to spend more. They continued with the various price- and wage-control programs of FDR’s first New Deal, and also with the 1935 Wagner Act. Finally, they culminated, in 1938, in the nation’s first minimum wage law.[2]

As those last two measures mentioned illustrate, some of those depression-era measures remain in place to this day; and as a vast empirical literature suggests, they together with a host of other factors—whether legislative, contractual, or psychological—continue to limit the extent of downward nominal price and (especially) wage adjustment that occur in response to spending downturns in modern economies.

Murphy has himself written eloquently of the destructive effects of minimum wage increases; and he presumably understands that the same lawmakers responsible for such increases have never so much as considered reducing the minimum wage in response to an economic downturn. In light of this, and of the aforementioned empirical evidence, can he really be capable of such a stroke of cognitive dissonance as would allow him seriously to maintain that wage rates and prices are perfectly flexible?

Alas, I suspect he can. But that’s no reason why anyone else should.

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[1] So, back in 2008, were David Henderson and Jeff Hummel, whose outdated Monetarist metrics I criticized at the time. Using it they concluded that Greenspan’s Fed contributed little if anything to that era’s housing boom. I can’t help wondering now what Bob Murphy thinks of this old exchange!

[2] These depression-era impediments to downward price and wage adjustments are nowhere better described than in the historical chapters of Rothbard’s America’s Great Depression. That makes it particularly perplexing that, in its opening chapters, the same work treats concerns about downward wage rigidity as a question-begging obsession of “Keynesian” economics, dismissing them—and arguments for preserving a stable level of overall spending on final goods—accordingly. “The Keynesian linkage of total employment with total monetary demand for products,” Rothbard writes, “implicitly assumes rigid wage rates downward; it therefore cannot be used to criticize the policy of freely-falling wage rates.” “Policy”? The question isn’t whether it would be best if wages fell as needed. It’s whether they can fall that far in fact. Generally speaking, they can’t.

[Cross-posted from Alt‑M.org]

Today, Alt‑M features a guest blog post from Brian Nolan, a bank treasury professional and co-founder of Finteum in London, UK, which is creating an interbank market for intraday borrowing and lending.

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In a speech on February 6 at the Money Marketeers Club of New York University, Federal Reserve Vice Chair Randal Quarles proposed that banks change their internal liquidity stress testing (ILST) assumptions—that is, their expected resilience to stress events—by assuming that they can obtain funds from the Fed’s discount window on the first day of such events. On February 13, George Selgin wrote a post about Vice Chair Quarles’ proposal, expressing doubts about the wisdom of Quarles’ advice given the stigma attached to discount window borrowing.

Since then Jamie Dimon, Chairman and CEO of JP Morgan and Jennifer Piepszak, Morgan’s CFO, have announced their decision to take Quarles’ advice, and help shed some of the stigma surrounding discount window borrowing, by incorporating regular use of the discount window into Morgan’s stress-planning scenarios going forward. They implied that JP Morgan also plans on taking advantage of Fed daylight overdrafts.

Here I offer a bank treasury perspective on Vice Chair Quarles’ proposal and JP Morgan’s decision to implement it, focusing on how the challenges of governance and mechanics relate to the discount window stigma and to the standing repo facility. (To be clear, the main challenge with Vice Chair Quarles’ proposal is the stigma. The governance and mechanics challenges are secondary and complementary, but worth considering.)

Some Brief Reminders

Firstly, a reminder about the problem that Quarles is trying to solve: Quarles recognizes that the September repo market dislocation was caused partly by banks holding onto large reserve balances. They do so in part because they believe high balances are necessary for day one of their liquidity stress scenarios, particularly ILST. Of course, the more reserves they believe they need on hand, the fewer of them they lend through the repo market. Quarles believes this is a problem, particularly because the Fed is trying to incentivize banks to hold fewer reserves, which will help the Fed reduce its own balance sheet.

Quarles’ proposed solution is for banks to assume they will not need high reserves on day one of a severe stress scenario, because they can borrow reserves from the Fed through the discount window instead. Instead of high reserves, banks would hold other assets on their balance sheets to cover their day one stress scenario liquidity needs. They could lend out their remaining reserves in the repo market. If each bank agrees to hold fewer reserves, the Fed can, in theory, reduce its balance sheet.

So, is Quarles’ proposal credible? Who should decide—and on what basis?

ILST Requires Bank Boards to Decide

Ultimately, a bank’s board of directors decides whether to assume central bank support as part of the ILST scenarios that it uses to determine the size of its liquid asset buffer. The board’s decision is informed partly by regulation (especially Regulation YY) and guidance from supervisors, but also by the board’s own judgment on sound risk management.

For example, JP Morgan’s most recent Liquidity Coverage Ratio (LCR) disclosure says “… the Firm does not view this borrowing capacity at the Federal Reserve Bank discount window and the other central banks as a primary source of liquidity.” This statement reflects the risk appetite of the board of JP Morgan, which uses the liquid assets on its balance sheet as its primary liquidity sources for ILST scenarios.

However, if the board of JP Morgan, or any other bank board, decides that the bank should be able to survive a severe stress event without using the discount window, but misjudges how severe that stress can get, they can request additional funding from the discount window as a backup.

While Vice Chair Quarles might believe that the discount window is a potential source of day one inflows for stress events, challenging the long-held discount window stigma will require each individual bank to change its discount window usage and revise its ILST assumptions, so it will take time to enact.

Boards Normally Decide to be Self-Sufficient

Usually, when bank boards decide how much they need in liquid assets to survive a severe stress scenario, they expect to survive as a self-sufficient company and not to rely on funding from the discount window. In fact, banks are expected to rely firstly on their own resources, and secondly on funding from private markets, before thirdly requesting central bank funding.

Vice Chair Quarles highlighted that global central banks and regulators “… expect firms to manage their liquidity risk prudently—to self-insure …”. This is also reflected in the international BCBS Principles for Sound Liquidity Risk Management and Supervision: “… [A]n expectation that central banks will provide liquidity support, alongside the guarantees to depositors provided by deposit insurance, could diminish the incentives of the bank to manage its liquidity as conservatively as it should.”

Vice Chair Quarles emphasis on banks maintaining their self-sufficiency, even while proposing that they assume discount window access on day one of a stress scenario, is an oxymoron. The idea that banks should be self-sufficient runs counter to the assumption that they will borrow from the Fed at the first sign of trouble. Vice Chair Quarles recognized but did not fully address this oxymoron in his speech. It is another matter for bank boards to consider before changing their ILST assumptions.

Committed Timing Mechanics Create a Credibility Problem

Let’s change our focus from the process of changing ILST assumptions to the timing of borrowing from the discount window. According to its official description, the Fed’s discount window does not provide immediate settlement of loans. Loans can be requested on the same day against pre-positioned collateral, but the Fed states that “proceeds are posted to the agreed-upon account (usually the borrowing institution’s account or its correspondent’s account), normally after the close of Fedwire.”

Yet a bank U.S. dollar funding practitioner informed me that, when their bank recently tested their access to the Fed’s discount window, it received credit immediately rather than after the close of Fedwire. There seems to be a discrepancy between how the Fed explains its discount window timing mechanics officially, and how these mechanics work in practice. Certainly, there is no official commitment from the Fed that borrowing institutions will receive funds immediately.

For banks to credibly assume they can obtain funding from the Fed’s discount window on day one of stress events, they will require a commitment from the Fed that it will credit such funding that day, before a pre-determined cut-off time. Ideally, the cut-off should be early enough during the business day so that banks can use the reserves for their expected payment and settlement activity. It is not clear from JP Morgan’s announcement whether the board of JP Morgan considered this when it approved the assumption change.

Why Spend Resources on a Discount Window Solution?

Dr. Selgin’s earlier post describes the stigma associated with borrowing from the discount window. It is important to note that addressing the observations and recommendations above for governance and mechanics will not remove this stigma. The stigma remains the primary challenge with Quarles’ proposal, whereas governance and mechanics are secondary challenges.

Providing assurances that the discount window can be used during stress will not change entrenched attitudes towards it. Discount window borrowing will probably remain an “option E”, as a US bank treasurer recently described it. Even if the mechanics of the discount window were changed, and even if the Fed committed to settle discount window loans before an early cut-off time, banks might still not use it, except as a last-resort emergency lending facility, simply because of the stigma surrounding it.

Dr. Selgin proposes that a standing repo facility could provide a lower-stigma alternative to discount window borrowing, if designed correctly. Some of the governance and mechanics considerations mentioned above could inform the design of a standing repo facility—for example, funding should be available early in the day, and for same-day settlement.

Following Quarles’ speech, some commentators suggested that the creation of a standing repo facility looks less likely. Creating a new facility requires Fed resources and Quarles stated a preference to use tools that are already at the disposal of the system.

However, enacting Quarles’ proposal requires changing the discount window mechanics and changing banks’ ILST assumptions. This, in turn, requires significant resources from supervisors and from banks’ boards and treasury teams. Most likely, the Fed is already quantifying the resources required to achieve this, comparing them to the resources required to create a standing repo facility, and considering whether the latter represents better value for money.

It may be worthwhile for the Fed to consider a request for comment for specific and actionable proposals for the design and implementation plan of a standing repo facility, after the Covid-19 disruption has calmed again.

Vice Chair Quarles’ proposal raises some other interesting questions about the minimum and maximum levels of reserves in individual banks: should banks be required to hold any reserves at all? What are the differences between LCR, ILST and Federal Regulation D? These are complex questions that deserve separate posts of their own.

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Finteum is an early-stage company, based in London, creating an interbank market for intraday lending through FX swaps, repo, and securities lending. We have prepared guidance for banks’ treasury teams and boards as an extension to this post, which can be obtained from info@​finteum.​com covering (i) implications of Vice Chair Quarles’ proposal for resolution planning, (ii) explanation and analysis of the USD system’s minimum required reserves, (iii) analysis of the risks and early warning indicators today in US Treasurys, (iv) alternative proposals to reduce risk in the USD repo market and avoid a recurrence of the September dislocation, (v) alternative risk-free benchmarks to SOFR, and (vi) alternative proposals to reduce the Fed balance sheet.

Watching the frenzy surrounding Judy Shelton’s confirmation hearing before the Senate Banking Committee on February 13, one is led to believe that the gold standard is a “nutty” idea, for which no serious economist or monetary policymaker could possibly have a kind word. This post critiques that wholesale refutation of the gold standard. In recent years (as well as in the past), both serious economists and reputable monetary policymakers have recognized the benefits of a gold standard in reducing regime uncertainty and promoting monetary and social order. Whatever one may think of President Trump’s recent Fed picks, the gold standard itself deserves more respect than it’s been getting.

Misguided Criticisms

All serious persons agree that stable money of some sort is crucially important to social order. But journalists and others commenting on Judy Shelton’s views took for granted that a gold standard could not be consistent with such stability. Catherine Rampell, a respected journalist with The Washington Post, wrote that “pegging the dollar to gold could restrict liquidity just when the economy needs it most, as happened during the Great Depression,” while Robert Kuttner, another widely read journalist, opined:

As we painfully learned from economic history, a gold standard is profoundly deflationary, because it prevents necessary expansion of the money supply in line with economic growth. No serious person advocates it. …[I]f you want lower interest rates, the last thing you want is a gold standard.

In considering these claims, one must first of all distinguish between the “classical” gold standard, which functioned from the 1870s until World War I, and the interwar “gold exchange standard.” While some highly respected authorities have good things to say about the classical gold standard, the interwar gold exchange standard has been universally condemned. And it was the breakdown of that interwar standard, which depended much more heavily on cooperation among various central banks than its pre-1914 counterpart, that contributed to the Great Depression.[1] George Selgin, Doug Irwin, Barry Eichengreen, Michael Bordo , and Milton Friedman elaborate on this argument.

Furthermore, not even the generally defective gold exchange standard can be blamed for having restricted liquidity in the United States’ case. So far as the U.S. was concerned, as Friedman states,

It was certainly not adherence to any kind of gold standard that caused the [Great Depression]. If anything, it was the lack of adherence that did. Had either we or France adhered to the gold standard, the money supply in the United States, France, and other countries on the gold standard would have increased substantially.

Even a constitutional political economist like James Buchanan can point to the gold standard and see both its benefits and flaws. He writes: “I am not necessarily anti-gold standard. I think gold would be far better than what we have. But I think there might be better regimes.”

The gold standard is not a panacea. It is only one of many monetary arrangements that might succeed in checking arbitrary government. There are others. And all of them are imperfect. Because no arrangement is ideal, we must choose among realizable, imperfect alternatives—there are always tradeoffs. But it is also important to take a principled approach to thinking about monetary reform and not to simply accept the status quo.

That the “gold standard”—or, more accurately, the interwar “gold exchange standard”—contributed to the Great Depression, understood as a worldwide depression, is something most economic historians accept. Yet the belief that the pre-1914 gold standard was responsible for the U.S. economic collapse of the early 1930s is a myth. It was the Federal Reserve’s policy mistakes, rather than its commitment to the gold standard, that was the major cause of the Great Depression. That, at least, is what Milton Friedman and Anna J. Schwartz claim in their landmark book, A Monetary History of the United States.

The United States entered the 1930s with massive excess gold reserves. The Fed was not constrained in using those reserves to expand base money, and thus the broader money supply. As Richard Timberlake wrote in 2008:

By August 1931, Fed gold had reached $3.5 billion (from $3.1 billion in 1929), an amount that was 81 percent of outstanding Fed monetary obligations and more than double the reserves required by the Federal Reserve Act. Even in March 1933 at the nadir of the monetary contraction, Federal Reserve Banks had more than $1 billion of excess gold reserves. …Whether Fed Banks had excess gold reserves or not, all of the Fed Banks’ gold holdings were expendable in a crisis. The Federal Reserve Board had statutory authority to suspend all gold reserve requirements for Fed Banks for an indefinite period.

More recently, both Timberlake and Thomas Humphrey, in their path-breaking book—Gold, The Real Bills Doctrine, and the Fed: Sources of Monetary Disorder, 1922–1938—identified the real culprit responsible for the Fed’s misconduct. Instead of adhering to the rules of the gold standard, Fed officials managed the Fed’s policies according to a fallacious theory known as the “Real Bills Doctrine.” That doctrine holds that the money supply can be regulated by making only short-term loans based on the output of goods and services. The problem is that adhering to that doctrine would link the nominal value of the money stock to the nominal expected value of real bills, and there would be no anchor for the price level. Lloyd Mints had it right when he argued: “whereas convertibility into a given physical amount of specie [gold or silver]… will limit the quantity of notes… the basing of notes on a given money’s worth of any form of wealth… presents the possibility of unlimited expansion of loans.”

Setting up straw men, misreading economic history, and using ad hominem arguments are no way to conduct a hearing or improve monetary policy. Richard Timberlake is correct in noting that unless policymakers understand the real causes of the Great Depression—namely, the failure of Fed policy to maintain a steady path for nominal GDP and the failure of the Real Bills Doctrine to guide monetary policy in an era that did not have a real gold standard—then they “are forever in danger of repeating past mistakes or inventing new ones.”

It is true that, during the classical gold standard, mild deflation did occur, but it was generated by robust economic growth and was beneficial, in contrast to the severe deflation that occurred during the Great Depression due to Fed mismanagement of the money supply.

In their meticulous study of the link between deflation and depression for 17 countries over more than a century, Andrew Atkenson and Patrick J. Kehoe find:

The only episode in which there is evidence of a link between deflation and depression is the Great Depression (1929–1934). We find virtually no evidence of such a link in any other period. …[M]ost of the episodes in the data set that have deflation and no depression occurred under a gold standard.

Moreover, under a commodity standard, long-run price stability allowed the British government to issue bonds without a maturity date, called “consols.” Interest rates on those securities were relatively low and actually fell, going from 3 percent in 1757 to 2.75 percent in 1888, and 2.5 percent in 1903. The United States issued consols during the classical gold standard, in the 1870s.

The Importance of Thinking about Monetary Alternatives

There are many alternative monetary regimes, ranging from a pure commodity standard to a pure fiat money system. Serious debate over those alternatives is a worthwhile project, which Cato has been involved with for decades (e.g., see The Search for Stable Money and Monetary Alternatives: Rethinking Government Fiat Money).

The importance of studying the properties of alternative monetary regimes and their consequences for safeguarding an essential property right—namely, the promise of a monetary unit that maintains a stable purchasing power in both the short- and long-run—cannot be understated. Indeed, we should not forget that Article 1, Section 8, of the U.S. Constitution grants Congress “the power …to coin money, regulate the value thereof, and of foreign coin, and fix the standard of weights and measures.” That power was given to Congress, not to inflate the money supply, but to safeguard its value under a rule of law. Consequently, sympathy for gold can begin with a strict reading of that constitutional clause, the language of which clearly presupposes a commodity (gold or silver) standard. As Milton Friedman himself told members of Congress, “As I read the original Constitution, it intended to limit Congress to a commodity standard.”

The “chief architect” of the Constitution, James Madison, was clear that his preference was for a commodity standard, not for a fiat money standard:

The only adequate guarantee for the uniform and stable value of a paper currency is its convertibility into specie—the least fluctuating and the only universal currency. I am sensible that a value equal to that of specie may be given to paper or any other medium, by making a limited amount necessary for necessary purposes; but what is to ensure the inflexible adherence of the Legislative Ensurers to their own principles and purposes?

Maybe such a concern is quaint, but it’s hardly nutty. In fact, it’s backed by a considerable base of knowledge on the history of money and monetary arrangements. (Lawrence H. White provides an admirable bibliography.)

Michael Bordo and Finn Kydland highlight the gold standard’s ability to solve the time-inconsistency problem: “When an emergency occurred, the abandonment of the [gold] standard would be viewed by all to be a temporary event since, from their [the public’s] experience, only gold or gold-backed claims truly served as money.”

Arthur J. Rolnick and Warren E. Weber, in their classic study “Money, Inflation, and Output under Fiat and Commodity Standards,” find that, “under fiat standards, rates of money growth, inflation, and output growth are all higher than they are under commodity standards.” And Nobel Laureate economist James Buchanan, who favored a rules-based approach to monetary policy, argues:

The dollar has absolutely no basis in any commodity base, no convertibility. What we have now is a monetary authority [the Fed] that essentially has a monopoly on the issue of fiat money, with no guidelines that amount to anything; an authority that never would have been legislatively approved, that never would have been constitutionally approved, on any kind of rational calculus.

The constitutional political economist is interested in thinking about how to shape institutions to limit the power of government and allow free individuals to go about their own affairs. The pre-1914 gold standard provided “rules of the game,” in which human creativity flourished—and people could count not only on long-run price stability, but also on stable exchange rates. Finally, most authorities agree that the period from 1880 to 1914, when the classical gold standard prevailed, was one of innovation, wealth creation, free trade, and sound money. Joseph Schumpeter emphasized:

An “automatic” gold currency is part and parcel of a laissez-faire and free trade economy. It links every nation’s money rates and price levels with the money-rates and price levels of all the other nations that are “on gold.” It is extremely sensitive to government expenditure and even to attitudes or policies that do not involve expenditure directly, for example, to foreign policy, to certain policies of taxation, and, in general, to precisely all those policies that violate the principles of [classical] liberalism. …It is both the badge and the guarantee of bourgeois freedom—of freedom not simply of the bourgeois interest, but of freedom in the bourgeois sense. From this standpoint a man may quite rationally fight for it.

Even John Maynard Keynes recognized the great benefits stemming from the pre-1914 gold standard:

What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot. But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages.

It is a legitimate and important role of scholars to think about monetary alternatives—even when they may not appear politically feasible. This is one reason the Cato Institute established a Center for Monetary and Financial Alternatives. It’s also why each year, our Annual Monetary Conference brings together the best minds to discuss, in a civil manner, how to improve current policies in order to increase trust in the future value of money and promote financial stability. From constitutional political economists to central bankers, we welcome contributions from across the spectrum in what we consider a crucial ongoing conversation.

What Would Gold Principles Bring to the Fed?

If one is unfit to serve on the Federal Reserve Board because he or she sees the beauty of the classical gold standard, then Alan Greenspan also should never have been allowed to serve on the Board. He too was a strong defender of the classical gold standard. In 1966, he wrote:

An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense—perhaps more clearly and subtly than many consistent defenders of laissez-faire—that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other. In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.

The operation of the classical gold standard offered many lessons, including the importance of enforceable private contracts under a just rule of law, to how the existing system might be improved. This does not mean we should necessarily return to such a standard. It simply means that we shouldn’t dismiss that system as a “nutty idea.” Karl Brunner, the cofounder of the Shadow Open Market Committee, for example, once called for an international “club of financial stability” in which member states would agree to bind themselves to a monetary rule and thereby help reduce the uncertainty inherent in a discretionary government fiat money regime. To return to rules-based monetary policy would, itself, be to honor lessons learned during the era of the gold standard.

Although Greenspan lauded the classical gold standard, he realized that, once appointed, he would have to work within the existing legal framework—not advocate a return to the pre-1914 gold standard. Yet, his knowledge of how that system worked to maintain the value of money—and to allow interest rates, not central bankers, to allocate scarce capital—helped inform his approach to monetary policy at the Fed. Even many years after he began his long tenure as Fed chairman, Greenspan stated, at a 2001 congressional hearing: “Mr. Chairman, so long as you have fiat currency, which is a statutory issue, a central bank properly functioning will endeavor to, in many cases, replicate what a gold standard would itself generate.”

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[1] The gold exchange standard operated from 1925 to 1931. Under that system, central banks could sterilize gold flows to insulate their domestic money supplies. Moreover, countries (other than the United States and United Kingdom) were allowed to hold their reserves in the form of dollars or pounds, in addition to gold. This system collapsed in 1931, after the UK ended convertibility to stem large outflows of gold and capital (see Bordo).

[Cross-posted from Alt‑M.org]

One of the challenging parts of my job here at Cato is that it calls for me, not only to make the case for monetary alternatives, but to comment on current Fed policies. Why is that such a challenge? Because so far as many of my fellow free-market fans are concerned, saying that the Fed should do X rather than Y amounts to endorsing monetary central planning—a major free-market no-no. Their own preferred policy recommendation is simple: “End the Fed.”

Well, I’m not against ending the Fed, provided it can be done without raising havoc, and particularly without harming innocent people, including the many holders of U.S. dollar-denominated assets. My own ideal resembles Milton Friedman’s plan for replacing the FOMC with a computer, the difference being that my computer would automatically provide, not for stable growth of some monetary aggregate, but for a stable level of nominal spending. Whether such a reform would amount to “ending” the Fed is a question of semantics. Anyway, it would be good enough for me, if we ever managed to get there. But in the meantime, I don’t favor a “do nothing” Fed. Moreover, I deny there’s any such thing.

As I write this, for example, the Fed has just announced an immediate, emergency 50 bps rate cut in response to the coronavirus panic. I don’t know if that response is ideal; but despite what many of my libertarian friends think, I’m certain it’s better than no Fed response at all. Nor do I believe that a prudent libertarian case can be made for claiming we’d be better off had the Fed stood pat—let alone vanished in a puff of smoke!

Supply and Demand

Saying that it’s appropriate for the Fed to respond to coronavirus outbreak isn’t the same as saying that it can prevent the outbreak from doing some serious damage to the world economy. Fed actions won’t cure the disease, keep it from spreading, undo government lock-downs, or prevent disease-related factory closings from disrupting supply chains and production elsewhere. But Fed officials know this, as do most economists who have called for a fed response. Their claim isn’t that the Fed either can or should try to make-up for the disease’s adverse supply-side consequences. It’s that it can and should take steps to keep the financial-market repercussions of these supply-side developments, which have included a sharp worldwide increase in the demand for dollar-denominated assets, from leading to a collapse in spending.

The idea, in short, is to spare the U.S. and world economy from the double-wammy of a combination adverse supply AND adverse demand (spending) shock. To do that the Fed can’t just stand pat; and telling it to do so is offering advice which, were it taken seriously, would not harm the Fed so much as it would harm many innocent people.

A Fire-Fighting Analogy

Let’s set monetary policy aside for the moment and consider a different case: fire-fighting policy. And let’s assume, for the sake of argument, that fire-fighting is a government monopoly and that private fire-fighting companies would, if allowed to, handle it better than the government does. That of course would justify one in arguing for fire-service privatization.

But now suppose that, that argument having fallen on deaf ears, dry weather, high temperatures, and high winds cause brush fires to break out everywhere, with some threatening major population centers. Would it be prudent for those who favor fire-service privatization to recommend that the government fire-fighting crews stay put? Would it help gain support for the case for privatization? Or would it merely make proponents of that idea appear irresponsible, if not callous?

I think the question answers itself. At least, I hope it does! While we may not like the government-run fire department, so long as it’s all we have, we should insist, not that it “do nothing,” but that it try to replicate the preferred private-market outcome as well as it can.

With Fiat Money, “Doing Nothing” is Meaningless

The fire-fighting analogy only goes so far, in part because in it the meaning of “doing nothing” is straightforward. When it comes to managing fiat money, that idea has no equally clear counterpart. Even when the Fed (or any other central bank) appears to “do nothing,” it’s still engaged in monetary central planning. In particular, it’s still influencing short-term interest rates. It’s therefore also meaningless for libertarians to say that the Fed should “let markets” set those rates. Whether we like it or not, and no matter what specific actions the Fed takes, it is “the” big player in the credit market, and in the short-term credit market especially, and it couldn’t avoid influencing short-term rates if it tried.

That the Fed can’t help influencing short-term interest rates should be especially obvious in the case of its present, abundant-reserve or “floor” operating framework. Here, the Fed’s policy stance is fundamentally a matter of the values it assigns to two rates it sets directly: the rate of interest it pays on banks’ excess reserves (the IOER rate) and the lower rate it pays other counterparties in its overnight reverse-repurchase operations (the ON-RRP rate). When, for example, the Fed lowered its rate target settings just now, it also lowered each of these administered rates by 50 basis points. When the Fed adjusts its own rates, market rates tend to follow, as a simple matter of interest-rate arbitrage.

Given this description of how the Fed operates, what would it mean for the Fed to have “done nothing” today? Suppose it had left rates alone. Would that have been “doing nothing”? Hardly: it would have meant pursuing an alternative Fed plan (“central plan” if you prefer), calling for a continuation of the plan the Fed happened to implement some days ago. Nor could one say that any Fed rate settings would have been equivalent to its “not” engaging in monetary central planning. Finally, because “natural” or “neutral” interest rates (rates consistent with minimal Fed disruption of market-clearing price signals) can themselves change frequently, there’s no reason to suppose that an unchanging Fed stance is generally better than a changing one.

No Different Before 2008

I’ve said that the meaninglessness of a “do nothing” Fed policy is especially obvious nowadays. But it was also meaningless before 2008, when the Fed influenced market interest rates, not by adjusting its own, administered interest rates, but by adjusting the size of its balance sheet.

If the point seems any less obvious here, it’s because of the temptation to equate an unchanging Fed balance sheet—more particularly, its refraining altogether from either buying or selling assets in the open market—with “doing nothing.” But the temptation should be resisted. A constant Fed balance sheet under the pre-2008 regime was no less a monetary central plan then than a constant Fed interest-rate setting is today.

What’s more, it could be a particularly foolish monetary central plan. It would have been a lousy alternative to the classical gold standard, which itself allowed for steady growth in the monetary base, and thereby kept deflation within tolerable limits. Nor would it have been a wise plan in 1930–33 (cf. Milton Friedman and Anna Schwartz), or on 9/11, or in 2008. And, if we still relied on that old framework today, it would be a particularly foolish plan now.

Not Chutzpah

In observing that some monetary central plans are worse than others, I don’t mean to gloss over the difficulties of monetary central planning. Much less do I intend to suggest that I myself know the “right” plan, either now or at any time. I don’t know whether the Fed’s decision today was the best one it could have made or not. I only know that when it comes to Fed policy there’s nothing especially “free market” about sheer inertia. Allowing that the Fed’s central planning was lousy yesterday, why should its plan for yesterday be a good plan for today?

By all means, let’s keep making the case for limiting the Fed’s powers, and putting it on automatic pilot, while encouraging the development of private monetary alternatives. But let’s not suppose that we forward the case for such alternatives, or reduce the Fed’s powers and privileges, by having it do less than it might to contain a crisis. The Fed’s serious policy blunders have seldom led to any reduction in its powers in the past. On the contrary: as I pointed out some years back, at the Fed, nothing succeeds like failure.

[Cross-posted from Alt‑M.org]

This morning, upon logging in to my Twitter account, I found it brimming with reports that the Hong Kong government was about to embark upon an unprecedented experiment with helicopter money. “Helicopter Money is Here,” blurts an FT Alphaville headline. “Hong Kong Embraces Helicopter Money,” says Zero Hedge. The foreign press has also chimed in: “Helicopter Money Comincia a Hong Kong,” writes Italian financial journalist Maurizio Blondet.

In typically understated fashion, Zero Hedge’s report concludes thus:

So Hong Kong is about to unleash the mother of all stagflations on its people—who were already on the brink of massive social unrest before the virus forced lockdowns. Supply chains have collapsed, therefore there is no supply of goods or services, but demand is about to soar (thanks to free money drops from the government)…What happens to prices we wonder?

To which the correct answer is, not much—or nothing, at any rate, that can be blamed on exceptional additions to Hong Kong’s money stock. Why not? Because Hong Kong’s plan doesn’t actually involve any extraordinary growth in the supply of Hong Kong dollars. That is, Hong Kong isn’t planning to resort to helicopter money at all. Nor does its plan even come close.

Been There, Done That

This isn’t to say that the Hong Kong government isn’t planning to give away money. According to the more sober FT piece, under the proposed plan

Hong Kong permanent residents aged 18 and above will each receive a cash handout of HK$10,000 (US$1,200) in a HK$120 billion (US$15 billion) relief deal rolled out by the government to ease the burden on individuals and companies, while saving jobs.

So far so good. But what the FT fails to note is, first, that such handouts are nothing new, and, second and more importantly, that fiscal handouts aren’t the same thing as helicopter money.

Concerning the first point, far from being unprecedented, the current Hong Kong plan will be the fourth such handout there. The first was 2011’s “Scheme $6,000,” by which the Hong Kong government gave every permanent Hong Kong resident over 18 years of age that many Hong Kong dollars. The second took place in 2018, and involved handouts of up to HK$4000, while the third, with handouts twice as big as those of the 2018 amount, was announced last summer. So the only unprecedented thing about the current plan is its scale, and even that change is far from sensational.

Grounded

But the second point is more important. “Helicopter money” isn’t just another name for government handouts, whether they’re distributed by whirlybirds or not. It refers to handouts financed by new money creation rather than by either taxes or bond-financed deficits. As “Helicopter Ben” himself puts it, ” a “‘helicopter drop’ of money is an expansionary fiscal policy—an increase in public spending or a tax cut—financed by a permanent increase in the money stock.”

So, is Hong Kong planning to finance its latest handouts by printing money? No. Nor is it planning to finance them by borrowing more. Instead, it’s financing them the same way it financed those earlier handouts: with tax revenues. Specifically, it plans to finance them by drawing upon its substantial “fiscal reserve” of HK$1.1 trillion.

Hong Kong’s government is lucky enough, you see, to routinely take in tax revenues exceeding its expenditures. The difference—its annual fiscal surplus—funds its “fiscal reserve,” which is, in essence, funds it sets aside for a rainy day. That reserve of set-aside tax revenues allows the Hong Kong government to run an occasional deficit without having to either borrow more or print money. With the handout its planning for this year, it expects to run a deficit of $139 billion, or less than 13 percent of its reserves. That is, it might give away almost ten times as much and still avoid having to either borrow or print money.

A Currency-Board Twist

Some Twitter commentators wondered whether Hong Kong’s unusual currency system would itself prevent it from resorting to any genuine helicopter money plan. They wonder because the Hong Kong Monetary Authority (HKMA for short), instead of being a central bank, is a currency-board of sorts.

In an orthodox currency board, domestic currency is linked to some foreign “host” currency by a fixed exchange rate, and backed 100 percent by host-currency assets. Growth in the money stock is in turn geared to the domestic economy’s net receipts of host currency, and hence to its balance of trade surplus with the host country. In short, there’s no such thing as discretionary monetary policy, let alone a radical monetary policy experiment like helicopter money. The Hong Kong dollar is fixed to the U.S. dollar at a rate of about $7.8 to $US1. And like any currency board the HKMA is not allowed to issue Hong Kong dollar notes that are not fully backed by equivalent U.S. dollar assets. So it might appear that Hong Kong couldn’t resort to helicopter money even if it wanted to.

Only the appearance is deceiving: for the workings I just described are those of an orthodox currency board; and Hong Kong’s “currency board of sorts” is far from orthodox. That’s mainly because, instead of holding U.S. dollar assets just equal to an equivalent value in outstanding HKD banknotes, the Hong Kong Monetary Authority’s “Exchange Fund,” which manages its currency issues and manages its asset portfolio, has for some time now held U.S. dollar reserves far in excess of the value of Hong Kong’s currency stock. At latest count, they amounted to US$440.6 billion dollars, or about seven times the value of outstanding HKD banknotes! It follows that, if the government let it, the HKMA could easily finance this year’s planned handout by just creating a like value of banknotes (or, more accurately, “certificates of indebtedness” that the HKMA awards to Hong Kong’s currency-issuing banks in order to allow them to issue notes) without violating the 100 percent reserve requirement. Instead, the HKMA will probably end up selling some of its U.S. dollar assets to acquire notes with which to cash-out part of the government’s account balance with it.

***

To conclude: Far from being created “out of thin air,” to be given away, Hong Kong’s planned cash handouts have already been paid for, in full, by its taxpayers—and with plenty to spare. The handouts are nothing more than a government income-redistribution scheme, with no monetary policy implications whatsoever. Those looking for a test of the theory of helicopter money, or for an outbreak of Hong Kong hyperinflation, will have to wait longer for it. With a little luck, they’ll wait forever.

[Cross-posted from Alt‑M.org]

The winter 2020 edition of the Cato Journal is now available online! Articles in this issue discuss a range of topics—from the proper size of government, to the relationship between tariffs and monetary policy, to the life and legacy of Frederick Douglass. Below, you’ll find summaries of each article, with links to the full-text versions embedded in the titles.

“Freedom and Authority: ‘Right-Sizing’ Government,”

John Norton Moore, Professor, University of Virginia School of Law

This edition’s inaugural article begins by asking: where should we turn for answers about the proper size, and role, of government? Moore suggests that “individual exchange, or markets,” which he deems an “alternative” to government (not insofar as they are antithetical to government, but insofar as they, too, perform many similar functions essential to human flourishing) serve as “a readily available basis for answering many of the questions about right-sizing government.”

In fact, Moore believes that markets and governments can help one another perform these functions more effectively. This is partly because both are inherently vulnerable to different types of failure. His article elaborates on these, beginning with the reasons for and categories of “market failure”: issues surrounding negative (or positive) externalities; information asymmetries; literal or figurative insurance failures; monopolies; and the inability to meet the needs of disenfranchised members of society. An effective government, therefore, should augment markets “in certain areas where [they] simply will not function efficiently,” such as by providing constitutional structures, legal systems, and institutional checks that facilitate fair competition.

Moore then explores the various causes and classes of “government failure.” He notes that governments are prone to favor certain electoral groups, often at the expense of minorities, the unborn, and individuals below voting age. They also suffer from “time horizon problems” in which officials “seek to reap the benefits of public actions prior to the next election but postpone the costs as long as possible.” Then there are issues with bureaucratic rent-seeking; “overly risk-averse behavior”; the “limited legal accountability” of government institutions; and the tendency to “tax at a federal level and spend at a state level.” (Of course, many of these vulnerabilities have composites within the market. The difference is that corporations are subject to oversight from both government and consumers, who can simply refuse to patronize those firms that act disingenuously or fail to provide the services they desire.)

Just as governments can check or ameliorate the fallout from market failure, markets and citizens have a vital role to play when it comes to reducing government failure. Given the “inherent limitations on government action,” Moore determines that “where markets work it is markets that should be the choice for action rather than government. Markets, however, require government action to provide stable expectations in exchange, and to deal with areas of market failure.”

“The U.S.-China Trade War: Is There an End in Sight?”

Simon Lester, Associate Director of the Herbert A. Stiefel Center for Trade Policy Studies, Cato Institute, and Huan Zhu, Research Associate at the Center

The United States’ tense trade history with China began long before Donald Trump ascended to the office of the presidency. The authors explore this checkered relationship, beginning by establishing a connection between China’s economic liberalization and its status as a trade competitor with the U.S. After implementing a series of free-market reforms, China’s economy surged; and once it joined the World Trade Organization in 2001, it quickly came to rival the U.S. in certain trading markets.

Yet China soon began to flout both the letter and the spirit of its WTO commitments, leading both the Bush and Obama administrations to respond in very different ways. Lester and Zhu attribute the Bush administration’s “sluggish” response to its overly optimistic outlook on China’s continued liberalization; its anxieties over a potential trade war with the country; its desire to protect our corporate interests in China; and its preoccupation with both the war on terror and the global financial crisis. The Obama administration, on the other hand, took a different tack, with President Obama declaring that “other countries should play by the rules that America and our partners set,” and that “the United States, not China, should write [those rules].”

As it happened, the United States did write the rules of the Trans-Pacific Partnership (TPP)—and deliberately excluded China from negotiations. Bolstering commentators’ claims that the thrust of TPP was not so much fair trade as it was China’s “containment” as a global power, the Obama administration also imposed tariffs and brought formal complaints against China. It did, however, try—and fail—to complete “a bilateral investment treaty negotiation” with the nation.

Nor is it clear that the Trump administration will fare much better in its efforts. Thus far, President Trump’s trade war with China has concentrated mainly on the arena of technology transfer, with each side imposing escalating tariffs on the other. Although both remain engaged in bilateral trade negotiations, Lester and Zhu write that these are “focused on a narrow sub-set of issues,” since the sum total of both countries’ complaints are too “difficult to resolve all… at once.” More pointedly, they add, President Trump’s indiscriminate use of tariffs and his “general skepticism about trade liberalization may be undermining his efforts to take on China, which might go better in a coordinated approach with others.” Lester and Zhu suggest that a moderate Democrat might be more effective at concluding our current stalemate with China, first, by ending trade disputes with our allies; and then by collaborating with those allies to incentivize China’s liberalization by “filing WTO complaints against China and negotiating with China in a good faith manner.” Such negotiations, they add, will require the U.S. to at least be “willing to make concessions of our own.”

“Tariffs and Monetary Policy: A Toxic Mix”

Michael D. Bordo, Distinguished Professor at Rutgers University and Distinguished Visiting Scholar at the Hoover Institution, and Mickey D. Levy, Chief Economist for the Americas and Asia at Berenberg Capital Markets

Continuing with the theme of President Trump’s trade war with China, Bordo and Levy consider whether the recent tariffs—and subsequent uncertainties over the future of global trade—had anything to do with Federal Reserve’s repeated (and perhaps unwarranted) decision to lower its interest rate target, bringing the federal funds rate increasingly near the zero lower bound throughout the latter half of 2019. Should the Fed continue cutting rates, Bordo and Levy warn—especially given our record low unemployment rates and the stability of our markets—it will compromise its ability to “implement effective countercyclical policy in response to a future economic downturn.”

President Trump’s tariffs are hastening a global trend toward protectionist trade policy, the authors write. They discuss the monetary and economic consequences of these initial and retaliatory tariffs. Not only have they adversely affected the industries they target, they’ve heightened uncertainties across the economy, depressing overall market performance as a result. Bordo and Levy point to several models that suggest the Trump administration’s preference for tariffs correlates directly with slower worldwide GDP growth, declines in aggregate investment, and dwindling numbers of U.S. real exports. “The negative impacts of tariffs and related uncertainties on exports, industrial production, business investment, and confidence have offset the positive impulses of the Trump administration’s deregulatory and tax reform initiatives,” they write.

They also cite a statement from Federal Reserve Chairman Jerome Powell in which Powell suggests that these same trade uncertainties can shift “the appropriate stance of monetary policy.” Yet the authors warn that adjusting monetary policy in response to anticipated trade policy changes is both dangerous and beyond the proper conduct of monetary policymakers. While our current “trade barriers… impose supply constraints on productive capacity and distort global supply and distribution channels,” these consequences, though unfortunate, “are beyond the scope of monetary policy to remedy.” Any responsibility that our central bankers assume for mitigating the economic effects of a trade war can only backfire: not only is it beyond both the scope of the Federal Reserve’s policy mandate and its administrative powers to reduce the burden of tariffs, trying and then failing to do so will compromise what remains of its public trust and political independence.

“Money Market Turmoil”

Allan M. Malz, Adjunct Associate Professor at Columbia University

This article chronicles the evolution and the effects of post-crisis monetary policy. Much of Malz analysis explores the relationship between the Fed’s new Quantitative Easing (QE) powers, its policy of paying interest on banks’ excess reserves (IOER), its overnight reverse-repo operations (ON-RRPs), and the shocking spike in repo market interest rates that occurred in late 2019. The “repo market” is where banks and other investors procure overnight (or very short-term) loans using securities—such as Treasuries and Mortgage-Backed Securities—as collateral, which the borrowers agree to repurchase at a slightly higher price. Since repo loans are collateralized, they should trade at slightly lower interest rates than the overnight federal funds rate (the average rate that banks charge one another to borrow short-term liquidity). But, from 2017 onward, the repo rate trended higher than the federal funds rate, culminating in an unprecedented September 16, 2019 spike. Malz examines how the Federal Reserve’s new monetary policy regime contributed to this event, critiques its response to date, and suggests how the Fed can avoid similar episodes in the future.

The Fed’s current monetary policy regime, which Malz describes as “ad hoc” and discretionary by design, heightens market uncertainty while providing little in the way of financial stability. Today, the FOMC uses a number of discretionary tools in hopes of pegging both short-term and long-term market interest rates. Particularly concerning are the Fed’s large-scale asset purchases (another name for its QE programs), which Malz writes have “aimed, not to influence short-term rates, which… were loosely governed by interest on excess reserves (IOER), but to push down long-term interest rates.” IOER, for its part, was how the Fed attempted to avoid a commensurate crash in short-term lending after flooding the market with reserves, by enticing banks to hold some of those excess reserves in exchange for marginal interest payments. This served to sterilize large increases in base money.

By itself, however, IOER proved ineffective at “anchoring” the federal funds rate toward its target. This prompted the Fed to adopt still another tool: overnight reverse repos, which gave the Fed a new way to participate in repo lending. Combining overnight reverse repos with IOER seemed to help the Fed tighten its grip on the ostensibly market-directed federal funds rate. But even as the federal funds rate trended closer to its very low target, the repo rate spike of 2019 made it clear that the Fed’s new policy regime had created a dangerous disunion between the once-integrated federal funds and repo markets. Although the Federal Reserve had successfully pinned down the federal funds rate, which had formerly trended in a similar direction as the repo rate, it and its tools “had proven ineffective in anchoring rates in both loose and tight money markets.” The repo rate began to climb.

Malz reviews the potential causes of the repo market’s tightening: first, the Fed’s large-scale asset purchases—and its short-lived attempts to sell them back off again—created extreme fluctuations in the Fed’s balance sheet, and in turn, the supply of reserves in the money markets. Yet these fluctuations affected the repo and federal funds markets differently. Whereas the federal funds rate remained relatively steady throughout—mainly due to the cocktail of additional tools the Fed could use to manipulate it—the repo rate tightened, throwing the two formerly “integrated” markets out of alignment. Second, government borrowing has lately accelerated, leading to an influx of T‑bills in the market. More significant, however, are the “countervailing… [and] ongoing regulatory and supervisory developments” that are bidding up the repo rate. Post-crisis regulations have placed higher liquidity coverage ratios on banks, who can count both reserves and “high-quality collateral received in a reverse repo as part of the stock of liquid assets they must maintain to satisfy the liquidity coverage ratio.”

The asymmetries in the money markets as well as the uncertainties over how the Fed plans to use unconventional monetary policy going forward are causing the very volatility that the Fed attempted to avoid when it first tightened its grip on market interest rates. Malz warns that “the impossible attempt to reshape every specific feature of the financial system… has predictably resulted in myriad unanticipated consequences.” He suggests that “higher regulatory capital requirements would be a more efficient approach” to maintaining financial stability and preventing systemic collapse.

“On Targeting the Price of Gold”

George Selgin, Director, Cato Center for Monetary and Financial Alternatives

Just in time for Judy Shelton’s Federal Reserve Board confirmation hearing, Selgin revisits some of her prior comments, which some interpreted as being sympathetic to a gold standard, alongside Fed Chairman Jerome Powell’s remarks that switching to a gold price target would be unsound monetary policy. His article poses three questions: first, are Shelton and Powell referring to similar policies—would reviving the gold standard have a similar effect as implementing a gold price target? He discusses the differences between a gold standard and a gold price target, noting that gold price targeting, which would require the Fed to adjust the money supply to keep the value of paper money on par with the price of gold, amounts to something more like a “pseudo” gold standard, since a real gold standard eliminates the need for a central bank entirely.

Selgin’s second question is whether Shelton herself has ever expressly endorsed either the gold standard or gold price targeting. A review of her comments shows otherwise. Finally, Selgin examines whether targeting the price of gold would be as disastrous as Powell suggests—or how it would differ from our current, interest rate targeting regime. He presents a reduced-form regression analysis of the price of gold on the Fed’s current interest rate target, the federal funds rate, to determine “first, where the fed funds target would have had to be set at any given time to maintain a fixed value of gold and, second, how inflation and output would have responded to that rate setting.” After reviewing some methodological caveats, Selgin concludes that had the Fed tried to target the price of gold “within still-narrower bounds it would have had to tolerate much more dramatic swings in its fed funds target.”

“Real and Pseudo Gold Price Rules”

Richard M. Salsman, Assistant Professor of Political Economy, Duke University and Senior Fellow at the American Institute for Economic Research

Salsman approaches the issue on gold price targeting from a slightly different angle. A gold-price rule, he writes, would indeed require a fundamental restructuring of our central bank’s role in our economy—but that wouldn’t be a bad thing. Over the past half-century, central banks have come increasingly to “finance politics and politicize finance,” a trend that, in the U.S., accelerated after our country abandoned the gold standard. By design, fiat currency regimes render monetary policy more discretionary and increase a central bank’s vulnerability to politicization. The Federal Reserve was no exception, in Salsman’s view. He also associates the Fed’s increasingly political role with its power to monetize debt. Initially, it began doing so in an effort to help finance military expenditures during wartime, but has now become part of its strategy to “moderate long-term interest rates”—the third, and less-well-known, prong of its so-called dual mandate to achieve “maximum employment and price stability.”

Next, Salsman clarifies the distinction between “targets”—the objects of a particular policy or strategy—“tools”—the policies and strategies themselves, or the means through which a target is achieved—and “rules”—specific prescriptions about when and how to use particular tools. While the Federal Reserve certainly has its targets and tools, it lacks a precise system of rules to keep it both independent and accountable. This is problematic for Salsman, who writes: “Targets or tools… are infeasible and ineffective. …Nor do they diminish current central bank power or capriciousness.” A gold price rule, on the other hand, would do so both easily and effectively. Salsman explains that under a gold price rule, the Fed would no longer need to forecast the trajectory of its current, primary target (the federal funds rate); it would also relieve the Fed of any responsibility for planning or regulating market fluctuations (an impossible task anyhow, even under the most restrictive monetary regime). Both of these changes would dramatically constrain the Federal Reserve’s authority and limit its operations, in turn freeing monetary policymakers from political pressure and restoring the natural ebb and flow of the markets. A gold price rule would also open the doorway to currency competition and choice.

Salsman contrasts a gold-price monetary system with a classical “gold standard”-based regime (in which central banks would have to redeem their currencies in physical gold, and the private sector would be prohibited from trading in gold or issuing its own payments media.) He then describes how a gold price-based monetary system would operate today, as well as how it could regulate inflation without compromising natural market processes. Finally, he discusses what a central bank would not do under a gold price rule: it would not engage in additional open-market operations; it would not monetize government debt; and it would not pay interest on excess reserves. It would not, in short, be as vulnerable to politicization and scorn as our central bank is today.

“A Fresh Look at Central Bank Independence”

Paul Wachtel, Professor of Economics at New York University, and Mario I. Blejer, Visiting Professor in the Institute of Global Affairs at the London School of Economics

Over the past century, the concept of central bank independence (which Wachtel and Blejer abbreviate CBI) has evolved considerably. Although we continue to idealize CBI, no country has achieved a truly “independent” monetary policy regime in practice. (There is, moreover, a difference between central bank independence and central banker independence: we tend to conflate the two, but safeguarding the independence of a central bank has nothing to do with allowing central bankers to conduct monetary policy independent of any rules or oversight.)  

The authors write that our present understanding of what CBI is, and our attitude toward it, is the product of four key developments. The first were the inflationary spikes that plagued the U.S. during the 1970s. These contributed to a general sense that monetary policymakers were politically pliable, and measures needed to be taken to separate monetary policy from political expediency. The second was the influx of central banks in newly independent or transitioning countries during the latter half of the twentieth century. Many of these countries saw central bank independence as a hallmark of economic prosperity. The third was the “rational expectations revolution,” which altered the way many central bankers understood the role of monetary policy. The fourth were the increase in empirical studies that showed a correlation between high rates of CBI and low rates of inflation.

Yet CBI is undergoing a conceptual shift today. This owes partly to the global financial crisis and the additional responsibilities that central bankers have assumed for the economic recovery. Wachtel and Blejer discuss how, as a result of these changes and other factors, “CBI is a far more nuanced concept than it seemed 30 years ago.” A more “constrained” view of CBI, they write, suggests that “central banks must often work with or listen to political authorities,” especially with respect to crisis responses, which have a significantly fiscal component. But debates over the precise meaning and merits of CBI are ongoing. Central banks and elected officials have yet to determine how or whether to separate central banks’ monetary policy decisions from “other policy interventions with fiscal and distributional consequences.”

“The Phillips Curve: A Poor Guide for Monetary Policy”

James A. Dorn, Vice President for Monetary Studies and Senior Fellow at the Cato Institute

The Federal Reserve owes much of its current policy approach—and even its “dual mandate” to maintain a level of inflation consistent with maximum employment—to the Phillips curve, which suggests an inverse relationship between price inflation and unemployment. Dorn argues that the Phillips curve has been repeatedly misinterpreted, erroneously applied, and that, even if it were understood correctly, a number of factors make the original Phillips curve “a poor guide” for conducting monetary policy today. When A.W. Phillips first introduced the monetary policy world to his now-famous curve in 1958, he noted that the inverse relationship it stipulated between inflation and unemployment was a short-run correlation only. To this day, no one has demonstrated a long-run or causal relationship between inflation and unemployment. Overlooking this caveat, however, monetary policymakers have used Phillips’ observations “to believe they could fine-tune the economy by choosing a socially optimal point on the Phillips Curve”—somewhere between low employment and low inflation, or high employment and high inflation. Dorn suggests that the two are not tied to one another, but to a third lever: “changes in aggregate demand that cause changes in both unemployment and inflation.”

Furthermore, additional studies suggest that the inverse correlation between inflation and unemployment is only stable “under fixed exchange rates which… anchor inflation expectations.” That the Phillips Curve is an unsuitable barometer for monetary policy has been proven time and time again, Dorn demonstrates; notably, during the “stagflation” episodes of the 1970s, when in Peter Ireland’s words, “the Federal Reserve’s efforts to exploit that Phillips curve led… not to lower employment at the cost of higher inflation but instead to the worst of both worlds: higher unemployment and higher inflation.” Dorn also reviews what Milton Friedman called the three stages of the Phillips curve. The initial, short-run, inverse correlation between inflation and unemployment precedes the second stage, in which the Phillips curve maintains its shape but adjusts its position. That is, “an increase in inflation… temporarily reduces unemployment below its long-run ‘natural level’”. Once workers and employers recognize this higher inflation rate, however, they change their behavior, unemployment returns to its ‘natural’ rate and the Phillips curve adjusts accordingly. This is because, as Alan Meltzer writes, “any influence of nominal variables [e.g., prices] on real variables [e.g., employment] last[s] only as long as it takes markets to learn and adjust.”

The third stage, per Friedman, pertains to the long-run Phillips curve, which by that point ceases to be a curve at all but becomes instead a vertical line—followed by a positively sloped Phillips curve. According to Friedman, sustained inflation, albeit at variable rates, “plants the seeds for higher future unemployment by distorting relative prices and increasing ‘regime uncertainty,”’ which has a chilling effect on economic productivity.

During the Great Moderation, both inflation and unemployment dropped, further throwing into question the validity of the Phillips curve. More likely, as Dorn and other experts suggest, aggregate demand—which may be partly influenced by inflation expectations, and partly by myriad other factors—is a better determinant of unemployment. Yet the Phillips curve remains a tempting distraction for central banks, who continue to use it to determine how to adjust monetary policy according to their economic projections. Dorn suggests revising our present monetary policy framework by replacing the present dual mandate (“which is flawed by assuming a tradeoff between inflation and unemployment”) with a single directive to keep NGDP on a stable path. By doing so, the Fed would cease to gamble its monetary policy decisions on the accuracy of a decades-old model, and in turn, “increase the credibility of monetary policy, reduce regime uncertainty, mitigate business fluctuations, and avoid stop-go monetary policy.”

“The Transportation-Communication Revolution: 50 Years of Dramatic Change in Economic Development”

Joseph Connors, Assistant Professor of Economics at Florida Southern College, James D. Gwartney, Gus A. Stavros Eminent Scholar Chair at Florida State University, and Hugo M. Montesinos, Assistant Professor of Statistics at Ursinus College

While the Industrial Revolution ushered in rapid and unprecedented improvements in technology, the economy, and the lives of millions, its immediate impact was still only felt by a small handful of the world’s population—about 15 percent. Over the past 50 years, however, we have witnessed what Connors, Gwartney, and Montesinos call the “Transportation-Communication Revolution,” marked by far more dramatic—and much further-reaching—changes in global technology, infrastructure, and productivity. The authors review the factors leading to and resulting from this second economic revolution, and compare it favorably—in terms of its scope, impact on trade, and effects on global wealth inequality—to the Industrial Revolution of the 18^th and 19^th centuries.

The extensive data series that Connors, Gwartney, and Montesinos provide in their article show a dramatic 50-year spike in worldwide income and per capita GDP, which they attribute to the past half century’s “huge reductions in transportation and communication costs.” These have catalyzed four major economic shifts, each of which has had a disproportionately positive impact on developing countries. First, the authors discuss the significant advancements from “large increases in international trade”; second, the “higher rates of entrepreneurship and expanded opportunities [especially for lower-income countries] to borrow successful technologies and business practices from high-income countries”; third, the improvements “in economic freedom”; and finally, “the virtuous cycle of development,” whereby innovation begets further innovation.

The authors’ multiple regressions and empirical analyses show that “measured in real dollars, the size of the international trade sector was 44 times higher in 2017 than it was in 1960.” What’s more, these additions to the international trade sector came mainly from lower-income countries. The advantages of increased and freer trade have brought these lower-income countries’ real per capita GDP up at a rate nearly double that of higher-income countries. The authors contrast this with the Industrial Revolution, which predominately affected countries that were already well-developed or comparatively wealthy. The Transportation-Communication Revolution, on the other hand, has had a much more extensive reach, and its benefits have been most palpable in new or lower-income countries and markets. “As a result,” the authors write, “worldwide income inequality has declined sharply in recent years.” Their data are a testament to the fact that reduced costs and freer trade have exponentially positive effects on the productivity—and the livelihoods—of newer entrants into the global marketplace.

“The Effect of War on Economic Growth”

Clifford F. Thies, Chair of Free Enterprise and Professor of Economics and Finance at Shenandoah University, and Christopher F. Baum, Professor of Economics and Social Work at Boston College and Research Fellow at the German Institute for Economic Research

Conventional wisdom holds that war stimulates economic activity. This perspective comes from the fact that measures of employment and income tend to rise along with weapons and munitions manufacturing. But as Thies and Baum demonstrate, the relationship between “war” (which is itself difficult to qualify) and per capita GDP is not so clear-cut. Although wartime manufacturing can reduce unemployment, it often results in the destruction of both human and material capital. It also stifles trade and can reduce investment in new products and services. To date, no clear-cut method has been developed for measuring the true cost of war on per capita GDP. The authors therefore address the question of how per capita GDP changes, both during and after wartime, conducting an extensive quantitative analysis that uses different data sets’ definitions of war and other violent conflicts. Their panel data measure changes in multiple countries’ GDP per capita over consecutive five-year periods ranging from 1955 to 2015. The results show that high-magnitude wars and coups “lower per capita GDP significantly”; that “political instability [in general] depresses economic growth”; and that “economic freedom… [has] a significant, positive effect on per capita GDP.”

The authors’ findings deviate from prior research in that theirs suggest that war has a negative impact on economic growth. They attribute the originality of these results to the fact that national income accounting “ignores the loss of lives and the destruction of physical and human capital associated with war. Moreover, resources devoted to war are treated [in most studies] as final goods or services instead of as costs of production.” Since “war and other forms of armed conflict should be considered a major impediment to the economic development of low-income countries,” the authors’ conclusion provides an overview of several policy alternatives aimed at conflict resolution.

“Frederick Douglass and the American Dream”

Timothy Sandefur, Vice President for Litigation at the Goldwater Institute and Chair in Constitutional Government

Based on remarks delivered at Reason magazine’s “Reason Weekend” in March 2019, Sandefur’s article gives a compelling account of Frederick Douglass’ life and legacy, concentrating especially on how Douglass’ wisdom bears on contemporary race relations, debates over the meaning of freedom and the validity of the American dream, attitudes toward self-determination, and interpretations of the U.S. Constitution.

Sandefur devotes much of his article to comparing Douglass’ personal and political philosophy—which aimed at the realization and perfection of our constitutional principles—to the philosophies of past and present civil rights advocates, especially Ta-Nehisi Coates and others who disavow America’s founding documents and institutions as inherently racist. Contrary to what these contemporaries—both Douglass’ and our own—suggest, Sandefur argues that Douglass’ life epitomizes the American Dream, and that his achievements provide a stirring testimony to his conviction that America is exceptional precisely because its founding principles necessitated the eventual abolition of slavery and the death of racial injustice. Sandefur concludes by discussing precisely why it remains incumbent upon Americans to share Douglass’ legacy with one another as they confront contemporary questions about civil rights, equality, and the battle between liberty and the false flag of nihilism.

Speaking to NYU’s “Money Marketeers” last week, Randy Quarles, the Fed’s Vice Chair for Supervision, shared his views on Fed policy, and particularly on steps he thinks the Fed should take to reduce the size of its balance sheet.

Perhaps better than anyone else at the Fed, Mr. Quarles understands the role that liquidity requirements play in propping-up banks’ demand for excess reserves, and how those requirements foiled the Fed’s attempt to get the quantity of such reserves substantially below its crisis-era peak.

Rather than accept that defeat, Mr. Quarles wants the Fed to try again, after first doing something to reduce banks’ demand for reserves. Reducing the Fed’s balance sheet, he says, is worth the effort because it will ultimately make its policies more credible:

Although I fully support the FOMC’s current plan to purchase Treasury bills and increase the size of the balance sheet in the very short term, over the longer-term, I believe that the viability of balance sheet policies is enhanced if we can show that we can meaningfully shrink the size of the balance sheet relative to gross domestic product following a recession-induced balance sheet expansion. In effect, I believe that balance sheet policies are more credible if we can show that there is not a persistent ratcheting-up effect in the size of the Fed’s asset holdings.

Abundant, but Finite, Reserves

The danger to which Mr. Quarles refers, if only vaguely, is one that BPI’s Bill Nelson has repeatedly emphasized, namely, that unless something is done to reduce banks’ appetite for excess reserves, they might gobble-up as many reserves as the Fed tosses their way, and still end up crying for more. “Such a dynamic,” Bill told a packed house at Brookings last December, “led the Norges Bank (the central bank of Norway) in 2010 to switch from a system with abundant reserves to a system with more scarce reserves.” As Norges Bank officials explained at the time,

When Norges Bank keeps reserves relatively high for a period, it appears that banks gradually adjust to this level…With ever increasing reserves in the banking system, there is a risk that Norges Bank assumes functions that should be left to the market. It is not Norges Bank’s role to provide funding for banks…If a bank has a deficit of reserves towards the end of the day, banks must be able to deal with this by trading in the interbank market.

Where Mr. Quarles differs from his Norges Bank counterparts is in holding that the Fed can shrink its balance sheet without abandoning its abundant reserves (or “floor”) operating framework. For him, as for most Fed officials, the Fed’s announcement early last year that it planned to stick to a floor system might as well have been chiseled on a stone tablet. “As the FOMC announced in January of 2019,” Quarles says, “the Committee intends to implement monetary policy in an ample-reserves regime.” In light of events since last January, this digging-in of official heels seems imprudent, to say the least. Yet it’s an all too common Fed practice, to which Fed officials are all the more inclined to resort when they have good reason to doubt the merits of some past decision.

Though Mr. Quarles rules out any alternatives to a floor system, he at least wants a floor system that keeps banks from becoming excess reserve junkies. In explaining how to limit banks’ appetite for excess reserves, he harkens back to something he said at a Hoover Institution conference back in May 2018. Asked by the very same Bill Nelson quoted earlier whether “despite how the LCR [Basel’s Liquidity Coverage Ratio requirement] is written, banks are told that they have to meet a material part of their high-quality liquid assets requirements with reserves,” Mr. Quarles answered that “I do know that that message has been communicated at least in some supervisory circumstances in the past. I would say that that’s in the process of being rethought.”

Evidently, despite last year’s repo-market turmoil, the Fed’s rethink has still not gone far. Hence Mr. Quarles’ New York remarks urging it forward.

I think it is worth considering whether financial system efficiency may be improved if reserves and Treasury securities’ liquidity characteristics were regarded as more similar than they are today—that is to say, that reserves and Treasury securities were more easily substitutable in the context of liquidity buffers. … I want to explore options that would maintain at least the level of resilience today while also facilitating the use of HQLA beyond reserves to meet the immediate liquidity needs projected in banks’ stress scenarios.

Assume a Can-Opener Reliable Lender of Last Resort

The option Mr. Quarles prefers is that of having banks and their supervisors “assume” that the Fed stands ready to “provide liquidity to bridge the monetization characteristics of HQLA [High Quality Liquid Asset] securities versus reserves”:

If firms could assume that this traditional form of liquidity provision from the Fed was available in their stress-planning scenarios, the liquidity characteristics of Treasury securities could be the same as reserves, and both assets would be available to meet same-day needs.

Which brings us to the main shortcoming of Mr. Quarles’ remarks. For he proposes no actual changes to the Fed’s long-standing last-resort lending arrangements. Instead, he appears to consider those arrangements, and the Fed’s discount window in particular, adequate. The problem, he suggests, isn’t institutional: it’s psychological. The change that’s needed is a change in the beliefs of Fed supervisors and the bankers they supervise. Instead of treating Treasurys as less-than-perfect substitutes for reserves, they should assume henceforth that they can and will “rely on the Fed’s discount window” to make those assets practically identical whenever markets become stressed.

But this solution begs the question: assuming that bankers and their regulators can be coaxed into taking such a leap of faith, would their doing so be prudent? If experience counts for anything, the answer to that question is a resounding “no.”

The Stigma Problem

The rub is the notorious “stigma problem”—bankers’ reluctance to take advantage of the Fed’s discount window loans for fear that doing so will cause people to suspect that they’re in hot water. Though the problem has been around much longer, it became notorious during the last financial crisis. During that crisis, Ben Bernanke explains in his memoir, “banks were reluctant to rely on discount window credit to address their funding needs” because they worried that the word would get out, and that that would “lead market participants to infer weakness.” If that happened a bank’s normal funding sources could dry. Worse than that, it could suffer a run.

Proving that the stigma problem is real can be difficult, for there are all sorts of reasons why a bank might resist borrowing from the Fed. But in December 2007 the Fed set up an emergency facility—the Term Auction Facility—specifically designed to be a stigma-free alternative to the discount window. So, it’s possible to gauge the severity of the discount window stigma by comparing its popularity with that of the newer facility, and especially by noting the extent to which banks turned to the TAF even when that meant paying more interest than the Fed’s discount windows would have charged.

Several years ago, Olivier Armentier and his coauthors did just that. And they found that the stigma problem was indeed severe. First of all (as the figure below, reproduced from an article by Atlanta Fed economist Larry Wall, clearly shows), while the TAF became an instant hit, banks remained reluctant to borrow from the discount window throughout the crisis. Just as importantly, “more than half of the TAF participants submitted bids above the DW [discount window] rate.”

On the basis of these findings, Armentier and his coauthors conclude that

Although the DW may still have a role to play as an emergency lending facility when a bank cannot find financing in the market for occasional and idiosyncratic reasons, one may question the ability of the DW as a channel to supply liquidity to a broad set of banks after a systemic funding shock.

Nor is there any reason to suppose that the stigma problem has gone away since the last crisis. On the contrary: thanks to a provision in the 2010 Dodd-Frank Act compelling the Fed to publish bank-specific data on its discount-window operations after a two-year lag, it seems to have gotten worse. Discount window borrowings have been considerably lower during the last decade than they were in the years leading to the financial crisis (see here), with recent figures the lowest on record. Most significantly of all, as David Benoit reported last November in the Wall Street Journal, discount window borrowings didn’t increase much when repo rates spiked last September. Yet that spike was an example of just “the kind of stress the discount window is designed to ease.”

Mr. Quarles instead thinks the stigma problem exaggerated. “While there has long been discussion about how the discount window is ‘broken’ because of stigma about using it,” he says,

we know it is still an important part of firms’ contingency planning and preparations. Banks currently pledge over $1.6 trillion in collateral to the discount window, which means that banks have gone to the trouble of working with their local Reserve Bank to make sure they have access to the window, if needed, and they have set aside a portion of their balance sheets as collateral to do so.

This is far from compelling. Experience shows rather that, while many (though hardly all) banks pledge collateral with their reserve banks, they may do so only in case they must borrow from the discount window for those “occasional and idiosyncratic reasons” to which Armentier et al. refer. They may have no intention of using the discount window otherwise. Since roughly half of the collateral banks pledge for primary credit borrowings consists of low opportunity cost commercial and consumer loans, such discount-window insurance comes cheap.

A Stigma-Free Alternative

If the discount window’s stigma problem can’t simply be waved aside, the Fed needs to take seriously Armentier et al.‘s conclusion that it

complement the DW by designing new “stigma proof” facilities specifically aimed at supplying liquidity to the entire banking sector. This is precisely what the Fed did when it created the TAF. Similarly, the BoE recently adopted a twofold approach: a DW for meeting idiosyncratic liquidity shocks, and a contingency liquidity facility activated in response to exceptional market-wide stress.

While it’s tempting to suppose that a revived TAF might solve the problem, things aren’t so simple. Instead of standing ready to lend to any bank at any time, the TAF supplied funds only during auctions held once every two weeks. It also took three days to actually credit the funds to winning banks’ accounts. For these reasons alone, it might not be of any use to a bank facing a genuine stress scenario. The TAFs auction-determined rates based on fixed credit allotments would also render it useless as a means for policing the upper limit of the Fed’s overnight target range.

What the Fed could really use is a full (that is, unlimited) allotment, fixed rate standing facility that’s also stigma-free, for unless it’s so banks might still be willing to borrow on the private market for more than the Fed’s upper rate limit, thereby causing the Fed to miss its target, much as it did last September.

Is it possible to design such a facility? In a note written several years ago, the Atlanta Fed’s Larry Wall expressed his doubts.

The original TAF was not designed to set an upper bound on overnight rates. If the Fed wanted to establish a new TAF that would be effective for monetary control, several changes would have to be made in the new facility. First, the new TAF would need to provide funds at a fixed rate if it were to set an effective upper bound on short-term rates. Additionally, the new TAF would have to provide for full allotment, that is, every bank would have to get the full amount of its request—otherwise, it would need to buy funds at the elevated market rate. Finally, if the new TAF were going to set a limit on overnight rates, it would need to be available every day and would have to settle the same day as the auction. In other words, the new TAF would have to operate just like primary credit if it is to set an effective ceiling on short-term rates. But if a new TAF were set up with the same terms as primary credit, it would seem to be just as vulnerable to stigma as primary credit.

The SRF Alternative

If Wall’s “new TAF” won’t answer, could the Standing Repo Facility (SRF) proposed by Jane Ihrig and David Andolfatto, which resembles that idea in many respects, do so? Ihrig and Andolfatto believe it could. In particular, they say it “would not suffer from stigma problems that make the discount window an ineffective tool in these circumstances.”

Why not? Although the proposed SRF wouldn’t possess the same stigma-reducing features as the TAF, it has other features that might serve just as well. For starters, instead of lending at a “penalty” rate, the SRF would supply funds at a rate only slightly above the Fed’s target-range upper limit. Discount window loans, in contrast, are made at rates substantially above that limit—at present the surcharges are 50bps and 100 bps for primary and secondary credit, respectively. The lack of a penalty rate would prevent anyone from inferring that firms taking advantage of the SRF are doing so because they’re desperate. The SRF would, in other words, avoid the “adverse selection” problem that gives people a reason to doubt the soundness of any firm that borrows at above-market rates. The SRF’s modest rate premium would also make it more tempting for banks to plan on using it in drafting their living wills.

But there’s perhaps a more important reason why the SRF would not stigmatize banks that take advantage of it. Because it exists in part to enforce the Fed’s rate target upper limit, while charging a rate slightly above that limit, it would become active only at times when reserve-market stress causes private-market overnight rates to reach the Fed’s target upper limit: at other times banks needing cash in a hurry, including large banks that have filed resolution plans, would be better-off swapping Treasurys for cash in the private repo market. But once private market rates do reach the SRF rate, any bank might find it economical to borrow from the SRF. The presence of a substantial number of borrowers, borrowing at rates that actually carry no real penalty at all, would further help to avoid a stigma problem, if not to eliminate it altogether.

Nor are these the only reasons why an SRF might be stigma-free. According to Bill Nelson (him again!), the fact that the SRF would probably accept only Treasurys and other first-tier HQLA’s as collateral would also help to render it stigma-free, since any “bank that has Treasury securities available to secure a loan from the Fed is unlikely to be a bank experiencing liquidity pressures.” Also, although SRF “transactions would be subject to the same two-year disclosure requirement as discount window loans,” they “would be provided under Section 14 of the Federal Reserve Act, which authorizes monetary policy operations, rather than section 10B, which authorizes discount window advances” and to that extent would resemble the temporary repo operations the Fed once routinely engaged in with primary dealers, which bore no stigma on account of them. (Nor, one can now add, do any of the banks that have participated in the Fed’s recent, ad-hoc repo operations appear to have feared being stigmatized by doing so.)

If It Ain’t Broken…

Why doesn’t Mr. Quarles consider the SRF alternative? Actually, he does: instead of having banks rely on the discount window, he says,

Another approach could be to set up a new program or facility: For example, there has been much discussion among market participants, as well as policymakers, about the potential benefits of setting up a standing repurchase agreement, or repo, facility for banks and how such a facility could improve the substitutability of reserves and Treasury securities for these firms.

However, Quarles adds that “While this option is still of interest, there may be benefits to working first with the tools we already have at our immediate disposal.”

Considering all the new tools the Fed has toyed with since the onset of the last crisis, one might find Mr. Quarles’ stance refreshing. I fear, however, that he has chosen the wrong occasion on which to put a kind word in for old-fashioned bureaucratic inertia. For in this case any potential gains from sticking to the Fed’s old toolkit are far outweighed by the potential costs of having to rely upon a tool which, if it isn’t quite “broken,” is too close to it for comfort.

[Cross-posted from Alt‑M.org]