Alt-M Ideas for an Alternative Monetary Future Thu, 27 Aug 2015 16:54:50 +0000 en-US hourly 1 Fed Officials Endorse Monetary Commission! Thu, 27 Aug 2015 12:59:24 +0000 You heard it here first. According to a report I have before me, straight from the U.S. Senate, prominent Federal Reserve officials, including the presidents of the Federal Reserve Banks of New York and Philadelphia, have publicly endorsed legislation that would establish a bipartisan Monetary Commission authorized "to make a...

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You heard it here first.YellenandPaul8

According to a report I have before me, straight from the U.S. Senate, prominent Federal Reserve officials, including the presidents of the Federal Reserve Banks of New York and Philadelphia, have publicly endorsed legislation that would establish a bipartisan Monetary Commission authorized "to make a thorough study of the country's entire banking and monetary set-up," and to evaluate various alternative reforms, including a "return to the gold coin standard."  The proposed commission would be the first such undertaking since the Aldrich-Vreeland Act established the original National Monetary Commission in 1908.

Surprised?  It gets better.  The same Senate document includes a letter from the Fed's Chairman, addressed to the Senate Banking Committee, indicating that the Board of Governors itself welcomes the proposed commission.  Such a commission, the letter says, "would be desirable and could be expected to form the basis for conservative legislation in this field."

Can it be?  Have Fed officials had a sudden change of heart?  Have they really decided to welcome the proposed "Centennial Monetary Commission" with open arms?  Is it time to break out the Dom Pérignon, or have I just been daydreaming?

Neither, actually.  Who said anything about the Centennial Monetary Commission?   The Senate report to which I refer isn't about that commission.  It concerns neither S. 1786, the Centennial Monetary Commission bill just introduced in the Senate, nor its House companion, H.R. 2912.  Instead, the report refers to S. 1559, calling for the establishment of a National Monetary Commission.  That's S. 1559, not of the 114th Congress, but of the 81st Congress – the one that sat from 1949 to 1951, when Harry Truman was president.

It turns out, you see, that the Centennial Monetary Commission legislation isn't the first time that Congress has tried to launch a new monetary commission.

Things were, evidently, rather different in 1949 than they are now.  Back then, the Fed was thoroughly under the Treasury's thumb, where it had been throughout World War II.  In particular, it found its powers of monetary control severely diminished by both the vast wartime increase in the Federal debt and by the Treasury's insistence that it intervene to support the market for that debt.  Fed officials hoped to reestablish the Fed's powers of monetary control by having it acquire the ability to set reserve requirements for non-member banks.  In short, Fed officials, including then Federal Reserve Chairman Thomas McCabe (who would later lose his job for standing up to the Treasury), favored a new Monetary Commission because they anticipated that such a commission would end up recommending reforms that would enhance the Fed's then truncated powers.

S. 1559 ended up being killed by the Subcommittee on Monetary, Credit, and Fiscal Policies of the Joint Committee on the Economic Report.  Interestingly, that body argued that the proposed, comprehensive study of the U.S. monetary system should instead "be made by a committee composed exclusively of Members of Congress rather than, as proposed in S. 1559, by a mixed commission composed of Members of Congress, members of the executive department, and members drawn from private life."  As it happens, the  currently proposed Centennial Monetary Commission is to have 12 voting members, all of whom are to be members of Congress. *

As for any possibility that the Centennial Monetary Commission bill might itself garner support from highly-placed Fed officials: fuhgeddaboudit.  Those officials now have all the power they could possibly desire.  Why should they look kindly upon legislation that's far more likely to lessen that power than to enhance it?

Although the fact that the Fed welcomed a new National Monetary Commission in 1949 is no cause for celebration today, supporters of the new reform may still have reason to be cheered by the Fed's earlier stance.  After all, should Fed officials declare themselves against the new proposal, they can be reminded of their predecessors' stance, and asked to explain why they should oppose the same sort of inquiry that those  predecessors considered a jolly good idea.  If they are good for nothing else, their answers should at least be good for a chuckle.


* A person with expert knowledge of the legislation in question tells me that the crossed-out statement is incorrect.  Although the latest version of the Centennial Monetary Commission bill calls for that Commission to have six voting members "appointed by the Speaker of the House of Representatives, with four members from the majority party and two members from the minority party," and another six "appointed by the President pro tempore of the Senate, with four members from the majority party and two members from the minority party," it does not require that these appointees themselves be members of Congress.

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Monetary Rules: Solving the Knowledge Problem Tue, 25 Aug 2015 13:01:27 +0000 In its  "Free Exchange" column, the Economist recently took up the issue of monetary rules.  Provocatively titled “Rule It Out,” the column announced that “setting interest rates according to a fixed formula is a bad idea.” Reading the column one quickly learns the author doesn’t understand what constitutes a rule,...

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Hayek, knowledge problem, monetary policy, monetary rulesIn its  "Free Exchange" column, the Economist recently took up the issue of monetary rules.  Provocatively titled “Rule It Out,” the column announced that “setting interest rates according to a fixed formula is a bad idea.”

Reading the column one quickly learns the author doesn’t understand what constitutes a rule, and what the argument for a rule is.  The column moves from a general consideration of monetary rules to considering specifically the Taylor Rule.  I leave it to Professor Taylor to defend his rule, which he did on his blog.  I, however, consider the general case for monetary rules.

"Free Exchange" links the case for rules to the 1977 article by Finn Kydland and Edward Prescott, “Rules Rather than Discretion: The Inconsistency of Optimal Plans.”  The title is not cited nor is the article’s central argument addressed: Discretionary economic policy cannot be optimal.  Their article undermines the case for discretion over rules that "Free Exchange" attempts to make.  "Free Exchange" lamely says that Kydland and Prescott’s argument “helps to explain the high inflation of the 1970s.”  It did far more than that.  It explains why policymakers cannot credibly commit to future policies.  That is known as the time inconsistency problem.

The argument for rules versus discretion in monetary policy goes back at least to Henry C. Simons' 1936 article, “Rules versus Authorities in Monetary Policy.”  The case for a monetary rule was re-argued by Milton Friedman in the 1960s and he anticipated the dynamics developed in Kydland and Prescott.

"Free Exchange" states that “monetary policy based on rules has one major advantage: transparency.”  Certainly a rule will likely be more transparent than policy discretion.  But it has never been the central argument for a monetary rule.  The central argument for a monetary rule is what is known as the knowledge problem in economics and social affairs.

Policymakers cannot in principle possess the knowledge required to devise an optimal (or time consistent) monetary policy.  The information required for centralized policymaking is dispersed among the millions of actors in society.  It cannot be aggregated or concentrated in one mind.  No expert or set of experts can ever know as much as the totality of individuals in society.

Rules are a response to the knowledge problem.  Uncertainty generates reliance on rules.  Rules are constructed or evolved based on accumulated experience over long periods of time.  Rules encapsulate the totality of knowledge and experience not only of all alive today, but also of those who preceded them.

Rules can be formal or informal, and could – but need not – be a formula.  (Most rules are not a formula.)  When people do not possess the information required to optimize, they rely on rules.

The knowledge problem arises in any attempt to set centralized policy or planning.  Even before Simons, F. A. Hayek articulated the knowledge problem in monetary policy and in the debate over centralized economic planning.

"Free Exchange" turns the knowledge problem upside down: “Until the day the economy is fully understood, human judgment has a crucial role to play.”  No, actually, it is just the opposite.  There would be no need for reliance on a rule if the economy were fully understood.  The less we know about the specifics of a situation, the more we must rely on rules.  A good rule incorporates the general features of a class of situations, in which the specific features vary unpredictably.  If we possess full information, why would we want to rely on a rule?

In a paper that I will present at Cato’s annual monetary conference on November 12th, I develop in more depth the case for rules in monetary policy.  I attribute the central argument to Hayek.  But I note that Friedman also adduced an argument based on the knowledge problem in support of his monetary rule.

Monetary rules and policy rules more generally are a subset of behavioral rules.  The case for a monetary rule is ultimately the same as the case for the rule of law in society.  For those would like to see that argument in print, along with the philosophical tradition undergirding it, see my recent article in the Journal of  Private Enterprise, “Hayek and the Scots on Liberty.”

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A Bitcoin Constitutional Amendment Wed, 19 Aug 2015 21:39:25 +0000 Some influential developers of the software that runs Bitcoin have proposed an important amendment to the functioning of the leading cryptocurrency.  It's a development as important to Bitcoin as a constitutional amendment aimed at the Fed would be to the dollar. The debate has been characterized in some headlines as...

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Bitcoin, Bitcoin XT, cryptocurrencySome influential developers of the software that runs Bitcoin have proposed an important amendment to the functioning of the leading cryptocurrency.  It's a development as important to Bitcoin as a constitutional amendment aimed at the Fed would be to the dollar.

The debate has been characterized in some headlines as "existential," and one write-up called it a "constitutional crisis."  Both are probably overstating the situation.  But it's worthwhile to dig in and see what we should make of the debate.  Doing so can tell us how things might go for lots of things in the world of cryptocurrency, including potential future proposals to alter Bitcoin's embedded monetary policy.

I'll begin with some basics about the protocol that are essential for understanding what this amendment does, then I'll discuss the nature and tenor of the debate, which is important for at least the debaters to have in mind.

Much like email is a system for sending "mail" around the globe digitally via the Internet, the Bitcoin protocol is a system for maintaining a global public record book, or ledger.  The ledger is optimized for recording transfers of value in the form of digital units called bitcoins.

When one person seeks to send bitcoins to another, he or she broadcasts a message to the Internet, where it is shared among a global web of Bitcoin "nodes."  The nodes confirm the validity of each new transaction by checking the authority of the sender to transfer bitcoins from a given address.

Another group of actors called "miners" gather validated transactions from the nodes and, about every ten minutes, add a new page to the ledger by broadcasting new ledger pages back to the nodes.  (They're rewarded for the service with a pre-set payout of new bitcoins, which is what causes the total stock of bitcoins to increase over time.)  If the nodes validate the new page, they add it to the consensus ledger and continue validating the latest transactions, while miners begin work on the next page.

This brief description passes over much in the process.  And in Bitcon jargon, ledger pages are known as "blocks"; the ledger is called the "blockchain."

One of the potential challenges for the Bitcoin protocol, and thus for Bitcoin, is its capacity to handle the kind of transaction volumes one would expect of a global, digital currency.  The current maximum size of a ledger page, or block, is 1 megabyte, which equates to about seven transactions per second.  The Visa network, by comparison, has a capacity of about 22,000 transactions per second.

It is not a given that Bitcoin should be able to handle every payment around the world, of course.  It would still be a happy result for Bitcoin if a significant subset of the world's bazillion daily payments occurred through "off chain" services using bitcoins, with the blockchain serving as a global settlement network.

But the group of Bitcoin developers advocating for the software change believe that the network will begin to bump up against the 1 megabyte block limit next year.  Significant numbers of transactions could be dropped, resulting in badly delayed validations and re-sent transactions that clog and degrade the network.  They have been arguing for an increase in the blocksize, and last weekend they introduced a new version of Bitcoin software called Bitcoin XT.

The new software switches to 8 megabyte blocks after January 2016 if 75% or more of mined blocks indicate that they were produced by miners who support the change.  If the switch occurs, the maximum block size limit would then double every two years. (You can follow along, seeing XT and non-XT nodes and blocks here.)

Seventy-five percent is an interesting choice.  Proposals to amend the U.S. Constitution are validated and become part of the Constitution if they are ratified by legislatures or conventions in 75% of U.S. states.  I don't know if the authors of Bitcoin XT were thinking of that cherished U.S. document when they set their 75% threshold, but they are doing something very much like a Bitcoin constitutional amendment.

(Full disclosure: I know Gavin Andresen and Mike Hearn better than I know most other developers, and I've had very brief communications with each about this debate.  I'm doing my best to write this post down the middle, and I'm open to correcting it if others think I'm skewing things — and of course if I've gotten technical details flat wrong.)

At its essence, the choice whether to run Bitcoin XT is a simple plebiscite. Miners will "vote" with their feet. If they adopt it, the amendment passes.  If they don't, it doesn't, and nothing changes.

If the 75% threshold is reached, it is a near certainty that the remaining miners will switch to Bitcoin XT, as well.  The coins they would produce using the old software would be incompatible with the majority's coins, and there is far less value to cryptocurrency that is incompatible with the majority currency.  There is no permanent Bitcoin schism in the offing.

But that doesn't mean that all is sweetness and light.  As in debates about constitutional amendments, things are starting to run a little hot.  A technical change like this reallocates power and profitability to some degree.  Larger blocks propagate slightly less quickly, which may disadvantage miners with weaker Internet connectivity.  Higher transaction volumes will consume more storage, raising the cost of operating nodes and potentially reducing their numbers, which threatens Bitcoin's decentralization and resistance to control.  A software change like this always risks producing unforeseen security flaws, which is not pattycake on a network that currently stores about US$3.5 billion-worth of value.  So the debate is, and will be, intense.

Cato Institute alumnus and friend Timothy B. Lee wrote a helpful Vox piece on the controversy earlier this week.  It was entitled, "Bitcoin is on the Verge of a Constitutional Crisis."  I don't think "crisis" is quite right, though, for a number of reasons.

For one, the paths forward are clear.  There are only two of them: adoption or non-adoption of the amendment.  A "constitutional crisis" implies unpredictable behavior of contested legality.  That can't happen here, as control of the use of the software is firmly in the hands of its users, the nodes and miners — not developers.

There is an argument that the software's users are collectively being duped, but it doesn't seem strong.  This debate is occuring in an environment that is susceptible to testing and rigor.  Valid theses about how nodes and miners will be affected have been discussed and modeled — a thing that can't be done with legal rules. Miners in particular are keenly focused on their interests, and the effects of the amendment on those interests seem pretty well understood.

Given the visibility of behavior in the Bitcoin ecosystem and the threat of exit (which I discuss below), mistaken amendments are more likely to be reversed than a "bad" amendment to a legal-world constitution.  The dynamics that lock in bad laws and regulations are not in play — or at least they're much weaker — with the Bitcoin protocol.  Someone seeking economic rents through manipulation of the software's functioning is very likely to end up drinking their own blood, and pretty much everyone knows that.  We are in an environment of virtuous incentives.

The key difference between the Bitcoin protocol and a paper constitution, though, is jurisdiction.  The rules that govern Bitcoin are not as important as the rules that govern a country.

Bitcoin is but the most popular of numerous cryptocurrencies, and — putting aside some poorly worded regulatory proposals — anyone with the technical skills can create a new one.  Different cryptocurrencies can function differently in ways that optimize them for different uses and needs.  And it is very easy to switch among cryptocurrencies.

If the Bitcoin XT proposal is adopted, if its demerits prove greater than its merits, and if switching back doesn't or can't occur, developers and users have a relatively easy exit to another cryptocurrency.  It is not costless, but some lost Bitcoin wealth and a move to a new cryptocurrency is not as hard as uprooting oneself from a physical place and moving to a different location on Planet Earth.  Bitcoin is important, exciting, and precious, but the stakes in the Bitcoin XT debate are somewhat lower than in a true constitutional debate.

Without testable propositions to hold them to account, legal-world politicians spin the most favorable evidence for their positions nearly from whole cloth.  They often portray their opponents as animated by venal, fully hidden motives.  The stakes are very high because everyone has to live under one rule, so they permit themselves to seek victory at all costs.  Government politicians play to the hilt for a largely uninformed audience of voters who happen to respond better to ad hominem attacks than the merits.  (Then they adjourn together to the bar — ah, the ruling class….)

This kind of debate is not like that kind of debate.  As hot as the debate feels in the Bitcoin developer community — and it does: you can see some developers speaking carelessly to and about each other — it is relatively genteel.  And it should stay that way.

The reason why developers should stay moderate with their arguments and language is because perceptions of instability in the Bitcoin ecosystem are bad for adoption, and everyone needs adoption.  Were it possible to "win" the Bitcoin XT debate with bombast and exaggeration, such a victory would be Pyrrhic.

As I write this post, the Bitcoin price has seen a sharp drop (and recovery) against the dollar.  Coincidental or not, and lasting or not, it's the kind of thing that reporters who don't pay much attention to Bitcoin — or who actively dislike it — will join to the Bitcoin XT debate.  They'll use the simple tale of developer angst and price volatility to sow doubts about cryptocurrency among the public at large.

Rancor in the Bitcoin developer community gives succor to the opponents of monetary alternatives.  The debate about amending the Bitcoin software should be fascinating to watch, and it should be kept on a high plane.

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A Rush to Judge Gold Wed, 12 Aug 2015 13:03:22 +0000 Of course I didn't expect my recent post, listing "Ten Things Every Economist Should Know about the Gold Standard," to stop economists from repeating the same old misinformation.   So I'm not surprised to find two of them, writing for a New York Fed blog, repeating recently some  of the very...

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gold standard, federal reserve, deflation, gold rushOf course I didn't expect my recent post, listing "Ten Things Every Economist Should Know about the Gold Standard," to stop economists from repeating the same old misinformation.   So I'm not surprised to find two of them, writing for a New York Fed blog, repeating recently some  of the very myths that I would have liked to lay to rest.

The subject of James Narron and Don Morgan's August 7th Liberty Street Economics post is the California gold rush.  After describing the discovery at Sutter's mill and the "stampede" of prospectors anxious to get their hands on part of the "vast quantities of gold" whose existence that discovery had revealed, Narron and Morgan observe that the

large gold discovery functioned like a monetary easing by a central bank, with more gold chasing the same amount of goods and services.  The increase in spending ultimately led to higher prices because nothing real had changed except the availability of a shiny yellow metal.

No economist worthy of the name would deny that, other things being equal, under a gold standard more gold means higher prices.  But other things evidently weren't equal in the U.S. in the late 1840s and early 1850s, for if they had been the path taken by the U.S. CPI between 1830 and 1880 would not have looked as it does in the chart shown below, which was also in my above-mentioned post:

*Graphing Various Historical Economic Series," MeasuringWorth, 2015.

As you can see, the gold rush didn't even cause a blip in the CPI, which was about as stable from 1840 to 1860 as it has ever been.  Indeed, prices fell slightly, making for an annual inflation rate of minus .19 percent.  For the shorter period of 1845 to 1860 the inflation rate is, admittedly, much higher: a whopping .63 percent.  But even this higher rate was, according to the Fed's current credo, dangerously low.  Were one to assume that a 2 percent inflation rate was as desirable 167 years ago as Fed officials claim it to be today, one would have to conclude that the gold rush, far from having made the U.S. money stock grow too rapidly, didn't suffice to make it grow rapidly enough.

Having left their readers with a quite false impression regarding the inflationary effects of the gold rush, the Liberty Street authors go on to claim that "the gold standard led to more volatile short-term prices (including bouts of pernicious deflation) and more volatile real economic activity (because a gold standard limits the government's discretion to offset aggregate demand shock [sic])."

Here again, a little more attention to both the statistics themselves and the economic forces underlying them, casts doubt upon the Fed experts' conclusions.

It is, first of all, notorious that early macroeconomic statistics tend to be based on smaller samples, and ones that lean more heavily on relatively volatile components, than modern ones.  Christina Romer documented this fact with respect to early real GNP estimates, but the same goes for early price-level measures.  Consequently it is more than likely that at least some of the gold standard era's apparent short-run price level and real output volatility is nothing more than a statistical artifact.

Second, and more fundamentally, the authors' implicit premise — that an ideal monetary standard avoids short-run price level volatility — is false.  What's desirable isn't that the price level not fluctuate, or that it only fluctuate within narrow limits, but that it should fluctuate only to the extent that is needed to reflect corresponding changes in the general scarcity of final goods.  In other words, the price level ought to vary in response to shocks to "aggregate supply," but not because of shocks to total spending or "aggregate demand," which an ideal monetary system will prevent.

A sharp rise in prices connected to a drought-induced harvest failure, for example, isn't the same thing as one caused by a surplus of exchange media.  The rise supplies a desirable signal of underlying real economic conditions.  Far from making anyone better off, a monetary system that kept prices from rising under the circumstances would have to do so by reducing the flow of spending, which would only mean adding the hardship of tight money to the damage done by the drought itself.

As numerous studies (including several that I, Bill Lastrapes, and Larry White cite in "Has the Fed Been a Failure?") have shown, harvest failures and other sorts of aggregate supply shocks were a relatively much more important cause of macroeconomic volatility during the gold standard era than they have been in more recent times.  It follows that one would expect both the price level and real output to have varied more during the gold standard days than they do now even if, instead of having been governed by a gold standard, the money supply back then had been regulated by a responsible central bank.  As a matter of fact, according to a fairly recent study by Gabriel Fagan, James Lothian, and Paul McNelis, had a Taylor Rule been in effect during the gold standard period, it would not have resulted in any welfare gain.

Just as there are good reasons for allowing adverse supply shocks to be reflected in higher prices, so too are there good reasons for allowing the price level to decline in response to positive supply innovations.  Those reasons can be found both in my writings defending a "productivity norm"  and in arguments by Scott Sumner and others for targeting  NGDP.

Consideration of these arguments brings me to Narron and Morgan's claim that the gold standard was responsible for "bouts of pernicious deflation."  That the gold standard did bring periods of deflation no one would deny.  But it doesn't follow that those deflationary episodes, or most of them, were "pernicious."  In fact, Michael Bordo, whom Narron and Morgan give as the source for their claim, has himself denied that "pernicious" deflation was a frequent occurrence under the classical gold standard.  According to the abstract to Bordo's paper, "Good versus Bad Deflation: Lessons from the Gold Standard Era," written with John Landon Lane and Angela Redish,

the deflation of the late nineteenth century reflected both positive aggregate supply shocks and negative money supply shocks.  However, the negative money supply shocks had little effect on output.  This we posit is because the aggregate supply curve was very steep in the short run during this period.  This contrasts greatly with the deflation experience during the Great Depression.  Thus our empirical evidence suggests that deflation in the nineteenth century was primarily good.

Several other recent studies reach broadly similar conclusions, including a brief research note from another Federal Reserve economist.[1]

To say that deflation can be either "good" or "bad," depending on whether it stems from goods becoming more abundant or from money becoming more scarce, and to observe that, under the gold standard, deflation was mostly good, isn't to deny that there's such a thing as bad deflation.  But if it's striking examples of bad deflation that one seeks, one will find them, not by peering back into the days before the Fed's establishment, but by looking no further back than the Coolidge recession of 1920-21, or the Great Contraction of 1930-33, or the Roosevelt Recession of 1937-8.  Heck, instead of even going back that far, one could just consider the subprime deflation of 2008-9.  According to the linked sources, in each of these instances, deflation was to some considerable extent an avoidable consequences of the Fed's deliberately-chosen policies, rather than something beyond the Fed's control.[2]

Besides exaggerating both the inflationary and the deflationary risks posed by the classical gold standard, Narron and Morgan repeat the myth that a gold standard costs considerably more than a fiat standard:

Apart from their macroeconomic disadvantages, gold standards are also expensive; Milton Friedman estimated the cost of mining the gold to maintain a gold standard for the United States in 1960 at 2.5 percent of GDP ($442 billion in today's terms).

What Friedman's calculation actual showed was, not that "gold standards" are quite expensive, but  that one very peculiar sort of gold standard is so, namely, a "pure" gold standard arrangement in which gold coins alone serve as exchange media, without the help of any fractionally-backed substitutes!  Not a single one of modern history's actual "gold standards" ever even came close to Friedman's fictional case.  (Even mid-17th century goldsmith-banks are said to have kept specie reserves equal to about a third of their "running cash" liabilities.)  If one assumes that banks in 1960 would have required 10 percent gold reserves, one arrives at a gold-standard cost estimate of .25 percent of GDP; if one assumes (still more plausibly) that 2 percent reserves would have sufficed, one arrives at an estimate one-fiftieth as large as Friedman's!  When, oh when!, will economists stop taking Milton Friedman's absurd 2.5 percent estimate seriously?

Yet correcting Friedman's estimate is only part of the story.  All sorts of other things are wrong with the claim that the gold standard was expensive.  Those interested in a quick summary may consult item # 2 of my "Ten Things" post.  I will only add here that even Friedman himself came to doubt that fiat money was a bargain.

Narron and Morgan conclude their article thus:

Despite the demonstrable disadvantages of a gold standard, some observers still call for the Unites States to return to a classical gold standard.  Should we?  Let us know what you think?

What I think is that, if the gold standard really does have "demonstrable disadvantages," Messrs. Narron and Morgan haven't managed to put a finger on any of them.


[1]See also Atkeson and Kehoe, Borio et al., and Beckworth.

[2]The U.S. did, of course, experience several less-severe cases of "bad" deflation during the classical gold standard era.  But these episodes resulted, not from the ordinary working of the gold standard, but from financial crises that were peculiar consequences of misguided U.S. banking and currency laws.

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Milton Friedman and Monetary Freedom Mon, 10 Aug 2015 12:59:11 +0000 Milton Friedman with  Cato's Ed Crane and Jim Dorn Although I don't call myself a Friedmanite or a monetarist (or anything else), and many of my opinions on monetary economics are ones that he rejected, I'm a huge Milton Friedman fan.  I regard him as the most influential champion of...

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Milton Friedman with  Cato's Ed Crane and Jim Dorn

Although I don't call myself a Friedmanite or a monetarist (or anything else), and many of my opinions on monetary economics are ones that he rejected, I'm a huge Milton Friedman fan.  I regard him as the most influential champion of free market economics after Adam Smith, and as one of the greatest monetary economists of the last century.  He is certainly among the dozen monetary economists of any era from whom I have learned the most.  Finally, in my own dealings with him I found him to be an upright and generous man, as well as one who gave me a great deal of encouragement and support when I most needed it.

Consequently it distresses me to see Friedman attacked, and especially so when the attacks come from persons who share my fondness for monetary freedom.  One such attack came my way two weeks ago, in the shape of a complaint about a Cato email notice commemorating what would have been Friedman's 103rd birthday, on July 31.  The writer, a free-market gold standard advocate, and a generally pleasant and mild-mannered fellow, called "Chicago School" monetary economics "a virulently anti-free market conception that has institutionalized our unstable…monetary system,"  and said that, in leading it, Friedman "did us and the world an unfathomable disservice."

Alas, far from being rare, harsh opinions about Friedman are easy to come by among the more uncompromising critics of government intervention in monetary affairs.  Ludwig von Mises, another of my monetary economics heroes, may have started the trend when, according to Friedman himself, he stormed out of a debate at the first (1947) Mont Pelerin meeting after calling its other participants, Friedman among them, "socialists."  Some years later, in 1971, Murray Rothbard reached a similar verdict, this time in print, though he substituted "statist" for "socialist."  (That  Friedman was more of a statist than Rothbard himself was certainly true.  But who, in 1971, wasn't?) Today more than a few "End the Fed" libertarians still accept Rothbard's judgement.*

My first personal encounter with Friedmanophobia took place in 1988.  Thinking that The Freeman might review it, I had sent a copy of The Theory of Free Banking  to the Foundation for Economic Education.  But instead of getting a review, I got a terse letter from Hans Sennholz, FEE's director at the time, who was also a well-known champion of monetary freedom.  In the letter Sennholz lashed out at me for having had the brass gall to send him a book that expressed approval for some of Friedman's ideas, while also offering some (mild) criticisms of "The Master."  ("The Master," in case you don't know it, was von Mises.)  Of course I was taken aback, and all the more so since I considered myself, back then, much more a Mises than a Friedman fan.

Even now I'm sure I'm as aware as any of Friedman's toughest critics of the various forms of government intervention in the monetary system he favored at one time or another.  Throughout most of his career Friedman categorically favored a managed fiat standard over a gold standard.  He also favored (as was only natural given that first preference) flexible over fixed exchange rates.  Finally, for much of his career he dismissed free banking as the equivalent of legal counterfeiting.  These are all, needless to say, positions that are objectionable, if not obnoxious, to persons who believe that unhindered markets are more capable than governments are of producing orderly and reliable monetary systems.

But there is another side to the ledger that Friedman's more radically free-market critics seem to overlook.  Two items especially deserve notice.  Although he favored fiat money, Friedman was an unflinching and relentless opponent of monetary discretion.  We also have him (and Anna Schwartz, another of my economist-heroes), to thank for the fact that the Great Depression is no longer considered proof of the inherent instability of free markets.**

Friedman's more strident critics also seem unaware of how his monetary ideas changed over time, evolving in a way that fans of either the gold standard or free banking ought to find gratifying.  Much of this evolution appears to have taken place during the mid-1980s.  In various articles written then, Friedman admitted having erred in treating fiat money as a less expensive alternative to gold.  He also renounced his previous defense of central banks' currency monopolies, conceding that there was in fact no good reason for prohibiting commercial banks from issuing their own paper notes.  Instead of recommending a constant growth rate for the money stock, as he had in the past, he switched to arguing for a constant or "frozen" monetary base, which was tantamount to recommending that the Fed's monetary and discount window operations be altogether shut down.  Finally, he publicly declared himself in favor of abolishing the Fed on numerous occasions.  Think what you will of Friedman's later opinions, you will go blue in the face trying to convince me that they are those of a "statist."

Finally, had it not been for Milton Friedman, I and other academic (or formerly academic) proponents of monetary laissez-faire would be an even more pathetically forlorn bunch than has actually been the case.  For setting a handful of "Austrian" economists aside, the list of academic economists, including economists working for central banks and other financial regulatory authorities, who have shown a willingness to take free banking ideas seriously, and to treat their authors courteously, even allowing some of their articles to get published in mainstream academic journals, consists overwhelmingly of prominent "Chicago-School" monetary economists, if not of Friedman's own students.  Had it not been for Friedman and his students, in other words, there would almost certainly not be a Modern Free Banking School of any academic standing today.***

One of those students — and yet another of my monetary economics heroes — is David Laidler, who wrote me just recently.  Like that other recent correspondent David was passing on some of his thoughts about Milton Friedman on the 103rd anniversary of his birth, in the shape of a copy of his speaking notes for a talk he gave on "Milton Friedman's Intellectual Legacy" at Canada's Institute of Liberal Studies.  David has kindly allowed me to make those notes available here.  As David's appraisal of Friedman is, like all of his work, both thoughtful and well-written, I urge everyone to read it.

In fact, I disagree with only one sentence in David's otherwise excellent talk.  This occurs when David says that, starting in the 1980s, "Milton's…inclination was to drift toward 'free banking'."   That doesn't sound right to me, for "drifting" was hardly Friedman's style.  Instead, I'm inclined to believe — and Friedman himself claimed — that he moved toward free banking quite deliberately, upon finding that the predictions of its theorists conformed better to observed reality than his own earlier views did.

I hope that David would not disagree.


* An amusing illustration of this — though one of admittedly doubtful evidential value — consists of a straw poll taken on the Ron Paul Forum in which 16 out of 28 participants held that Friedman was either "a statist leaning libertarian, or a flat out statist."  (Since I eat vegetables now and then, I suppose I must be a "radical vegetarian-leaning carnivore.")

**In America's Great Depression, originally published in the same year as Friedman and Schwartz's  Monetary History of the United States, Murray Rothbard also blamed the Great Depression on the Fed, basing his arguments not on monetarist ideas but on the Mises-Hayek theory of the business cycle.  But regardless of the the different theories, it was Friedman and Schwartz's work rather than Rothbard's that was primarily responsible for reversing the tide of opinion, especially among academic economists.

***I also owe a particular debt to Dick Timberlake, a Chicago-trained monetary economist who had Friedman among his teachers.  It was Dick who brought Larry White to the University of Georgia and who later, with Larry's help, got me a job there.  Dick has been yet another hero to me, as a monetary economist certainly, but also in lots of other ways.

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That's Right: "Famously Sound and Famously Stable" Sat, 08 Aug 2015 11:03:39 +0000 In one of my recent posts I observed, not only that Canada's ca. 1913 currency and banking system was sound and stable, but that it was "famously" so.  Many of my readers may wonder about that description.  After all, relatively few people today are aware of Canada's having had such a...

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branch banking, Canadian banking system, William Jennings BryanIn one of my recent posts I observed, not only that Canada's ca. 1913 currency and banking system was sound and stable, but that it was "famously" so.  Many of my readers may wonder about that description.  After all, relatively few people today are aware of Canada's having had such a successful system; and most current writings on U.S. monetary history don't even refer to it.  That one can read one official Federal Reserve account after another of that history, and especially of the Fed's origins, without hearing so much as a whisper about Canada's having had a well-working banking and currency system, albeit one without a central bank, goes without saying.

But the story was far different a century or more ago.  Back then, just about any U.S. adult who paid attention to current events knew all about Canada's smoothly-working monetary system, and also about various reformers' efforts to replicate it's success in the U.S.   Where's my proof?  It's all right here, in hundreds of articles that appeared in scores of U.S. newspapers between 1890 and 1913.

Read 'em, or some of them at least.  And weep.

The foreign press also took some notice of Canadian banking.  One such notice, consisting of a long letter in the September 7, 1896 London Times, seems to me especially noteworthy.  Though it  was sent from Blackfriars, it's author, Thomas G. Shearman, was actually a British-born American citizen then visiting London.  A lawyer by trade (he defended Henry Ward Beecher in his sensational trial for adultery), he was also a well-respected political economist and the original author of the "Single Tax" proposal that was subsequently endorsed by Henry George.

What distinguishes Shearman's letter from many of the other writings I've referred to is the fact that it traces William Jennings Bryan's popularity — especially among farmers — and that of the free silver and greenback movements, to the peculiar shortcomings of the U.S. currency and banking system, and especially to the lack of adequate banking facilities in many parts of the country:

In the south and west it is quite common to find numerous populated districts…in which there is not a single bank of deposit.  In most of the agricultural regions back of the North Atlantic States payment by cheque is practically unknown.  All transactions are settled either by payment in paper money or by book accounts.

For reasons pointed out in my earlier post, there simply wasn't enough coin and paper money to pay for half of the crops, let alone to pay for them all.  Consequently farmers were forced to buy goods on credit from country or "crossroad" stores, at stiff annual rates of between 20 and 40 percent, to be settled eventually with their crops.  "Is it at all surprising, under such circumstances," Shearman asks, "that these small farmers, hardly pressed for a living, should clamorously demand more money of every kind — gold, silver, paper, or rags?"

A much less dangerous remedy, Shearman observes, would be to simply give farmers better access to banking facilities.  In the U.S., however, that solution was ruled out both by laws against branch banking and by a tax of two or three percent on bank capital.  Not so in Canada:

Just across the northern boundary of the United States lies a country, inferior in climate and lacking many of our natural and social advantages, shut out from its natural commerce by absurd tariffs on each side, even more dependent upon agriculture than we are, and having no opportunities which we do not possess in at least equal measure.  Why does not Canada have a currency question?  Why do not Canadian farmers clamour for silver coinage and fiat money?

The answer, of course, was nationwide branch banking, thanks to which

first class banks of deposit and discount are made easily accessible to every farmer, mechanic, lumberman, and fisherman in the remotest parts of Canada on substantially the same terms with the residents of the largest cities.  Each branch… has at command a supply of loanable funds ten times greater than it actually needs, because the head office always has millions lent on call in the United States, which it would be glad to use among the farmers of Canada.  A similar state of things might easily exist in the United States; but it is made impossible by legislation…  .

In short, "the true remedy for the hardships of American farmers is to be found (as in so many other cases) not in more restriction, but in more liberty."

Couldn't have said it better myself.

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Rules versus Discretion: Insights from Behavioral Economics Fri, 07 Aug 2015 12:59:13 +0000 For half a century now, the “rules versus discretion” debate in monetary economics has focused on the so-called “time inconsistency” problem.  The problem is that, although a discretionary central bank might promise not to allow the inflation rate to rise above zero (or some other ideal value), the fact that...

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behavioral economics, monetary economics, discretionary monetary policyFor half a century now, the “rules versus discretion” debate in monetary economics has focused on the so-called “time inconsistency” problem.  The problem is that, although a discretionary central bank might promise not to allow the inflation rate to rise above zero (or some other ideal value), the fact that an inflation “surprise” can boost employment and output in the short run will tempt it to break its promise.  Realizing this, market participants will anticipate higher inflation.  The long-run result is a higher inflation rate with no improvement in either employment or output.  By limiting the central bankers’ options, a monetary rule solves the time inconsistency problem.

An earlier rules-versus-discretion debate had taken place in the 1920s and 1930s.1  The later one, which was inspired by the stagflation of the 1970s, differed in that it was influenced by the New Classical revolution that was taking place around the same time.  Consequently, the later critics of monetary discretion, including Finn Kydland and Edward Prescott,  Guillermo Calvo, Benn McCallum, Robert Barro and David Gordon, and John Taylor,2 differed from their predecessors by building their arguments on the premise that central bankers were both well (if not quite perfectly) informed and well intentioned.  Discretion, according to them, leads to less than ideal outcomes not because central bankers are ignorant or misguided, but because of misaligned incentives.

Naturally, champions of discretionary monetary policy also regarded monetary policy makers as well-meaning and well-informed experts.  Their counterargument was simply that such experts could in principle out-perform any rule.  Well-trained monetary technocrats might, after all, resist the short-run temptation to take advantage of established inflation expectations by creating inflation surprises.

But just how likely is it that technocrats will behave well in practice?  Even such a technocratically-inclined proponent of discretion as Joseph Stiglitz recognizes that the “decisions made by the central bank are not just technical decisions; they involve trades-offs, judgments.. .”3  Will such “judgments” typically be wise ones?  Although the sub-discipline didn’t even exist when the rules-versus-discretion debate was revived in the 1970s, let alone when it was first aired in the 1920s, the findings of behavioral economists are the natural place to turn to for answers to this question.  At least some of those answers seem to decidedly favor the rules side of the rules-versus-discretion debate.

As Nobel winning economist and psychologist Daniel Kahneman has observed, experts suffer from all sorts of biases that result in bad decisions and outcomes.  Building upon the work of Paul Meehl,4 Kahneman argues that expert decisions can be inferior to simple algorithms (like a Taylor Rule) because experts “try to be clever, think outside the box, and consider complex combinations of features in making their predictions.”5

In the studies reviewed (and sometimes conducted by) Kahneman, experts are always looking for that one additional data point that suggests a different course of action.  Fed officials have behaved that way lately in repeatedly insisting that their decisions will be “data-dependent,” without actually saying what data they have in mind or how its components will be weighted.  Kahneman also notes that experts are often inconsistent, giving different answers to the same (or similar) question.  Here, too, Fed experts conform to the theory, thereby making it difficult if not impossible for market participants to grasp the direction of monetary policy.  Kahneman reaches  the “surprising” conclusion that “to maximize predictive accuracy, final decisions should be left to formulas, especially in low-validity environments.”6  With respect to monetary policy, that  conclusion would seem to favor a policy rule over discretion.

In research conducted with psychologist Gary Klein, Kahneman has also investigated the conditions that are or are not favorable to discretionary decision making.  Previous scholars had  found that firefighters often have surprisingly good intuition about such things as when the floor of a burning building is about to collapse.7  Kahneman and Klein find, however, that such expert skills must be built up over time.  Novice firefighters do not possess them in the way that veterans do.

Interestingly, Fed officials often liken themselves to “firefighters.”  If the analogy is a good one, and Kaheman and Klein are also correct, then having long (14 year) terms for Fed governors is a good idea.  Unfortunately, Fed governors seldom serve more than a modest fraction of their maximum terms.  As major economic crises and downturns happen only so often — every 13 years in case of U.S. crises, according to Reinhart and Rogoff8 — relatively few Fed governors ever experience more than one crisis, and most are unlikely to witness more than two cyclical turning points.  For a Fed staffed by such novices, the case for rules is especially strong.  Indeed, because monetary policy operates with “long and variable lags,” as Milton Friedman famously put it, even seasoned Fed governors cannot be counted on to employ discretion responsibly.

To summarize these implications of behavioral economics, experts can be expected to employ their discretion advantageously when 1) they operate in a regular, predictable environment, and 2) there is an opportunity for learning via repeated practice.  Neither of these conditions characterize monetary policy.  Behavioral economics has sometimes been presented as an avenue to justify government intervention to correct the failings of ordinary people.  But the same literature reminds us that even the most expert policymakers also suffer from a variety of biases.  Just as default rules may be useful in minimizing consumer errors, monetary rules can serve to minimize errors of monetary policy.


[1] For an overview of earlier debates see Robert Hetzel, “The Rules versus Discretion Debate Over Monetary Policy in the 1920s.” Federal Reserve Bank of Richmond Economic Review ( November 1985), p. 1-12 and George Tavlas, “In Old Chicago: Simons, Friedman and the Development of Monetary-Policy Rules.” Journal of Money, Credit and Banking 47(1) (January 2015), p. 99-121.

[2] Finn E. Kydland and Edward C. Prescott, “Rules rather than discretion:  The inconsistency of optimal plans,” Journal of Political Economy, 85(3) (June 1977), p. 473-490; Guillermo A. Calvo, “On the Time Consistency of Optimal Policy in a Monetary Economy,” Econometrica 46(6) (November 1978), p. 1411-1428; Bennett T. McCallum, “Monetarist Rules in the Light of Recent Experience,” American Economic Review 74(2) (May 1984), p. 388-91; Robert J. Barro and David B. Gordon, “Rules, Discretion, and Reputation in a Model of Monetary Policy,” Journal of Monetary Economics 12(1) (July 1983), p. 101-121; Robert J. Barro and David B. Gordon, “A Positive Theory of Monetary Policy in a Natural-Rate Model,” Journal of Political Economy 91(4) (August 1983), p. 589-610; and John B. Taylor, “What Would Nominal GNP Targeting Do to the Business Cycle?” Carnegie-Rochester Conference Series on Public Policy 22 (9) (January 1995), p. 61-84.

[3] Joseph Stiglitz. “Central Banking in a Democratic Society,” De Economist 146(2) (July 1998), p. 199-226.

[4] Paul E. Meehl, Clinical vs. Statistical Prediction: A Theoretical Analysis and a Review of the Evidence (University of Minnesota, 1954).

[5] Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus, and Giroux, 2011). Especially chapters 21 and 22.

[6] Ibid.

[7] Perhaps the most well known popular version of these arguments is found in Malcolm Gladwell, Blink (New York: Little Brown and Company, 2005).

[8] Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009), p. 150, Table 10.2.

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The Federal Reserve's War on Drugs Wed, 05 Aug 2015 12:28:24 +0000 That's right: the Federal Reserve is now in the business of enforcing the U.S. government's drug laws, even if that means making a mockery of both state governments' right to set their own drug policies and the Fed's own governing statutes. The Fed's involvement in drug prohibition became official last...

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Janet Yellen, Federal Reserve, War on Drugs

That's right: the Federal Reserve is now in the business of enforcing the U.S. government's drug laws, even if that means making a mockery of both state governments' right to set their own drug policies and the Fed's own governing statutes.

The Fed's involvement in drug prohibition became official last month, when the Federal Reserve Bank of Kansas City informed Denver's Fourth Corner Credit Union — a non-profit cooperative formed by Colorado's state-licensed cannabis manufacturers — of its decision to deny its application for a master account.  Since asking any sort of depository institution to operate without such an account, and hence without access to the Fed's payment facilities, including its check clearing, wire transfer, and ACH facilities, is like asking a commercial airline to make do with propeller-driven biplanes, and established banks don't want the extra hassle that comes with dealing with pot growers, the Kansas City Fed's action forces  Colorado's marijuana industry to do business on a cash-only basis, with all the extra risk and inconvenience that entails.[1]

The Fourth Corner Credit Union isn't taking this sitting down.  On the contrary: it is suing the Federal Reserve Bank of Kansas City.  Your typical civil action isn't exactly a page turner.  But this one reads like a chiller, largely because that's exactly what it is.  If you like a good horror story, I suggest you read the whole thing.  But for the sake of those in a hurry, here are the CliffsNotes.   Unless otherwise indicated, the details are as alleged by the lawsuit itself.

The basic legal facts as set forth in that document are, first, that it is the essence of the so-called "dual" banking system that both state governments and the Federal government have the right to grant charters to banks and other depository institutions, and, second, that, according to the 1980 Monetary Control Act, "All Federal Reserve bank services…shall be available to nonmember depository institutions and such services shall be priced at the same schedule applicable to member banks."

Furthermore, as if to resolve any doubts regarding whether access to the Fed's payment services was to be granted even to depository institutions that did business with pot growers, on August 13, 2014 the Board of Governors, together with the FDIC, the Comptroller of the Currency, and the National Credit Union Authority, issued guidelines declaring that

Generally, the decision to open, close, or decline a particular account or relationship is made by a bank or credit union, without the involvement of the supervisor.  This decision may be based on the bank or credit union's particular business objectives, its evaluation of the risks associated with offering particular products or services, and its capacity to effectively manage those risks.[2]

Now to the facts of the case, also as presented in the suit.  On November 19, 2014, The Fourth Corner Credit Union acquired an unconditional charter from the state of Colorado, having received  a conditional charter from the state some months before, pending its application for share deposit insurance.  Fourth Corner applied to the Kansas City Fed for a master account on the same day.  As it had previously applied for and received a Routing Number from the ABA, and had applied with the National Credit Union Authority (NCUA) for deposit insurance (and was exploring options for private insurance in case its NCUA request was denied), it had satisfied the only eligibility requirement for having such an account, and so had only to submit a "resolution" authorizing the Fed to open an account for it, together with an FRB "Official Authorizations List."  Once these documents were approved, the Kansas City Fed was expected to accept and process a one-page Master Account Agreement completed by the credit union.  No other documents were necessary.

According to the Kansas City Fed itself, the suit alleges, processing a Master Account Agreement "may take 5-7 business days."  That is, it usually takes only a week or so for an account to be established once the necessary paperwork is submitted.  But although Kansas City Fed officials quickly approved of the credit union's paperwork, the bank refused to process its Master Account Agreement, saying that its application would be processed "upon approval by credit and risk."  When the Fourth Corner's lawyers asked the Kansas City Fed what the rules for such approval were, they were at first told that no such rules existed.

Months later, on January 7, 2015, Kansas City Fed president Esther George at last sent a letter to Fourth Corner's lawyers.  In it she observed that the Fed Bank's Operating Circular, besides setting for the explicit requirement for opening a master account,

also states that a master account is subject to other applicable Federal Reserve regulations and policies.  These include policies related to risk posed by a financial institution and how the risk will be mitigated when determining whether and under what conditions an account may be opened.  Issuing of a master account is within the Reserve Bank's discretion  and requires that the Reserve Bank be in a position to clearly identify the risk(s) posed by a financial institution and how that risk can be managed to the satisfaction of the Reserve Bank (my emphasis).

Given the time normally allowed to process a master account application, it is doubtful that the Kansas City Fed can have bothered to investigate the risks posed by previous applicants for such an account.  One may wonder, moreover, whether any Reserve Bank, or the Fed Board, has ever shown itself capable of  "clearly" identifying the risks posed by different financial institutions — let alone ones that have yet to open for business.  But the more important point, which the credit union's attorneys claim they pointed out to the Kansas City Fed, was that it simply had no authority to deny their client an account, on any grounds whatsoever, given that it had already met all of the provisions of the law.

Still Fourth Corner received neither an account nor any further explanation.  In vain did Deirdra O'Gorman, its CEO, write to both Esther George and Janet Yellen to request a meeting to discuss the risks to which George had alluded.  Not only did both decline, but the Kansas City Fed replied by instructing the credit union to stop submitting documents to it, whether testifying to its safety or otherwise.  Nor did an earlier letter to Yellen and George, from Colorado Senator Michael Bennet, noting the "significant public safety concerns" raised by the  cash-only basis to which Colorado's cannabis industry was being confined, appear to have made any difference.

And so matters stood until July 2, almost nine months after Fourth Corner had applied for its master account.  On that day the NCUA's Office of Consumer Protection denied the credit union its application for federal share deposit insurance, while (according to the complaint) secretly and illegally sharing a copy of its confidential letter with the Kansas City Fed.[3]  Two weeks later, on July 16, 2015, the Kansas City Fed denied Fourth Corner's request for a master account, justifying its decision in part on the grounds that the NCUA had rejected its application for federal insurance.  The decision remains the sole instance in which the Kansas City Fed has denied a master account to any applicant since the passage of the 1980 Monetary Control Act.

Although the Kansas City Fed attempted to justify its action by referring to the NCUA's refusal to grant federal insurance to Fourth Corner, according to the credit union's attorneys that justification had no legal merit: a state-chartered credit union is entitled to a master account "irrespective of whether it has obtained federal share deposit insurance; it only need be 'eligible to make application to become' federally insured."  In fact, federal law doesn't require that a state-chartered credit union have any insurance at all.  In any event, as I've noted, the Fourth Corner Credit Union was prepared to arrange for private insurance when its master account was denied.  Currently, 129 credit unions  rely primarily if not solely on private insurance, and all have master accounts.[4]

According to Fourth Corner's attorneys, the Kansas City Fed had acted in concert with NCUA:

The NCUA is on record that it is against private deposit insurance because the NCUA has no authority to supervise, regulate, or examine privately insured state chartered credit unions.  Apparently, the NCUA does not trust the highly qualified state regulators with superior local knowledge to supervise state-chartered credit unions without NCUA oversight.  Thus, in order to carry out their nefarious scheme to unlawfully block TFCCU [The Fourth Corner Credit Union] from the Federal Reserve payments system, FRB-KC and the NCUA concocted an aggressively expressed denial of the federal deposit insurance application that also gratuitously impugned the reputation and work of the multitude of highly qualified professionals…  .

Here, finally, is the verdict of the plaintiff's counsel regarding the Kansas City Fed's actions:

FRB-KC's denial of the TFCCU's master account application is anti-competitive; it is detrimental to public safety; it is an abuse of monopoly power; it is a collusive practice in restraint of trade; and it is statutorily and constitutionally unlawful.

I'm an economist, not a lawyer.  Still, this seems like a fair conclusion to me.


[1]  Since February 14, 2014, when formal Federal guidelines for dealing with "Marijuana-Related Businesses" were first issued, hundreds of financial institutions in states (and the District of Columbia) where marijuana production and sales are partly or entirely legal, have been compelled to submit several thousand marijuana-related "suspicious activity" reports.  On the legal reasons for banks' reluctance to offer accounts to marijuana related businesses, see Julie Andersen Hill, "Banks, Marijuana, and Federalism," in the Case Western Law Review.

[2] This is the wording as it appears in the suit.  That of the original guidance, as I discovered it, has a few typographical differences.  The suit also incorrectly gives the year of this statement as 2013 rather than 2014.

At the time of Fourth Corner's application for a master account, the Federal Reserve's official payments system risk management policy included a passage stating that "relevant safety and soundness issues associated with [relationships between financial institutions and their customers] are more appropriately addressed through the bank supervisory process" than by policies governing access to the payments system.  This passage was, however, removed in the December 31, 2014 amended policy.

[3] According to 12 U.S.C. 1784 – "Examination of Insured Credit Unions," the NCUA is permitted to share information about a credit union with the Fed only "for the purpose of facilitating  insured credit unions' access to liquidity" and then only provided that the Fed offers "appropriate assurances of confidentiality" (my emphasis).  The NCUA's conduct is the subject of a separate Fourth Corner Credit Union lawsuit.

[4] Although the NCUA has tried for years to get Congress to abolish the private insurance option, and to give it control over state-chartered credit unions, Congress has consistently refused to support its plan.


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Reserve Requirements Basel Style: The Liquidity Coverage Ratio Fri, 31 Jul 2015 18:03:38 +0000 Over the last couple of decades, reserve requirements all but vanished as a means of bank regulation and monetary control.  But now a new variation on reserve requirements is being introduced through the capital controls of the Basel Accords. Canada, the UK, Sweden, Australia, New Zealand, and Hong Kong have...

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Shawneetown bankOver the last couple of decades, reserve requirements all but vanished as a means of bank regulation and monetary control.  But now a new variation on reserve requirements is being introduced through the capital controls of the Basel Accords.

Canada, the UK, Sweden, Australia, New Zealand, and Hong Kong have all abolished traditional reserve requirements.  In many other countries, reserve requirements have become a dead letter.  In the U.S., for instance, the Fed under Alan Greenspan reduced all reserve requirements to zero except for transactions deposits (checking accounts), while permitting banks to evade reserve requirements on transactions balances by using sophisticated computer software to regularly “sweep” those balances into money market deposit accounts, which have no reserve requirement.  In 2011 Congress went a step further by allowing the Fed to eliminate all reserve requirements if it so desired. The Eurozone, for its part, began with a reserve requirement of only 2 percent, which was reduced to 1 percent in January 1999.

There were good reasons for this deregulatory trend.  Economists consider reserve requirements an implicit tax on banks, requiring them to hold non-interest earning assets, while central banks considered changes in such requirements too blunt an instrument for monetary control.  The Fed discovered the latter shortcoming when, in the midst of the Great Depression, having just gained control over the reserve requirements of national banks, it doubled them, contributing to recession of 1937.

Ostensibly designed to keep banks more liquid, reserve requirements can prevent them from drawing on their liquidity when it is most needed.  As Armen A. Alchian and William R. Allen point out in University Economics (1964): “To rely upon a reserve requirement for the meeting of cash-withdrawal demands of banks’ customers is analogous to trying to protect a community from fire by requiring that a large water tank be kept full at all times: the water is useless in case of emergency if it cannot be drawn from the tank.”

As reserve requirements became less fashionable, advocates of more stringent bank regulation resorted instead to risk-based capital requirements, as implemented through the international Basel Accords.  More recently the increasingly widespread practice of paying interest on bank reserves has also given central banks an alternative and less burdensome means for inducing banks to hold more reserves.

But in Basel III, agreed upon in 2010-2011, there appeared a new kind of liquidity requirement that mimics reserve requirements in many respects.  Known as the “Liquidity Coverage Ratio” or LCR, it requires banks to hold “high quality liquid assets” (HQLA) sufficient to cover potential net cash outflows over 30 days.  In September 2014 the Fed, the Comptroller, and the FDIC finalized the rule implementing the Liquidity Coverage Ratio.  The rule, which took effect at the beginning at 2015, must be fully complied with by January 2017.

Far from involving a simple ratio, as earlier reserve requirements did, the Liquidity Coverage Ratio is extremely complicated, filling 103 pages in the Federal Register.  The rule does not apply to small community banks but instead to banks with more than $250 billion of assets, with a modified rule applying to the holding companies of both banks and savings institutions.  The Fed also plans to impose a similar rule on non-bank financial institutions.  But because a variant of the rule applies to bank holding companies on a “consolidated basis,” the Liquidity Coverage Ratio already affects most major investment banks, which are owned by bank holding companies.

Unlike traditional reserve requirements, the Liquidity Coverage Ratio does not call for any minimum quantity of cash reserves.  Instead, it calls for a minimum quantity of various high quality liquid assets.  Weighting bank assets according to their maturity, marketability, and riskiness, the LCR even counts as high quality some forms of corporate debt at half of face value.  The LCR also differs in being applied, not just to bank deposits, but to nearly all bank liabilities, including large CDs, derivatives, and off-balance sheet loan commitments, according to their maturity.

In short, the Liquidity Coverage Ratio is designed to reduce maturity mismatches for large financial institutions in order to protect against the kind of panics in the repo and asset-backed commercial paper markets that occurred during the financial crisis of 2007-2008.  In any case, the rule will still require banks to hold more reserves or short-term Treasury securities than they otherwise might prefer.  Since the rule was under discussion by 2010, it could be another reason—along with interest on reserves and capital requirements—why U.S. banks have continued to hold more than 100-percent reserves behind M1 deposits.

Every time there is a financial crisis, the proposal to force banks to hold higher reserve ratios, if not 100-percent reserves, resurfaces.  During the Great Depression, this proposal went under the name of the Chicago Plan and even received support from Milton Friedman in his early writings.  The proposal was called “narrow banking” during the savings and loan crisis.  Since the recent crisis, it has been advocated in one form or another by such economists as Laurence Kotlikoff of the Boston University, John Cochrane of the University of Chicago, and Martin Wolf of the Financial Times. All of these proposals hinge on the government paying interest on bank reserves.

The new Liquidity Coverage Ratio in one sense is less restrictive than these proposals but in another is more so.  It is less restrictive in that it allows deposits to be covered by liquid securities other than cash equivalents, and in that sense is a bit reminiscent of the discredited real-bills doctrine that insisted the banks should make only short-term, self-liquidating loans.

But the Liquidity Coverage Ratio is more restrictive than conventional reserve requirements in so far as it applies to a much broader range of bank liabilities.  Unlike such requirements, it is striving to prevent banks from engaging in significant maturity transformation, which involves bundling and converting long-term securities into short-term securities.  That makes it closest in spirit to Cochrane’s reform proposal, which combines a 100-percent reserve requirement for deposits with a 100-percent capital requirement for all other bank liabilities.  Cochrane’s proposal really would eliminate all maturity mismatches; indeed, it would make all banks resemble combinations of safe-deposit businesses on the one hand and mutual funds or, for that matter, Islamic banks, on the other.

Will the Liquidity Coverage Ratio ultimately work? Although the question requires further thought and study, I doubt it.  Several monetary economists, considering the rule’s implementation in Europe (here and here), are more optimistic than I am, and a few even think that it will not be restrictive enough.  But they may be overlooking the long-term downsides.

As with so many past banking regulations, this one could ultimately end up being non-binding. Banks may find loopholes in the rule, or may innovate around it, and the rule’s very complexity and supposed flexibility is likely to make doing these things easier.  On the other hand, when the next financial crisis hits, by hobbling a bank’s discretionary control over its balance sheet, the rule may well exacerbate the crisis.  To the extent that the rule is binding, it changes the fundamental nature of banking in a way that may curtail efficient financial intermediation.  Whatever happens, it definitely increases the government’s central planning of the allocation of savings.  In the final analysis, it is another futile attempt to use prudential regulation to overcome the excessive risk taking resulting from the moral hazard created by deposit insurance and too-big-to-fail.

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There Was No Place Like Canada Wed, 29 Jul 2015 13:04:26 +0000 Speaking of myths about U.S. banking, another that tops my list is the myth that the Federal Reserve, or some sort of central-bank-type arrangement, was the best conceivable solution to the ills of the pre-1914 U.S. monetary system. I encountered that myth most recently in reading America's Bank, Roger Lowenstein's...

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Canada, banking system, currencySpeaking of myths about U.S. banking, another that tops my list is the myth that the Federal Reserve, or some sort of central-bank-type arrangement, was the best conceivable solution to the ills of the pre-1914 U.S. monetary system.

I encountered that myth most recently in reading America's Bank, Roger Lowenstein's forthcoming book on the Fed's origins, which I'm reviewing for Barron's.  Lowenstein's book is well-researched and entertainingly written.  But it also suffers from an all-too-common drawback:  Lowenstein takes for granted that those who favored having a U.S. central bank of some kind (whatever they called it and however they chose to disguise it) were well-informed and right-thinking, whereas those who didn't were either ignorant hicks or pawns of special interests.  He has, in other words, little patience with history's losers, whether they be people or ideas.  Like other "Whig" histories, his history of the Fed treats the past as an "inexorable march of progress towards enlightenment."

Don't get me wrong: I'm no Tory, and I certainly don't think that the pre-Fed U.S. monetary system was fine and dandy.  I know about the panics of 1884, 1893, and 1907.  I know how specie tended to pile-up in New York after every harvest season, and that by the time it got there not one but three banks were likely to reckon it, or make claims to it, as part of their reserves.  I also know how, when the harvest season returned, all those banks were likely to try and get their hands on the same gold, and how this made for tight money, if it didn't spark a full-scale panic.  Finally, I know that one way to avoid such panics, on paper at least, was to establish a central bank, or "federal" equivalent, capable of supplying banks with emergency cash when they needed it.

Yet I still think that the Fed was a lousy idea.  How come?  My reason isn't simply that the Fed turned out to be quite incapable of preventing financial crises, though that's certainly true.   It's that there was a much better way of fixing the pre-Fed system.  That alternative was perfectly obvious to many who struggled to reform the U.S. system in the years prior to the Fed's establishment.  It could hardly have been otherwise, since it was then almost literally staring them in the face.  But it should be equally obvious even today to anyone who delves into the underlying causes of the infirmities of the pre-Fed National Currency system.

What were these causes?  Essentially there were two.  First, ever since the Civil War state banks were prohibited from issuing circulating notes, while National banks could issue notes only to the extent that they backed them with specified U.S. government bonds.  Those bonds were getting harder to come by (by the 1890s National banks had already acquired almost all of them).  What's more, it didn't pay for National banks to acquire the costly securities just for the sake of meeting harvest-time currency needs, for that would mean incurring very high opportunity costs for the sake of having stacks of notes sitting idle in their vaults for most of the year.

The other, notorious cause of trouble was the fact that most U.S. banks, whether state or National, didn't have branch networks of any kind.  Instead, ours was for the most part a system of "unit" banks.  This was so mainly owing to laws that prohibited them from branching, even within their own states.  But even had branching been legal, the restrictions on banks' ability to issue notes would have made it less economical by substantially raising the cost of equipping bank branches with inventories of till money.[1]

That unit banking limited U.S. banks' ability to diversify their assets and liabilities, and thereby made the U.S. banking system much more fragile than it might have been, is (or ought to be) well-appreciated.  Unit banking also encouraged banks to deposit their idle reserves with "reserve city" correspondents, who in turn sent their own surplus cash to New York.  The National Banking Acts actually encouraged this practice by letting correspondent balances satisfy a portion of banks' legal reserve requirements.  The set-up kept money gainfully employed when it wasn't needed in the countryside; but it also made for a mad scramble when cash was needed back home.

Far less well appreciated is how unit banking also contributed to the notorious "inelasticity" of the pre-Fed U.S. currency stock.  Before I explain why, I'd better first lay another myth to rest, which is the myth that complaints concerning the "inelasticity" of the pre-Fed currency stock were a hobbyhorse of persons who subscribed to the "real-bills" doctrine  — that is, the view that the currency supply could and should wax-and-wane in concert with the total quantity of "real bills" or short-term commercial paper presented to banks for discounting.

It's true that many persons who complained about the "inelastic" nature of the U.S. currency system, including many who were instrumental in designing (and later in managing) the Federal Reserve System, also subscribed to the real bills doctrine, and that that doctrine is mostly baloney.  But that doesn't mean that the alleged inelasticity of the U.S. currency stock was a mere bugbear.  The real demand for currency really did vary considerably, especially by rising a lot — sometimes by as much as 50 percent — during the harvest season, when migrant workers had to be paid to "move" the crops.  And U.S. banks really were unprepared to meet such increases in demand by issuing more notes, even if doing so was only a matter of swapping note liabilities for deposit liabilities, owing to the legal restrictions to which I've drawn attention.  In short, you don't have to have drunk the real-bills Kool-Aid to agree that the pre-Fed U.S. currency system wasn't capable of meeting the "needs of trade."

How, then, did unit banking contribute to the problem of an inelastic currency stock?  It did so by considerably raising the cost banks had to incur to redeem rival banks' notes, and thereby limiting the extent to which unwanted banknotes made it back to their issuers.  In a branch-banking system, note exchange and redemption are mostly a local, and therefore cheap, affair; add a few regional clearinghouses to handle items not settled locally, and you've got all that's needed to see to it that unwanted currency is rapidly removed from circulation.

In the U.S., on the other hand, banks had to bear substantial costs of sorting and shipping notes to their sources, or to distant  clearinghouses, which costs were made all the greater by the sheer number of National banks — tens of thousands, eventually — and resulting lack of economies of scale.  These factors would normally have caused National banks to accept the notes of distant rivals at discounts sufficient to cover anticipated redemption costs, as antebellum state banks had been in the habit of doing.  The authors of the 1863 and 1864 National Banking Acts were, however, determined to give the nation a "uniform" currency.  Consequently they stipulated that every National bank had to accept the notes of all other national banks at par.  That got rid of note discounts, sure enough.  But it also meant that National banknotes would no longer be actively and systematically redeemed.[2]  As I like to say, any fool can fix most any problem — so long as he ignores the others.

If my dog is limping, and I discover that she's got a pebble wedged between her paw pads, I don't think of calling for a team of stretcher bearers: I just pull the pebble out.  In the same way any reasonable person, knowing the underlying causes of the infirmities of the pre-Fed U.S. currency system, would first consider removing those causes.  And that was precisely what many advocates of currency reform tried to do before any dared to suggest anything like a U.S. central bank.  That is, they tried to get bills passed — there must have been at least a dozen of them — calling for some combination of (1) repeal of the bond-backing requirement for National banknotes; (2) allowing National banks to branch, and (3) restoring state banks' right to issue currency.  The restrictions on note issue had, after all, been put into effect for the sake of helping the Union government fund the Civil War — a purpose now long obsolete.  The restrictions on branching, on the other hand, were widely understood to be another deleterious consequence of the unfortunate decision to model the National Banking Acts after earlier, state "free banking" laws.

Might deregulation  alone, as was contemplated in such "asset currency" reform proposals (so-called because they would have allowed banks to issue notes backed by general assets, rather than by specific securities),  really have given the U.S. a perfectly sound and stable currency and banking system?  Yes.  How can I be so confident?  Because it would have given the U.S. a currency system like Canada's.  And Canada's system was, in fact, famously sound and famously stable.[3]

"Don't mention the war!"  is what Basil Fawlty tells his staff, out of concern for the sensibilities of his German guests.  (Basil himself nevertheless can't help referring to it again and again.)  "Don't mention Canada!" is what a Whig historian of the Fed must tell himself, assuming he knows what went on there, lest he should broach a topic that would muddle-up his otherwise tidy epic.  For to consider Canada is to realize that there was, in fact, no need at all for all the elaborate proposals, hearings, secret meetings, and political wheeling-and-dealing, that ultimately gave shape to the Federal Reserve Act, if all that was desired was to equip the United States with a currency system worthy of a nation already on its way to becoming an economic powerhouse.  Like Dorothy's ruby slippers, the solution to the United States' currency ills had been there all along.  Legislators had only to repeat to themselves, "There's no place like Canada," while taking steps that would tap obstructive legal restrictions out of the banking system.

Of course that didn't happen, thanks mainly to a combination of banking-industry opposition to branch banking and populist opposition —  spearheaded by William Jennings Bryan — to any sort of non-government currency.  "Asset currency" was, if you like, "politically impossible."

So reformers at length turned to the alternative of a central bank.  And how was that supposed to work?  Though buckets of ink have been spilled for the sake of offering all sorts of elaborate explanations of the "science" behind the Federal Reserve, the essence of that solution, once considered against the backdrop of the "asset currency" alternative, couldn't have been simpler.  It boils down to this:  instead of allowing already existing U.S. banks to branch and to issue notes backed by assets other than government bonds, the government would leave the old restrictions in place, while setting up a dozen new banks that would be uniquely exempt from those restrictions.  If National banks (or state banks, if they chose to join the new system) wanted currency, but lacked the necessary bonds, they still couldn't issue more of their own notes no matter what other assets they possessed.  But they might now take some of those other assets to the Fed, to exchange for Federal Reserve Notes.  The Fed was, in short, a sort of stretcher corps for banks lamed by earlier laws.

To an extent, the more centralized reform resembled an asset currency reform one step removed.  But there were two crucial differences.  First, by setting the "discount rate" at which they would exchange notes for commercial paper and other assets, the Federal Reserve Banks could either encourage or discourage other banks from acquiring their notes.  Second, because member banks could count not just gold and greenbacks but Fed liabilities as reserves, the Fed's discount rates influenced the overall availability of bank reserves and, hence, of money and credit.  These differences, far from having been innocuous, were, as we now realize, portentous.

Still the Fed did have one incontestable advantage over previous reform proposals. For it alone was politically possible.  It alone was a winning solution.

But the fact that the Fed won in 1913 doesn't mean that other, rejected options aren't worth recalling.  Still less does it warrant treating the Fed as sacrosanct.  History isn't finished.  Just a few years before the Federal Reserve Act was passed, most people still believed that Andrew Jackson had put paid once and for all to the idea of a U.S. central bank.  Today most people still consider the Federal Reserve Act the last word in scientific monetary control.  As for what most people will think tomorrow, well, that's partly up to us, isn't it?

[1] Although they typically appreciate the debilitating consequences of unit banking, many U.S. economists and economic historians appear unaware of the crucial role that freedom of note issue played historically in facilitating branch banking.  That banking systems involving relatively few restrictions on banks' ability to issue banknotes, like those of Scotland before 1845 and Canada until 1935, also had extremely well-developed branch networks, was no coincidence.

[2]  On the limited redemption of National banknotes and attempts to address it see Selgin and White, "Monetary Reform and the Redemption of National Bank Notes, 1863-1913."  Business History Review 68 (2) (Summer 1994).

[3] For a very good review of the features and performance of the Canadian system in its heyday, see R.M. Breckenridge, "The Canadian Banking System, 1817-1890," Publications of the American Economic Association, v. X (1895), pp. 1-476.  Not long ago, when I spoke favorably of Canada's system at a gathering of economic historians, one asked afterwards, rather superciliously, whether I realized how large Canada's economy had been back around 1913.   Apparently my interrogator thought that Canada's small size made its success irrelevant.  I can't see why.  Nor, evidently, could the many persons who proposed and lobbied for various asset currency proposals over the course of over a decade or so.

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