Today was a busy day for financial regulatory policy. In the morning, the Department of the Treasury released its long-awaited report on nonbank financials, fintech, and innovation. A few hours later, the Office of the Comptroller of the Currency announced that it will start taking applications for a special purpose charter for “fintech companies engaged in the business of banking.”

Over the eighteen months since President Trump signed an executive order outlining the core principles for financial regulation under his watch, the fintech sector has been gripped by policy uncertainty and the looming threat of regulation by enforcement. Today’s events bring much-needed clarity on the Trump administration’s outlook for financial innovation, and the likely way forward.

At 222 pages, the Treasury report is a mammoth document. However, in grappling with the chief ailments of the U.S. financial regulatory framework, the report starts a discussion that will hopefully lead to major revision of existing rules and regulatory approaches.

Three problems afflict the current edifice of the financial regulatory system. Firstly, it was largely designed at a time when most of the technologies that are changing financial services provision did not exist. Secondly, there is a great deal of fragmentation, both horizontal—with rulemaking, supervisory, and enforcement power dispersed across many federal agencies—and vertical—with competences distributed between states and the federal government. Thirdly, it is by design a precautionary system, focused on protecting consumers at all costs, often at the expense of beneficial innovation.

Comprehensively addressing these three problem areas will take more than a sympathetic attitude from the executive. However, the report helpfully points the way forward in seven areas.

1. Clarity about how financial providers talk to consumers

The rules governing communications between financial providers and their customers stem from the Fair Debt Collection Practices Act (FDCPA) and the Telephone Consumer Protection Act (TCPA), passed respectively in 1977 and 1991. Unsurprisingly, both laws fail to take account of the increasing reliance on text and email communication via smartphones—and the Federal Communications Commission has given a wide interpretation to statutory provisions, constraining providers’ ability to reach their customers using new media. The Treasury report finds that the reach of current regulations is overly broad, an assessment vindicated by recent court rulings. It recommends changes to the FDCPA and TCPA to make it easier for consumers to revoke consent to be contacted. It also calls for greater clarity about the ways in which providers can reach consumers and the information they can disclose over email and voicemail services.

2. Data access and use by fintech firms

More people are making use of technology platforms for budgeting, saving, investment, and debt management. Enabling fintech applications to gain access to one’s financial data can improve consumer welfare by making it easier and cheaper to refinance loans, manage bank accounts, and learn about suitable new financial products. But banks and other established financial firms are reluctant to give access to customer data to third parties—partly because it is a competitive threat but also because it can compromise the confidentiality of those data, for which banks could be found liable. The Treasury report calls for increased efforts to improve data aggregation. It favors private-sector action and standardization of applications to make data-sharing easier and more secure but doesn’t rule out federal standards.

3. Credit scoring

One of the key ways that financial innovation is improving consumer welfare is by helping to model risk and predict default in more accurate ways. This lowers the cost of credit and expands access to marginal borrowers. For instance, a recent Federal Reserve paper finds fintech credit scoring to lead to better default estimates and lower interest spreads than FICO scores. The Treasury recognizes the value of alternative data use for better credit scoring, but it is wary of potential discrimination. Growing empirical evidence, on the other hand, suggests that better outcomes can be achieved without undermining equal treatment laws.

4. Harmonizing or federalizing money transmitter and nonbank lender licensing

As Brian Knight from the Mercatus Center has discussed at length, a key weakness of existing financial regulation is its fragmentation across states. The Treasury is aware of the onerous licensing and compliance costs that such fragmentation imposes on providers, and its report encourages voluntary harmonization by states, via passporting rules. If states cannot achieve the requisite degree of equivalence, the Treasury advocates federal action. Given New York’s fierce opposition to any perceived dilution of its financial rules, it looks like federal preemption will come sooner or later. Federalization would foreclose healthy regulatory competition, but in light of the operating costs imposed by fragmentation, the trade-off may redound to the benefit of consumers.

5. Codifying valid-when-made for banks and nonbank lenders

Legal precedent for two hundred years has established that, if a loan extended by a national bank did not violate usury laws at the time or location of its issue, then it is valid at a subsequent time and location within the United States. More recent judicial decisions have expanded the application of this doctrine to nonbanks, but a recent case involving defaulted credit card debt questioned the principle, throwing interstate marketplace lending into disarray. The Treasury rightly calls on Congress to codify the valid-when-made doctrine. In fact, the House already passed a bill that does exactly that.

6. Rescind the BCFP’s payday rule

Nobody likes high-cost short-term credit, but the accumulated evidence—contrary to popular wisdom—shows that payday loans serve many customers much of the time—especially those with urgent need for funds and no access to alternatives. Despite this evidence, the Bureau of Consumer Financial Protection (BCFP) under its previous director sought to apply new rules on payday lenders that would have required them to verify the borrower’s ability repay. These checks would be inappropriate precisely because payday loans are a last-resort emergency product, meaning that some non-negligible proportion of borrowers will indeed end up not paying them back. That makes payday loans costly to extend, but it does not mean they do not help the typical borrower. The Treasury recommends that this draconian BCFP rule be rescinded. Instead, the emphasis should be on removing regulation to encourage a broader spectrum of lower-cost small-dollar products provided by banks and nonbanks alike.

7. Adopt regulatory sandboxes as a spur to innovation

Existing rules aiming to protect consumers may not pose a threat to established institutions, but they do raise barriers to entry for challenger firms, reducing competition. A pragmatic way to maintain existing protections—even though the case to do so is often dubious—while encouraging innovation is to allow for regulatory sandboxes: in which new firms can begin operations under regulatory supervision, but without being subject to the full corpus of regulation. Leading financial jurisdictions such as Britain and Singapore have implemented sandbox programs. The Treasury report calls for similar policies from U.S. regulators, and, if needed, congressional action to facilitate innovation and preempt state barriers. While the sandbox approach eschews the broader question of whether existing rules are appropriate, it almost surely will improve the environment for innovators.

The above is not a comprehensive discussion of the report, but a summary of its key proposals. The tenor of the Treasury’s recommendations is laudable and many of the specific reforms much-needed. However, perhaps the thorniest of issues goes unmentioned, namely, whether the sheer number of regulators and regulatory restrictions placed on financial services firms is making the financial services industry less dynamic and innovative than it could be. That is the question underlying present efforts, however modest, at regulatory relief for banks, nonbank lenders and new players such as cryptocurrency issuers and exchanges.

The tone of the Treasury’s report suggests an answer, but it remains to be seen whether executive and legislative action will measure up to the challenge.

[Cross-posted from Alt‑M.org.]

In February 2018 Agustin Carstens, the General Manager of the Bank for International Settlements in Basel, gave a speech at Goethe University in Frankfurt entitled “Money in the digital age: what role for central banks?” The speech quickly became notorious in the cryptocurrency community for its brusque dismissal of Bitcoin and other cryptoassets. Among other things, Carstens there called Bitcoin "a combination of a bubble, a Ponzi scheme and an environmental disaster." A combination? One may judge the price of Bitcoin a bubble, but there is no other sense in which Bitcoin is a “Ponzi scheme.” The BIS being the central bankers’ bank, crypto supporters in response mocked Carstens for merely representing the interests of national fiat currency monopolies in quashing potential competitors.

More recently Carstens gave an interview to a Swiss periodical, available in English translation on the BIS website, in which he reiterated his anti-cryptocurrency position. “It's a fallacy to think money can be created from nothing” was one of the oddest claims he made there, given that fiat monies are closer than cryptocurrencies are to being gratuitously created. This interview too has provoked criticism from crypto defenders.

Overlooked in the debate over Carstens’ dubious statements about Bitcoin and cryptocurrency have been the dubious statements he makes about historical forms of private money. I want to shine some critical light on those statements.

Early in the speech, Carstens (p. 1) declares: “Experience has also shown that to be credible, money requires institutional backup, which is best provided by a central bank.” Best by what criteria? The dollar hasn't been better under the Federal Reserve than it was under the classical gold standard with private banknotes. The experience of other countries under fiat monies has been even worse than that of the United States. Central banks have brought higher inflation rates, higher price level uncertainty, and higher resource costs of the monetary system. They have diminished fiscal discipline. Floating rates have diminished the gains from international trade and cross-border investment. (For the evidence behind these summary contrasts see Selgin, Lastrapes, and White (2012).)

Carstens (p. 2) states: “Money is an IOU, but a special one because everyone in the economy trusts that it will be accepted by others in exchange for goods and services. One might say money is a ‘we all owe you’.” But this is a nonsensical use of terms. A fiat dollar is not an IOU or a “weOU;” a gold coin is not an IOU or a weOU. An IOU specifies the number of units to be repaid. By contrast, a fiat dollar or a gold coin does not entitle the hold to any specific quantity of any good or service. The future purchasing power is not pre-determined. It will depend on spot prices prevailing at a future date.

Carstens correctly notes (p. 2) that “many things have served as money.” He gives some examples and provides pictures of them. But in the next paragraph (p. 3) he curiously declares: “Common to most of these examples is that the nominal value of the items that have served at one time as money is unrelated to their intrinsic value.” Most of his examples (4 of 6) are commodity monies. The claim that “the nominal value … is unrelated to their intrinsic value,” while true for fiat monies, is false for commodity monies. A full-bodied gold coin (one of his examples) normally has a nominal value in proportion to its gold content.

Surprisingly, Carstens even gets wrong the details of a non-profit community currency project in his native Mexico, called the túmin. He describes it as “a local currency circulating (illegally) for some time around 2010 exclusively in the Mexican municipality of Espinal.” A little Googling reveals, however, that the túmin is still circulating in 2018, and has spread beyond its town of origin to 16 states of Mexico’s 32 states.

In a section of his speech entitled “What constitutes good money?,” Carstens goes seriously off track. He says this (p. 5) about the history of private money: “Over the ages, many forms of private money have come and gone. … While some lasted longer than others, most have invariably given way to some form of central bank money. The main reason for their disappearance is that the ‘incentives to cheat’ are simply too high.” Even putting aside the incoherence of the expression “most have invariably,” this is far from an accurate account of why legislatures granted central banks monopolies in money issue. The view that fraud (“wildcat banking”) was endemic to open-entry private note-issuing systems, and that the United States experience demonstrated this as Carstens believes (p. 6), was once popular. Even such a free-market stalwart as Milton Friedman subscribed to it in his 1960 Program for Monetary Stability. After examining later-published evidence on free banking episodes, however, Friedman and Schwartz (1986) realized that prevalent wildcat banking was a myth, accurately summarizing the facts this way: “Historically, producers of money have established confidence by promising convertibility into some dominant money, generally, specie. Many examples can be cited of fairly long-continued and successful producers of private moneys convertible into specie.” Dr. Carstens should begin to catch up with the literature and read the historical studies cited by Friedman and Schwartz.

While it is true, as Carstens notes, that banknotes did not circulate a par nationwide in the United States during the antebellum period, the reason was not fraud but government interference in the form of legal restrictions against interstate branching. Nationwide par circulation was the norm where banks were free to branch, as in Canada and Scotland. When Carstens (p. 7) refers to “the unhappy experience with private forms of money” he ignores the facts. When he suggests that “the experience with currency debasement that has peppered history” should warn us against “the proliferation of such private monies,” he inverts the facts. Currency debasements have been symptomatic of government monopoly in currency, not of private competition. A central bank with a monopoly on currency issue can debase the currency. A single bank in a multi-issuer system cannot, neither legally nor practically. As Adam Smith noted, the greater the proliferation of private note-issuers, the lesser the consequence to the public of the failure of any one of them. The system is robust. A central bank monopoly, by contrast, is a fragile single point of failure.

Lately the old-timers here at Cato’s Center for Monetary and Financial Alternatives — which is to say, Jim Dorn and I — have been talking a lot about the Phillips Curve, which seems to be playing a part in monetary policy discussions today almost as big as the one it played in the 1970s. And you can bet that, because both Jim and I actually remember what happened in the 70s, and afterwards, neither of us has a good word to say about the concept, except as a very reduced-form means for describing very transient relationships.

Because Jim has a CMFA Policy Briefing on Phillips Curve reasoning in the works, I won’t belabor here his — and my — general objections to it. My main concern is to draw attention to a current example of that reasoning at work, in the shape of a recent New York Times op-ed by Jared Bernstein, entitled “Why Real Wages Still Aren’t Rising.”

Noting that, despite the low and still falling U.S. unemployment rate, real wage rates for workers in factories and the service industries have been stagnant for several years. Mr. Bernstein finds this stagnancy puzzling: According to the BLS, he writes, as of this June money “wages” (presumably meaning hourly wage rates) grew at an annual rate of 2.7 percent, whereas “looking at the historical link between wages and unemployment, wage growth should have been rising about a percentage point faster.” The “historical link” to which Mr. Bernstein refers is based partly on the Phillips Curve — a negative relation between the unemployment rate on one hand and the rate of either nominal “wage” or price inflation on the other — and partly on the historical tendency for the rate of nominal wage inflation to exceed that of price inflation. In the present instance, prices have failed to rise as rapidly as the decline in unemployment suggests they should, while wages — factory workers’ wages especially — have been rising still less rapidly.

How to account for this recent failure of reality to conform to the implications of the Phillips Curve? For Mr. Bernstein, this development

is mainly the outcome of a long power struggle that workers are losing. Even at a time of low unemployment, their bargaining power is feeble… . Hostile institutions — the Trump administration, the courts, the corporate sector — are limiting their avenues for demanding higher pay.

Eventually Mr. Bernstein also points a finger at “the increased concentration of companies and their unchecked ability to collude against workers.”

We’ve No Need for These Hypotheses

The least unfavorable thing that can be said about such shadowy conjectures is that one ought not to resort to them without first exhausting more prosaic possibilities.

To his credit Mr. Bernstein himself recognizes one such possibility: the well-known, general slowdown in productivity growth since the recession, which he allows to have placed “another constraint on wages.” He recognizes as well the possibility that the recent Trump-initiated trade war may have exacerbated the decline, though he dismisses it on the grounds that “ ‘final products’ — things that consumers buy versus intermediate materials used for production — have so far been spared.” Here Bernstein is surely mistaken: when intermediate materials get more expensive, so do final products produced at home. Yet the trade war does nothing to boost nominal wages. So real wages may already have been adversely affected, not by a Trump administration anti-labor conspiracy, informed by its hostility to ordinary workers, but by one of that administration’s avowed policies, informed by its ignorance of rudimentary trade theory.

In fact, as we’ll see, the general decline in productivity since the Great Recession and the more recent trade war are alone quite capable of accounting for a considerable decline in the once substantial difference between the rate of wage inflation and that of output price inflation, and hence in the growth rate of real wages.

A Phillips Curve Refresher Course

Any historical Phillips Curve relationship is just that: a historical relationship. Whatever it was then, it may have shifted around since. Consequently a decline in real wages that might, for any given Phillips Curve relationship, point to a weakening of the labor market, may point to other developments, including declining productivity, when the (short run) Phillips Curve itself has been on the move.

To overlook the ever-shifting nature of Phillips Curves is to neglect something that was driven home, painfully, to an entire generation of economists during the 1970s, as they witnessed the baneful consequences of attempts to exploit the “historical link” between inflation and unemployment represented by the 1960s vintage Phillips Curve. In particular, it’s to neglect the fact that any short-run Phillips Curve relationship depends on some underlying state of aggregate supply. When that state changes, either because workers come to anticipate future inflation, as they did in the 70s, or because productivity declines, as it has recently, the former Phillips Curve breaks down, and a new one takes its place.

For the sake of readers seeking a more explicit explanation of the logic behind naive Phillips Curve reasoning, and why such reasoning goes awry when Phillips Curves don’t stand still, I offer here a quick review, starting with some simple supply and demand diagrams representing the markets of goods and services (left) and labor (right).

Given some state of aggregate supply, as reflected by fixed, upward-sloping short-run aggregate supply (SAS) and labor supply (LAS) schedules, changes in nominal spending on goods (AD, for aggregate demand) and labor (LD) will cause prices and wages (or their respective inflation rates), employment, and output to increase together, with no tendency for wages to fall behind prices.

The standard Phillips Curve, portraying a negative relationship between the rate of price inflation and the unemployment rate, is just a reduced-form representation of these more involved relationships, showing the set of alternative, equilibrium values of inflation, π(P), and unemployment (L‑N, where L is the size of the labor force) consistent with different levels of spending (AD and LD), consistent with given short-run, upward-sloping SAS and SLS schedules. By noting that one can also express the relationship in question as one between the rate of wage inflation, π(w), and the unemployment rate, one arrives at “the historical link between wages and unemployment” to which Mr. Bernstein refers. What that relationship really means is that, for any given short-run labor supply schedule, as aggregate and labor demand schedules shift out, unemployment declines, while wage rates go up.

But a historical Phillips Curve relation, whatever it may be, ceases to hold once short-run aggregate or labor supply schedules themselves start shifting. In particular, if there’s a general productivity setback, due to a trade war or for any other reason, the aggregate supply schedule shifts in, or at least fails (in a dynamic setting) to shift out as fast as the aggregate demand, labor demand, and labor supply schedules. That difference is all it takes to cause a growing gap between the equilibrium nominal wage rate and the equilibrium price level, so that real wages stagnate, assuming they don’t actually decline.

As our diagrams are necessarily static, getting from them to a more accurate, dynamic account of recent labor market developments takes a little imagination. In reality, for starters, all of the schedules tend to be shifting outwards over time. Typically the AS schedule shifts out faster than the LS schedule, thereby providing for a general increase in real wages. Since the Great Recession, however, although AS never actually shifted to the left, the difference between the growth rate of AS and that of LS has shrunk. Consequently, instead of actually declining, real wages have merely ceased to increase as quickly as they once did.

The Real Puzzle: Labor’s Fallen Share of Productivity Gains

There remains, however, one real wage rate puzzle that post-crisis aggregate supply developments alone can’t explain. The puzzle consists, not of the breakdown of the “historical link between wages and unemployment” to which Mr. Bernstein refers, but of the breakdown of the historical link between the real wages of workers, apart from managerial-level workers, and overall productivity growth. The puzzle is that, while productivity growth has slowed down considerably, it’s still positive, whereas real wages for many sorts of workers have been altogether flat. Labor’s share of national income has, in other words, fallen. And so far it seems down for the count.

But this more genuine puzzle, which has nothing to do with the relation between wage inflation and the unemployment rate, is itself hard to attribute to some relatively recent rise of “hostile institutions,” either within the Trump administration or elsewhere in the United States. For one thing, labor’s share of income started to decline long before the recent crisis, let alone the most recent presidential election! By most accounts, labor’s share began to drift downward in the 1980s, and reached its nadir just before the 2008 crisis. For another, the decline has occurred, not just in the U.S., but in many other developed and emerging economies — despite large differences in all these countries’ governments, court systems, and collective bargaining arrangements. As Loukas Karabarbounis and Brent Neiman show in a 2017 NBER Report on “Trends in Factor Shares: Facts and Implications,” “Country-specific changes in policies … might be important for specific countries but are unlikely to account for much of the overall trend that the world has experienced.”

And there’s no shortage of explanations for the global decline in labor’s share of income that are far more compelling than vague references to “hostile institutions.” Karabarbounis and Neiman attribute half of it to “progress with IT-related technologies” that has “induced firms to produce with greater capital intensity.” A San Francisco Fed Study by Mary C. Daly, Bart Hobijn, and Benjamin Pyle attributes the stagnation of real wages to “secular shifts in the composition of the labor force.” In particular, while baby boomers earning relatively high wages have been retiring, younger workers “sidelined” during the recession have had to settle for relatively low-paying full-time jobs. A 2017 MIT working paper argues that an increase in product market concentration, particularly as manifested in the rise of “superstar firms,” may also have contributed to the reduction in labor’s share of total income. But the reason isn’t superstar firms’ “unchecked ability to collude against workers”: it’s just that “there is a fixed amount of overhead labor … needed for production” in the industries in question, so that greater concentration means less labor-intensive production.

In a still more recent working paper Princeton’s Gene Grossman and several coauthors suggest that the productivity slowdown may also account for part of the decline, because “when human capital is more complementary with physical capital than with raw labor” such a slowdown “can itself lead to a shift in the functional distribution of income away from labor and toward capital.” Finally, some part of the decline in labor’s share may be a figment of the data. According to a Brookings study published in 2013, “about a third of the decline in the published labor share appears to be an artifact of statistical procedures used to impute the labor income of the self-employed that underlies the headline measure.”

While none of these alternative explanations for the stagnation of workers’ earnings may alone suffice as an alternative to Mr. Bernstein’s more sinister explanations, several could easily do so. And these are but some of many plausible possibilities. For some others, along with a good general discussion of the topic, I recommend this pair of posts by Timothy Taylor.

In short, there’s no need to suppose that the courts, the Executive Branch, and “the corporate sector” have been conspiring — or conspiring more than usual, to be precise — to deprive workers of some portion of their already meager share of the real GDP pie. And even if they were trying, it couldn’t account for the actual historical and global behavior of worker’s earnings.

The moral of the story is that it’s unwise for economists to put too much faith in historical relationships — whether between inflation and unemployment or between total income growth and workers’ real wage rates — and to conclude, when these relationships “break down,” that some conspiracy must be afoot. That courts, corporations, and presidential administrations are capable of perfidy no one can deny. But historical macroeconomic relationships are themselves untrustworthy, for reasons unconnected to goings-on in smoke-filled rooms.

[Cross-posted from Alt‑M.org]

As regular Alt‑M readers know, I’ve been saying for over a year now that, despite their promise to “normalize” monetary policy, Fed officials have been determined to maintain the Fed’s post-crisis “floor” system of monetary control, in which changes to the Fed’s monetary policy stance are mainly achieved by means of adjustments to the rate of interest the Fed pays on banks’ excess reserve balances, or the IOER rate, for short.

Until recently the Fed’s intentions had to be inferred by reading between the lines of its official press releases, or by referring to personal preferences expressed by leading Fed officials. But with today’s release of the Fed’s official Monetary Policy Report by the Board of Governors, it’s no longer necessary to speculate. The section “Interest on Reserves and Its Importance for Monetary Policy,” on pp. 44–46, leaves hardly any room for doubt that the Board of Governors still regards the IOER rate as “the principal tool the FOMC [sic] uses to anchor the federal funds rate,” and that it plans to keep on doing so after it “normalizes” monetary policy by completing its ongoing balance sheet unwind and by further raising its fed funds rate target upper limit by another percentage point or so.[1]

An Awkward Start

Having already spilled several gallons of ink criticizing the Fed’s floor system, on these pages and in Floored!, my forthcoming book on the subject, I don’t see the point of reviewing those criticisms here, by way of a comprehensive reply to the Board’s recent remarks defending that arrangement. Still I can’t resist pointing out some especially galling aspects of those remarks, starting with this opening passage:

The financial crisis that began in 2007 triggered the deepest recession in the United States since the Great Depression. In response, the Federal Open Market Committee (FOMC) cut its target for the federal funds rate to nearly zero by late 2008. Other short-term interest rates declined roughly in line with the federal funds rate. Additional monetary stimulus was necessary to address the significant economic downturn and the associated downward pressure on inflation. The FOMC undertook other monetary policy actions to put downward pressure on longer-term interest rates, including large-scale purchases of longer-term Treasury securities and agency-guaranteed mortgage-backed securities.

These policy actions made financial conditions more accommodative and helped spur an economic recovery that has become a long-lasting economic expansion.

Although the passage itself doesn’t refer to interest on reserves, its purpose is to introduce a discussion devoted to singing the praises of that policy instrument. It’s in light of that intention that the passage raises my hackles. For what the Fed’s report doesn’t say is that, when the Fed introduced IOER in early October 2008, it did so, not because it thought “monetary stimulus was necessary to address the significant economic downturn and the associated downward pressure on inflation,” but because it was determined to prevent its then-ongoing emergency lending from having any stimulus effect, and from thereby becoming a source of unwanted upward pressure on inflation! IOER was, in other words, originally intended to serve as a contractionary monetary policy measure, just when monetary expansion was desperately needed.

And boy did it work! NGDP, which had been growing, albeit at a snail’s pace, went into a tailspin. Nor was that all. Because the Fed’s IOER rate — first set at 75 basis points, briefly lowered to 65 bps, then quickly raised to 100 basis points, and finally lowered again (in early December 2008) to 25 basis points, where it remained for the duration of the crisis — was designed to prop-up the fed funds rate by encouraging banks to accumulate excess reserves, when the Fed finally determined that the U.S. economy could use a little stimulus after all, it had no choice but to resort to “other monetary policy actions to put downward pressure on longer-term interest rates, including large-scale purchases of longer-term Treasury securities and agency-guaranteed mortgage-backed securities.”

But we mustn’t be too hard on the authors of the report. After all, it would have been awkward for them to laud the Fed’s floor system after first pointing out how, during the last months of 2008 and the start of 2009, that system played an important part in bringing the U.S. economy to its knees.

Not a Popular System

Another irksome passage in the Board’s report is the one declaring that “Interest on reserves is a monetary policy tool used by all of the world’s major central banks.” Yes, and no. Plenty of central banks pay interest on bank reserves. But the policy the report defends isn’t simply that of paying interest on bank reserve balances, including excess reserve balances. It’s that of using the IOER rate as the Fed’s chief instrument of monetary control, which is the essence of a “floor” operating system. And that means setting an IOER rate high enough to encourage banks to stock-up on excess reserves, instead of trading them for other assets.

Although the central banks of several other nations have employed floor systems in the past, today, besides the Fed itself, only the Bank of England and the ECB still rely on floor systems — or something close. Most central banks now rely on “corridor” systems of some kind, in which the central bank’s IOER (“deposit”) rate sets a lower bound on movements in its policy rate, and open-market operations are routinely employed to keep the actual policy rate at a target set somewhere between that lower bound and an upper bound consisting of the central bank’s own lending rate. Finally, a number of other central banks that either used floor systems before the crisis or adopted such systems during it, including the Swiss National Bank, the Bank of Japan, Norges Bank, and the Reserve Bank of New Zealand, switched to “tiered” or “quota” systems afterwards. In a tiered system, reserves may earn interest at a rate that makes them seem attractive relative to other safe assets, but they do so only up to a fixed limit. Beyond that limit they earn only a relatively modest return — if not a zero or negative return. Because the marginal opportunity cost of reserves remains positive in tiered systems, such systems operate more like corridor systems than like a floor system.

Just How Low Has the Fed Really Gone?

But of all the irritating claims of the Board’s report, the one that has gone furthest in putting me in high dudgeon is this one:

The rate of interest the Federal Reserve pays on banks’ reserve balances is far lower than the rate that banks can earn on alternative safe assets, including most U.S. government or agency securities, municipal securities, and loans to businesses and consumers. Indeed, the bank prime rate — the base rate that banks use for loans to many of their customers — is currently around 300 basis points above the level of interest on reserves.

To which the following footnote is appended:

The Congress’s authorization allows the Federal Reserve to pay interest on deposits maintained by depository institutions at a rate not to exceed the “general level of short-term interest rates.” The Federal Reserve Board’s Regulation D defines short-term interest rates for the purposes of this authority as “rates on obligations with maturities of no more than one year, such as the primary credit rate and rates on term federal funds, term repurchase agreements, commercial paper, term Eurodollar deposits, and other similar instruments.” The rate of interest on reserves has been well within a range of short-term interest rates as defined in Board regulations.

Where to begin?

It’s absurd, first of all, to treat interest rates on “loans to businesses and consumers,” the prime rate included, as rates on safe assets. But don’t take my word for it: consider what two Fed senior economists, one of whom works at the Board of Governors, have to say on the subject, in a Liberty Street Economics post entitled, “What Makes a Safe Asset?” Safe assets, they write,

are those with a very high likelihood of repayment, and are easy to value and trade …. As a result, safe assets typically trade at a premium, known in the academic literature as a “convenience yield,” which reflects the nonpecuniary benefits investors receive for holding them …

In today’s financial system, the prime example of a safe asset is U.S. Treasury securities. These securities are considered to have zero credit risk, can be easily sold, and can be used as collateral either to raise funding or to post as margin in derivatives positions. … Treasuries’ safe asset status translates into an average yield reduction of 73 basis points. This yield spread can be interpreted as a measure of the convenience yield embedded in Treasuries.

However, Treasuries differ significantly in maturity and that affects their safe asset characteristics. Treasury bills (T‑bills) have the shortest maturities and are often thought of as “money-like” assets, that is, assets similar to physical currency. Because of this moneyness, yields on short-term T‑bills are typically lower than those on comparable assets….

The private sector can also create safe assets. For example, many of the benefits ascribed to public safe assets are also attributed to private short-term debt of certain issuers. An important difference between public and private safe assets, however, is that the reliability of private safe assets can come into question.

Stretch the notion as much as you like, you will never get “safe assets” to include even the safest bank loans. That is, you won’t be able to do it unless you are a Fed official trying to claim that the Fed’s IOER rate has been “far lower than the rate that banks can earn on alternative safe assets.”

Nor is it possible to justify comparing the Fed’s IOER rate — a rate on assets (reserves) of essentially zero maturity — to rates on otherwise safe longer-term assets. Instead, to sustain the claim that the Fed’s IOER rate has been low relative to that on assets of comparable safety, including comparably low exposure to interest-rate (or duration) risk, Fed officials would have to show that the IOER rate is below rates on safe assets with very short (if not zero) maturities. That rules out comparisons to Treasury and agency bonds and notes, leaving only Treasury bills. Even then the comparison is a bit unfair, as even the shortest-term Treasury bills have longer terms — and are therefore less liquid and safe — than bank reserves.

But let that pass. Instead, let’s just consider how the report’s assertion that the Fed’s IOER rate “is far lower than the rate that banks can earn on alternative safe assets” stacks up against the record regarding yields on various Treasury bills. Let FRED do the talking:

As the chart shows, throughout most of its existence the IOER rate has been well above, not just rates on shorter-term Treasury Bills, but those on 1‑year T‑bills; indeed, for a long interval banks had to hold T‑bills of 2‑year maturities or longer to earn as much interest as excess reserves paid. And while the situation isn’t nearly so bad today, it remains the case that reserves pay more than one-month Treasury bills. That’s not “far lower than the rate that banks can earn on alternative safe assets.” It’s not even a little lower. It’s higher. Nor could things be otherwise, because having a floor system means having an IOER rate that’s high enough “to remove the opportunity cost to commercial banks of holding reserve balances,” which it wouldn’t be if it were really “far lower than the rate that banks can earn on alternative safe assets.”

“D” for Deception

And what about that footnote? It just adds insult to injury by showing the lengths to which the Fed has been willing to go to twist and bend the law authorizing it to pay interest on bank reserves. As the note correctly observes, that law requires that the Fed’s IOER rate not exceed “the general level of short-term interest rates.” Since the IOER rate is itself, as we’ve seen, a rate on a riskless zero-maturity asset, any reasonable interpretation of the statute would have it refer to the general level of rates on other short-term, riskless assets, such as 4 week-Treasury Bills or, perhaps, overnight Treasury-secured repos.

So, in preparing Regulation D, how did the Fed define short-term rates for the purpose of implementing the statute? Why, as “rates on obligations with maturities of no more than one year, such as the primary credit rate and rates on term federal funds, term repurchase agreements, commercial paper, term Eurodollar deposits, and other similar instruments” (my emphasis). If you can’t see how self-serving — not to say dishonest — the Fed’s definition is, please read it again, carefully, bearing in mind what “term” rates are and that the Fed’s “primary credit rate” is what’s more commonly known as its “discount” rate — that is, “the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility–the discount window.”

That Regulation D refers to “term” rates rather than overnight rates, when the latter are obviously more appropriate, is the least of it. The inclusion on the Fed’s list of comparable rates of the Fed’s primary credit rate is the real kicker. First of all, that rate isn’t a market rate but one that the Fed itself administers. What’s more, the Fed has long had a policy of setting it well “above the usual level of short-term market interest rates” (my emphasis again). These days, for example, it sets it “at a rate 50 basis points above the Federal Open Market Committee’s (FOMC) target rate for federal funds.” Because the IOER rate once defined the upper limit of the FOMC’s fed funds target rate range, and is now set 5 basis points below that limit, any interest rate that the Fed pays on reserves is bound to be lower than the Fed’s primary credit rate. Thus the Fed has cleverly interpreted and implemented the statute in a manner that allows it to claim that it is obeying the law requiring that its IOER rate not exceed “the general level of short-term interest rates” no matter how it sets that rate, including when it sets it well above truly comparable market-determined short-term rates!

Now I hope you’re at least starting to see why the Fed’s report has got my goat.

_______________________
[1] “Sic” because it is the Board of Governors, rather than the FOMC, that sets the IOER rate. Concerning this anomalous exception to the rule assigning responsibility for the conduct of monetary policy to the FOMC, see my January 10, 2018 testimony before the Monetary Policy and Trade Subcommittee of the House Financial Services Committee.

[Cross-posted from Alt‑M.org]

Recently David Beckworth and Martin Sandbu, among others, have drawn attention to an interesting paper by James Bullard and Riccardo DiCecio unveiled in Norway earlier this year. In it, Bullard and DiCecio investigate a model economy possessing both a large private credit market and “Non-state contingent nominal contracting (NSCNC).” They conclude that, in such an economy, NGDP targeting is the “optimal monetary policy for the masses.”

Here is David Beckworth’s intuitive explanation for that finding:

The basic idea is that in a world of fixed-price nominal debt contracts (i.e. the real world), a NGDP level target provides better risk sharing among creditors and debtors against economic shocks than does a price stability target.

This is because a NGDP level target makes inflation countercyclical. During recessions, inflation rises and causes creditors to bear some of the unexpected pain by lowering the real debt payments they receive from debtors. During booms, inflation falls and allows creditors to share in some of the unexpected gain by increasing the real debt payments they receive from debtors. Debtors, in other words, bear less risk during recessions but also share unexpected gains during expansions.

NGDP level targeting, in other words, causes a fixed-price nominal debt world to look and feel a lot like an equity-world. In a similar spirit, some observers have called for a risk-sharing mortgages as a way to avoid another Great Recession. The point of this paper is that the same benefit that such risk-sharing mortgages would bring can be had by having a central bank target the growth path of NGDP.

Although Bullard and DiCecio’s specific argument is novel, the idea that fluctuations in the general price level can actually contribute to optimal risk sharing in a world of fixed nominal debts is itself by no means knew. Bullard and DiCecio themselves refer to previous work making the same basic argument by Evan Koenig and Kevin Sheedy , while in my previous article here I traced the idea all the way back to Samuel Bailey’s (1837) classic monograph, Money and its Vicissitudes in Value.

I myself first cottoned-on to the view that what’s now called NGDP targeting is more conducive to what economists nowadays call achieving optimal risk sharing in a world with many fixed nominal debt contracts (but which used to be called avoiding “debtor-creditor injustice”) while working on my PhD dissertation in the early 1980s. Back then I still didn’t know about Bailey, though I did discover a few other works — all written some years before — supporting my perspective.

My conclusions eventually found their way into my dissertation, and thence into my first (1988) book, The Theory of Free Banking. I later expanded and refined them in Less than Zero (1997, especially pp. 41–5; new edition forthcoming!). Because my earlier discussion is especially informal and intuitive, I thought that persons interested in more recent works addressing the same issue, like those of Koenig, Sheedy, and Bullard and DiCecio, might find it of interest, if not helpful to their understanding of these much more sophisticated works. So here it is, with no changes save (1) the addition of a new note; (2) the removal of two original notes that contained references only; and (3) the insertion of ellipses in place of a phrase that would seem meaningless here, where it has been stripped of its context.

***

To address the problem of debtor-creditor injustice, one must first understand how different kinds of price changes actually affect the well-being of parties on either side of a debt contract. One also has to have a definition of injustice. For the latter we may adopt the following: parties to a long-term debt contract may be said to be victims of injustice caused by price-level changes if, when the debt matures, either (a) the debtors on average find their real burden of repayment greater than what they anticipated at the time of the original contract and creditors find the real value of the sums repaid to them greater on average than what they anticipated; or (b) the creditors find the real value of the sums repaid to them smaller on average than what they anticipated and debtors find their real burden of repayment smaller than what they anticipated at the time of the original contract. When injustice occurs the parties to the debt contract, if they had had perfect foresight, would have contracted at a nominal rate of interest different from the one actually chosen.

It is not always appreciated that not all movements in the general level of prices involve injustice to debtors or creditors. Unanticipated general price movements associated with changes in per-capita output…do not affect the fortunes of debtors and creditors in the same, unambiguous way as do unanticipated price movements associated with monetary disequilibrium.* Where price movements are due to changes in per-capita output, it is not possible to conclude that unanticipated price reductions favor creditors at the expense of debtors. Nor can it be demonstrated that unanticipated price increases favor debtors at the expense of creditors. The standard argument that unanticipated price changes are a cause of injustice is only applicable to price changes caused by unwarranted changes in money supply or by unaccommodated changes in money demand.

This is so because in one of the cases being considered aggregate per-capita output is changing, whereas in the other it is stationary. In both cases a fall in prices increases the value of the monetary unit and increases the overall burden of indebtedness, whereas a rise in prices reduces the overall burden, other things being equal. In the case where per-capita output is stationary (the monetary disequilibrium case), the analysis need go no further, and it is possible to conclude that falling prices injure debtors and help creditors and vice versa. Were parties to long-term debt contracts able to perfectly anticipate price-movements, they would, in anticipation of higher prices, contract at higher nominal rates of interest; in anticipation of lower prices they would contract at lower nominal rates of interest. In the first case the ordinary real rate of interest is increased by an inflation premium; in the latter, it is reduced by a deflation discount. These adjustments of interest rates to anticipated depreciation or appreciation of the monetary unit are named the “Fisher” effect, after Irving Fisher who discussed them in an article written just before the turn of the century.

When per-capita output is changing, one must take into account, in addition to the Fisher effect, any intertemporal-substitution effect associated with changes in anticipated availability of future real income. Here (assuming no monetary disequilibrium) reduced prices are a consequence of increased real income, and increased prices are a consequence of reduced real income. Taking the former case, although the real value of long-term debts increases, debtors do not necessarily face a greater real burden of repayment since (on average) their real income has also risen. In nominal terms they are also not affected because, as distinct from the case of falling prices due to a shortage of money, their nominal income is unchanged. Thus debtors need not suffer any overall hardship: the damage done by the unanticipated fall in prices may be compensated by the advantage provided by the unanticipated growth of real income. If the parties to the debt contract had in this situation actually negotiated with the help of perfect foresight, their anticipation of reduced prices would have caused the nominal rate of interest to be reduced by a deflation discount — the Fisher effect. But their anticipation of increased real income would also reduce their valuations of future income relative to present income, raising the real component of the nominal rate of interest — the intertemporal-substitution effect. Since the Fisher effect and the intertemporal substitution effect work in opposite directions it is not clear that the perfect-foresight loan agreement would have differed from the one reached in the absence of perfect foresight — at least, the direction in which it would have differed is not obvious. So there is no reason to conclude that a monetary policy that permits prices to fall in response to increased production would prejudice the interests of debtors.

Similarly, to allow prices to rise in response to reduced per-capita output would not result in any necessary injustice to creditors, even if the price increases were not anticipated. Here the Fisher effect in a perfect-foresight agreement would be positive, and the intertemporal substitution effect would be negative, so it cannot be said a priori that the perfect-foresight nominal rate of interest would differ from the rate agreed upon in the absence of perfect foresight.

____________________________________

*By “monetary disequilibrium” I mean unanticipated changes in nominal spending (MV or, equivalently, Py). Earlier in my book I explain that a monetary policy “that maintains monetary equilibrium [is one] that prevents price changes due to changes in the demand for money relative to income without preventing price changes due to changes in productive efficiency.” I would have chosen my terms more carefully had I known better.

[Cross-posted from Alt‑M.org]

As The Wall Street Journal, The New York Times, and several other news outlets reported recently, although it has managed to avoid setting off another taper tantrum like that of 2013, the Fed is having a bad case of unwind jitters, thanks to unanticipated tightening in the market for fed funds.

That tightening has manifested itself in a considerable narrowing, since the Fed began unwinding in late October 2017, of the gap between the Fed’s IOER rate and the “effective federal funds” (EFF) rate — meaning the actual rate banks have had to pay other banks, or GSEs with Fed accounts, for unsecured, overnight funds.

In effect the narrowing IOER-EFF gap means that the Fed’s recent IOER rate hikes have ended up being more potent than was expected. As a step toward addressing the problem, the FOMC at its last meeting decided to redefine its funds rate target range upper limit. Now, instead of being equal to the going IOER rate, the upper limit is defined as the IOER rate plus 5 basis points. By itself the new definition is the sheerest of window dressings. But because the Fed, which had been contemplating raising its IOER rate to 200 basis points, could now raise it to just 195 basis points, whilst still sticking to its original rate move, as defined by the upper and lower bounds of its rate target range, the change marked a slight retreat from the Fed’s original tightening plans.

That the Fed risked over-tightening if it adhered to its original normalization plans is something Heritage’s Norbert Michel and I warned about, in an American Banker op-ed, a little over a year ago. “If the Fed keeps paying banks not to lend at the same time it starts slimming its balance sheet,” we said, “we could be in for very tight money.” That’s because the Fed’s plans called for it to shrink its balance sheet at a predetermined rate, while also adhering to a schedule of rate hikes aimed at re-establishing a supposedly “normal” effective funds rate sometime in 2019. Last May the Fed anticipated getting the funds rate back to 3 percent; since then it has lowered that goal to 2.8 percent.

That raising the IOER rate tightens money is obvious enough. But why, in a system in which banks hold trillions of dollars in excess reserves, should shrinking the Fed’s balance sheet itself lead to further tightening? The short answer is that, instead of being spread evenly throughout the banking system, excess reserves have mostly piled-up in a small number of very large banks, and especially in a handful of foreign banks with U.S. branches. For various reasons these banks find the return on reserve balances especially attractive compared to what they might earn by parting with those reserves. When the Fed was gobbling-up assets, these banks were gobbling-up reserves, thereby keeping them from contributing to any general increase in lending.

Now that the Fed has begun selling assets in order to buy-back reserves, the same IOER payments that encouraged certain banks to hoard reserves in the first place are discouraging them from parting with them. Instead, banks that held relatively small reserve cushions are choosing to swap reserves for other assets, and to rely more on federal funds to stay liquid. That means competing harder for a relatively small pool of fed funds, now supplied exclusively by GSEs, and driving the fed funds rate up closer to the IOER rate. (That the EFF rate never goes noticeably above the IOER rate is easily explained by the fact that the supply of fed funds becomes highly elastic at rates at or above the IOER rate, for such rates will convince even the most aggressive reserve hoarders to disgorge reserves.)

The question remains whether, and how, the new circumstances will alter the Fed’s future plans. Should money market conditions continue to tighten, Fed officials will face two options. One is to reduce their planned IOER rate increases, either by reducing their announced target range increases or by further increasing the difference between the IOER rate and the range’s upper limit. The other is to renege on their promised balance sheet unwind.

Not surprisingly, Fed officials appear increasingly inclined to take the latter course, and to thereby abandon a large chunk of their long-promised normalization plan. As the NYT reported,

That narrowing gap between the federal funds rate and the interest on excess reserves, or IOER, has stoked a debate over whether the Fed’s reduction of its massive bond holdings, which started in October 2017, has made it more expensive for banks to borrow excess reserves to meet regulatory requirements or fund their daily needs, analysts said.

This outcome was also one I predicted a while ago. In a March working paper version of Floored!, my forthcoming book-length critique of the Fed’s post-crisis operating system, I wrote that

the Fed’s determination to raise its policy rate (or rates) to a preconceived “normal” level, and to do so within a relatively rapid span of time, seems imprudent, and may, if pursued obstinately, ultimately cause it to further delay its planned balance sheet reduction, or even to abandon it altogether.

Of course, the Fed could easily stick to, or even hasten, its balance-sheet unwind, while still providing for a plentiful supply of federal funds, by lowering its IOER rate enough, relative to other market rates, to encourage the handful of banks now holding 90 percent of all excess reserves to part with them. But that would mean abandoning the Fed’s “floor” operating system, and establishing a “corridor” system in its place. Alas, whether its because they subscribe to some dubious Fed economics or for other reasons, most Fed officials seem unwilling to entertain such a switch — despite having once planned on it, and despite the well-established advantages of corridor systems, and their corresponding worldwide popularity.

It may yet be possible to change those officials’ minds. Let’s hope so. For if not, as I warned in a previous post, the day may not be far off when Mr. Powell finds himself transformed into the world’s first Six Trillion Dollar central banker. That is perhaps a burden he’s willing to bear. But it shouldn’t be one we’re willing to assign, to him or to any other mortal.

[Cross-posted from Alt‑M.org]

***

So constantly have the ideas currency and government been associated — so universal has been the control exercised by lawgivers over monetary systems — and so completely have men come to regard this control as a matter of course, that scarcely any one seems to inquire what would result were it abolished.[1] Perhaps in no case is the necessity of state-superintendence so generally assumed; and in no case will the denial of that necessity cause so much surprise. Yet must the denial be made.

That laws interfering with currency cannot be enacted without a reversal of state-duty is obvious; for to either forbid the issue or enforce the receipt of certain notes or coin in return for other things, is to infringe the right of exchange — is to prevent men making exchanges which they otherwise would have made, or to oblige them to make exchanges which they otherwise would not have made — is, therefore, to break the law of equal freedom in their persons.[2] If there be truth in our general principle, it must be impolitic as well as wrong to do this. Nor will those who infer as much be deceived; for it may be shown that all such dictation is not only needless, but necessarily injurious.

The monetary arrangements of any community are ultimately dependent, like most of its other arrangements, on the morality of its members. Amongst a people altogether dishonest, every mercantile transaction must be effected in coin or goods; for promises to pay cannot circulate at all, where, by the hypothesis, there is no probability that they will be redeemed. Conversely, amongst perfectly honest people paper alone will form the circulating medium; seeing that as no one of such will give promises to pay more than his assets will cover, there can exist no hesitation to receive promises to pay in all cases; and metallic money will be needless, save in nominal amount to supply a measure of value. Manifestly, therefore, during any intermediate state, in which men are neither altogether dishonest nor altogether honest, a mixed currency will exist; and the ratio of paper to coin will vary with the degree of trust individuals can place in each other. There seems no evading this conclusion. The greater the prevalence of fraud, the greater will be the number of transactions in which the seller will part with his goods only for an equivalent of intrinsic value; that is, the greater will be the number of transactions in which coin is required, and the more will the metallic currency preponderate. On the other hand, the more generally men find each other trustworthy, the more frequently will they take payment in notes, bills of exchange, and checks; the fewer will be the cases in which gold and silver are called for, and the smaller will be the quantity of gold and silver in circulation.

Thus, self-regulating as is a currency when let alone, laws cannot improve its arrangements, although they may, and continually do, derange them. That the state should compel every one who has given promises to pay, be he merchant, private banker, or shareholder in a joint-stock bank, duly to discharge the responsibilities he has incurred, is very true. To do this, however, is merely to maintain men’s rights — to administer justice; and therefore comes within the state’s normal function. But to do more than this — to restrict issues, or forbid notes below a certain denomination, is no less injurious than inequitable. For, limiting the paper in circulation to an amount smaller than it would otherwise reach, inevitably necessitates a corresponding increase of coin; and as coin is locked-up capital, on which the nation gets no interest, a needless increase of it is equivalent to an additional tax equal to the additional interest lost.[3]

Moreover, even under such restrictions, men must still depend mainly upon each other’s good faith and enlightened self-interest; seeing that only by requiring the banker to keep sufficient specie in his coffers to cash all the notes he has issued, can complete security be given to the holders of them; and to require as much is to destroy the motive for issuing notes. It should be remembered, too, that even now the greater part of our paper currency is wholly unguaranteed. Over the bills of exchange in circulation[4], which represent liabilities three times as great as are represented by notes, no control is exercised. For the honouring of these there exists no special security, and the multiplication of them is without any limit, save that natural one above mentioned — the credit men find it safe to give each other.

Lastly, we have experience completely to the point. Whilst in England banking has been perpetually controlled, now by privileging the Bank of England, now by limiting banking partnerships, now by prohibiting banks of issue within a specified circle, and now by restricting the amounts issued — whilst “we have never rested for many years together without some new laws, some new regulations, dictated by the fancy and theory fashionable at particular periods”[5] — and whilst “by constant interference we have prevented public opinion, and the experience of bankers themselves, adapting and moulding their business to the best and safest course”[6] — there has existed in Scotland for nearly two centuries a wholly uncontrolled system — a complete free-trade in currency. And what have been the comparative results? Scotland has had the advantage, both in security and economy. The gain in security is proved by the fact that the proportion of bank failures in Scotland has been far less than in England. Though “by law there has never been any restriction against any one issuing notes in Scotland; yet, in practice, it has ever been impossible for any unsound or unsafe paper to obtain currency.” And thus the natural guarantee in the one case has been more efficient than the legislative one in the other. The gain in economy is proved by the fact that Scotland has carried on its business with a circulation[7] of £3,500,000, whilst in England the circulation is from £50,000,000 to £60,000,000; or, allowing for difference of population, England has required a currency three times greater than Scotland.

When, therefore, we find á priori reason for concluding that in any given community the due balance between paper and coin will be spontaneously maintained — when we also find that three-fourths of our own paper circulation is self-regulated — that the restrictions on the other fourth entail a useless sinking of capital — and further, that facts prove a self-regulated system to be both safer and cheaper, we may fairly say, as above, that legislative interference is not only needless, but injurious.

If evil arises when the state takes upon itself to regulate currency, so also does evil arise when it turns banker. True, no direct breach of duty is committed in issuing notes; for the mere transfer of promises to pay to those who will take them, necessitates neither infringement of men’s rights nor the raising of taxes for illegitimate purposes. And did the state confine itself to this, no harm would result; but when, as in practice, it makes its notes, or, rather, those of its proxy, legal tender, it both violates the law of equal freedom and opens the door to abuses that were else impossible. Having enacted that its agent’s promises to pay shall be taken in discharge of all claims between man and man, there readily follows, when occasion calls, the further step of enacting that these promises to pay shall be taken in discharge of all claims on its agent. This done, further liabilities are incurred without difficulty, for they can be liquidated in paper. Paper continues to be issued without limit, and then comes depreciation; which depreciation is virtually an additional taxation, imposed without the popular consent — a taxation which, if directly imposed, would make men realize the extravagance of their national expenditure, and condemn the war necessitating it. Seeing, then, that there could never occur depreciation, and its concomitant evils, were there no notes made inconvertible by act of parliament — and seeing that there could never exist any motive to make notes legally inconvertible, save for purposes of state-banking — there is good reason to consider state-banking injurious. Should it be urged that, for the occasional evils it entails, state-banking more than compensates by the habitual supply of many millions’ worth of notes, whose place could not be supplied by other notes of equal credit, it is replied that had the Bank of England no alliance with the state[8], its notes would still circulate as extensively as now, provided its proprietors continued their solicitude (so constantly shown at the half-yearly meetings) to keep their assets more than three millions above their liabilities.

There is a third capacity in which a government usually stands related to the currency, viz., as a manufacturer of coins. That in theory a government may carry on the trade of stamping bullion without necessarily reversing its proper function is admitted. Practically, however, it never does so without collaterally transgressing. For the same causes which prevent it from profitably competing with private individuals in other trades, must prevent it from profitably competing with them in this — a truth which inquiry into the management of the mint will sufficiently enforce. And if so, a government can manufacture coins without loss, only by forbidding every one else to manufacture them. By doing this, however, it diminishes men’s liberty of action in the same way as by any other trade restriction — in short, does wrong. And, ultimately, the breach of the law of equal freedom thus committed results in society having to pay more for its metallic currency than would otherwise be necessary.

Perhaps to many it will seem that by a national mint alone can the extensive diffusion of spurious coinage be prevented. But those who suppose this, forget that under a natural system there would exist the same safeguards against such an evil as at present. The ease with which bad money is distinguished from good, is the ultimate guarantee for genuineness; and this guarantee would be as efficient then as now. Moreover, whatever additional security arises from the punishment of “smashers”[9] would still be afforded; seeing that to bring to justice those who by paying in base coin obtain goods “under false pretences,” comes within the state’s duty. Should it be urged that in the absence of legislative regulations there would be nothing to prevent makers from issuing new mintages of various denominations and degrees of fineness, the reply is that only when some obvious public advantage was to be obtained by it, could a coin differing from current ones get into circulation. Were private mints now permitted, the proprietors of them would be obliged to make their sovereigns like existing ones, because no others would be taken. For the size and weight — they would be tested by gauge and balance, as now (and for a while with great caution). For the fineness — it would be guaranteed by the scrutiny of other makers. Competing firms would assay each other’s issues whenever there appeared the least reason to think them below the established standard, and should their suspicions prove correct, would quickly find some mode of diffusing the information. Probably a single case of exposure and the consequent ruin would ever after prevent attempts to circulate coins of inferior fineness.[10][11]

It is not unlikely that many readers, though unprepared with definite replies to these reasonings, will still doubt their correctness. That the existing monetary system — an actual working system, seemingly kept going by the state — would be benefited by the withdrawal of state-control, is a belief which the strongest arguments will in most cases fail to instill. Custom will bias men in this case, much as in another case it does the vine-growers of France, who, having long been instructed by state-commissioned authorities when to commence the vintage, believe that such dictation is beneficial. So much more does a realized fact influence us than an imagined one, that had the baking and sale of bread been hitherto carried on by government-agents, probably the supply of bread by private enterprise would scarcely be conceived possible, much less advantageous. The philosophical free-trader, however, remembering this effect of habit over the convictions — remembering how innumerable have been the instances in which legislative control was erroneously thought necessary — remembering that in this very matter of currency men once considered it requisite “to use the most ferocious measures to bring as much foreign bullion as possible into the country, and to prevent any going out” — remembering how that interference, like others, proved not only needless but injurious — remembering thus much, the philosophical free-trader will infer that in the present instance also, legislative control is undesirable. Reasons for considering trade in money an exception to the general rule, will weigh but little with him; for he will recollect that similar reasons have been assigned for restricting various trades, and disproved by the results. Rather will he conclude that as, in spite of all prophecies and appearances to the contrary, entire freedom of exchange has been beneficial in other cases, so, despite similar prophecies and adverse appearances, will it be beneficial in this case.

_____________________

[1] [Although few arguments were heard either before or after Spencer’s time for the privatization of coinage, many economists before him, and some afterwards, had argued against government monopolization of paper currency and in favor of free banking. For a general survey of these debates see Vera Smith’s The Rationale of Central Banking. — Ed.]

[2] [The “Law of Equal Freedom,” also known as the “Law of Equal Liberty,” is a fundamental principle of classical liberal thought, an early statement of which can be found in Locke’s Second Treatise on Government. In chapter 4 of Social Statics Spencer defines it as the principle “that every man may claim the fullest liberty to exercise his faculties compatible with the possession of like liberty to every other man.” — Ed.]

[3] [In this passage Spencer draws on Adam Smith’s famous discussion of the advantages of paper currency, in Book II, chapter 2 of The Wealth of Nations, in order to argue against Smith’s arguments in favor of laws prohibiting banks from issuing smaller-denomination banknotes, including Scotland’s 1765 ban on notes of less than £1. For a recent, critical assessment of that ban, see Tyler Goodspeed’s superb book, Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772. According to Hugh Rockoff, Goodspeed “shows convincingly” that the ban defended by Smith but opposed by Spencer was “pushed by the largest Scottish banks with the goal of reducing competition from smaller competitors,” and that by doing so it “encouraged the larger banks to pursue riskier investments, making the system less stable.” — Ed.]

[4] Though not literally currency, bills of exchange, serving in many cases to effect mercantile transactions which would otherwise be effected in money, to that extent perform its function. [For more on the use of “inland” bills of exchange as currency see T.S. Ashton’s classic article, “The Bill of Exchange and Private Banks in Lancashire, 1790–1830.” — Ed.]

[5] Capital, Currency, and Banking. By James Wilson, Esq., M.P. [James Wilson was the founder and first Chief editor of The Economist. His oldest daughter married Walter Bagehot, who took over the magazine when Wilson departed for India in 1859. — Ed.]

[6] Ibid.

[7] Ibid. [For further details concerning Scotland’s unregulated and competitive or “free” banking and currency system bearing out all the virtues Spencer claims for it see Larry White’s Free Banking in Britain:Theory, Experience and Debate, 1800–1845. A quick survey, also by Larry, of various free banking episodes can be read here on Alt‑M. — Ed.]

[8] The alliance consists in this, that on the credit of a standing debt of £14,000,000, due from the Government to the Bank, the Bank is allowed to issue notes to that amount (besides further notes on other security), and hence to the extent of this debt the notes have practically a Government guarantee.

[9] [“Smasher” is Victorian slang for anyone who passes counterfeit coin. — Ed.]

[10] Whilst these sheets are passing through the press, facts, which he is not now at liberty to quote, have been communicated to the writer, conclusively proving the superior economy of a coin-manufacture conducted by private individuals; together with other facts suggesting the obvious truth that the debasement of coinage, from which our forefathers suffered so much, was made possible only by legal compulsion — would never have been possible had the currency been left to itself. [Spencer here is almost certainly referring to a coinage contract recently struck between the Royal Mint and Heaton and Son, a private mint that had only recently been established in Birmingham using equipment auctioned off from the former Soho Mint. Heaton and Son’s, which later became the Birmingham Mint, continued making coins for the British and other governments until 2001, when the Royal Mint forced it out of business by breaking a long-standing agreement to negotiate foreign coin contracts for it and several other private mints in return for their help in supplying Great Britain itself with coins. — Ed.]

[11] [Although Spencer’s claims about the advantages of private coinage may be especially controversial, available evidence fully supports them. Consider, for example, his claims that “Were private mints now permitted, the proprietors of them would be obliged to make their sovereigns like existing ones, because no others would be taken” and that “Competing firms would assay each other’s issues whenever there appeared the least reason to think them below the established standard, and should their suspicions prove correct, would quickly find some mode of diffusing the information.” It happens that, as Spencer was speculating thus, precisely what he claimed would happen in a private coinage system was happening in fact in California, where in the absence of any Federal mint a number of private mints were established to meet the needs of the gold mining industry. For details see Brian Summers 1976 Freeman article, “Private Coinage in America.” — Ed.]