Vaidas Urba on competitive central banking
I had a delightful lunch the other day with Vaidas Urba, a NGDP targeting supporter from Lithuania. Lars Christensen once let him do a post, and I agreed to publish this one. Before turning it over to Vaidas, however, let me anticipate one objection. He talks about “competitive central banking” where others might simply refer to “free banking.” If you object to his terminology, I’d encourage you to look past that superficial issue into the substance of what he has to say. I can see links with the free banking approach of White/Selgin/Woolsey, etc, but also with the Woodfordian interest rate targeting cashless economy. See where you think it fits in:
Free Central Banking
On December 16, 2010, the ECB has decided to increase its capital from €5.76 billion to €10.76 billion, citing increased risks and volatility. [ http://www.ecb.int/press/pr/date/2010/html/pr101216_2.en.html ] Did insufficient capital position of central banks contribute to the depth of the Great Recession? On September 29, 2008, markets have crashed after the TARP was not approved by the House of Representatives. Did the TARP alleviate the shortage of central bank capital, or did it work through the regular fiscal channels? Is modern central banking compatible with the principles of free market? To answer these questions, a model of free competitive central banking is presented here. To enable competition, this model avoids discretion in central banking. It uses Taylor-like rules and NGDP level targeting as its building blocks. The key advantage of free central banking is the automatic inflow of capital into the central banking sector when risk-adjusted return on central banking business is expected to be elevated.
During the Great Recession, many central banks have earned above-normal return on capital, and with hindsight it is clear that extra capital could have been profitably deployed in central banking. During the most dangerous episodes of the crisis, central banks wanted to expand the quantity of capital devoted to macroeconomic stabilization. On September 17, 2008, Bernanke, Paulson and Geithner have reached the consensus that the Fed was not able to solve the crisis on its own, and that there was a need to ask the Congress for TARP funds. On the other side of Atlantic, policymakers were comfortable with the capital position of the European Central Bank. On October 8, 2008, the ECB decided to provide unlimited euro liquidity against a wide range of acceptable collateral, and after a few days the ECB started providing unlimited dollar liquidity, this was a decisive step that eventually restored the functioning of dollar money markets. [ http://www.ecb.europa.eu/press/pr/date/2008/html/pr081015.en.html ] It was only later, during the euro sovereign debt crisis, when the ECB decided that the additional capital was needed to preserve macroeconomic stability, and then the fiscal authorities have established EFSF and EFSM programs. TARP, EFSF and EFSM share a common feature – these capital pools reduce money demand, thus softening the blow when risk management considerations prevent central banks from expanding the money supply sufficiently.
Free central banking makes the process of attracting new capital automatic. Suppose there are multiple competing private central banks in a single country. All liabilities of these central banks have the status of a legal tender, and all equally and interchangeably serve as a medium of account and exchange. All the central banks have to follow the same exact rules, and no discretion is allowed. The only place where discretion exists is on the level of investors, they have to decide on the optimal use of their capital. If they believe the expected risk-adjusted return is attractive, they can establish a new central bank, or they can purchase the shares of existing central banks on the market.
All the central banks in this model have to pay the interest on reserves according to the same variant of Taylor rule that uses the deviation from the nominal GDP level target as the key element. The leading contender in the rules versus discretion debate is the Taylor rule, the most promising idea for monetary stability is the nominal GDP level targeting, this free central banking model combines them both.
Additional rules are needed to regulate the risk of central banking. Central bank asset risk needs to be limited in a manner consistent with macroprudential requirements. Central banks must be well capitalized, extraordinarily high capital requirements need to be imposed to mimic the current low risk profile of main central banks who do not really need explicit capital buffers as their financial strength is enhanced by the monopoly rents they will earn in the future. Three forces shape the rules that regulate the central bank asset purchases: the need to avoid discretion, optimization of risk exposure, and systemic macroprudential considerations. Government bonds are not good assets for central banks to hold as their risks are hard to measure and to control, and when money demand is elevated, the term risk premium of government bonds is likely to disappear. On March 1, 2013, Bernanke presented a chart, according to which the 10-year treasury term premium is negative, in other words, on average the Fed is expected to lose money from treasury purchases. Bank of Japan is allowed to purchase equity index ETFs, however equities are too risky to comprise a major portion of central bank balance sheets. Taking ECB’s three year LTROs as an inspiration, safer assets can be constructed from equity index baskets by using them as a collateral for non-recourse three year loans, while applying large haircuts to reduce risk. The interest for such overcollateralized three year loans is the interest paid on reserves plus a margin that is not regulated, but that rather is determined by markets. Haircut size is determined according to a fixed formula that is based on stock-market index/GDP ratio at the inception of the loan, so the macroprudential considerations are taken into account in this model.
Would free central banking have made any difference before the crisis? In my opinion, no. The demand for non-cash base money was very low before the crisis, central banking was very unattractive as a business (with the exception of cash which is ignored here), and the regular commercial and shadow banks have competed with central banks by supplying lots of better and cheaper substitutes for base money. We can say that before the crisis, central banks have emulated the actions of a competitive free central banking sector. By the way, I am aware of a quasi-Austrian argument that central banks have in effect employed too much capital before the crisis by supplying underpriced implicit bailout guarantees to the commercial and shadow banking sectors. If this argument is correct, free central banking would have constrained the unsustainable credit growth boom before the crisis.
The special character of free central banking would only become visible during the crisis. When the credit crunch started, the outlook for the non-central bank part of the financial sector deteriorated, while simultaneously higher demand for central bank money created new profit opportunities in the expansion of monetary base. The disruption that was caused by the credit crunch would have been softened by the automatic reallocation of capital to the central banking sector. At the same time, the aggregate demand would have remained anchored by the NGDP level targeting that is encoded in the Taylor-like rule for calculating the interest on reserves.
The free central banking model discussed here is presented as an illustration only. It is not intended to serve as an actual policy proposal. Centuries of additional data and huge volumes of new research are needed before we could set a particular Taylor-like rule in stone. Indeed, many market monetarists do not believe at all that it is possible to produce a robust Taylor rule. In Scott Sumner’s NGDP futures targeting model the setting for the policy instrument is produced as an outcome of profit-maximizing market process. Free central banking model is different, as it uses the profit-maximizing market process for a different purpose – to allocate capital. Correspondingly, Scott Sumner’s proposal would result in a suboptimal quantity of capital deployed in the activities of central banks, while free central banking would result in a higher and possibly suboptimal volatility of NGDP-linked bonds.
Some central banks, especially those with publicly listed equity, could use some of the elements of free central banking in practice. Taking Switzerland as an example, we can argue that by issuing a new class of callable equity instruments to the public, the Swiss central bank could have established an exchange rate ceiling at a level that is more conductive to macroeconomic stabilization with a lower risk to the central bank itself.
Alan Greenspan once remarked that history has not dealt kindly with the aftermath of protracted periods of low risk premiums. When the next such period ends and a new credit crunch arrives, let us hope that central banks will employ optimal levels of capital.
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9. June 2013 at 20:29
The reason I prefer not to talk about “free banking” is because I make no assumptions and no policy recommendations about commercial banking whatsoever. Commercial banks, money market funds, shadow banks and other financial institutions compete vigorously in various lines of business and in some of them they do supply substitutes for base money. There are various issues with this process (moral hazard, regulation, deposit insurance, etc.), but to some extent market competition does work in the commercial banking.
I am concerned with a very narrow question – how does the capital allocation process work in the central banking. There is absolutely no market competition here, and for illustrative purposes it is very interesting to compare the real world capital allocation outcomes in central banking to a model with the competitive capital allocation. The results are interesting – central banks do ask politicians for more capital in one form or another when they feel that more capital can be usefully employed in central banking.
10. June 2013 at 01:38
I probably have to read it again to understand, but doesn’t standard free banking literature already approximate nominal income targeting? Here’s Selgin on “The Theory of Free Banking: Money Supply under Competitive Note Issue”: http://oll.libertyfund.org/index.php?option=com_staticxt&staticfile=show.php%3Ftitle=2307&layout=html
It seems they take money (ideally) as unit-elastic, and that would – without any “rules” – be an NGDP target (since P*q is NGDP).
I’m not very well-versed on free banking lit, so I’m probably missing something.
10. June 2013 at 02:36
After some more reading/searching, Lars Christensen has also advanced this view here: http://marketmonetarist.com/2011/10/23/scott-sumner-and-the-case-against-currency-monopoly-or-how-to-privatize-the-fed/
So I’d be curious to know why in a free banking system the NGDP target wouldn’t be automatic.
10. June 2013 at 04:00
Ashok: As far as I understand the idea that is most associated with free banking nowadays (with all CB supposedely following some rule) is about seignorage. It means that the business of money printing could be outsourced to private sector with some possible spillover effects.
If you ask me it does not seem to be too persuasive. First seignorage is really low nowadays – basically 2% from total stock of money which is under normal conditions between 5-10% of GDP. So we are talking about approximately 0,25 to 0,5% of GDP – which would be probably substituted with some tax anyways.
As far as this article goes it seems to be focused more on lebder-of-last-resort role of CB. I am not that convinced but if Scott seems it is worth looking into I will invest some time to it for sure
But the bread-and-butter of what Scott and other economists talk about – monetary policy – is not addressed by free banking. Monetary policy is mostly about managing value of medium of exchange/medium of account. It is more important to have a good rule to determine the value of MoE/MoA that is consistent with sufficient Aggregate Demand than to have “free banks” satisfying demand for money in an inflexible monetary regime such as gold standard.
But I can see why MM is appealing to supporters of free banking. It constrains Central Bank by rule that harnesses power of markets to deliver optimal results. So in the end the CB will deal with daily operations + with more important stuff such as research on a monetary regime that can be even better than NGDPLT.
So in his way supporters of free banking are possible allies or at least not enemies to NGDPL targeting. But at the end of the day I would say it is more about Scott reaching out to this community to gather support of his ideas – which is great if you ask me.
10. June 2013 at 05:47
Vaidas, That helps clarify things.
Ashok, The question is why would it be automatic? I haven’t seen any model where profit maximizing behavior by free banks leads to an NGDP target. I have seen people make the claim, but I have yet to see a persuasive model.
JV, Vaidas is concerned that central banks will underperform their stabilization role due to a lack of capital. I think they have enough capital, but what matters is not what I think, but rather how they behave. He thinks they would have done more during the crisis if not held back by fears of going broke.
10. June 2013 at 05:58
Ashok Rao,
free banking usually involves commodity standard. Here I am discussing fiat competitive central banking, or alternatively, you could also describe as money backed by financial assets.
Please note, that the Taylor Rule does all the real work in targeting NGDP level target here. If you would use a different Taylor rule, you could target dual mandate, or you could target price level, the possibilities are endless, just change the Taylor rule.
If you would like to compare free banking and competitive central banking, the right parameter would be the volatility or variance of NGDP. With competitive central banking, you could use the Taylor Frontier to discuss this issue. Maybe there is something in the free banking literature too.
Competitive central banking model allows you to debate the issues Paul Krugman discussed in his post called “Who Has Draghi’s Back?”. Basically, if you believe the private investors would voluntarily subscribe to a new capital issue by the ECB to allow for additional monetary stimulus, you also say that the ECB has insufficient fiscal backing.
10. June 2013 at 06:12
“I haven’t seen any model where profit maximizing behavior by free banks leads to an NGDP target.”
I’m not remotely able to understand it (I’m trying to relearn math), but Appendix A of Larry Sechrest’s “Free Banking: Theory, History, and a Laissez-Faire Model” contains what he calls “A Mathematical Model of Free Banking.” He also states on p. 68 his belief that “under Free Banking, nominal national income remains constant.” Any thoughts?
http://library.mises.org/books/Larry%20J%20Sechrest/Free%20Banking%20Theory,%20History,%20and%20a%20Laissez-Faire%20Model.pdf
Also, I believe you’ve said favorable things about Glasner’s Free Banking book (which I haven’t read yet). Did it have anything to say about the automatic maintenance of nominal income?
Fwiw, here’s Selgin on formal models vs. verbal exposition, with a quick comment on Sechrest’s book: http://www.freebanking.org/2011/06/22/where%E2%80%99s-my-model/
I’ve definitely changed to a more favorable opinion on NGDP targeting mainly due to your Mercatus paper (and your testimony with Beckworth), not b/c of a model. Bill Woolsey also manages to explain a lot exclusively with words.
10. June 2013 at 06:24
J.V. Dubois,
I agree with your estimate of seigniorage. However, please note that during financial panics seigniorage revenues may be larger, and this means that seigniorage revenue stream is attractive for risk-averse agents (i.e. it has negative beta).
Even though the seigniorage is low, and even though the seigniorage is the secondary issue, we still can ask what is the optimal level of siegniorage. This question is equivalent to the problem of the optimal level of fiscal backing of central banks. See Paul Krugman’s recent post “Who Has Draghi’s Back?”.
So yes, the primary issue of managing value of medium of exchange/account is addressed by the Taylor-like Rule here. Free banking mechanism is employed here to address the secondary issue of seigniorage/fiscal backing.
10. June 2013 at 06:31
Btw, I also want to say thank you to Prof. Sumner for having the courtesy to engage Free Banking ideas. As Bill Woolsey has said before, Market Monetarism and Free Banking are really kissing cousins (perhaps step-siblings, even?), and all the main Free Banking theorists endorse NGDPLT as a 2nd best alternative.
J.V. Dubois,
“It is more important to have a good rule to determine the value of MoE/MoA that is consistent with sufficient Aggregate Demand than to have “free banks” satisfying demand for money in an inflexible monetary regime such as gold standard.”
Free Banking certainly doesn’t have to be limited to a commodity standard (e.g. Greenfield-Yeager imagine using financial assets for interbank clearing). But Canada’s gold-based free banking system (which was not hampered, like the US system, by branch banking restrictions and 100%+ bond collateral requirements for new notes) was quite flexible.
See Selgin’s comments here from 14:30 to 20:00 (although the entire talk is excellent) http://www.youtube.com/watch?v=JeIljifA8Ls
10. June 2013 at 06:33
John, OK, let me explain my reservation about free banking with words. It seems to me that under any monetary regime the demand for the medium of account (gold or cash) will be inversely related to the nominal interest rate. If nominal interest rates change, so does the demand for the medium of account. Why should profit maximizing banks have an incentive to adjust the supply of the MOA in precisely the amount that would be needed to offset changes in the demand for the MOA due to interest rate variations? That doesn’t make any sense to me.
10. June 2013 at 06:43
Scott,
Perhaps the expression “fears of going broke” is too strong. Central banks certainly care about the risks they take, they care about the risk/return tradeoff, and they do coordinate their risk appetite with the fiscal authorities.
One could argue that main central banks should be consolidated with the rest of the public sector, and correspondingly they should have no fears of risk at all in the current macroeconomic environment. One could also argue that capital positions of all the central banks are very strong, if you take their future earnings stream into account. Both of these positions appear to be very reasonable. However, there is an agent-principal relationship between the central bank and the fiscal authority, and I do see the fiscal authorities often changing the risk appetite limits for central banks in both directions. The so-called “Fed secret loan scandal” in November 2011 is a part of such agent-principal relationship.
In the case of the Eurozone, I see the debate between various principals, who have got very different risk-taking attitudes. While Krugman says Eurozone suffers from the lack of fiscal backing, I would say the debate between the principals constrains the ECB’s actions so that the large portion of ECB’s economic capital remains unused.
10. June 2013 at 06:57
Vaidas, thanks that clears it up. By the way, I knew that free banking advocates liked hard money, but didn’t see it as a necessity. In a competitive bank market, I’m free to issue fiat money as long as people trust me, no?
Scott, you said “Ashok, The question is why would it be automatic? I haven’t seen any model where profit maximizing behavior by free banks leads to an NGDP target. I have seen people make the claim, but I have yet to see a persuasive model.”
As I mentioned, I’m not comfortable with the models myself, but am just noting what I’ve found to be a trend in some of the free banking literature (at least on the blogosphere).
I think the automatic NGDP comes from the idea that as per very basic microecon supply is elastic when all factors of production are mobile. Even then, I have yet to see a model, but see this used as the normal explanation.
A post on this topic would be interesting.
10. June 2013 at 07:09
Admittedly, I don’t see any reason why NGDP growth under Free Banking would hit 5% (or 3%, or even 0%) on the dot every year. But under such a system, wouldn’t nominal interest rates more closely match the Wicksellian natural rate and lead to better coordination btw savers and lenders (which is the ultimate goal isn’t it?)
Let’s say interest rates fall. Don’t consumers and businesses have more incentive to borrow? In a free banking system, banks won’t be constrained by reserve ratios (though they will maintain thick capital cushions, since there’s no FDIC), so wouldn’t banks lend more? Or if rates went up, potential borrowers would be less eager to borrow, but won’t healthy banks have more incentive to lend (and obtain more reserves/expand the monetary base so they can lend)?
Looking at Selgin’s graph at around 16:00, it seems that in 19th century Canada, the money supply did indeed bounce around somewhat, but that was b/c demand for notes was changing seasonally (as it still does today, to a lesser degree, around Christmas). That seems like evidence of a self-regulating money supply (long-term, the trend looks fairly flat). Having a money supply that constantly adjusts to changing monetary demand seems to be the best solution of all, isn’t it?
(I apologize in advance for my ignorance, but I really am trying my dreadful best to understand. Enjoying “Boom and Bust Banking,” btw)
10. June 2013 at 07:24
“I have yet to see a model”
What about the one in Appendix A of Sechrest’s book? Also, Larry White’s “Theory of Monetary Institutions” came out a decade after Selgin’s “Theory of Free Banking,” and it takes a more mathematical approach than Selgin’s work.
10. June 2013 at 08:00
Ashok,
I’m inclined to agree that “hard” money is bound to disappear in a free banking system: “Institutions, Gold, and Banking.” But, it depends on what kind of information insensitive assets the private sector can offer. Gold is the most obvious choice, but doesn’t have to be the only one.
10. June 2013 at 08:02
Btw, math models are available in Larry Sechrest’s Free Banking. And, yea, a 5 percent NGDP target probably wouldn’t happen. You’d have nominal income stabilization.
10. June 2013 at 08:19
“I had a delightful lunch the other day with Vaidas Urba, a NGDP targeting supporter from Lithuania.”
1. Desires central planning in money with a pseudo-“market” management flavor: check.
2. Desires NGDP targeting: check.
3. Lunch: “delightful”.
10. June 2013 at 08:19
he difference between between “free banking” and larry White, Kevin Dowd, Steve Horwitz and myself understand it and “competitive central banking” or “free central banking” is far from being merely terminological. One tires of having to say so, but “free banking” isn’t the same as hayek’s competitive fiat monies idea, in that “free banks” don’t issue irredeemable fiat money or “legal tender.” Mr. Urba’s idea is closest to Hayek’s. Under free banking, private bank currency consists of redeemable claims to some “outside” reserve medium, which must either be a commodity money of some kind, or a fiat reserve medium that is itself subject to some artificial regulation.
It follows that whether free banking tends to result in stable NGDP depends on the underlying base money regime. In my book, and more formally in my EJ article on “Free banking and Monetary Control,” I show that such a tendency does exist in a frozen base regime, or one where the monetary base itself grows steadily at a constant rate.
Concerning Mr. Dubois’ statement, “As far as I understand the idea that is most associated with free banking nowadays (with all CB supposedly following some rule) is about seignorage,” this comes as a surprise to me, as Ive always thought that free banking was “about” monetary stability; nor do I think it quite wrong for him to imagine that MM appeals to free bankers because it “harnesses market forces” more than conventional approaches to central banking do: as a matter of fact, apart from the name itself, I don’t see what market forces have to do with conventional Market Monetarist arguments, which are simply arguments for having central banks adhere to particular rules. (Indeed, when they are offered, as they often have been in recent years, in defense of central banks’ ad-hoc QE measures–and measures unconnected to any explicit NGDP targets– it isn’t even clear that MM arguments are arguments for responsible monetary rules!)
On the other hand, commitment to a stable NGDP monetary policy ideal is itself nothing knew. I took such an ideal for granted in my 1988 book; and many others proceeded me (as I show in my work on the history of the “productivity norm”). Having taken stability of AD as a proper goal of monetary policy, I endeavored to explainthere (and more formally, for those who insist prefer math to verbal reasoning, in a later EJ article called “Free Banking and Monetary Control”) how free banking can assist the achievement of that goal by reconciling it with a relatively simple (and easy to enforce) monetary base growth rule. (The gist of the argument is that, with free banking, the money multiplier tends to adjusts automatically to counter fluctuations in velocity, while total M is invariant to changes in the public’s relative demand for currency.) The argument also explains, btw, how pre-1935 Canada and pre-1845 Scotland could enjoy such high levels of monetary stability despite relying on the “rigid” gold standard.
So, with all due respect to Scott and company, free banking proponents have much more to offer them than a mere pool of potential sympathizers.
10. June 2013 at 08:23
My apologies for referring twice to my EJ article. That’s what happens when one elects to grab a coffee half way through writing a blog comment!
10. June 2013 at 08:25
“while total M is invariant to changes in the public’s relative demand for currency.”
Demand for currency is determined in part by the supply of currency. Demand is not exogenous.
This style of justification harks back to some of the original defenses of credit expansion. It was thought that if there is a demand for credit, then any increase in supply that meets that demand would be economically justified. Yet this defense did not take into account the fact that the demand for credit was itself in part determined by the supply of credit at the relevant new interest rates.
10. June 2013 at 08:58
George Selgin,
I’m glad you have noticed Hayek’s influence.
If I would interpret my post in free banking terms, I would say that there are three alternatives for base money regime:
– a frozen base regime,
– one where the monetary base itself grows steadily at a constant rate,
– one where the monetary base is fluctuating due to the decisions of private market participants, and the scarcity value of monetary base is preserved by the collateral requirements, and by the fact that the interest on base money is paid according to the Taylor-like Rule.
I am saying that the third option is as good as the two previous ones (if not better), and it is more comparable to contemporary situation. And by focusing on the third option, we get a free-market benchmark according to which we can judge the QE decisions of the Fed. Would private decision makers risk their capital to expand the monetary base like the Fed is doing now with QE? Let’s discuss that.
On a personal note, I would like to thank you for the currency board work you did in Lithuania.
10. June 2013 at 09:49
“Demand for currency is determined in part by the supply of currency. Demand is not exogenous.
This style of justification harks back to some of the original defenses of credit expansion. It was thought that if there is a demand for credit, then any increase in supply that meets that demand would be economically justified. Yet this defense did not take into account the fact that the demand for credit was itself in part determined by the supply of credit at the relevant new interest rates.”
With all due respect, Geoff, there isn’t the slightest connection between my theory and the real-bills sort of argument to which you refer. Nor have I said anything that warrants your assuming otherwise. My point, which I explain in detail in my book and elsewhere, is merely that, in a system in which banks can issue notes on the same terms by which they can offer demand deposits, and in which those notes are considered perfect or superior substitutes for the reserve medium, a change in the public’s preferred C/D ratio merely changes the form taken by bank IOUs, without impinging on banks’ reserves and, hence, without altering total M. The currency ratio thus ceases to be a factor influencing the money multiplier, which becomes simply 1/r. Confusing money and credit has nothing to do with it.
Larry White and I have taken great pains, in fact, to distinguish our theories from the “Banking School” doctrines to which you seem to refer. Indeed, Larry deserves credit for having helped to distinguish the old “Banking School” beliefs from those of the “Free Banking School” (see on this Anna Schwartz’ New Palgrave entry on “Currency School, Banking School, Free Banking School.”)
In my theory of money supply under free banking, the nominal quantity of (bank issued) money responds, not to changes in the nominal demand for money (which would indeed lead to an indeterminate result) but to prior changes in the real demand for money, and especially to the velocity of money. Thus a decline in V, by lowering system bank clearings, reduces the aggregate demand for precautionary (settlement) reserves. For a given nominal stock of reserves, the outcome is an reserve surplus, which is eliminated as banks take advantage of it to expand their loans and investments. Eventually clearings recover their former level, at which point the excess reserve supply is no longer.
Again, there is no confusion of money and credit here. As a big fan of Leland Yeager’s work (of which I prepared an edited collection) and a long-standing critic of the real-bills doctrine, that’s one brush I won’t easily let anyone tar me with!
10. June 2013 at 10:00
George Selgin:
“For a given nominal stock of reserves, the outcome is an reserve surplus, which is eliminated as banks take advantage of it to expand their loans and investments.”
What about the shocks that change the demand for reserves? Suppose there is a panic abroad in a regulated banking country that is transmitted and it changes demand for reserves domestically in the free banking system?
10. June 2013 at 10:19
“What about the shocks that change the demand for reserves? Suppose there is a panic abroad in a regulated banking country that is transmitted and it changes demand for reserves domestically in the free banking system?”
Like I say, there is a large FB literature out there addressing this and related questions (it isn’t as if they hadn’t occurred to us!), and I don’t propose to try and reproduce it in a series of blog comments[–and especially not on someone else’s blog! But on the matter in question I will point, for starters, to my own articles, “Legal Restrictions, Financial Weakening, and the Lender of Last Resort” (Cato 1989) and “In Defense of Bank Suspension” (Journal of Financial Services Research). I will only add that it is a mistake to treat runs on the reserve medium as if these were a common occurrence, and especially as if they are equally likely in any arrangement. In fact they were largely unheard of in both the Scottish and the Canadian cases (the ones that best approximate FB, and of which we have the most information). In principle, moreover, incentive-compatible suspension-of-payment clauses can be included on bank IOUs such as will rule out panic-based reserve runs. Such clauses were in fact employed by Scottish banks before they were outlawed in 1765, though they never were invoked except for the sake of thwarting interbank note “raids.”
The myth that all banking systems are equally and very prone to systemic panics is, I’m sorry to have to say, mainly a reflection of economists’ ignorance of experiences apart from those of England and the U.S., where bad laws created banking systems that were extremely vulnerable to macroeconomic shocks.
See also Bagehot’s Lombard Street. Bagehot–that wise fellow!–understood as modern apologists for central banking do not that his LOLR recommendations were but a poor substitute for the first best solution, to wit: not creating a uniquely privileges bank of issue in the first place.
10. June 2013 at 10:26
Vaidas, I’d start by not calling central banks “banks” at all. They are not banks. Then I’d merge them into the Treasury department, so we don’t have monetary and fiscal policy working at cross purposes. For 5 years we’ve had one foot on the accelerator, and the other on the brake. Not good.
Some want to solve the problem with tighter money, even though this would have led to even lower NGDP growth. (Note that NGDP growth since 2008 has already been the slowest since Herbert Hoover. Not sure how even slower NGDP growth helps the unemployed.)
John, You said;
“But under such a system, wouldn’t nominal interest rates more closely match the Wicksellian natural rate and lead to better coordination btw savers and lenders (which is the ultimate goal isn’t it?)”
I can’t imagine why.
As far as Canada is concerned, I have no objection to free banking, but that’s a separate issue from NGDP targeting. As you know, Canada did not have a stable NGDP.
George, I had assumed that Urba’s proposal contemplated the notes being redeemable into some other currency, but I’ll let him address that issue.
I don’t think it’s fair to say MMs have supported recent central bank policies. I’ve pretty clearly opposed the policies of all the major central banks, partly because they are too discretionary, and partly because they are too contractionary. AS you very ably demonstrated in a recent post, if the Fed insists on doing discretionary policy, it’s not unreasonable to recommend a policy stance that does less damage than the actual discretionary policy stance. That’s all I’ve done.
I favor a market-based monetary regime, where the markets (not the Fed) determined the level of interest rates and the money supply.
Regarding a fixed monetary base regime, that’s almost certainly going to lead to NGDP cycles that are positively correlated with cycles in the nominal interest rate, because the demand for base money is a downward sloping function of the nominal interest rate.
10. June 2013 at 10:39
I hadn’t meant, Scott, to suggest that you personally had lost cite of the key importance of rules over discretion. Some other MM enthusiasts have, in my opinion, been far less careful than you have been on this.
Concerning the fixed B regime, your argument neglects that it is mainly the public’s demand for currency and not the demand for base money as such that responds to changes in the nominal rate of interest. Under FB free bank notes tend to take the place of base money in public currency holdings. Consequently, when nominal i changes, it has no effect on the demand for the base as such, except to the very minor extent that banks demand for cash clearing reserves varies with the interest rate.
In the heyday of the Scottish system, for example, the public hardly held any coin (base money). Scottish bank notes were almost universally preferred. The banks in turn held cash (specie or bank of England notes) equal to less than 2% of their outstanding liabilities, which they used as the “small change” for their interbank settlements, the rest of which were accomplished using interest-bearing exchequer bills. It’s hard to see how a change in nominal rates of interest would have had much effect on Scottish real demand for base money, whether considered to consist of specie only or of specie plus B of E notes, in such an arrangement.
10. June 2013 at 10:47
George Selgin,
My comment was solely about the international transmission of panics. Maybe this channel was not as strong in the old days of Scottland and Canada. And this channel might interferre with the transition to FB on a single country basis.
I support bail ins, suspension clauses and other tools that reduce the fragility of banking systems.
And we have to ask why have all the FB systems disappeared. Public choice problems? I hope the efforts of FB scholars will help us with that, but I am not too optimistic.
10. June 2013 at 11:05
Scott, if you merge the Fed and the Treasury, you’d get the principal-agent problem in the Treasury – Congress relationship. The same big mess.
“I’d start by not calling central banks “banks” at all. They are not banks.”
Their primary mission is not banking. The primary mission is providing an anchor for AD. And you can envision a central bank with very limited and unimportant banking services. Stop paying interest on reserves. Shrink the monetary base. Target NGDPLT. But Milton Friedman argued you should get a decent return on currency holdings to avoid certain distortions. That’s banking.
“Some want to solve the problem with tighter money, even though this would have led to even lower NGDP growth.”
Tighter money is not the answer. We need neutral money that is based on rules. And in the current instance, this means we need higher NGDP.
10. June 2013 at 11:27
George, I don’t understand how the price level could be stable in a a frozen-base regime. Doesn’t the central bank need the ability to shrink the base (even if never exercised) in order to make a credible promise of price level stability? Otherwise it’s just a bubble, like bitcoin.
10. June 2013 at 12:01
123, for what it’s worth, Scotland and Canada were both remarkably immune to panics that afflicted their southern neighbors’ monetary systems, even though these systems were linked by fixed exchange rates and a common ultimate reserve medium.
As for why FB gave way to CB, the free bankers have spent plenty of time addressing the question, with respect to individual cases (Larry on the Scottish system, which was undermined through a misinformed decision to extend Peel’s Act to Scotland; Bordo and Redish on Canada, in “Why Did the Bank of Canada Emerge in 1935?”; and Vera Smith on Europe generally and the U.S.); and Larry and I for the general role of fiscal considerations (“A Fiscal Theory of Governments’ Role in Money”). Kurt Schuler, finally has surveyed the causes in his essay “A World History of Free Banking” in Dowd’s 1992 volume, The Experience of Free Banking.
Broadly, of course, “public choice problems’ have played a big part in the rise of central banks, as Larry and I argue in our above-named paper. But so, in the last 150 years or so especially, has (bad, imho) monetary and banking theory. Of course there are grounds for being pessimistic concerning the prospects of combating either of these forces. For my part, I’d happily rest content to see the latter one only beat a retreat!
Max, it isn’t P but MV that tends to be stabilized under free banking with a fixed base. In any event I don’t understand your remarks: what is it, in your scenario, that causes the price bubble to begin with? Just as one should never reason from a price change, one had better not answer a question that posits such a change without saying how it comes about!
10. June 2013 at 13:25
“Max, it isn’t P but MV that tends to be stabilized under free banking with a fixed base. In any event I don’t understand your remarks: what is it, in your scenario, that causes the price bubble to begin with? Just as one should never reason from a price change, one had better not answer a question that posits such a change without saying how it comes about!”
Ok, suppose that the money base isn’t initially fixed. And then the central bank goes out of business, which freezes the base. The value of the money is now purely speculative, since it isn’t supported by the bank.
Then an entrepreneur comes along and convinces everyone to switch to a different money. The fixed-base money is now worthless. Since this wipes out all debts, the potential profit is enormous.
10. June 2013 at 16:13
“Ok, suppose that the money base isn’t initially fixed. And then the central bank goes out of business, which freezes the base. The value of the money is now purely speculative, since it isn’t supported by the bank.
Then an entrepreneur comes along and convinces everyone to switch to a different money. The fixed-base money is now worthless. Since this wipes out all debts, the potential profit is enormous.”
Your premise that a central bank “supports” the value of its (fiat) base money in some manner other than by limiting its quantity is one I refuse to grant. On the contrary: I cannot imagine why a freeze on base growth, and especially one guaranteed to be permanent by virtue of the shutting down of a former issuing authority, should have any effect other than to pin down the value of the established base more assuredly than ever. (Consider: before “speculators” might have gambled that supply would grow excessively; now that possibility can no longer be reasonably entertained.) Nor can I imagine an entrepreneur coming along and convincing everyone to switch to some other money! Money is, above all, a network good. One doesn’t switch monetary standards as one might switch from potato chips to pretzels!
10. June 2013 at 16:43
George, The “Gibson Paradox” literature strongly suggests that interest rates had a big impact on the demand for gold, and when gold was the medium of account this caused NGDP instability. I would expect nominal rates to have a big impact on the demand for bank reserves as well. After all, the nominal interest rate is the opportunity cost of holding bank reserves. Unless I’m mistaken, the Tobin cash balances model predicts a pretty sizable elasticity of demand with respect to interest rates.
Vaidas, You said;
“But Milton Friedman argued you should get a decent return on currency holdings to avoid certain distortions. That’s banking.”
I don’t see why. The Treasury pays interest on T-bills, is that banking?
Regarding the principle-agent problem, democracy works better when voters know who to blame when we have a Depression. What good does it do voters to know that the Fed is to blame? Who do they vote for?
10. June 2013 at 17:09
Prof. Selgin,
I think 123’s question about the effects of int’l transmission of panics is a good one w.r.t. the Australian depression of the 1890s (which coincided with a FB system that was as free, or freer, than Scotland and Canada). You have written before that the Barings Crisis and sudden withdrawal of British investment precipitated/aggravated the Australian crisis. But if the Australian system was unable to cope with such capital flight, isn’t that a strike against FB?
10. June 2013 at 17:28
George, I believe we are seeing stronger international linkages in each crisis episode that happens. One good example is the equity risk premium, which is getting more correlated across countries in the crisis periods. International diversification has almost stopped working in equities in terms of reducing your losses. Arbitrage has never worked so good, and it is like we have a single global equity risk premium. So I am worried that a FB country will experience higher demand for base money when the global equity risk premium increases.
What was the mechanism that linked FB Canada and Scotland with their southern neighbors. Specie flows?
10. June 2013 at 17:40
John S: It is certainly true that any major reversal of capital flows within a base-money zone can put extreme pressure on the banks of that part of the zone experiencing capital outflows. And yes, it did happen in Australia in 1893, as well as in Scotland in the 1850s, when those nations were part of much larger sterling or gold areas. But it is by no means clear that central banking would have been better equipped than the free banks were to deal with the external drains in question. On the contrary, such banks tended to increase the risk of external drains by occasionally promoting internal inflation; and they could combat drains only by raising their own lending (and deposit) rates so as to attract capital, which free banks were also capable of doing.
I expand upon some of these points, and address the Australian case specifically, in my JFSR paper “Bank lending ‘Manias’ in Theory and History.”
Scott, thunk we are perhaps talking past one another. My arguments refer to a fixed or frozen _fiat_ base regime with free banking. I take it that the Gibson paradox story applies to a gold regime only. As for Tobin’s argument, again it matters to what degree banks are able to limit the opportunity cost of reserves by settling with interest-earning securities. The Scottish banks, as I said, held only very tiny non-i-bearing cash reserves, to the extent absolutely necessary to cover the “loose change” requirements of settlement. It is unclear how they could have economized more than they did in response to higher real (or nominal) i while still adhering to the prevailing net settlement rules.
10. June 2013 at 17:41
For “thunk” read “I think.” (Don’t ask how that happened!)
10. June 2013 at 17:44
123 asks, “What was the mechanism that linked FB Canada and Scotland with their southern neighbors. Specie flows?” Ultimately, yes. And relatively (or, in the British case, entirely) free trade, including largely unrestricted capital flows.
10. June 2013 at 18:02
Scott:
“The Treasury pays interest on T-bills, is that banking?”
It is financial intermediation. For example, this is what Stehpen Williamson wrote on fiscal policy when credit markets experience problems:
“Is there some case for a fiscal policy initiative that we could construct based on the particulars of the financial crisis? If we think that a key source of our recent problems is a temporary increase in credit market frictions, one approach might be a pure Ricardian one. When there are credit-constrained economic agents, a temporary tax cut for everyone, with a promise to pay off the resulting debt with higher future taxes, is effectively a large government credit program. It does not require any new government bureaucracy, and just works through the existing income tax mechanism. Those who are credit constrained spend the tax cut as if they were getting a loan, and work harder or consume less in the future so as to pay the higher future taxes, as if they were paying off the loan. Those who are not credit-constrained save the tax cut so as to pay their future taxes. There are no long-run implications for the government budget. Why didn’t we just do that?”
10. June 2013 at 18:46
George Selgin,
I have just read your “Synthetic Commodity Money” paper again. I’m interested in this part:
“Although synthetic commodity money might be regarded as nothing more than a particular kind of a rule-bound fiat money, I think it proper to distinguish between these. The difference warranting the separate designations is that real resource costs alone limit monetary base growth in a synthetic commodity-money regime, whereas in rule-based fiat money regimes, as these are conventionally understood, base growth is limited by positive transactions costs, including any penalties to which rule-violating authorities are subject.”
My thinking is that the model I have described here is closer to the synthetic commodity regime than to rule-based fiat money regime. Why? Because the financial collateral is scarce, and most of the time it makes more sense to use it in riskier transactions, and it is not profitable enough to post it in an ultra-safe transaction that creates base money. Only during the financial crisis episodes the risk return calculation changes due to increased risk-aversion, and only then we would see the significant amounts of base money creation.
10. June 2013 at 23:52
George, “Your premise that a central bank “supports” the value of its (fiat) base money in some manner other than by limiting its quantity is one I refuse to grant.”
If you grant that central banks can devalue, then I think you also have to grant that they can support.
Keep in mind that price level targeting is not a restriction on what central banks can do. Nothing prevents them from switching to a different target in the event that the price level ceases to be meaningful.
11. June 2013 at 02:41
“If you grant that central banks can devalue, then I think you also have to grant that they can support.” In a fixed exchange rate regime, the value of a fixed money derives from that into which it is convertible. Thus under a gold standard paper notes are worth as much as the gold they represent. “Backing” matters in that case, because it bears on the likelihood that redemption pledges will be honored.
None of this applies to a floating fiat currency. It is a category mistake–alas, an all too common one–to confuse the factors that determine the value of redeemable monetary liabilities with those that determine the value of irredeemable paper money.
Vaidas, it had occurred to me also that your scheme had some elements in common with my “synthetic commodity money” idea, but I had already referred to my own work too often in these comments! Please feel free to write me at Selgin@uga.edu so we can talk further without my trespassing more on Scott’s blog.
11. June 2013 at 03:21
George, “None of this applies to a floating fiat currency. It is a category mistake-alas, an all too common one-to confuse the factors that determine the value of redeemable monetary liabilities with those that determine the value of irredeemable paper money.”
Consider this analogy. Non-dividend paying companies (e.g. Warren Buffet’s company) are valued in fundamentally the same way as dividend paying companies. A company that can never pay a dividend is worthless.
Irredeemable monies are valued in fundamentally the same way as redeemable monies. Monies that can never be redeemed are worthless.
Irredeemable describes what has not happened, not what can’t happen.
11. June 2013 at 03:56
“Monies that can never be redeemed are worthless.”
The U.S. dollar has not been a redeemable currency, even on a limited basis, since 1971. (“Redeemable” doesn’t simply mean “exchangeable for goods at finite prices”: if it did your claim would be a mere truism. “Redeemable” means freely convertible into some commodity or other currency at a fixed price or rate.) Nor is there any considerable prospect of it becoming a redeemable currency in the future. It is a floating-rate fiat currency. Yet dollars aren’t worthless. So your statement appears quite contrary to the facts; indeed, it seems to me to provide a neat illustration of why it is a “mistake” to treat theories applicable to redeemable monies as being equally applicable to irredeemable ones.
11. June 2013 at 04:31
“The U.S. dollar has not been a redeemable currency, even on a limited basis, since 1971. (“Redeemable” doesn’t simply mean “exchangeable for goods at finite prices”: if it did your claim would be a mere truism. “Redeemable” means freely convertible into some commodity or other currency at a fixed price or rate.)”
Yes, I agree.
“Nor is there any considerable prospect of it becoming a redeemable currency in the future. It is a floating-rate fiat currency.”
Yes, I agree.
Again, irredeemable doesn’t describe a constraint on the central bank. The Fed can redeem its dollars. There’s just no *need* to do so at the moment, because price level targeting is working. And everyone expects that it will continue to work. But this doesn’t imply that dollars should be valued like a money that can never be redeemed.
11. June 2013 at 05:26
Max, price level targeting “works” precisely because it entails limiting the nominal quantity of money. So I see nothing in your last remarks that contradicts my original point, which is that it is that limitation of the quantity of fiat money suffices to “support” the value of such money.
11. June 2013 at 05:30
George, Unless I’m mistaken the size of the medium of account is of no importance. Everything else (in a nominal sense) is endogenous. Even if the MOA is tiny, you’d expect its demand to be responsive to changes in the opportunity cost of holding that asset.
I mentioned gold because I thought you had mentioned that as a possibility. But the same argument that applies to gold also applies to a fixed monetary base.
11. June 2013 at 11:34
George, if you agree that central banks haven’t lost the ability to redeem their money, then why should the fundamental nature of the money have changed just because redeem-ability has been suspended for an indefinite period of time?