This issue of the Cato Journal is dedicated to Allan H. Meltzer who passed away on May 8, 2017. Allan spoke at the 1st Annual Monetary Conference in 1983 and many thereafter. He was a frequent contributor to the Cato Journal, a friend, and mentor. He will be sorely missed.

The 16 monetary articles in this issue were originally presented at the Cato Institute’s 35th Annual Monetary Conference, “The Future of Monetary Policy,” on November 16, 2017. The conference was hosted by Cato’s Center for Monetary and Financial Alternatives and generously supported by a grant from the George Edward Durell Foundation. I thank the Durell board members for their continuing support of the Annual Monetary Conference and the authors for their assistance in preparing their papers for publication.

There will be many challenges as the Federal Reserve and other major central banks exit their unconventional monetary policies and normalize their balance sheets. Ultra-low interest rates, quantitative easing, and forward guidance have increased risk taking and pumped up asset prices. Rising volatility in global stock markets reflect, in part, the uncertainty of future monetary policy.

The authors in this volume focus on four major issues: (1) the case for a rules-based international monetary system, (2) normalizing monetary policy, (3) the future of currency, and (4) the future of China in the global monetary system.

In this time of great uncertainty, it is reassuring that dedicated scholars are providing the intellectual basis for improving monetary institutions that will help avoid future crises.

This article originally appears as the Editor’s Note in Volume 38 Number 2 of the Cato Journal entitled “The Future of Monetary Policy”

Last month, in what will presumably be one of his last public speeches before he retires this June, New York Fed President William Dudley defended the Fed’s current “floor” system of monetary control against the alternative of a corridor arrangement. Because Dudley’s is one of the more complete arguments for retaining the current system to be publicly aired by a high-ranking Fed official, it’s worth quoting it at length:

In my view, the case for retaining the current floor system is very compelling for a number of reasons. First, it is operationally much less complex than a corridor system. In the current regime, the setting of IOER is largely sufficient to maintain the federal funds rate within the FOMC’s target range, as we have seen over the past few years. In contrast, a corridor system requires forecasting the many exogenous factors that affect the amount of bank reserves outstanding, and then engaging in open market operations on a near daily basis to keep reserves at a level consistent with the FOMC’s target range. This task would likely be more difficult now because of greater fluctuation in these exogenous factors relative to when the corridor regime was last in place.

Second, a corridor system constrains the Federal Reserve’s ability to provide the types of lender-of-last-resort backstops that can help support financial stability. Prior to gaining the authority to pay interest on reserves in the fall of 2008, Federal Reserve officials — myself included — were faced with a question: if the take-down on a proposed liquidity facility were large, how would we be able to drain the added reserves on a timely basis to maintain control of the federal funds rate? This was not just a theoretical issue during the financial crisis. The initial auctions of the Term Auction Facility, or TAF, were kept relatively small, in part, because of concerns that larger programs would make it more difficult for the manager of the System Open Market Account (me, in that particular case) to drain sufficient reserves to offset the TAF reserve additions. Similarly, the Term Securities Lending Facility (TSLF) — which involved the swap of Treasury collateral from the Federal Reserve against lower-quality collateral held by primary dealers — was introduced in large part because collateral swaps, unlike cash loans, did not affect the amount of reserves in the banking system. My overall point is that broad-based, open-ended lender-of-last-resort facilities are more difficult to accommodate in a corridor system because of the need to drain any reserve additions to keep the federal funds rate close to the FOMC’s target.

I see this as an important shortcoming of the pre-crisis corridor regime that does not get sufficient attention. Having the ability to introduce broad and credible lender-of-last-resort backstops — well secured by pledged collateral — can be critical when confidence falters and financial stability is at risk. Private sector participants are more likely to continue to engage with their counterparties — and to borrow and lend — when they know a central bank backstop will be available if economic and financial conditions deteriorate. A corridor regime could cause the Federal Reserve to delay or avoid providing such backstops, which could increase financial stability risks by causing lenders and borrowers to disengage with one another earlier.

Dudley added that his opinions were shared by most other members of the FOMC.

For the sake of clarity, let’s label Dudley’s two arguments for a floor system the “Unrestrained Last-Resort Lending” argument and the “Simplified Monetary Control” argument.

The Floor System and Last-Resort Lending

How compelling are those arguments? Let’s start with the “Unrestrained Last Resort Lending” argument. According to Dudley, the Fed’s floor system allows it to avoid the “constraints” a corridor system would place on its ability to engage in last-resort lending. Specifically, unlike a corridor system, the Fed’s floor system allows it to expand its balance sheet, whether through last resort lending or by means of open-market security purchases, to any desirable extent, without altering its monetary policy stance. In particular, by switching to a floor system after October 6, 2008, the Fed was able to prevent its emergency lending from contributing to a general loosening of credit without having to continue “sterilizing” its loans by disposing of securities from an already depleted Treasuries portfolio.

What Dudley neglects to point out, which anyone conversant with the history of the Great Recession knows, is that the last thing the U.S. economy needed in the fall of 2008 was a new device for keeping a tight reign on the supply of credit! Rather than helping the Fed to maintain a desirable monetary policy stance, its new floor system contributed to what proved, in retrospect, to be a severe over-tightening of monetary policy. Consequently, on that occasion at least, the U.S. economy would have been better off had the Fed stuck to its old, corridor-type operating system.

Might the advantage Dudley claims for a floor system come in handy on some future occasion? It’s highly unlikely, for two reasons. The first is that occasions on which a central bank is warranted in making last-resort loans on a large scale are ipso facto ones on which there’s an aggregate liquidity shortage. The second is that, to address an aggregate liquidity shortage, a central bank has not only to expand its total lending, but to see to it that its lending adds to the general flow of credit, and not just to the piling-up of excess reserve balances. Put another way, in economies with otherwise well-organized private credit markets, solvent private financial institutions will have recourse to central banks’ emergency credit facilities only when those private markets have themselves begun to run dry. The central bank in that case has a positive duty to see to it that those markets are replenished. It was this duty that the Fed so conspicuously failed to perform in late 2008.

Indeed, the overarching purpose of liberal last-resort lending has always been, according to thoughtful authorities going back to Bagehot (and probably beyond), not to engage in what Marvin Goodfriend calls “credit policy,” meaning the re-shuffling of existing credit among particular firms and markets, but to combat overall liquidity shortages. In taking the steps it took in the fall of 2008, first by sterilizing its emergency loans and then by encouraging banks to hoard the proceeds, the Fed seemed to have forgotten this. As Thomas Humphrey explains,

To classical writers, injections of base money were the essence of LLR operations: The LLR existed solely to expand the base temporarily in amounts sufficient to offset panic-induced falls in both the money multiplier and the circulation velocity of money thus preserving monetary supply-demand equilibrium and price-level stability in the face of bank runs.

In short, what Dudley sees as an advantage of the floor system in dealing with financial crises is no advantage at all. Although a floor system would make it easier for the Fed to engage in pure “credit policy,” such policy alone doesn’t usually suffice to avoid a credit crunch. On the other hand, a floor system undermines the capacity of either last-resort lending or open-market purchases to revive flagging credit markets. Indeed, because it encourages banks to lend to the Fed instead of funding private money markets, a floor system actually contributes to the drying-up of those markets.

The “Simplicity” of a Floor System

Now let’s turn to the “Simplifies Monetary Control” argument. Dudley’s basic claim here — that a floor system “is operationally much less complex than a corridor system” — is correct so far as it goes. Under its floor system, the Fed can stay within a very narrow Fed funds target range without having to resort to any open-market operations save the reverse repos it engages in for the sake of fixing the range’s lower bound.

But this gain in simplicity, far from being free, comes at the cost of (1) a substantial decline in interbank borrowing and lending, particularly on the (unsecured) federal funds market; and (2) a related increase in the Fed’s absolute and relative involvement in financial intermediation. As Ulrich Bindseil and Jukliusz Jablecki have compellingly argued, to arrive at a sound decision regarding the best operating framework for a central bank, one has to take all of the relevant trade-offs — that is, all of the costs and benefits of alternative arrangements — into account. One must recognize, furthermore, that instead of a simple choice between a floor system on the one hand and a corridor system on the other, central banks face a much larger set of options. These include systems with corridors of varying widths, where a narrower corridor makes conducting monetary policy less “complicated” than a broader one, though still more complicated than a floor system, while a broad corridor may be more conducive to active (overnight) interbank markets and maintaining a “lean” central bank balance sheet. Among these many alternatives, a floor system represents a corner solution, which ought to be reason enough to doubt that it’s optimal.

But does it really matter whether there’s an active interbank lending market or not? As Bindseil explains elsewhere, it does, for several reasons:

First, [an active interbank market] allows measuring easily the short term interest rate and thereby the degree of achievement of the operational target of monetary policy… . Second, it has been argued that interbank money markets are useful because they incentivize banks to cross‐​monitor each other, which strengthens the market mechanism (e.g. Blasques et al, 2016). Of course, incentives for monitoring banks should also be to some extent effective through other bank funding markets (e.g. short term paper, bond and equity markets). But it seems plausible that interbank markets, as a peer‐​to‐​peer market, have something particular in this respect. If monitoring is effective and long term relationships (and sufficient limits) are in place, this can also support financial stability as temporary capital market funding stress or deposit outflows affecting a single banks that are not due to fundamentals could be compensated by interbank money markets. Finally, an active interbank money market provides evidence of netting of the liquidity needs of the banking system before recourse is taken to central bank credit.

The study by Blasques et al, which looks at the Dutch interbank market, finds that encouraging banks to take part in that market results in more intense peer monitoring, strengthened relationships among the lending banks, reduced bank-to-bank credit risk, and an increase in the overall market liquidity associated with a given level of reserves. It’s one of several such studies inspired by the pioneering work of Jean-Charles Rochet and Jean Tirole (1996), who first drew attention to the advantages of interbank peer monitoring, while warning that, insofar as it discourages such monitoring, “government intervention…destroys the very benefit of a decentralizing [banking] system.”

Another recent study, by Marie Hoerva and Cyrol Monnet (2016) asks, “If liquidity provision is centralized during crisis times, with a central bank acting as the intermediary, why isn’t it centralized also in normal times? What is the role of decentralized money markets? What is the function of unsecured and secured markets, respectively?” These are excellent questions, and one only wishes that all regulators would ask them. Hoerva and Monnet’s answer is that money markets, and unsecured interbank markets especially,

can provide market discipline, which we define as an ex ante provision of incentives to banks to conduct business in a safe and sound manner. The bilateral interaction between a borrower and its lender in the money market ensures that incentives to take on excessive risk are tamed.

The authors find, furthermore, that

In the absence of aggregate liquidity shocks, a central bank subject to the same informational friction as lenders in the money market cannot improve on the money market allocation. In fact, we show that unsecured financing by the central bank is harmful since it hurts market discipline. When there is an aggregate liquidity shortage, however, we show that secured lending by the central bank is beneficial. In this case, some borrowers with valuable collateral who do not meet lenders in the secured money market can get financing from the central bank. This prevents inefficient liquidation of projects, while preserving market discipline in the unsecured market.

All of which sounds to me a lot like what I just said about the “classical” purpose of last-resort lending.

Finally, there’s Craig Furfine’s (2001) study, “Banks as Monitors of Other Banks,” where he looks specifically at lending on the federal funds market and finds

that the interest rate charged on federal funds transactions reflects, in part, the credit risk of the borrowing institution. In particular, borrowing banks with higher profitability, higher capital ratios, and fewer problem loans pay lower interest rates on federal funds loans. Thus, the empirical evidence suggests that banks identify risk in their peers and effectively monitor other banks.

It was mainly owing to their desire to reinvigorate their economies’ unsecured interbank lending markets that all save three of the monetary authorities that adopted floor systems either before or during the financial crisis have since abandoned them. Although most have reverted to corridor systems, several have instead opted for “tiered” systems in which a fixed quantity of reserves only earns the going policy rate, which reserves beyond that amount earning a lower, and in some cases a negative, rate. If Fed officials have some reasons for thinking it O.K. to ignore the considerations that caused so many other central banks to resist keeping their floor systems in place, I hope they will eventually share them with us.

Apart from discouraging unsecured interbank lending, a floor system can also allow central bank intermediation to crowd-out other sorts of private intermediation, including bank lending to businesses and consumers. The extent of such crowding-out will, of course, depend on the extent of banks’ excess reserve holdings. In principle, one can have a floor system where the crowding-out effect isn’t all that large. But that’s far from the sort of floor system Dudley has in mind: instead, he’d rather the Fed’s balance sheet got no lower than $2.9 trillion, or roughly three times its pre-floor-system level, and would prefer to have it stay even larger. Such a big balance sheet will keep life simple for the staff at the New York Fed’s trading desk, all right. But don’t expect it to do the U.S. economy any good.

In the long, tragic chronicle of the Great Recession, April 30, 2008, doesn’t resonate as an infamous date. It lacks the notoriety of March 16, 2008, when, by guaranteeing $30 billion of Bear Stearns’ assets, the Federal Reserve crossed a last-resort lending Rubicon, extending its safety net to an investment bank for the very first time. Nor does it conjure up headlines like those of September 15, 2008, when the Fed reversed course by letting Lehman Brothers — a much larger investment bank — go under.

Yet April 30, 2008 was no less critical a turning point in the recession’s history than these other dates, for it was then that the FOMC, having cut the Fed’s target interest rate to 2 percent, resolved to cut it no further — drawing a line in the sand by which it unwittingly helped seal the fate of the US, and world, economy.

At the time neither Fed officials nor anyone else knew that a recession had started, let alone that it was to be the worst recession since the 1930s. Not until December would the NBER’s Business Cycle Dating Committee officially decide that the economy had been shrinking for a year. Instead, having apparently calmed markets by helping to rescue Bear, Fed officials imagined that the worst was over. “When I look at where I was in the last [March] FOMC meeting,” Frederic Mishkin told his fellow FOMC members during that fateful late April gathering, “I sounded so depressed…as though I might take out a gun and blow my head off… . But my sunny, optimistic disposition is coming back…. I think there is a very strong possibility that the worst is over.”

Despite the financial system’s shaky state, what several Fed officials most feared that April was, not a looming recession, but inflation. Between the fall of 2007 and the Fed’s April 30th meeting the CPI inflation rate had jumped from about 2 percent to twice that level. Thanks mainly to rising oil prices, it kept going up well into the summer, when it peaked at 5.5 percent. In response the FOMC’s hawks, led by Dallas Fed President Richard Fisher and Richmond Fed President Jeff Lacker, having already opposed the Fed’s last rate cut in March, refused to support any further cuts, and would keep on successfully opposing them until October.

Ben Bernanke, for his part, was determined to avoid any further public displays of inter-FOMC dissent. To Fed Vice Chair Donald Kohn he privately complained, in an email sent the day after the FOMC’s August meeting, that he found himself “conciliating holders of the unreasonable opinion that we should be tightening even as the economy and financial system are in a precarious position and inflation/​commodity pressures appear to be easing.” But he did so, he says in his memoirs, because he worried that too many FOMC dissents would “undermine our credibility.”

Thus the Fed’s monetary policy stance continued to reflect a minority of FOMC members’ preoccupation with inflation even as financial markets began to crumble. To shore up those markets, the Fed supplied over $1 trillion in emergency credit, issued through various emergency lending facilities, to various sorts of financial institutions, while extending a further $85 billion line of credit to AIG. Lending on so vast a scale would normally have flooded the banking system with liquid reserves, causing interest rates to fall in turn. The Fed was nevertheless determined to hold the line it drew that April, and to do it by hook or by crook.

In the event the Fed used both a hook and a crook. The crook consisted of its decision to “sterilize” those emergency loans, yanking-back as many reserves as its emergency loans created by emptying its portfolio of Treasury securities worth as much as the loans it made. That strategy lasted until Lehman’s demise, after which the volume of Fed lending exploded, while its Treasury holdings dwindled. So on October 6^th out came the hook, consisting of the Fed’s offer to start paying interest on bank reserves. By paying banks more to hoard reserves than they could make by lending them, the Fed could effectively sequester those reserves, preventing them from contributing to increased lending, spending, and prices.

By then, however, the Fed’s Maginot Line had already been breached. With market interest rates in free fall, the Fed’s 2 percent rate target was mere wishful thinking. Consequently, on the same day that it announced its plan to pay interest on bank reserves, the Fed at last relented by cutting its rate target to 1.5 percent. But no sooner had it done so than reality made a mockery of the new target as well. Eventually the Fed settled on an interest-rate target “range,” with the interest rate paid on bank reserves as its upper bound, and a lower bound of zero. The new target range had at least one undeniable advantage: the Fed couldn’t miss it. But despite that innovation it wasn’t until sometime in November 2008, as the unemployment rate approached 7 percent, that the FOMC determined that monetary stimulus was, after all, just what the economy needed.

The anniversary of a blunder is a good time for taking stock. Could it happen again and, if it could, what can be done to keep it from happening?

The bad news is that it certainly could happen again, and that it probably will happen so long as many Fed officials insist on treating the inflation rate as an all-purpose indicator of the stance of monetary policy. The good news is that there’s a far better alternative, if only the FOMC will use it. That alternative, which Market Monetarists like David Beckworth, Lars Christensen, and Scott Sumner have been pushing ever since the Great Recession started, is for the FOMC to keep its collective eye, not on the inflation rate, but on the level and growth rate of nominal GNP — a measure of the flow of spending on goods and services in the economy. While oil supply shocks and such can cause misleading upsurges in inflation, as happened in the summer of ’08, they don’t make people spend more. Nor, so long as spending grows at a reasonable pace, can money be said to be over-tight. Finally, a Fed that maintains a stable growth rate of spending is less likely to blow an asset-price bubble than one that obsesses over the inflation rate.

For evidence, consider the chart below, showing (1) the Fed’s preferred inflation measure (the so-called PCE inflation rate) (dashed line), (2) the unemployment rate (dotted line), and (3) nominal GDP growth (solid line), from 1996 until recently. The vertical shaded bars mark the dates of the dot-com and subprime recessions. Suppose that, instead of paying attention to the inflation rate, the Fed had set itself the task, from 1996 onward, of keeping nominal GDP growing at a steady rate of, say, 4.5 percent. Would we have had more or less severe cyclical ups and downs, and accompanying jumps in unemployment? In macroeconomics, nothing is ever perfectly clear. But here, for once, the answer seems clear enough.

It so happens that the latest GDP growth rate figure, for the last quarter of 2017, was just shy of 4.5 percent. So, here is a modest proposal: let the Fed commemorate the decennial of April 30, 2008, by announcing that it intends, henceforth, to devote itself to keeping that growth rate from changing. Would that step solve all of our monetary and macroeconomic problems? Heck no. But it sure could help.

(I thank Sam Bell for his helpful feedback on an earlier version of this article.)

[Cross-posted from Alt‑M.org]

When the New York Attorney General launched an inquiry into cryptocurrency exchanges last week, his office cited “significant volatility, instability, and risk” as motivating factors for the probe. This echoes statements by International Monetary Fund chief Christine Lagarde and Agustín Carstens of the Bank for International Settlements.

Politicians are, as a rule, no better at dispensing investment advice than your barber. Yet, they have a point when they warn about cryptoasset price fluctuations. In the last two years, the annual volatility of bitcoin and ether — computed from the standard deviation of daily returns — has been 100 to 150 percent, four to six times that of commodities such as gold and oil, and of emerging-market currencies.

There is a danger, however, in basing policy on eye-catching numbers like these. For the current volatility of individual cryptoassets tells us little about the true risk exposure of investors, now and in the future.

What matters is the risk of the portfolio as a whole

Changes in the price of cryptoassets have so far correlated little with stock market movements. The table below, taken from the IMF’s latest Global Financial Stability Report, shows that daily returns on bitcoin, on one hand, and on stocks, bonds and currency, on the other hand, rarely move together.

This matters because investor exposure has less to do with the risk of individual assets than with the risk of the portfolio as a whole. Portfolio risk in turn is affected by how much the component assets move together.

Consider a multi-stock asset (called ‘Market’) with mean annual return of 7 percent and annual volatility of 20 percent. Consider also an asset (called ‘Crypto’) with mean return of 500 percent, consistent with recent cryptoasset performance, and volatility of 200 percent. ‘Market’ and ‘Crypto’ returns have a correlation of 0.02, equal to the one between the S&P 500 and bitcoin in the IMF table.

Now imagine your portfolio is a 90–10 mix of ‘Market’ and ‘Crypto’. The expected portfolio return is a weighted average of the expected return on each of the component assets. It comes to 56.3 percent — not bad for a year’s investment!

What about portfolio volatility? Here things get a bit more complicated, because portfolio volatility depends on both the volatility of each component asset and on the correlation between these independent volatilities. It turns out that portfolio volatility in this case is 27 percent.

That sounds like a lot: in any year, the return on the portfolio may vary from the expected return by plus or minus 27 percentage points. It’s also clearly higher than the 20 percent volatility associated with owning ‘Market’ alone.

But consider the change in expected returns. Adding in ‘Crypto’ to represent 10 percent of holdings increases the expected annual return from 7 percent to 56.3 percent. An eightfold increase in average gains in exchange for raising volatility by a third.

This is all hypothetical, but it goes to show that a high-volatility, high-return cryptoasset may not increase portfolio risk nearly as much as might at first be apparent.

Volatility will likely decrease as more people use cryptoassets

Now consider the table above, also from the IMF, which shows how much individual cryptoassets move together. These correlations are relatively low when compared to stocks: share returns on the S&P 500 had a median correlation of 50 to 60 percent for much of the last fifteen years.

Why does this matter? Because it suggests that cryptoasset prices are relatively independent from one another, rather than moving in unison as is implied by the narrative of an irrational cryptoasset ‘bubble’ popular in some circles.

This also serves to illustrate the second reason why cryptoassets may not turn out to be as risky as some think. To wit, that they feature network externalities. Cryptoassets succeed to the extent that they can attract users, and the more people adopt them, the more attractive it becomes for others to do the same. After all, the only function that cryptoassets serve is as currency to transact on blockchain-based platforms. The more counterparties on the platform, the more interesting it becomes to hold the cryptoasset.

Some may wish to place bets on how willing other people will be in future to hold individual cryptoassets. Yet, in the long run, cryptoassets’ value comes from the goods and services they serve to acquire. Therefore, as networks grow and as the uses of cryptoassets become more widely understood, prices will likely converge to that utility value and may fluctuate less.

None of this should assuage worries about the future performance of individual cryptoassets. That the three-figure returns we have recently witnessed will continue is unlikely. Furthermore, when (and at which speed) cryptoassets will begin to converge to their true values remains unknown. Additionally, in the real world there are sources of risk other than volatility, such as the risk of not finding willing buyers at certain times (liquidity risk) and the risk that cryptoasset ventures will fail (default risk).

Finally, there is no guarantee that the low stock-crypto correlations recorded today will carry on into the future. If cryptoassets are widely adopted by retail investors, their co-movement with other asset classes may well increase, raising portfolio risk.

Nevertheless, the discerning Alt‑M reader should take claims of extreme volatility in cryptoassets with a grain of salt, especially if he or she is a financial policymaker.

The world has lost one of its greatest monetary economists ever: Leland Yeager (b. 1924) has passed away, and boy will I miss him.

Leland’s writings on monetary economics taught me a big chunk of all that I know about the subject. Among other things, they gave me a better understanding of just what “money” means; of what banks do and why it matters; of how changes in the price level clear the market for money balances (and why those changes can take time, giving rise to bouts of “monetary disequilibrium”); and of how various international monetary arrangements can either aggravate or limit the extent of such disequilibrium.

Beyond matters of strict economics, Leland taught me — by example mainly — the importance of clear writing, and of steering clear of such enervating impediments to good scholarship as excessive preoccupation with one’s “methodology” or exclusive devotion to any one school of economic thought.

But mostly I will miss Leland simply because, besides being a kindred spirit, he was one of my all-time favorite human beings. Although it has now been many years since I last spent time with him, we corresponded regularly until recently, and I remember our past encounters with great affection. Leland was simply a blast to be with, and all the more so if the occasion involved plenty of good food and wine, for which he had a fine appreciation (and, in the case of wine, an apparently unlimited tolerance).

But all that food and wine was just so much fuel and lubricant. The motive force behind those rollicking rendezvous was Leland’s gift for conversation. His erudition and curiosity were such that one could always count on learning something, despite never knowing just where the conversation was going. And with Leland’s broad interests it could end up anywhere. Well, almost anywhere: so far as I can recall we never talked about professional sports, TV shows, or consumer electronics. That alone was a reason, so far as I was concerned, for cherishing Leland’s company.

Leland also spoke more languages than anyone I ever knew — and more than anyone I’ve ever heard of save Richard Burton (the explorer, not the actor), who commanded 29 of them! So depending on the food we were eating or where the conversation wandered we might switch to Italian, or French. But whereas I speak the one fluently, the other haltingly, and nothing apart from them besides English, Leland was conversant with at least half a dozen natural languages, as well as with the planned languages Esperanto and Interlingua. For all I know, he was perfectly capable of waxing lyrical, in Swahili of course, over a well-seasoned bowl of ugali.

Though we eventually became close, and despite my having admired Leland before we ever met, for a time he wanted nothing to do with me. Believe it or not, instead of being repulsed by any of my many, genuinely off-putting qualities, he disliked me because of my name. It happens, you see, that Leland once had a colleague whom he intensely disliked, whose last name also began with “Sel.” That alone made me persona non grata. It was, Leland later explained to me, a matter of simple prudence. “ ‘Selgin,’ ‘Sel_​_​_​’ … Too close for comfort!”

After I’d known him for some years, it occurred to me that, although I’d learned plenty from Leland’s writings on monetary economics, most of those writings were scattered throughout various professional journals, some of which weren’t easy to come by. (This was, needless to say, in the days before the world-wide-web and PDFs and all that.) So I had the bright idea of gathering them together under one cover, along with several of Leland’s unpublished papers. I approached Liberty Fund with the proposal, knowing that, if they went for it, I’d end up not only with a beautiful book, but with one that, in its paperback version especially, even grad students might reckon a bargain. Such was the genesis of The Fluttering Veil.

That title, by the way, alludes to a remark by John Gurley, another monetary economist who once summed up Milton Friedman’s monetarism, facetiously but not inaccurately, as holding that “Money is a veil, but when the veil flutters, the economy sputters.” Although Leland was nothing if not eclectic when it came to schools of economic thought, the label he was most happy with was “old-fashioned monetarist,” by which he mainly meant to distinguish himself from New Classical economists like Bob Lucas, Robert Barro, and Tom Sargent. The New Classicals imagined that, by modeling expectations as model-consistent or “rational,” while assuming that prices always adjusted to their Walrasian market-clearing values, they were proffering a more “rigorous” version of monetarism.

Yeager, who was equipped with an especially sensitive version of the device Ernest Hemingway referred to as a “built in, shock-proof s***t detector,” saw right through the New Classical pretense. Instead of perfecting monetarism, by invoking the deux ex machina of instantaneous Walrasian pricing, the New Classical economists managed instead to strip it of its capacity to account for the real consequences of monetary disturbances.[1]

But while he rejected the “equilibrium always” theorizing of New Classical economists, and understood instead that an economy has to “grope” its way to a new set of equilibrium prices following any major monetary disturbance, Yeager was far from embracing either “Keynesian” or “New Keynesian” economics. While he denied that prices adjust instantly to clear the market for money balances, he was if anything still more adamantly opposed to the “old” Keynesian treatment of the rate of interest as the “price” of money — with its implicit assumption of a parametrically “given” price level. “New” Keynesian models, with their staggered pricing parameters and other devices for simulating “sticky” prices, are no doubt better. But those models’ basic tenets, Yeager pointed out, are in fact neither “New” nor particularly “Keynesian,” having roots that trace back to Classical economics, and having been a feature of old-fashioned Chicago-school thinking since the days of Herbert J. Davenport.

Now that Leland is gone, it cheers me up somewhat to think that future students can still learn from him, and that they might even do it using the collection of his articles I assembled for the purpose. But no amount of exposure to Leland’s writings can suffice to give someone who hasn’t met him a true measure of the man. He had too many facets; and he was, in his peculiar way, infinitely delightful. I thank my lucky stars for having had the chance to know him.

_______________________________

[1]For all his awareness of the drawbacks of “equilibrium always” reasoning in monetary economics, Yeager was far from holding general equilibrium theory in contempt. On the contrary: he insisted, against its (mainly Austrian School) detractors, that it supplied “a necessary background” for monetary analysis as well as an important check against many kinds of fallacious reasoning. Yet Yeager would also have been the first to defend valuable Austrian-school insights against THEIR detractors among more mainstream economists. Yeager was, in short, a scholar remarkably free of partisanship and bias, save one favoring reasonable arguments over unreasonable ones.

Last week the White House announced that Richard Clarida will be nominated to become Vice Chair of the Federal Reserve Board. More than a month ago, Clarida became the front-runner for the role. He is widely seen as a centrist and a pragmatist holding mostly conventional views on monetary policy. Mostly.

As Vice Chair, Clarida will be the third pillar of the Fed’s new leadership, joining Chair Jerome Powell and recently announced incoming NY Fed President John Williams. Having been an economics professor at Columbia University since 1988 and a Global Strategic Advisor at Pacific Investment Management Company (PIMCO) since 2006, Clarida provides a complement to both Powell’s largely business background and Williams’ career inside the Fed.

With a couple of mutual research interests, Clarida and Williams will likely work well together. They’ve both explored the natural rate of interest (r*) — Williams is the coauthor of the widely cited r* estimates and Clarida has examined natural rates from an international perspective. Another area of mutual interest is price level targeting. As I have noted previously, Williams is an advocate of the Fed adopting such a target while Clarida has also explored its merits for monetary policy.

At first blush this may be concerning, given the shortcomings of price level targeting. However, the evolution of Clarida’s post-crisis thinking on monetary policy, including towards price level targeting, shows that he may be persuaded by the superior merits of nominal GDP level targeting.

In 2010, Clarida presented a paper at the Boston Fed conference, Revisiting Monetary Policy in a Low Inflation Environment. The paper discussed what economists had learned throughout the 2000s, with a particular focus on what they ought to learn after years of low inflation (a subject with renewed saliency in recent years).

He also discussed the large-scale asset purchases of the Fed’s quantitative easing program, casting doubt on much of the literature of the day — which tended to find positive, but limited effects of such purchases on reducing bond yields. Clarida, on the other hand, thought large-scale asset purchases could be very robust. He had two main points, one flawed and one overlooked.

The first was that a determined central bank, prepared to buy the requisite amount of securities up to the outstanding stock, could always put a ceiling on the yield (or, put another way, a floor underneath the price) of the securities it targeted. Now, this proposal puts the central bank squarely into the credit allocation business, which is a role it ought to avoid.

However, the second, subtle point in his framework that should not be ignored is that Clarida recommends the central bank fully commit to an outcome rather than announce various mechanical steps. This goal-oriented strategy suggests that Clarida may indeed become receptive to the benefits of nominal GDP level targeting — a point to which I will return.

But why did Clarida suggest focusing on securities’ yields at the time, rather than consider changing the central bank’s nominal target?

He explained that adopting a price level target, a possible alternative to the Fed’s then “stable prices” mandate and now 2% inflation growth rate target, was not a time consistent policy. That is to say, a central bank would initially commit to level targeting when its policy was below the trend line but then fail to run an expansionary policy to reacquire that trend line. Clarida believed that, while attractive in theory, a central bank could not credibly commit itself to future actions. Modern Fed parlance would call this forward guidance and, to Clarida, that was not a sufficiently robust strategy because it lacked the “proper commitment technology” to satisfy markets and the public that the central bank would indeed execute its promises in the future.

But by 2016, as the recovery from the Great Recession proved to be weaker than expected, Clarida’s thinking about forward guidance and the viability of a level target had changed.

At a Brookings conference early that year, which focused on whether the US was ready for the next recession, Clarida said that despite the fact that textbooks and economic theory suggest forward guidance should not work in practice, it, in fact, does. He also suggested, or perhaps wondered, if this meant a price level targeting strategy could work (his slides are here).

He rightly pointed out that a price level target would have the advantage of making up for past monetary policy failures that inflation growth rate targeting lacks. Level targeting corrects for the bygones problem in growth rate targeting, making up for past mistakes rather than embedding those errors in current policy.

Incidentally, this was not the first time he had suggested a price level target for the Fed.

In a Global Perspectives note at PIMCO published in 2014, Clarida endorsed a price level target. He believed such a target would be an improvement for the new Yellen Fed over the Evans Rule, which had been in effect for more than two years. Promising to leave rates at the zero lower bound until either inflation was above 2.5% or the unemployment rate was below 6.5% was not enough to guide policy going forward. These thresholds were not goals and therefore were insufficient anchors for monetary policy (indeed the Fed abandoned the Evans Rule the following month).

Clarida saw the weakness in the Fed’s communication strategy of putting thresholds on inflation and unemployment and proposed a price level target as an alternative.

As mentioned, a price level target is not the proper alternative for the Fed’s target because it can make a central bank procyclical and thus amplify, rather than dampen, the business cycle. A price level targeting central bank runs the danger of tightening policy because of an adverse supply shock and over-easing because of a productivity boom. Nevertheless, Clarida was right to criticize the kind of open-ended policy that characterized the Evans Rule and this kind of thinking will be a welcome addition to the Board.

Clarida now seems predisposed to three views about monetary policy that could significantly influence the Fed’s actions going forward:

1. That a central bank fully committed to reaching a nominal target is superior to one focused on mechanical operations.
2. That employing forward guidance is indeed an effective tool for conducting monetary policy.
3. That level targeting can make up for past errors in monetary policy in a way that growth rate targeting cannot.

Combined, I think these views point to Clarida being more amenable to a nominal GDP target than even he may presently admit. After all, nominal GDP level targeting requires two things of a central bank to work in practice: first a central bank must credibly pledge to keep nominal GDP growing along a stable trend line and then it must be prepared to do whatever is necessary to achieve that level of nominal growth.

Clarida has already expressed the importance of both of these elements. In addition, he has repeatedly shown a willingness to let his thinking evolve when presented with new information. Therefore, he may yet be persuaded on the shortcomings of price level targeting in favor of a superior option.

Clarida may have said little about nominal GDP targeting to date — but with his nomination, the Fed may be getting a nominal GDP target advocate for the future.

[Cross-posted from Alt‑M.org]

Those who follow cryptocurrencies will know that an initial coin offering (ICO) refers to the issuance of digital tokens to finance a blockchain-based venture. They will also know that the legal status of tokens is an ongoing discussion among market participants and regulators.

ICOs have attracted policymakers’ attention because they are growing in number and size. For example, late last year Filecoin, a venture promising to reduce the costs of data storage, raised $257 million in a token offering. A Filecoin token gives its holder the right to buy storage services on the Filecoin platform.

Besides being a means by which users purchase goods and services on blockchain platforms, tokens are the reward to those users who help to effect transactions. In the case of Bitcoin, the gains to these ‘miners’ come from their role in validating exchanges of bitcoin. Filecoin miners, for their part, are rewarded for making abundant storage space available.

How do blockchain ventures price tokens in an ICO? Do they have a financial incentive to mislead buyers? How do venture capitalists, who invest in ventures with an expectation of future profits, differ from people who acquire tokens because they expect to use the goods and services to which tokens entitle them?

A new NBER working paper by MIT’s Christian Catalini and Joshua Gans from the University of Toronto supplies answers to these questions by studying a two-period model of a token offering, covering the ICO stage during which interested buyers acquire tokens, and a market stage at which the platform goes live.

Among its findings:

1. Token prices reveal buyers’ valuation of tokens’ usefulness.

The near-term objective of an ICO is to raise funds for a venture. But buyers bid for tokens on the basis of the gains they expect to make from using them. For example, those who took up the Filecoin offering did so in the expectation that the tokens would be valuable as means to buy data storage. Thus an ICO reveals buyers’ valuation of the venture’s business proposition.

Without a claim against future profits, and because the tokens on offer have no established exchange value, a token buyer’s gain comes solely from his or her ability to enjoy the goods and services that the platform promises to make available. That’s why the issues in an ICO are known as ‘utility tokens’ and why many analysts have opposed their designation as securities.

It’s true that a token buyer could re-sell the token, thereby perhaps deriving a gain — although many ventures, to stay on the safe side of the SEC, have followed the SAFT (Simple Agreement for a Future Token) model of issuance, which forecloses secondary trading until the platform is live. But even if there is secondary trading, the ultimate source of a token’s value — the reason the final purchaser will pay good money for it — is the claim it offers against a particular good or service.

2. ICO funding is less certain than equity funding. But successful ventures funded by an ICO have higher returns than when financed with equity.

There are benefits to funding a venture by issuing tokens. The venture is able to attract not just funds but future users of the platform. As we saw above, success in doing so is a measure of whether the venture is likely to become popular.

Yet utility tokens don’t entitle their holders to any profits, just the goods and services that the token promises to buy. Catalini and Gans show, as a result, that ICOs may sometimes fail to raise enough funds even when they are predicted to be viable, whereas equity financing, in their model, always raises sufficient money to fund viable ventures.

This finding helps explain why many ventures, including Filecoin, have venture capital investors in addition to raising funds through token issuance. VC investment helps to cover the fixed costs of development and increases the probability that viable ventures will come to fruition. On the other hand, equity-funded ventures yield lower returns to developers than ICO-funded ones. A better chance at success doesn’t come free of charge.

3. Commitment has financial value.

Much recent discussion of ICOs has involved the incentives of the venture. With so many crypto-asset scams in the press, some have wondered whether it might be the technology itself that encourages deception.

Catalini and Gans’ paper suggests otherwise. If the venture cannot, for example, commit to a predictable schedule of token growth (or no growth) over the lifetime of the platform, then the value expectations of prospective buyers will change. Uncertainty about platform governance thus makes it less likely that an ICO will raise sufficient funds. The doomed launch of the Venezuelan Petro last month underscores the problems that unreliable token offerings face in raising capital.

The venture must inspire confidence that the tokens it issues will remain the only medium to purchase goods and services on its platform. If dollars can subsequently buy one access to the platform as well as tokens, then the latter have no utility value.

This finding explains why ICO white papers — see, for instance, the one issued by developers of Filecoin — go to great lengths to explain the mechanics of their platform. Some ICOs, it is true, lured investors with the promise of large gains while giving little detail about the function of the proposed platform. But can those poor buyers be said to have had rational expectations about anything?

4. Network effects are virtuous (for the platform).

If users derive value from other people’s joining a blockchain platform, i.e. there is a network effect, then they will be willing to pay more for ownership of tokens. In the case of Filecoin, there is a benefit to those buying storage space from more miners’ being involved, namely better pricing through more competitive bidding by those selling storage space.

But if token buyers have rational expectations and all benefit from network effects, then Catalini and Gans show that no individual buyer will be able to pay any less for the tokens than their true valuation. As the authors put it, unfavorable expectations about demand are not sustainable.

Skeptics may quibble with the paper’s simplified model, particularly its assumption of rational expectations from token buyers. Given cryptocurrency volatility, isn’t irrational exuberance perhaps a more plausible assumption?

Still, Catalini and Gans’ conclusions reveal much about the incentives and trade-offs facing blockchain ventures. To succeed, they must commit to predictable governance and clearly show the gains to be had from ownership of the token.

Perhaps most relevant for policymakers, the paper’s findings suggest that utility tokens should not be designated as securities according to the Howey test. In Catalini and Gans’ model, the tokens are not an investment for profit but an advance purchase of goods and services on a platform. In legal terms, tokens are commodities, not securities.

Whether regulators will be persuaded by these arguments is an altogether different question.