The Federal Reserve Bank of New York has made its decision. On June 18 of this year John Williams, currently serving as the President of the Federal Reserve Bank of San Francisco, will succeed William Dudley as New York Fed President. This decision will have many ramifications in the years to come, but several key points immediately stand out.

It means that Jerome Powell, the newly minted chair of the Fed, who is a lawyer not an economist, will have someone steeped in monetary policy by his side on the Federal Open Market Committee (FOMC) — the NY Fed President serves as the vice chair of the FOMC and is a permanent voter.

Williams has spent nearly his entire career within the Federal Reserve System. A student of John Taylor, Williams earned his PhD in 1994 at Stanford and immediately went to work at the Board of Governors. He stayed at the Board until 2002 when he moved to the San Francisco Fed. In 2011, Williams succeeded Janet Yellen as president there, having served as her research director.

The move to NY continues Williams’ ascension through the ranks of the Fed. While the NY Fed is one of a dozen regional banks, it is far and away the most important.

As president of the San Francisco Fed, Williams was already a voter on this year’s FOMC, but leading the NY Fed gives him a vote every year — the San Francisco Fed President votes only once every three years.

With the trading desk housed at the NY Fed, it is responsible for executing the monetary policy decisions of the FOMC. The NY Fed’s special placement makes its president one of the top three officials within the Federal Reserve System — along with the Vice Chair of the Board and, of course, the Fed Chair.

While Williams has never worked directly in financial markets, that fact should not be seen as a criticism. His career in monetary policy complements Chair Powell’s business background, which is important as long as the Vice Chair of the Board remains a vacant seat. Furthermore, and perhaps because he has not worked directly in markets, Williams understands that monetary policy should not overreact to short term data, particularly drops in financial markets. In his most recent speech, he said that there is no reason to expect a “knee-jerk reaction” from the Fed in response to recent events.

Williams’ specific monetary policy expertise is important in additional ways.

For nearly twenty years Williams has been discussing ways to measure the natural rate of interest (r*), which is a key input into many monetary policy rules, including the Taylor Rule. Though r* had been declining shortly before the Great Recession, it fell sharply during the financial crisis and has not recovered. This line of research has led Williams to the conclusion that the Fed is quite likely to be at the Zero Lower Bound again during future downturns. Because of this, Williams has become one of the most prominent advocates inside the Fed for finding an alternative target for conducting monetary policy. His preferred alternative to the Fed’s current inflation rate target is price-level targeting.

Targeting the inflation rate means that policy errors are ignored going forward. When the Fed undershoots its inflation rate, as it has almost without exception since adopting it in 2012, it doesn’t take corrective action to atone for those errors. Price level targeting, on the other hand, does correct for these mistakes by returning the price level to its overall trend. Level targeting offers a stability that inflation rate targeting cannot.

While Williams should be commended for his willingness to rethink the central bank’s inflation target from within the Fed, a price level target is not the answer.

Level targeting is certainly preferable to targeting the growth rate of a nominal variable, like the inflation rate, because level targeting obliges a central bank to make up for past policy errors. But price level targeting can sometimes contribute to the business cycle.

For example, when there is a negative real shock to the economy, like a decline in the output of oil, the price level will naturally tend to rise. Yet Fed tightening under these circumstances would only cause output to fall still further. (Williams, to his credit, admitted that adverse supply shocks would pose a challenge to a price level targeting central bank when I asked him about this at a recent Shadow Open Market Committee event).

A central bank that keeps the price level stable despite rapid productivity growth may, on the other hand, overheat the economy. Partly for these reasons, there is little reason to believe that price level targeting would have improved the Fed’s performance during the financial crisis and Great Recession, even if it might have improved upon the Fed’s actual policies at other times.

That said, John Williams is a monetary policy expert steeped in decades of research that shows evolution in his thinking — which, over the years, has earned him a reputation as a data-driven Fed official. As more economists call for a new target, we can hope he joins them in seeing the benefits of a nominal GDP level target over a price level target.

And critically important, at the NY Fed he will see the new operating framework up close and speak to those in charge of executing it on a daily basis. Janet Yellen called the new operating framework, particularly the interest rate paid on banks’ reserves, the key tool for monetary policy. Powell at his first press conference said there was essentially no decision made or forthcoming on whether the Fed will return to the corridor system used before the crisis.

Let us hope that Williams uses his expertise to critically examine the new operating framework during his leadership of the NY Fed — particularly the role this operating system may be playing in the Fed’s inability to reach its inflation target for years.

There are of course still many open questions regarding the future conduct of monetary policy, including how much the balance sheet will shrink, and whether the Fed will ever return to its pre-crisis operating framework based upon a market-determined federal funds rate. The New York Fed will play a lead role in deciding how such questions will be answered. Williams’ openness to new ideas and in engaging his colleagues, scholars, and the public on monetary policy issues is a good sign for those interested in the debate about how the Fed should conduct monetary policy.

[Cross-posted from Alt‑M.org]

Forty years ago, in the spring of 1978, I had no intention of becoming an economist. Instead, I was studying marine biology at Duke University’s Marine Lab at Pivers Island, on the beautiful North Carolina Coast. There, when the wind was up, my classmate Alan Kahana and I enjoyed going out on his Hobie 16, with Alan manning the tiller and myself hiked-out on the trapeze. We weren’t, truth be told, especially prudent sailors. On the contrary: we were so inclined to push things to the limit that one day we took the Hobie out just as a gale was getting up, and ended up…well, that’s a long, sad story. Suffice to say that it doesn’t take much to capsize a Hobie, and that on that day we capsized Alan’s boat once and for all.

What, you are no doubt wondering, has any of this to do with Interest on Excess Reserves? I’m getting there. You see, although it doesn’t take much to capsize a Hobie — a little over-trimming of the sail will suffice — once one capsizes, it’s likely to start to turn turtle as its mast fills with water. And as that’s happening, it may be all that two reasonably trim lads can do — by pulling for dear life on a righting line attached to the boat’s mast, whilst leaning backwards on its uppermost hull — to lever the thing back upright. The more the mast fills, the harder it gets. And the same sort of thing goes for letting a central bank slip into, and then trying to wrest it out of, a floor system of monetary control: the more liquidity the banking system takes in while that system’s in place, the more effort it takes to pull out of it.

As faithful readers know, I’ve long insisted that the modest interest rates the Fed began paying on excess reserves in October 2008 were enough to encourage bankers, who long made do with only the slimmest of excess reserve cushions, to hoard all the reserves they could lay their hands on. That modest little bit of Fed sail-trimming was enough to overturn the Fed’s traditional monetary control system. The Fed had long relied on a sort of asymmetrical “corridor” system, with a target fed funds rate set somewhere between zero and the Fed’s discount rate, and the effective federal funds rate kept near that target by means of small-scale open market operations. Now it had flipped-over to a “floor” system, with changes in the Fed-administered IOER rate serving as its chief instrument of monetary control.

Some economists, to be sure, refuse to believe that the modest IOER rates the Fed paid in the early stages of the crisis could account for the switch in question, or for banks’ subsequent tendency to hoard reserves. Paul Krugman even accused those who thought so of failing a “reality test,” by overlooking how, in the U.S. in the 1930s and in Japan more recently, banks hoarded non-interest-bearing reserves. But Professor Krugman himself might be said to have failed a “logic test,” calling for an understanding of the difference between a necessary and a sufficient cause. Then there’s the pesky fact that Ben Bernanke and other Fed officials secured permission to pay interest on bank reserves for the express purpose of getting banks to hoard them. Had they done so for no reason? Had Ben Bernanke himself forgotten about the 1930s? A page from his 2014 textbook is illuminating (HT: Alex Schibuola):

But allowing that a modest above-zero return on bank reserves was indeed all it took to establish a floor system, and to get banks to stock-up on excess reserves, it doesn’t follow that restoring the IOER rate to zero would have the opposite effects. The reason has to do with the immense growth in the total supply of reserve balances that has since taken place. That growth matters because, under a floor system, the greater the nominal stock of bank reserves, the lower the IOER rate must be to reduce the quantity of excess reserves demanded to zero. The accumulation of liquidity in a “floored” monetary control system thus acts like the accumulation of water in the mast of a capsized Hobie Cat, making it much harder to revert from a floor to a corridor system than it was to switch to the floor system in the first place. Call it the Hobie Cat effect.

The Hobie Cat effect can be illustrated formally using a diagram showing the supply of and demand for bank reserves or federal funds under a floor system. The supply schedule for federal funds is, as usual, a vertical line, the position of which varies with changes in the size of the Fed’s balance sheet. The reserve demand schedule, on the other hand, slopes downward, but only until it reaches the going IOER rate, here initially assumed to be set at 25 basis points. At that point the demand schedule becomes horizontal, because banks would rather accumulate excess reserves that yield the IOER rate than lend reserves overnight for an even lower return.

For the initial stock of reserves R(1), starting at the equilibrium point “a,” a slight reduction in the IOER rate would suffice to get the banking system back onto the sloped part of its reserve demand schedule, at point “b,” where reserves are again scarce at the margin. But once the stock of reserves has increased to R(2), it takes a much more substantial reduction in the IOER rate — perhaps, as the move in the illustration from “c” to “d” suggests, even into negative territory — to make reserves scarce at the margin again, and to thereby make switching to a corridor system, by a modest further reduction in the IOER rate, possible without any need for central bank asset sales.[1]

Does this mean that the Fed can never hope to escape from its current floor system unless it reduces its IOER rate substantially, and that it might even have to resort to a negative rate? It doesn’t. And it’s here that the Hobie Cat analogy fails, for while you can’t drain the mast of a Hobie Cat that’s turned turtle, the Fed can drain the banking system of any or all of the reserves it created after 2008. The obvious, and most prudent, way out of the floor system is, therefore, for the Fed to retrace the steps that got it into that system, by first shrinking its balance sheet far enough to return the stock of reserves to a point close to the kink in the federal funds demand schedule, and then reducing the IOER rate enough to make reserves scarce at the margin, thereby reviving interbank lending and establishing a corridor system.

Considering how many excess reserves banks are now holding, all of this is still a tall order. But it beats having an operating framework that leaves our monetary system sodden and adrift.

____________________________

[1] Because the move from “c” to “d,” like that from “a” to “b,” involves no change in the total stock of bank reserves, readers may be tempted to assume that it also involves no reduction in the quantity of excess reserves, and hence no change in banks’ inclination to hoard such reserves. The temptation should be resisted: although banks hold the same total quantity of reserves at “d” as at “c,” the former equilibrium involves a higher quantity of bank lending and deposit creation, hence a higher value of required reserves, with a correspondingly lower value of excess reserves.

[Cross-posted from Alt‑M.org]

Venezuela has the largest oil reserves in the world. Crude exports earn the country 95 per cent of its foreign exchange. That figure used to be lower, but relentless nationalization and the government’s insistence on controlling prices and exchange rates have made other exports unviable. Not that productive activity has reoriented inward: the IMF expects Venezuelan GDP to have dropped by 15 per cent in real terms each year in 2016 and 2017, and to do so again in 2018. This is a country in freefall.

Nor have price controls helped to sustain Venezuela’s currency. The bolivar, dubbed with cruel irony ‘strong’ because it replaced the old, weaker, bolivar at a 1:1,000 rate, has itself lost 99.9 per cent of its value against the U.S. dollar since March 2016. Shortages induced by controls, inept state management of nationalized companies, and capital flight have joined unlimited central bank money-printing to extinguish the purchasing power of Venezuelan money.

Rational policymakers would react to such a catastrophic state of affairs by enacting a dramatic U‑turn and committing to it. Previous episodes of hyperinflation in Latin America were most effectively quelled by dollarization and the subsequent liberalization of goods and capital markets. But the extreme form of socialism that is the ruling regime’s ideology makes the leadership unwilling to countenance change.

Instead, they regale the population with a mixture of repression and gimmicks. The launch of the Petro, a state-sponsored cryptocurrency announced late last year, belongs in the latter category.

The Petro, which according to the Venezuelan government’s clumsy white paper is available for purchase as of yesterday, is supposed to be linked to the price of Venezuelan oil. From the white paper:

In words: the government vows to accept Petros in payment for taxes and government fees at a rate determined by the previous day’s price of Venezuelan oil. Dv is a discount rate.

Because the quantity of Petros in circulation is fixed and governance of the cryptocurrency is technically decentralized, the government argues that future manipulation of the Petro’s value is outside its control.

The reality, unsurprisingly, is more complicated. The Petro will run on the NEM blockchain, where transactions are validated differently from most cryptocurrencies. Bitcoin, for example, relies on a proof-of-work consensus algorithm, where computing power determines which transactions are validated. NEM, on the other hand, uses a proof-of-importance system where transactions are confirmed by the most important nodes, with importance defined as the number of coins owned and the frequency of transactions.

The Petro will ostensibly be accepted for payment of Venezuelan taxes and government fees, but little else. Moreover, the government has issued 100 million tokens but only 82.4 million are available for sale. Venezuelan authorities will presumably retain the remainder, so they will play an outsize role in the governance of the cryptocurrency under the POI system, despite the nominally decentralized blockchain.

Second, the supposed “backing” of the Petro by oil reserves is nothing of the kind. There is a link between the market price of Venezuelan oil and the Petro’s bolivar exchange rate, but ownership of the cryptocurrency gives its owner no claim on sovereign oil assets. By buying Petros, one is giving the country’s socialist government full faith and credit that it will fulfill its promise to redeem liabilities at the prevailing oil price. Given recent experience and Venezuela’s multiple oil commitments to sovereign creditors such as Russia and China, that would be a lot of faith indeed.

The Petro might offer Venezuelan citizens a distraction from their nation’s dire problems; it may even allow the Venezuelan dictatorship to evade some U.S. sanctions, despite President Trump’s decision to ban U.S. citizens from buying Petros. But as a cryptocurrency, it is doomed to fail.

A true crypto-asset might instead represent claims on real barrels of oil, which could be traded in a decentralized market through transactions recorded on the blockchain. It’s unclear how much of an improvement this would yield over futures trading on an exchange, although it’s probably cheaper for some market participants to transact on the blockchain. But the Petro offers no true claim on anything, so its utility is dubious given the likelihood that the Petro’s state sponsor will default on its promises.

If you needed another reason not to buy any currency, digital or otherwise, issued by the Venezuelan government, then this is it.

[Cross-posted from Alt‑M.org]

In 2014 the government of Ecuador, under then-President Rafael Correa, announced with great fanfare that the Ecuadorian Central Bank (BCE) would soon begin issuing an electronic money (dinero electrónico, or DE). Users would keep account balances on the central bank’s own balance sheet and transfer them using a mobile phone app. Enabling legislation was passed in September, qualified users could open accounts beginning in December, and the accounts became spendable in February 2015. A headline on CNBC’s website declared: “Ecuador becomes the first country to roll out its own digital cash.”

The subsequent fate of the electronic money project has received less attention in the American press. Less than three years after opening, the system is now shutting down. In December 2017 Ecuador’s National Assembly, at the urging of President Lenin Moreno, Correa’s hand-picked successor who took office earlier in the year, passed legislation to decommission the central bank electronic money system. The legislation simultaneously opens the market to mobile payment alternatives from the country’s private commercial banks and savings institutions. As described below, the state system had failed to attract a significant number of users or volume of payments. Account holders now have until the end of March 2018 to withdraw their funds. Complete deactivation is scheduled for mid-April.

The substitution of open competition for state monopoly in mobile money is an important victory for the people of Ecuador. The entire episode is important internationally for the lesson it teaches us about the limits to a central bank’s ability to launch a new form of money when the public prefers established forms. The lesson provides an instructive contrast to “the case for central bank electronic money” recently made by Aleksander Berentsen and Fabian Schär in the pages of the Federal Reserve Bank of St. Louis Review.

The Birth of the Project

There is an important backstory to the episode: Ecuador had suffered a hyperinflation of its domestic currency, the sucre, in 1999, prompting residents to dollarize their own payments and finances. In January 2000 the government, bowing to the popular verdict, announced that it would officially dollarize, fixing a parity of the sucre to the US dollar and retiring all sucres from circulation by September. (Concerning Ecuador’s dollarized system see my earlier post here.)

The electronic money project was born in 2014 legislation that gave the state a monopoly in electronic money. Only the central bank could issue electronic dollars, and only the state-owned mobile phone company CNT could provide mobile payment services. The law barred the private mobile phone companies and private financial institutions from providing competing systems. The legislature also banned cryptocurrencies.

Because President Correa (in office 2007–2017) had often complained about the discipline that dollarization imposed on his government, observers wondered whether the electronic money system was intended merely as a way for the government to gain some monopoly profits, or was a first step toward de-dollarization. To calm fears that the electronic money would become a forced currency to be followed by de-dollarization, the law declared that use of the electronic money would be voluntary, and that even public employees and state contractors would not be obliged to accept it in payments from the state. (Everyone knew that the Assembly could later revise that provision of the law, of course.)

The government was quite optimistic that the system would rapidly prove popular. The leading newspaper El Comercio reported on Christmas Day of 2014: “Fausto Villavicencio, responsible for the new payment mechanism in Ecuador, said that the authorities expect that some 500,000 people will use e‑money in 2015.”[1] The actual number of accounts opened in 2015 turned out to be less than 5000. The economist Diego Grijalva of the Universidad de San Francisco de Quito, citing the Ecuadorian central bank’s balance sheet, noted in early 2016 that “the Ecuadorian Electronic Money System is already implemented, but it has an uncertain future. In particular, financial institutions are not obliged to use it and the use thereof (less than US $ 800,000 for the end of January 2016) corresponded to less than 0.003% of the monetary liabilities of the Ecuadorian financial system.”

Its Failure to Achieve Popularity

One had to be skeptical of the stated rationale for the central bank electronic money project, to benefit the unbanked. Invited to speak in Ecuador about the dollarization regime in November 2014 (working paper in English, later published in Spanish) at events organized by the USFQ and the think-tank IEEP, I added some critical comments on the new project:

There is no reason to believe that a national government can run a mobile payment system more efficiently than private firms … If the government sincerely wishes to help the poor and unbanked, it should let private providers enter the competition, which will drive down the fees that the poor and unbanked will have to pay.

Private bankers in Ecuador made similar arguments during the life of the project. In its December 2017 legislation, the government conceded the case. According to one news account, “the Government hopes that with the transfer to the private financial system the means of payment can reach more unbanked population.”

I attributed a fiscal rationale to the project:

[W]hy does the government want to issue mobile payment credits as a monopolist? It seems likely that the project is meant as a fiscal measure. One million dollars held by the public in the form of government-issued credits is a million-dollar interest-free loan from the public to the government.

From the fact that the government is now closing its service, I infer that the central bank failed to make a profit even as a statutory monopolist. Float was smaller, and expenses higher, than had been hoped (see below). The new administration had no fiscal reason to keep it open.

Although I did not foresee the system’s failure to achieve sustainability, I did add one final dig at the system’s low trustworthiness:

Personally, I would find dollar-denominated account credits that are claims on [the leading private mobile phone companies] Movistar or Claro more credible than claims on the government of Ecuador. After all, unlike the government, neither company defaulted on its bonds in the past 12 years.

Trust, it turned out, was the crucial issue.

Unlike what is usually envisioned under the rubric “central bank electronic money,” the BCE was not creating nominally default-risk-free accounts denominated in its own domestic fiat money. It was issuing claims to US dollars that it might become unable or unwilling to repay. The government under Correa had in fact defaulted on sovereign dollar-denominated bonds in 2008. Although the sucre hyperinflation of 1999 had brought with it a banking crisis, since dollarization the commercial banks had by all indications become stable and prudently run.

Consequently it was reasonable for an informed citizen in 2014–17 to think that dollars on deposit at a private commercial bank in Ecuador were less risky than dollars on deposit at the central bank. The private banks had better incentives to behave prudently than the BCE had. A private bank could be taken to court if it failed to pay, but not so the government central bank with its sovereign immunity.[2] The enabling legislation specified no limit on the volume of electronic dollars the BCE could create, and no prudential requirement that the central bank hold adequate assets to redeem them.

The Ecuadorian public recognized a risk of default or devaluation with the central bank’s electronic money accounts, and stayed away from them, defying to the optimistic projections of government officials promoting the system. In June 2016 President Correa recognized that the project had critics, but he dismissed them as merely members of the opposition party and certain private bankers annoyed that the business was not going to them. In fact mistrust in the system was much more widespread.

At least one print commentator at the time pointed to the BCE’s lack of trustworthiness. El Comercio’s economic columnist Gabriela Calderón de Burgos in a June 2016 column clearly predicted that because of public mistrust the DE system would not succeed. She noted that, unlike the private bankers with their own wealth at stake, the BCE could behave irresponsibly, and would be pressured to do so by the Treasury with its chronic financing problems. Thus the electronic claims on the BCE are “a currency that does not inspire confidence,” and as a result “the DE will not work because it will not enjoy widespread acceptance. It would only achieve this if the government declares it to be a curso forzoso [forced tender].” But the government knows that such a move “would lead to chaos.”

Later that month, in a column on the “antics” of the central bank, she observed: “The government has intensified its campaign for people to deposit their dollars in the BCE and use ‘electronic money.’ I suspect that the campaign will have little success because of the justified distrust that the government and the BCE have earned in terms of their ability to take care of others’ funds.”

In May 2017 Calderón de Burgos returned to the theme, in a column entitled “Only the Dollar is Trusted.” The project for the Ecuadorian government to issue its own digital currency, denominated in US dollars, she wrote, “faces an insurmountable inconvenience: people will not voluntarily accept the new currency. That’s why they’ve been trying to convince us to use electronic money for three years and still few use it.” The US dollar itself, because it is something that Ecuadorian politicians cannot devalue, “generates much more confidence than any alternative that can occur to our politicians, even and particularly in times of financial crisis.”

A news article in December 2017 reported the answers that ordinary people gave when asked them directly why they weren’t using the BCE’s electronic money. Their answers confirm that many found the system not creditworthy. For example: “Mistrust is among the reasons, says Frank Guijarro, owner of a tire network.” And: “I do not trust opening an account with the Central Bank, so I pay in cash and sometimes with a debit card when I cannot get out,” says Katherine Alcivar, 26.” The president of the association of cooperative savings banks gave a similar answer in an interview: “The greatest confidence we can give is that your resources are in your financial institution and not in the BCE.” The BCE system was haunted by the “ghost” of the previous government’s default. In addition, the BCE did too little to promote acceptance by shopkeepers and other businesses: “Not enough strength was given to the reception channels.”

As a result of these shortcomings, the system peaked at only $11.3 million in account balances, less than 5 hundredths of 1% of the country’s narrow money stock M1 ($24.5 billion). According to the deputy general manager of the central bank electronic money system, before the announcement of the coming shutdown ironically raised the average level of activity due to withdrawals, the system averaged only about 1,100 transactions per day. The total value transacted over the entire life of the system was only about $65 million. Only 7,067 businesses ever conducted transactions with the electronic money. While a total of 402,515 accounts were eventually opened, the BCE found in retrospect that only 41,966 were ever used to acquire goods and services or to make payments. Another 76,105 were used only to upload and download money. The remaining 286,207 accounts (71%) that were opened were never used. (I do not know why the three reported component figures do not sum exactly to the reported total.)

Lessons from the Failure of the Project

We can make a back-of-the-envelope calculation of the Ecuadorian government’s profit from its monopoly electronic money project. Between 2014 and the present, the Ecuadorian government has been paying roughly 8% interest on the bonds it sells in international markets. Replacing $11.3 million of 8% bonds with zero-interest liabilities of the central bank provides an annual debt-service savings of less than $1 million, specifically $904,000. From the BCE’s 2014 income statement (the most recent that seems to be available), its “administrative expenses” (presumably payroll) were roughly $38 million. Thus the project would have turned a loss if it enlarged the BCE payroll by as little as 2.4%, even leaving aside non-salary expenditures on promoting and operating the project.

An accounting report on the DE project issued by GPR, an Ecuadorian government accounting office, puts the government’s expenditures on the project at $7,967,553.78. Comparing that figure to the estimated debt service savings of only $904,000, the fiscal loss is clear. My thanks to Luis Espinosa Goded and Santiago Gangotena of the USFQ Department of Economics for pointing me toward the GPR report and helping me read it.

It is instructive to contrast the outcome in Ecuador with the optimistic picture of central bank electronic money drawn by Berentsen and Schär, who write:

We believe that there is a strong case for central bank money in electronic form, and it would be easy to implement. Central banks would only need to allow households and firms to open accounts with them, which would allow them to make payments with central bank electronic money instead of commercial bank deposits. As explained earlier, the main benefit is that central bank electronic money satisfies the population’s need for virtual money without facing counterparty risk.

The BCE deposits, by contrast to the scenario they have in mind, were not free of counterparty risk. More generally, in a sound banking system a commercial bank’s counterparty risk for depositors can be negligible, very close to zero, so that the central bank’s zero default risk need not be a big draw. In episodes where the central bank and the commercial banks simultaneously circulate banknote liabilities (e.g. today’s Scotland or Northern Ireland), no public concern about a risk difference is evident.

The Ecuadorian case also shows that implementation of a central bank electronic money system isn’t so easy. It requires more than merely setting up a website (the US federal government has sometimes proven not even competent at that) and letting households and firms open deposits. A convenient point-of-sale deposit-transfer mechanism, requiring both hardware and software, must be provided to many thousands of merchants. Consumer service and marketing are part of the business of providing retail payments. There is no reason to think that central banks are or would be good at a commercial business operation. In short, it is far from clear that asking bureaucrats to build a “public option” electronic money system would have benefits in excess of its cost.

[1] All quoted statements from Ecuadorean sources are my own translations, assisted by Google Translate.

[2] George Selgin and I raised this point some years ago as part of a general case for preferring private competition to sovereign monopoly in currency.

The seven-year saga of Madden v. Midland began as a dispute over a four-figure consumer debt. But billions of dollars’ worth of loans, and the future of consumer lending markets, now hang in the balance.

Madden began in 2011 as a lawsuit based on a claim of usury. The plaintiff, New York resident Saliha Madden, had defaulted on $5,000 worth of credit card loans. The balance owed was later acquired by Midland Funding, a debt collector headquartered in California. Midland attempted to collect the debt with a default interest rate of 27 percent. Although the loan contract stipulated that it would be governed by Delaware law, which does not have a usury cap, Madden sued Midland, alleging unfair debt collection practices under federal law and usury under New York law — which considers interest rates above 25 percent usurious.

The District Court for the Southern District of New York ruled in favor of Midland, rejecting the claim of unfair collection practices and finding that the National Bank Act pre-empted the application of state usury law. But the Second Circuit Court of Appeals — which covers Connecticut and Vermont as well as Madden’s home state of New York — reversed the District Court ruling, finding that the National Bank Act pre-emption did not apply to Midland because Midland is not a national bank. Therefore, the opinion went, applying state usury law in this instance would not hinder any national bank’s powers. The Second Circuit thereby remanded the case back to the District Court, which in turn found that New York law should apply since applying Delaware law, which provides for no usury limit, would “violate a fundamental public policy of the state of New York.”

Should the District Court’s decision stand, Madden would jeopardize the long-standing judicial precedent of “valid-when-made,” which holds that non-usurious debt remains valid when acquired by a third party, even if the interest rate implied in the latter transaction is usurious. Not surprisingly, the uncertainty sparked in the aftermath of the Second Circuit’s ruling has prompted policymakers to turn to a legislative fix to restore the “valid-when-made” precedent by making it federal law governing consumer credit markets.

U.S. courts have long recognized the potential that usury caps might make the credit market more illiquid. The Supreme Court’s 1833 ruling that cemented the valid-when-made doctrine stated that:

by converting a sale on a discount into a loan on usury, and thus rendering null and void the act of endorsing it, a contract wholly innocent in its origin and binding and valid upon every legal principle is rendered at least valueless in the hands of the otherwise legal holder, and a party to whom the provisions of the act against usury could never have been intended to extend would be discharged of a debt which he justly owes to someone.

Back then, private promissory notes were used as collateral for transactions, both within and across state lines. But, as the notes changed hands, acquirers might discount them more steeply than the original lender, sometimes exceeding state usury limits. Valid-when-made ensured that the original validity of a loan would not be affected by changes in its implicit interest rate in subsequent transactions.

More recently, courts have tended towards a liberal interpretation of the National Bank Act, holding that it pre-empts state usury laws in all cases and not just for national banks. Georgetown law professor Adam Levitin has argued that this interpretation is inappropriate and that the pre-emption should only apply to national banks, which are subject to a specific federal statute.

Levitin states that a broader pre-emption only goes back to 1978. This date is significant because the late 1970s marked a turning point in U.S. consumer credit markets as banks started to consolidate and expand beyond state boundaries, credit card use became widespread, and loan securitization took off. The case Levitin cites, in fact, concerned a credit card dispute and the applicability of different state usury statutes. As trade in loan instruments grew and participating institutions became more varied, allowing for valid-when-made to overrule state usury laws was important to ensure these transactions could take place.

Note that the elements which gave rise to the change in judicial doctrine are in and of themselves positive. A secondary market for loans enables financial institutions to offload risky assets and free up capital to lend to new borrowers. Securitization, for its part, achieves this while also creating diversified instruments and thereby lowering loan risk. Both tend to lower the cost of credit to borrowers.

Last month, the House of Representatives passed the Protecting Consumers’ Access to Credit Act with bipartisan support. The bill, now with the Senate Banking Committee, acknowledged that “the valid-when-made doctrine, by bringing certainty to the legal treatment of all valid loans that are transferred, greatly enhances liquidity in the credit markets by widening the potential pool of loan buyers and reducing the cost of credit to borrowers.” Legislative change will, it is hoped, put an end to any lack of clarity as to the ability for consumer loans to be subsequently transferred across firms and states. The freedom to transact is essential for consumer lending markets to operate efficiently. To understand this, we must move from legal to economic principles.

The interest rate on any loan is composed of two parts. The first part represents the time value of money, that is, the fact that access to funds today is more valuable than access tomorrow, or next year. Secondly, there is a risk premium that compensates the lender for delays and potential non-repayment of the loan. Other things equal, the greater the likelihood of non-repayment, the higher the risk premium and so the total interest rate.

When loans are backed by collateral, such as a house or a car, the interest rate can be lower because lenders can always recoup at least some loan value by seizing the collateral. Collateral also acts as a signal: only borrowers with confidence that they will repay would place their possessions as guarantee. Consumer credit, such as credit card debt, is typically unsecured, so it carries a higher risk premium.

More variable earnings, a higher chance of unemployment, propensity to incur unexpected costs, and the absence of a financial cushion to fall back on are all credit risk factors. Because they are more common among lower-income households, loan interest is viewed by some as regressive: those of lesser means will pay more for a given amount of credit. This is how modern proponents of usury laws have often justified them.

Yet, as with other price controls, the consequences are often the opposite of those intended. A high interest rate is the only way that a high-risk borrower can compete for funds with a lower-risk borrower. In the absence of adequate compensation for additional risk, lenders eschew the high-risk borrowers — who are often those most in need of credit. Not only that, but credit risks can change as a loan matures. If a borrower fails to repay on time, her credit score will change and interest rates on future borrowing will adjust upwards.

This is what happened to Madden: her default created additional monitoring and collection costs, and it also revealed information about her likelihood to repay future borrowing. In the eyes of any lender, Madden had become a higher-risk borrower than previously anticipated. Her interest rate went up.

Last year’s Second Circuit decision surely made Madden happy, but it is unlikely to benefit future borrowers who find themselves in her position. Riskier applicants are more likely to be among those rationed out of the borrower pool. There is, in fact, already evidence that Madden has changed the fortunes of borrowers in the three states covered by the Second Circuit’s ruling. Those with low credit scores saw loan volumes decline by half in the months after the ruling; for similar borrowers elsewhere in the country, loan volumes more than doubled.

Madden has thrown consumer lending markets in the three states affected into disarray, so it is appropriate for Congress to provide clarity through legislation and ensure access to credit is available to those who can and are willing to pay for it. Not just legal precedent but economic reality demand a move in this direction.

Yi Gang, an American-trained economist who taught at the University of Indiana, will take over as governor of the People’s Bank of China. Since 2008, he has been deputy governor under Zhou Xiaochuan, who became head of the bank in 2002. The unexpected appointment of Mr. Yi will provide continuity at the PBOC and lend credibility to the pledge for financial liberalization.

Following his appointment, Yi Gang declared: “The main task is that we should implement prudent monetary policy, push forward the reform and opening-up of the financial sector, and maintain the stability of the entire financial sector.”

In November 2007, Yi Gang spoke at Cato’s Annual Monetary Conference, and his speech, "Renminbi Exchange Rates and Relevant Institutional Factors," was published in the Spring/Summer 2008 Cato Journal, which also included an article by Fed Chairman Ben Bernanke. That special issue of the CJ raised important questions about the types of monetary regimes that best protect the value and stability of money while promoting economic freedom.

In his article, Yi Gang, then deputy governor of the PBOC, gave a detailed view of the evolution of China’s exchange rate regime and argued that real reform takes time, so the West should be patient. He concluded:

The RMB exchange rate is an economic issue. The best way to bring about an equilibrium exchange rate is further reform. Constructive dialogue will help speed up the reform process and make the convergence to a new equilibrium smoother. However, it should be noted that it takes time to establish an efficient market. . . .

To move toward equilibrium, coordinated policy measures are needed for structural adjustment. To resolve China’s large trade surplus and restore external balance, measures are required for promoting domestic demand, increasing imports, investing abroad, and accelerating urbanization -- in addition to currency appreciation. In fact, many measures can generate impacts similar to currency appreciation, such as imposing environment protection requirements, enhancing labor standards, strengthening labor protection, and upgrading the judiciary system. All these measures mean higher costs, lower competitiveness, and a reduced trade surplus, which will move the economy toward equilibrium. Also, it is important to recognize that it will take time for these measures to bring about structural changes. Policymakers in Washington and elsewhere should therefore be patient as China makes its way toward a full-pledged foreign exchange market [Yi Gang 2008: 195–96].

As governor, Yi Gang will work closely with Liu He, the newly appointed “economic czar” and vice premier, who is also in favor of economic reform. By making these appointments, President Xi Jinping is signaling that he intends to address structural problems in China’s economic system. The question is whether he can do so while maintaining an iron grip on political power and preventing a free market in ideas.

Cracking down on dissent will be the job of Yang Xiaodu, who has been appointed to head the new National Supervisory Commission (a super “anti-corruption” body), designed to ensure that officials and public-sector workers adhere to the Chinese Communist Party line.

President Trump and his advisors should listen carefully to the PBOC’s new governor and Mr. Liu and work with them to help move China toward a more liberal trading regime, including a larger scope for trade in ideas as well as in goods and services.

Meanwhile, President Xi, who now has absolute power for life, should remember the words of Lao Tzu:

The more restrictions and limitations there are, the more impoverished men will be. . . . The more rules and precepts are enforced, the more bandits and crooks will be produced. Hence, we have the words of the wise [sage or ruler]: Through my non-action, men are spontaneously transformed. Through my quiescence, men spontaneously become tranquil. Through my non-interfering, men spontaneously increase their wealth [Chap. 57, Tao Te Ching, translated by Chang Chung-yuan].

In the book I advertised in my last post, I argue that the Fed’s decision to switch to a “floor”-type operating system “deepened and prolonged the Great Recession.” Yet the Fed is only one of several central banks that have adopted floor systems for monetary control during the last dozen years. That fact raises some obvious questions: Did those other floor systems have similarly dire consequences? If not, why not?

In this post I answer these questions for one of those other cases: New Zealand’s. By doing so I also hope to shed some further light upon the U.S. floor system experience.

New Zealand’s Corridor System

From 1999 until July 2006, the Reserve Bank of New Zealand (RBNZ), New Zealand’s Central Bank, relied upon a symmetric corridor system in which the benchmark policy rate, known as the Official Cash Rate, or OCR for short, was kept 25 basis points above the rate paid on banks’ reserve (“settlement”) balances, and 25 basis points below the rate that the RBNZ charged for overnight loans.

Not long before it established its corridor system, the RBNZ implemented a Real Time Gross Settlement (RTGS) system for wholesale payments, in which interbank payments are settled bilaterally and immediately, thereby becoming final and irrevocable as transactions are processed, rather than at the end of the business day only, following the determination and settlement of net balances. Because banks’ overnight settlement balances bore an opportunity cost under New Zealand’s corridor regime, as they do in any corridor-type system, banks held very few such balances — an aggregate value of just NZ $20 million was typical — relying instead on intraday credits from the RBNZ to meet their ongoing settlement needs.

The advantage of RTGS is that it allows payments to be made “final” as soon as they’re processed, so that payees don’t have to wait until the end of the day to find out whether their money came through. In a net-settlement system, in contrast, a transfer made earlier in the day remains tentative until banks pay their net settlement dues. Should a bank fail to settle, its intraday payments have to be “unwound,” reversing any transfers made with money the bank wasn’t good for.

“Cashing Up” the Banking System

The disadvantage of RTGS, or rather of any RTGS system that relies on intraday central bank credits by permitting overdrafts on participants’ settlement accounts, is that it exposes the central bank itself to credit risk: should a bank fail while in overdraft, the central bank would incur a loss. To avoid that risk the Reserve Bank, instead of supplying unsecured intraday credit by allowing banks to overdraw their accounts, chose to supply it in the form of free but nonetheless fully-secured intraday repurchase agreements. In principle at least, if a bank with an outstanding repo failed, the RBNZ could sell the purchased security to recover any cash it had advanced.

In practice, however, the RBNZ’s decision to accept municipal and corporate paper as repo collateral meant that it still faced some risk of loss; moreover, it soon discovered that the volume of its outstanding repos with particular banks was such as made that risk uncomfortably large. Recognizing the danger, and desiring as well to reduce the frequency of delayed or failed settlements, the RBNZ determined to encourage banks to rely on overnight settlement balances, instead of intraday repos, to meet their settlement needs.

With that aim in mind, in July 2006 the RBNZ began its program of “cashing up” the New Zealand banking system. Because the Reserve Bank’s intent was to enhance banks’ liquidity without altering its monetary policy stance, this program involved several components. The first consisted of the RBNZ’s creation, between July and October, of an additional NZ $7 billion of settlement balances, while the second consisted of a concurrent 25 basis-point increase, made in five five-point increments, in the interest rate paid on those balances, aimed at encouraging banks to hold them. Finally, these other steps having been taken, the RBNZ stopped providing intraday repos. As the figure below shows, although total settlement balances hovered around NZ $8 billion during the crisis, and occasionally were raised beyond NZ $10 billion, they eventually settled down near the RBNZ’s originally-chosen target of NZ $7 billion, where they’ve remained ever since.

New Zealand Settlement Balances, 1999–2014

A Floor System, but Not for Long

Since the Reserve Bank did not find it necessary to alter its policy rate until March 2007, when it raised the OCR from 7.25 to 7.5 percent, it seems to have achieved its goal of cashing-up the banks without altering its policy stance. However, the steps it took to cash-up the New Zealand banking system did involve a fundamental change in the central bank’s operating system: from a symmetrical corridor system to what most observers have regarded as a “floor” system, in which the interest rate on settlement balances was identical to the Reserve Bank’s policy rate, and banks were well-supplied, if not satiated with, liquidity.

However, at least two crucial facts distinguish New Zealand’s floor system from floor systems employed by the Fed, the ECB, and the Bank of England. One is that, while it involved a quantity of settlement balances that was adequate to meet banks’ settlement needs, the RBNZ never took advantage of it to engage in Quantitative Easing. Having supplied banks with a level of settlement balances it judged adequate for their ordinary liquidity needs, it never attempted to enlarge those balances substantially and for an extended period by means of further, large-scale asset purchases. Instead, as the world crisis deepened during the last half of 2008 and first half of 2009, it mainly responded by cutting the OCR, and hence the interest rate it paid on banks’ settlement balances, aggressively, from 8.25 percent in June 2008 to just 2.5 percent at the end of April 2009 — with the biggest cuts coming between September 2008 and January 2009. It was, it bears noting, while these cuts were in progress that the Fed introduced its own floor system, raising the interest rate it paid on banks’ excess reserves from zero to a final level of 25 basis points, where it was to stay until December 2015.

Second, while the Fed, the ECB, and the Bank of England retained full-fledged floor systems throughout the crisis and since, the Reserve Bank of New Zealand had already taken important steps away from such a system in August 2007, or well before the crisis reached its most critical stage with Lehman Brothers’ failure.

The RBNZ’s decision to modify its floor system was informed by a recommendation made in the same March 2006 consultation document that caused it to install that system in the first place, to wit: that “Incentives should be in place to foster an environment where the commercial banks get liquidity from each other and deal with the Reserve Bank only when liquidity is not otherwise available in the market.”

The RBNZ had hoped that its “cashed up” floor system would satisfy this requirement. “The increased base level of settlement account balances in the system,” the consultation document claimed,

should better foster the development of an inter-bank cash market. In the presence of significant market liquidity, market participants should transact cash with each other at the end of day in preference to using the Bank’s standing facilities. Development of the inter-bank market is desirable to improve the distribution of cash between ESAS [Exchange Settlement Account System] participants, leaving the Bank to concentrate on the liquidity to the system as a whole. This market, if developed, would also provide another source of information for the Bank on any inefficiencies in the market.”

However, once the floor system was up and running it became clear that, instead of encouraging banks to lend and borrow settlement balances in the private, overnight market, it was encouraging at least some banks to hoard any surplus balances that came their way. Like floor systems elsewhere, New Zealand’s involved a deposit rate equal to the central bank’s overnight policy rate, which tended to be higher than the corresponding, secured interbank overnight repo rate. New Zealand’s floor system therefore allowed banks to accumulate reserves without incurring any substantial opportunity cost by doing so.

New Zealand Adopts a Tiering System

To correct the problem of reserve hoarding, the Reserve Bank needed to modify the terms of its interest payments on banks’ settlement balances so as to keep banks from holding settlement balances beyond what they actually needed for settlement purposes. The solution it settled on was a “tiering system,” with settlement balances up to a bank’s assigned tier limit earning the OCR, and balances beyond that level earning 100 basis points less. The tier levels were themselves based on banks’ apparent settlement needs, but collectively still amounting to the aggregate target of NZ $7 billion.

Although it was originally supposed to go into effect in September 2007, the tiering system was put in place a month ahead of schedule to deal with stresses from the emerging global crisis — which “threatened to materially tighten monetary and credit conditions in New Zealand, jeopardising banks’ confidence in continuing access to credit.” In other words, the RBNZ found it more desirable than ever to move away from an orthodox floor system as credit markets, and markets for overnight bank funding especially, tightened, so as to keep its own payments arrangements from contributing unnecessarily to that tightening.

As Ian Nield (2008, p. 14) explains, the establishment of the tiering system, together with the Reserve Bank’s decision to accept domestic bank bills in its overnight standing facility, “had an immediate effect which, broadly speaking, re-normalised the domestic bank bill market,” especially by reducing short-term money market spreads. As the next figure shows, from Enzo Cassino and Aidan Yao (2011, p. 40), it managed to limit such spreads far more successfully then either the Fed or the ECB, and to do so without adding large quantities of fresh reserves to its banking system, though the difference also reflected the fact that New Zealand’s banks were not so encumbered with toxic assets as some U.S. and European banks.

Three-Month LIBOR-OIS Spread

Some Lessons

New Zealand’s floor experience makes for an interesting comparison with that of the United States. Of parallels, perhaps the most interesting is that in both cases a mere 25 basis point increase in the rate paid on banks’ central-bank balances proved sufficient to sustain a switch from a corridor or corridor-like operating system to a floor system. That such a small absolute change was all it took is particularly impressive in New Zealand’s case, for whereas in the U.S. between 2009 and 2015 25 basis points was a relatively significant amount in comparison to then-prevailing short-term rates, in New Zealand in July 2007 the OCR rate was 7.25 basis points — making the 25 point increase in the rate paid on bank deposits proportionately much smaller. The New Zealand case therefore seems to supply strong evidence in support of Donald Dutkowsky and David VanHoose’s claim that even very small changes in reserve-compensation schemes can suffice to trigger major central bank operating-system regime changes.

But it’s the differences between the two experiences that are, after all, most striking. Chief among these is the fact that New Zealand installed its floor system well before the financial crisis began, and did it for reasons unrelated to monetary control. It’s sole goal was that of boosting banks liquidity to limit its own exposure to intraday credit risk — not to combat a crisis. For this purpose, raising the reward paid on bank settlement balances made perfect sense, for the point was to encourage banks to hold more such balances, and therefore become more liquid, at a time when there was no credit crunch. The switch was undertaken, moreover, in a neutral manner, so as to leave the Reserve Bank’s monetary policy stance unchanged.

The U.S. in October 2008 was, in contrast, in the throes of a credit crisis, when, in retrospect at least, the last thing it needed was a further tightening of credit. Yet the Fed’s decision to start paying interest on bank reserves that month was motivated by its desire, not to enhance banks’ liquidity, but to get them to hoard reserves that the Fed was creating through its emergency lending programs, so that those reserves would not translate into a loosening of the Fed’s policy stance. Interest on excess reserves was therefore resorted to as an instrument of monetary control, and specifically as a means of monetary tightening aimed at offsetting the loosening that would otherwise follow fresh reserve injections. Later, the same new instrument would see to it that still larger reserve additions — the by-product of the Fed’s Large-Scale Asset Purchases — would also be hoarded as so many trillions of dollars of excess bank reserves.

In New Zealand, in contrast, even before the crisis struck authorities became anxious to prevent banks from accumulating more reserves than were deemed necessary for their settlement needs. In consequence a tiering system was planned, which would prevent such hoarding by imposing an interest penalty on above-tier settlement balances. The outbreak of the crisis merely caused the RBNZ to hasten its implementation of the new plan.

Thanks to New Zealand’s switch to a tiered system, its overnight interbank lending market remained active throughout the crisis. New Zealand’s banks therefore continued to rely upon one another as lenders of first resort, turning to the RBNZ for overnight funds only as a last resort — an outcome fully in accord with orthodox doctrine. In the U.S., in contrast, the establishment of a floor system caused the once active federal funds market to altogether cease to function as a conduit for interbank loans.

Finally, although the RNZB occasionally found it desirable to inject some extra cash into the New Zealand banking system during the crisis, as it did in August 2007 and again in fall of 2009, those cash additions were — as could be seen in our first figure and as the next figure (Cassino and Yao, 2011, p. 42) makes especially clear — both relatively modest and temporary. Even recently, New Zealand’s settlement balances amount to little more than 5 percent of that nation’s GDP, whereas banks’ reserve balances held at the Fed amount to about 13.5 percent of U.S. GDP.

RBNZ Settlement Balances, 2007–2009, Millions of NZ$

Those modest cash additions proved capable, together with several other Reserve Bank programs, of “maintaining the functioning of the New Zealand money market and the flow of domestic credit during the global financial crisis,” as a later RBNZ study concluded. That they did so was due in part to the fact that, by discouraging banks from hoarding reserves in excess of their fixed tier limits, New Zealand’s tiering system preserved the banking system money multiplier, instead of causing it to collapse, as happened in the U.S. The RBNZ’s success in keeping credit flowing may have in turn contributed, if only to a modest extent, to New Zealand’s Great Recession being both one of the first to end and one of the shallowest.

Conclusion

Although the Fed was hardly alone in establishing a floor system of monetary control — and not all floor systems had consequences like those I document in my book about the U.S. case — the relative success of these other floor systems does not necessarily serve as a vindication of the general concept. The New Zealand floor system, in particular, only functioned in a relatively orthodox manner for a period of less than a year, predating the financial crisis. As that crisis dawned, the Bank of New Zealand retreated from an orthodox floor system, by placing definite limits on the balances on which banks would incur no substantial interest opportunity cost. Having thus curtailed New Zealand banks’ appetite for settlement balances, the RBNZ could expect its additions to New Zealand’s monetary base to influence economic activity by way of the same orthodox transmission mechanism, leading to the same marginal stimulus affect, as might have been the case if settlement balances bore no interest at all. Federal Reserve authorities cannot, for all of these these reasons, point to New Zealand as supplying a precedent favoring their own decision to adopt and retain a floor system of monetary control.

[Cross-posted from Alt‑M.org]