About a (partial) return to the gold standard

In difficult times, it is easy to blame central banks for everything. Part of their role, after all, is to play the scape goat for policies the politician do not dare implementing. But then, there is only so much the central banks can do, as Europe and the United States no "nicely" show now. A substantial ingredient in the blame game is a call for a return to the gold standard, a nostalgia for supposedly better and easier times.

Olivier Ledoit and Sébastien Lotz echo this call and study what our current understanding is about the coexistence of fiat and commodity money. In principle, we can start from the idea that currency competition is good: this would force the central bank to be more careful with its fiat money. Indeed, we have learned from money search theory that bad money does not necessarily chase good money (the old Gresham's Law). Also, if the commodity has a positive return, its monetization is benefitial as long as its storage and transaction cost is sufficiently low. The question is then on how to find a commodity that has a real return from just sitting there. There is a larger problem, though, with small denominations. How do you mint coins measured in cents when the commodity is, for example, gold? Either the coins need to be very small or they have very small commodity content, to the point that they become ... fiat money. Monetary policy also becomes tricky, as quite obviously temporary easing becomes difficult if it risks driving fiat money out.

But in the end, isn't a commodity like gold only valuable because people believe it is valuable? Gold, to take an extreme and popular case, has little intrinsic value, as I argued before, and is thus just another fiat currency. It is all a question of perception.

Was medieval seigniorage welfare improving?

The presence of coins improves social welfare, as it allows for more trades than barter would allow. Coin minting also provides income to the minting authority, as it can buy stuff with coins that have more value than their production cost. This is called seigniorage. This was also the case in medieval times, where "seigneurs" would mint gold or silver coins with somewhat less metal content than indicated and thus get income. One would thus think that these minters would be profit maximizing, and thus enhance welfare only as a by-product.



Angela Redish and Warren Weber say this is not quite true. They build a random matching model of commodity money, where the supply of silver is exogenous. They derive the welfare maximizing size and quantity of coins as a function of the quantity of silver and the probability of acceptance of cash. Using data from medieval Venice and England, they find that the model predictions follow remarkably well the historical record. This probably means that authorities were benevolent. I say probably because they may have acted in the same way out of selfishness, but that is not documented in the paper. Indeed, the model assumes than any holder of silver can mint, while in reality a limited number of people could do that.

Trust in private money

Money does not have to be supplied by government. Private money could work under some circumstances, and it has in particular been argued that competition should be beneficial. While previous attempts have failed, the wider availability of information, rating agencies (gasp) and information technology could make it happen. So it is of interest to find out what those circumstances are.



Ramon Marimon, Juan Pablo Nicolini and Pedro Teles say that money is an experience good, as you only observes its quality after the exchange is performed. This leads to serious limitations. If issuer of currency cannot commit to not inflate in the future, then competition over currency in the present has no bite. Building a reputation can solve this to some degree, but building the necessary trust means that future rewards must be larger that immediate gains from inflating. That implies that full efficiency cannot be attained: inflation needs to remain positive, while full efficiency implies negative inflation so that money has the same return as a risk-free bond. Unfortunately it also implies that there is indeterminacy and any inflation rate could happen. Oh well, may be the government could step in to help achieve efficiency...

What if the US looses its reserve currency privilege?

Since the Bretton Woods agreement in 1945, the United States have enjoyed the so-called "Exhorbitant Privilege." During the fixed exchange rate regime, the US could conduct monetary policy without regard to what was happening in other countries. The US dollar was a reserve currency, which also helped the US maintain low interest rates and a guarantee that US dollars (and Treasury bonds) would always find a buyer. With flexible exchange rates, not much has changed. But with the recent shenanigans in a Congress that considered reneging on its debt, the likelihood of this advantage changing has dramatically increased. What would the consequences of the loss of the Exhorbitant Privilege be?



Wenli Cheng and Dingsheng Zhang study this scenario using a general equilibrium model where a peripheral country (say, the Asian economies) pegs its currency to the money of a central country (say, the United States), the latter being used as the vehicle currency for international trade. In addition, the foreign exchange reserves of the periphery are invested in government bonds of the center. This means that no matter what current account deficit of the center, it is always financed by the periphery. Yet the center may be tempted to inflate it away. This limitless and to some extend free borrowing is the Exhorbitant Privilege.



Now remove it by assuming that the periphery does not want to invest in the center, either because it views the Treasury bonds are excessively risky or because it does not peg to the dollar any more. This would lead to a dramatic readjustment of the terms of trade to favor the tradable sector of the center. This decpraciation of the dollar would be more pronounced of the center is incapable of raising taxes and finances its debt with inflation. This already all sounds familiar.

The welfare gain from inflation targeting

It is rather well accepted that transparency is preferred for policy, because it anchors better expectations, people generally do not like uncertainty, and discretion can lead to adverse biases compared to set policy rules. Yet, the United States exhibit little transparancy, with the Federal Reserve being one of the few western central banks not to declare some explicit policy target, and fiscal policy being as uncertain as ever. That would not be a big deal if the welfare costs were low, but you can think that there are high and in the case of fiscal policy are currenctly holding back the recovery.

Giorgio Di Giorgio and Guido Traficante are taking a closer look at the welfare benefits of inflation targeting. For this they use a model where households observe policy interest rates and do not know whether their changes are due to reactions to output gaps or shocks to the inflation target. Households are sophisticated, they use a signal extraction device to estimate the latent, unobservable variable. Yet, they still face substantial costs from the uncertainty. Money is not neutral because of Rotemberg pricing, a variant of Calvo pricing. Oh well, I guess this is what you need to do to get a result with some bite.

Households know there is a policy rule that determines the interest rate from the output gap (unobservable) and the inflation target (stochastic and persistent) as well as known preference and cost-push shocks. In other words, households know a lot about the structure of the economy and the shocks, except for the policy shock, but then somehow cannot figure out what the output gap is. The central bank can, though, but then has for obscure reasons a trembling hand when it comes to set its inflation target. That seems to be quite the opposite of what I would have thought: everyone is confused about the output gap, and only the central bank knows what the inflation target is. Instead of a story of households trying to disentangle output gap and inflation target from the interest rate signal, one would have a story of a central banker not quite sure what to do given the circumstances. Too bad, this could have been an interesting paper.

The shoe-leather cost of inflation is minimal

One popular way to justify the introduction of monetary frictions in macroeconomic models is to assume that there is some cost associated to changing cash holdings, ATM fees or more generally "shoe-leather" cost. Whether these cost matter at all is controversial and settling this requires a two-pronged approach: first find empirically how large these costs are, and second demonstrate that the costs are large enough to matter in a reasonable model.

Alessandro Calza and Andrea Zaghini estimate the shoe-leather cost for the US. This is by far not the first time this is performed, by it can be worth it as data change, and in this case one can suspect that transaction costs indeed have gone down over a few decades. But there is one critical aspect that they take into account: most on US M1 is not held domestically, and this share has increased to currently 60%. Ignoring this seriously biases estimates, first because it overstates domestic demand and second because the shoe-leather cost stemming from inflation is largely borne by foreigners. At an inflation rate of 10%, the cost amounts to negligible 0.05% of total income. At lower inflation rates, it is even negative thanks to foreigners giving up real resources to acquire US money. In other words, you cannot build a monetary theory on this,

Could the Shadow Open Market Committee have outperfomed the Fed?

Decisions of the Open Market Committee of the US Federal Reserve bank have long been scrutinized, both by market for obvious reasons and by academics. Some of the latter have even formed a Shadow Open Market Committee in reaction to the decision by President Nixon to impose price and wage controls in 1971, with the support of the Fed president. This committee has evaluated Fed policy and criticize Fed actions when due. But would it have done a better job?

William Poole, Robert Rasche and David Wheelock, who are all Fed employees, study how the policies advocated by the SOMC during the period of high inflation in the 1970s would have performed. Those policies where at odds with what the Fed was doing and even with what many academics were proposing. The policy rule was rather simple: reduce the target money growth rate by one percent every year, down to 4%. To evaluate this rule, you need a model, so they take the New-Keynesian model of Clarida, Gali, and Gertler (1999) off the shelf and run various experiments: one with the SOMC rule, one with the historic data (the Fed's action: a one time drop in money growth). While both policies eventually achieve their goal of reducing inflation, the SOMC one does so with less cost in output.

Now things are not that easy. To be fair to the Fed, it had at the time had rather little credibility, and it is not clear it could have gained any more credibility by adopting the SOMC's policy, as it requires some long-term commitment. Also, the Fed had to fight against attempts by Congress to take over monetary policy, and thus its policy choices were limited. And had the SOMC known that it policy would have been actually implemented, I am not convinced it would have taken the same choice. Indeed, it was rather risky, as it was at odds with what most other people were advocating. And markets may have reacted with incredulity to such an odd move.

The key to understand money: vacations

Monetary theorists have struggled for decades if not centuries to explain why we use and value money. Modern theory, which needs to be more explicit about its assumptions, has highlighted how silly some axioms of monetary theory are. For example, why would money make any sense in a utility function when future consumption is already taken into account? Or what about cash-in-advance in quarterly models of the business cycle. Money search model bring progress to the table as they model the problem of the absence of double coincidence of wants, although still with some rather crude assumptions. But at least it is going in the right direction.

Andrew Clausen and Carlo Strub come up with a new motivation for money. Suppose that there is a fix cost in production. Unless you want to produce at full capacity every period, you will then choose to close all operations from time to time and take a vacation. But you must live from something when you do not work and you have no savings technology. This is where money comes to the rescue. Without it, it would have been impossible to smooth consumption across periods, and thus money is valued and welfare enhancing. But beyond the possible elegance of the model, is anybody actually believing this story? I do not think in makes sense to discuss the intertemporal allocation of resources in a world without assets, especially if you want to apply it to anything modern.

What influences Fed presidents?

The European Central Bank is still a recent creation, so you can excuse its national governors for putting their country's interest first in the conduct of monetary policy. What about another federal central bank that is much older and whose governors territory does not necessarily coincide with political boundaries, the Federal Reserve System of the US?

Bernd Hayo and Matthias Neuenkirch have analyzed the speeches of Federal Reserve presidents over the span of twelve years and come to the conclusions that they equally represent the national and regional interests, except when it is not their turn to vote, when their region comes first. They find this by trying to fit a Taylor Rule to their positions, using a price index, a national and a regional unemployment rate. Unfortunately (and surprisingly), there are no regional price indexes in the US, which could have reinforced the regional focus of the presidents. Still, I am surprised how much they lobby for the general interest. After all, they are selected to represent their region.

What inflation target to set

Central banks, implicitly or explicitly, set targets for the inflation rate, usually in the form of an interval. What determines this interval and its mid-point? Theory tells you that larger economic fluctuations should leads to wider intervals and less central bank independence should like to higher targets.

Roman Horváth and Jakub Matějů set out to verify this by way of questionnaires to central bankers and sifting through official publications. They gather data from 19 countries, including how the targets have changed through history and confirm the conjectures above. They also find that targets seem to accommodate inflation expectations and follow world inflation. Interestingly, the party in power does not matter, even for less independent central banks. But one aspect that is not covered and I have always wondered about is how the dominant dogma would matter. Indeed, if a central bank believes in activist policy, it would presumably allow for a wider target interval. Or a neo-classical central banker would want a very low target inflation.

If anything goes wrong, it has to be the central banks

Some institutions are excellent scape goats to impose necessary reforms in a country, such as the International Monetary Fund or the World Bank. Local governments can always blame them if they have to put their fiscal house in order. Other institutions seem to attract conspiracy theorists in large numbers because someone needs to be blamed for some condition and the institution is poorly understood. The prime candidate here is the central bank. Indeed, the best central banks are those that act independently from the government, but people see this apparent lack of accountability as the origin of all trouble in the economy.

A very good example for this sorry confusion is a recent paper by Subhendu Das, with the following abstract:

In each country the central bank is a privately owned bank with no transparency and accountability to the government of that country. It is also the only bank that can print the money for that country and does it so out of thin air. At the same time this bank wants that the government returns the money with interest. We show that this structure creates deficit, introduces tax, and causes poverty around the globe. This paper shows how central banks control the economy by manipulating the financial system it has designed. The paper explains how easily the central banks can control the unemployment, create recessions, and transfer wealth from the lower economic group to higher economic group and perpetuate the poverty. The paper also proposes three methods of eliminating central banks.

Where to begin. Central bank governors are typically appointed by the government and are accountable to it (just see how frequently Bernanke is on Capital Hill). The central banker's decisions are independent from the government, and for good reasons: you want to avoid policy actions to be taken for a short term political gain that is detrimental in the longer run through higher inflation. Central banks that are not independent from governments typically have much higher inflation, as the government ends up relying on seigniorage for its expenses instead of taxation. The presence of the independent prevents deficits because governments know they cannot inflate debt away.

Then, central banks most often make profits. These profits are then transfered to the government. That reduces the need for taxes. But this does not absolve the government from raising taxes. If is it taking real resources form the economy (either labor or goods), that needs to be paid for in real terms one way or the other. For a typically government, the central bank would only be able to cover this with excessive inflation.

Do central banks create poverty? A central bank that is independent from the government leads to low inflation, which is good for poor people who are cash based. To repeat myself, a government controlled central bank will create more inflation, and that is when there is a transfer of wealth from poor to rich, who can shield their assets from inflation.

Do central banks have an impact on unemployment and recessions? Honestly, it is open to debate whether they have any significant impact on this. They can certainly mess up things, for example when influenced by the government, but a well-run independent central bank will just make sure the economic is well greased. It cannot fix structural problems. That is up to the government. Central banks cannot control the economy, and in fact in many countries do not even have regulatory authority over the financial sector.

All in all, this paper has everything backwards, except for the fact that money is created out of thin air. But keep in mind that most money is not created by the central bank, but by private banks, and the central bank makes sure not too much is created. So the author still got that wrong.

Heterodox money

Heterodox economics is frustrating because it keeps working in a self-referential vacuum, consistently ignoring advances in orthodox economics. This is not how progress can be made, and in particular this is not how you can get results from heterodox economics accepted or at least considered in the mainstream. It is now as if there were two parallel universes and no portal between them.

A good example is a recent paper by Randall Wray, grandiosely entitled "Money" that is supposed to teach us what money is. It lays on three principles (I quote):

1. Money buys goods and goods buy money, but goods do not buy goods.
2. Money is always debt; it cannot be a commodity from the first proposition because if it were that would mean that a particular good is buying goods.
3. Default on debt is possible.

It then proceeds to talk about how to understand this and how this defines money, with references to Keynes, Marx, Sraffa and Kaldor, and their disciples.

But have we not made some progress since? The only mention of the mainstream in the paper is a criticism of representative agent models where agents pay money to themselves and thus never default. Really? Really? Modern models that try to rationalize the use of money explicitly have heterogeneous agents and explicitly take into account that some may refuse money for payment. And this is not exactly an obscure and recent literature, Kiyotaki and Wright, for example, dates back to 1989 and already has all these ingredients. This money search literature is mentioned nowhere. The same applies to the literature on trading posts, which has rationalized the emergence of particular commodities as money (See recent post).

Also, why this reluctance to use formulas to make arguments and assumptions explicit? In this paper, there is implicit talk about budget constraints and accounting identities, but they are never explicitly laid out, which can make it easy for the author to sweep something under the carpet (I am not saying Wray does, though). But there is something essential about writing an equation: it forces you to define variables precisely, and it forces to use a logical proof of your arguments. Only then will your arguments be water tight.

Fiat money, 1683

We tend to think that fiat money is an invention of the twentieth century and thus does not predate the Italian car industry. But there have been a few experiments before this and in particular a remarkably successful one in the Netherlands starting in 1683.

Stephen Quinn and William Roberds tell the story of the Bank of Amsterdam that in 1683 started limiting the ability of depositors to withdraw coin. At a time where this would have been interpreted as "taking the money and running," this was remarkably well accepted by the depositors, and the Bank of Amsterdam never abused the situation, maintaining stable prices over the next century and greatly facilitating trade in the kingdom. All this without government supervision, basically out of private initiative. Call that almost-private central banking (the bank was sponsored by the city of Amsterdam), even conducting open market operations. Of course, this all ended went the Bank of Amsterdam went bust in 1795: the rest of the world still relying on precious metal, the lack of access to fresh silver during the Fourth Anglo-Dutch War led to a strong depreciation of the guilder, and the experiment ended due to lack of fiat.

On the emergence of money

Why are we using money? The answer we give to undergraduates is that money facilitates transactions and can be use as a store of value. But how do we get there? For money to be used, especially fiat money, there needs to be an agreement among many people that a particular commodity is the right one, and that we should all accept it for payment. How do you get there? If you look at the economic history of humanity, the use of money is in fact only a very recent phenomenon, and many previous attempts at introducing money failed. What makes money stick? All these are questions that are really difficult to answer and that will keep scholars busy for a long time. What we have so far are partial answers that are mostly of anecdotal nature.

Xue Hu, Yu-Jung Whang and Qiaoxi Zhang use a trading post approach to understand the emergence of money. A trading post economy includes households with heterogeneous endowments and wants who go to particular locations to meet and trade, and each trading post deals with only two goods. Under a monetary equilibrium, all trading posts deal with the same good, and another one that is different for each. The question is how to get there. The classic paper here is by Peter Howitt and Robert Clower, which was criticized for not having any maximization: this happened by pure chance, but eventually almost all experiments resulted in monetary equilibria. Hu, Whang and Zhang add to this utility maximizing households, but add substantial frictions to prevent convergence from happening too fast. These assume that there is a tâtonnement process that allows only 20% of households how want to switch trading posts to do so.

The conclusions are similar to Howitt and Clower, though. The good most likely to become money is the one that is the most saleable, either because there are large endowments and want for it, or because its trade is less costly. They also find that the absence of double coincidence of wants, traditionally used to justify the existence of money, actually makes the emergence of money more difficult. When money has not yet emerged, why would you experiment in trading your good for something you do not want?

Should food prices influence monetary policy?

Central banks care about inflation, but not about the inflation people care about. Because energy prices are volatile, they are not included in the price index a central bank typically looks at, because including it would made the indicator less informative. At they also include food prices, because those fluctuate a lot as well, in particular because of seasons. That can make sense for a rich country, where food represents only a small portion of the budget. For poorer countries, excluding food is more controversial.

Luis Catão and Roberto Chang note that world food prices seem to cause worldwide inflation, and this should have implications for inflation in small open economies that take food prices as given. The question is then whether central banks should react to such terms of trade shocks. For a net food importer, Catão and Chang find that including food in the price index relevant to the central bank is welfare enhancing. The reason is that if food has a larger weight domestically than in the rest of the world, the real exchange rate and the terms of trade can move in opposite directions following a food price shocks. The welfare improvement comes from a change in the correlations in aggregates leading to smoother consumption, but it possibly results in higher inflation and higher volatility of output and employment. It is thus not obvious including food prices would then be an easy sell.