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A Monetary Policy Primer

Part 1: Money
Part 2: The Demand for Money
Part 3: The Price Level
Part 4: Stable Prices or Stable Spending?
Part 5: The Supply of Money
Part 6: The Reserve-Deposit Multiplier
Part 7: Monetary Control, Then
Part 8: Money in the Latest Great Muddle
Part 9: Monetary Control, Now
Part 10: Discretion, or a Rule?
Part 11: Last-Resort Lending
Part 12: Monetary Alternatives

Part 1: Money
It occurs to me that, despite the unprecedented flood of writings of all sorts — books,
blog-posts, newspaper op-eds, and academic journal articles — addressing just about
every monetary policy development during and since the 2008 financial crisis,
relatively few attempts have been made to step back from the jumble of details for
the sake of getting a better sense of the big picture.

What, exactly, is “monetary policy” about? Why is there such a thing at all? What
should we want to accomplish by it — and what should we not try to accomplish? By
what means, exactly, are monetary authorities able to perform their duties, and to
what extent must they exercise discretion in order to perform them? Finally, what
part might private-market institutions play in promoting monetary stability, and how
might they be made to play it most effectively?
Although one might write a treatise on any one of these questions, I haven’t time to
write a thesis, let alone a bunch of them; and if I did write one, I doubt that
policymakers (or anyone else) would read it. No sir: a bare-bones primer is what’s
needed, and that’s what I hope to provide.

The specific topics I tentatively propose to cover are the following:

1. Money.
2. The Demand for Money.
3. The Price Level.
4. The Supply of Money.
5. Monetary Control, Then and Now.
6. Monetary Policy: Easy, Tight, and Just Right.
7. Money and Interest Rates.
8. The Abuse of Monetary Policy.
9. Rules and Discretion.
10. Private vs Official Money.

Because I eventually plan to combine the posts into a booklet, your comments and
criticisms, which I’ll be sure to employ in revising these essays, will be even more
appreciated than they usually are.


“The object of monetary policy is responsible management of an economy’s money


If you aren’t a monetary economist, you will think this a perfectly banal
statement. Yet it will raise the hackles of many an expert. That’s because no-one can
quite say just what a nation’s “money supply” consists of, let alone how large it
is. Experts do generally agree in treating “money” as a name for anything that serves
as a generally-accepted means of payment. The rub resides in deciding where to
draw a line between what is and what isn’t “generally accepted.” To make matters
worse, financial innovation is constantly altering the degree to which various
financial assets qualify as money, generally by allowing more and more types of
assets to do so. Hence the proliferation of different money supply measures or
“monetary aggregates” (M1, M2, M3, MZ, etc.). Hence the difficulty of saying just
how much money a nation possesses at any time, let alone how its money stock is
changing. Hence the futility of trying to conduct monetary policy by simply tracking
and regulating any particular money measure.

For all these reasons many economists and monetary policymakers have tended for
some time now to think and speak of monetary policy as if it weren’t about “money”
at all. Instead they’ve gotten into the habit of treating monetary policy as a matter of
regulating, not the supply of means of exchange, but interest rates. We all know
what interest rates are, after all; and we can all easily reach an agreement concerning
whether this or that interest rate is rising, falling, or staying put. Why base policy on
a conundrum when you can instead tie it to something concrete?

And yet…it seems to me that in insisting that monetary policy is about regulating,
not money, but interest rates, that economists and monetary authorities have
managed to obscure its true nature, making it appear both more potent and more
mysterious than it is in fact. All the talk of central banks “setting” interest rates is, to
put it bluntly, to modern central bankers what all the smoke, mirrors, and colored
lights were to Hollywood’s Wizard of Oz: a great masquerade, serving to divert
attention from the less hocus-pocus reality lurking behind the curtain.

But surely the Fed does influence interest rates. Isn’t that, together with the fact that
we can clearly observe what interest rates are doing, not reason enough to think of
monetary policy as being “about” interest rates? And doesn’t money’s mutable
nature make it inherently mysterious — and therefore ill-suited to serve either as an
object of monetary policy, let alone as a concept capable of demystifying that policy?

No, and no again. Although central banks certainly can influence interest rates, they
typically do so, not directly (except in the case of the rates they themselves charge in
making loans or apply to bank reserves), but indirectly. The main thing that central
banks directly control is the size and make up of their own balance sheets, which they
adjust by buying or selling assets. When the FOMC elects to “ease” monetary policy,
for example, it may speak of setting a lower interest rate “target.” But what that
means — or what it almost always meant until quite recently — was that the Fed
planned to increase its holdings of U.S. government securities by buying more of
them from private (“primary”) dealers. To pay for the purchases, it would wire funds
to the dealers’ bank accounts, thereby adding to the total quantity of bank
reserves.[1] The greater availability of bank reserves would in turn improve the
terms upon which banks with end-of-the-day reserve shortages could borrow
reserves from other banks.[2] The “federal funds rate,” which is the average
(“effective”) rate that financial institutions pay to borrow reserves from one another
overnight, and the rate that the Fed has traditionally “targeted,” would therefore
decline, other things being equal.

Because central banks’ liabilities consist either of the reserve credits of banks and the
central government, or of circulating currency, and because commercial banks’
holdings of currency and central-bank reserve credits make up the cash reserves
upon which their own ability to service deposits of various kinds rests, when a central
bank increases the size of its own balance sheet, it necessarily increases the total
quantity of money, either indirectly, by increasing the amount of cash reserves
available to other money-producing institutions, or indirectly, by placing more
currency into circulation.

Just how much the money supply changes when a central bank grows depends, first
of all, on what measure of money one chooses to employ, and also on the extent to
which banks and other money-creating financial institutions lend or invest rather
than simply hold on to fresh reserves that come their way. Before the recent crisis,
for example, every dollar of “base” money (bank reserves plus currency) created by
the Federal Reserve itself translated into just under 2 dollars of M1, and into about 8
dollars of M2. (See Figure 1.) Lately those same base-money “multipliers” are just .8
and 3.2, respectively. Besides regulating the available supply of bank reserves,
central banks can influence banks’ desired reserve ratios, and hence
prevailing money multipliers, by setting minimum required reserve ratios, or by
either paying or charging interest on bank reserves, to increase or lower banks’
willingness to hold them. [3]
Figure 1: U.S. M1 and M2 Multipliers

If the money-supply effects of central bank actions aren’t always predictable, the
interest rate effects are still less so. Interest rates, excepting those directly
administered by central banks themselves, are market rates, the levels of which
depend on both the supply of and the demand for financial assets. The federal funds
rate, for example, depends on both the supply of “federal funds” (meaning banks’
reserve balances at the Fed) and the demand for overnight loans of the same. The
Fed has considerable control over the supply of bank reserves; but while it can also
influence banks’ willingness to hold reserves, that influence falls well short of
anything like “control.” It’s therefore able to hit its announced federal funds target
only imperfectly, if at all. Finally, even though the Fed may, for example, lower the
federal funds rate by adding to banks’ reserve balances, if the real demand for
reserves hasn’t changed, it can do so only temporarily. That’s so because the new
reserves it creates will sponsor a corresponding increase in bank lending, which will
in turn lead to an increase in both the quantity of bank deposits and the nominal
demand for (borrowed as well as total) bank reserves. As banks’ demand for
reserves rises, the federal funds rate, which may initially have fallen, will return to its
original level. More often than not, when the Fed appears to succeed in steering
market interest rates, it’s really just going along with underlying forces that are
themselves tending to make rates change.
I’ll have more to say about monetary policy and interest rates later. But for now I
merely want to insist that, despite what some experts would have us think, monetary
policy is, first and foremost, “about” money. That is, it is about regulating an
economy’s stock of monetary assets, especially by altering the quantity of monetary
assets created by the monetary authorities themselves, but also by influencing the
extent to which private financial institutions are able to employ central bank deposits
and notes to create alternative exchange media, including various sorts of bank

Thinking of monetary policy in this (admittedly old-fashioned) way, rather than as a

means for “setting” interest rates, has a great advantage I haven’t yet mentioned. For
it allows us to understand a central bank in relatively mundane (and therefore quite
un-wizard-like) terms, as a sort of combination central planning agency and
factory. Central banks are, for better or worse, responsible for seeing to it that the
economies in which they operate have enough money to operate efficiently, but no
more. Shortages of money wastes resources by restricting the flow of payments,
making it hard or impossible for people and firms to pay their bills, while both
shortages and surpluses of money hamper the correct setting of individual prices,
causing some goods and services to be overpriced, and others underpriced, relative to
others. Scarce resources, labor included, are squandered either way.

Though they are ultimately responsible for getting their economies’

overall moneysupply right, central banks’ immediate concern is, as we’ve seen, that
of controlling the supply of “base” money, that is, of paper currency and bank reserve
credits — the stuff banks themselves employ as means of payment. By limiting the
supply of base money, central banks indirectly limit private firms’ ability to
create money of other sorts, because private firms are only able to create close
substitutes for base moneyby first getting their hands on some of the real McCoy.

But how much money is enough? That is the million (or trillion) dollar
question. The platitudinous answer is that the quantity of money supplied should
never fall short of, or exceed, the quantity demanded. The fundamental challenge of
monetary policy consists, first of all, of figuring out what the platitude means in
practice and, second, of figuring out how to make the money stock adjust in a
manner that’s at least roughly consistent with that practical answer.


1. Although people tend to think of a bank’s reserves as consisting of the currency

and coin it actually has on hand, in its cash machines, cashiers’ tills, and vaults,
banks also keep reserves in the shape of deposit credits with their district Federal
Reserve banks. When the Fed wires funds to a bank customer’s account, the
customer’s account balance increases, but so does the bank’s own reserve balance at
the Fed. The result is much as if the customer made a deposit of the same amount,
using a check drawn on some other bank, except that the reserves that the bank
receives, instead of being transferred to it from some other bank, are fresh ones that
the Fed has just created.

2. Although amounts that banks owe to one another are kept track of throughout the
business day, it is only afterwards that banks that are net debtors must come up with
the reserves they need both to settle up and to meet their overnight reserve

3. The Fed first began paying interest on bank reserves in October 2008. Although
some foreign central banks are now charging interest on reserves, the Fed has yet to
take that step; nor is it clear whether it has the statutory right to do so.

Part 2: The Demand for

Although there’s no such thing as a straightforward measure of the quantity of
money in an economy, monetary policy is nonetheless about managing that
quantity. How ought it to be managed? The (misleadingly) simple-sounding answer
is: so that it neither falls short of nor exceeds the quantity of money demanded by the
So much for a summary of Part 1. Now for the hard part: dealing with the many
questions this summary raises. How can a central bank manage a quantity without
being certain just how to define, let alone measure, that quantity? How is it possible
for the quantity of money supplied to differ from the quantity demanded? When
those things do differ, how can one tell? Finally, just what does “the demand for
money” mean?

The Demand for Money Isn’t Unlimited

The suggestion that there’s such a things as a “demand for money,” comparable to
the demand for, say, heating oil, is one that many people find hard to accept. But in
truth the demand for money is a lot more like the demand for heating oil than many
suppose. Just as anyone with an oil furnace needs to keep some heating oil on hand
in case the temperature drops, allowing the furnace to consume it gradually, while
counting on regular deliveries to replenish the supply, people who can afford to keep
some money — currency and bank deposits and checkable money funds and the like
— on hand, drawing down the inventory to pay for other things, and replenishing it
now and then out of their earnings, or perhaps by selling some non-monetary
assets. Notice that it’s by holding on to money rather than by spending it that
people evince a demand for the stuff.

Money’s role as a generally-accepted means of payment means that the real demand
for it (that is, the average sum of monetary purchasing power people like to have on
hand) tends to increase along with the amount of real purchasing to be done. But
just as the demand for heating oil in a city can increase independently of the total
volume of inhabited interior space in that city (owing, say, to a decline in average
temperature), so too can the demand for money vary independently of the total
volume of an economy’s output, becoming more intense, for example, when interest
rates on non-monetary assets are relatively low, and during times of greater
economic uncertainty.

One difference between money and heating oil that tends to obscure the fact that
people demand one no less than they do the other is that people actually purchase
heating oil, whereas they seldom purchase money except when trading one sort of
cash (say, dollars) for another (say, Euros). The reason for this is simple: because an
economy’s generally accepted means of payment is also what most people earn in
exchange for their labor, or for goods they sell, no one has to “shop” for
money. Instead, they get paid in money, and then trade whatever they don’t wish to
keep on hand for other things. In other words, people contribute to the overall
demand for goods and services, or “aggregate demand,” whenever they trade money
for other stuff, whereas they contribute to the overall demand for money to the
extent that they refrain from trading money for other things.

Receiving Money Isn’t the Same as Demanding It

The fact that the public’s demand for money consists of its willingness to hold on to
monetary assets instead of spending them is important for several reasons. First, it
allows us to distinguish the demand for money from mere willingness to receive
money in payments. The fact that money is a generally accepted means of payment
means that no one is likely to refuse to accept it in payments, let alone as a gift. But
this doesn’t mean that there’s no meaningful sense in which the public’s demand for
money can be said to be limited or finite. People may accept all the money they can
get their hands on; but they “demand” money only to the extent that they refrain
from spending it, and only for precisely as long as they refrain from spending it.

The insight also allows us to distinguish between the demand for money and the
demand for credit, that is, the demand for various sorts of loans. Here again,
money’s role as a generally accepted means of payment can be confusing, because it
means that a loan is likely to consist of a loan of money. Yet most borrowers borrow,
not to add to their money holdings, but to acquire other things, like cars and real
estate, or (if they are business borrowers) to pay for labor, raw materials, or other
inputs. The fact that the demand for credit is distinct from the demand for money,
and that the two things can change independently, means, among other things, that
interest rates, which adjust to “clear” markets for various kinds of credit, cannot also
be counted on to “clear” the market for money balances. No matter what all too
many textbooks say, interest can’t be the “price” of money, since it is busy being the
price of credit, which is something else again; and perhaps no belief in the history of
monetary economics has done more damage than the belief that monetary expansion
is a reliable means for reducing interest rates. In fact the relation between monetary
changes on one hand and interest rate movements on the other is, as I’ll explain in a
later segment, far more complicated than that.

Look, Ma: No Monetary Aggregates!

Finally, the fact that an increased demand for money manifests itself in peoples’
refraining from spending the stuff, while a decline in the demand for money
translates into increased spending, means that one can get a handle on whether an
economy has too much, too little, or just enough money without having to decide just
what “money” consists of. One need only keep track of overall spending or aggregate
demand. Whenever overall spending goes up, that’s a sign that the supply of money
is growing faster than the demand for it. When it shrinks, it’s a sign that demand for
money is growing relative to the available supply. In short, there’s no need to keep
track of any particular monetary measure, or to estimate the public’s demand for the
stuff that makes up that measure. The behavior of spending supplies most of the
information central bankers need to manage their nations’ money supplies

We are still a long way, though, from being able to say anything — or anything
compelling — about the proper conduct of monetary policy. That changes in
spending tend to imply that the demand for money is increasing or declining relative
to some given supply doesn’t necessarily mean that a stable level of spending is ideal,
much less that monetary policy should be conducted with the aim of keeping
spending stable. That’s so for two reasons. First, a person’s demand for money is,
strictly speaking, not a demand for any particular number of money units, such as
dollars, but a demand for a certain amount of purchasing power. If, at some given
level of prices, I consider an average money balance of $1000 adequate for my needs,
then, if prices fall to half that original level, $500 will serve me just as well as a
$1000 did before.

It follows — and this is the second point — that there are, in principle, two different
ways in which any shortage or surplus of dollars can be corrected. One is to
eliminate the shortage or surplus by means of an appropriate change in the available
number of dollars of different sorts; the other is to eliminate it by means of an
appropriate change in the general level of prices, and hence in every dollar’s
purchasing power. Other things equal, the higher the price level, the greater the
quantity of money people will wish to hold; and the lower the price level, the smaller
the quantity of money needed. In principle, then, instead of attempting to prevent
changes to the supply of or demand for money balances from leading to changes in
the flow of spending, monetary authorities might be inclined to allow total spending
to either rise or decline, perhaps at a rapid rate, or even to fluctuate willy-nilly, while
relying on changes in the price level to keep the demand for money from veering for
long, if ever, from the supply. If they could get away with that, there would be no
need to manage the supply of money after all.

There’s no doubting that, when monetary authorities allow spending in their

economies to rise or decline substantially, and even dramatically, the changes in
spending eventually promote such price level adjustments as are required to return
to a state of monetary equilibrium. It’s also true that, were prices all “perfectly
flexible,” so that they responded both immediately and adequately to any change in
the overall flow of spending, there could be no such thing as shortages or surpluses of
money. In such a world, a money supply that responded to changes in the demand
for money wouldn’t be much of an improvement, assuming that it would improve at
all, upon a money stock that was absolutely constant, or one that varied

Then again, in a world of perfectly flexible prices, an accommodative monetary

arrangement could hardly be worse than any other. And our price system is not, in
fact, one that can be expected to instantly accommodate every sort of change to the
supply of or demand for money. Why that is so, and why some monetary policies are
in fact a lot better than others, will be the subjects of the next installment.

1. In fact even perfectly flexible prices wouldn’t necessarily suffice to avoid troubles
connected to changes in the flow of spending so long as those changes are not fully
anticipated and contracts are not fully “indexed” so as to mimic contracts that would
have been written in a world of perfect foresight. Consider the case in which an
unanticipated halving of the money stock results in an immediate halving of all
prices. The halving of prices would suffice to keep the nominal quantity of money
supplied equal to the quantity demanded. But it could hardly serve to make up for
losses connected to any fixed nominal contracts outstanding at the time of the
monetary collapse.

Part 3: The Price Level

Few people would, I think, take exception to the claim that, in a well-functioning
monetary system, the quantity of money supplied should seldom differ, and should
never differ very much, from the quantity demanded. What’s controversial isn’t that
claim itself, but the suggestion that it supplies a reason for preferring some path of
money supply adjustments over others, or some monetary arrangements over others.

Why the controversy? As we saw in the last installment, the demand for money
ultimately consists, not of a demand for any particular number of money units, but of
a demand for a particular amount of monetary purchasing power. Whatever
amount of purchasing X units of money might accomplish, when the general level of
prices given by P, ½X units might accomplish equally well, were the level of prices
½P. It follows that changes in the general level of prices might, in theory at least,
serve just as well as changes in the available quantity of money units as a means for
keeping the quantity of money supplied in line with the quantity demanded.

But then it follows as well that, if our world is one in which prices are “perfectly
flexible,” meaning that they always adjust instantly to a level that eliminates any
monetary shortage or surplus, any pattern of money supply changes will avoid
money supply-demand discrepancies, or “monetary disequilibrium,” as well as any
other. The goal of avoiding bouts of monetary disequilibrium would in that case
supply no grounds for preferring one monetary system or policy over another, or for
preferring a stable level of spending over an unstable level. Any such preference
would instead have to be justified on other grounds.

So, a decision: we can either adopt the view that prices are indeed perfectly flexible,
and proceed to ponder why, despite that view, we might prefer some monetary
arrangements to others; or we can subscribe to the view that prices are
generally not perfectly flexible, and then proceed to assess alternative monetary
arrangements according to their capacity to avoid a non-trivial risk of monetary

Your guide does not hesitate for a moment to recommend the latter course. For
while some prices do indeed appear to be quite flexible, even adjusting almost
continually, at least during business hours (prices of goods and financial assets
traded on organized exchanges come immediately to mind), in order for
the general level of prices to instantly accommodate changes to either the quantity of
money supplied or the quantity demanded, it must be the case, not merely
that some or many prices are quite flexible, but that all of them are. If, for example,
the nominal stock of money were to double arbitrarily and independently of any
change in demand, prices would generally have to double in order for equilibrium to
be restored. (Recall: twice as many units of money will command the same
purchasing power as the original amount only when each unit commands half as
much purchasing power as before.) It follows that, so long as any prices are slow to
adjust, the price level must be slow to adjust as well. Put another way, an economy’s
price level is only as flexible as its leastflexible prices.

And only a purblind observer can fail to notice that some prices are far from fully
flexible. The reason for this isn’t hard to grasp: changing prices is sometimes costly;
and when it is, sellers have reason to avoid doing it often. Economists use the
expression “menu costs” to refer generally to the costs of changing prices, conjuring
up thereby the image of a restaurateur paying a printer for a batch of new menus, for
the sake of accommodating the rising costs of beef, fish, vegetables, wait staff, cooks,
and so forth, or the restaurants’ growing popularity, or both. In fact both the
restaurants’ operating costs and the demand for its output change
constantly. Nevertheless it usually wouldn’t make sense to have new menus printed
every day, let alone several times a day, to reflect all these fluctuations! Electronic
menus would help, of course, and now it is easy to conceive of them (though it wasn’t
not long ago). But those are costly as well, which is why (or one reason why) most
restaurants don’t use them.
The cost of printing menus is, however, trivial compared to that of changing many
other prices. The prices paid for workers, whether wage or salaried, are notoriously
difficult to change, except perhaps according to a prearranged schedule, which can’t
itself accommodate unexpected change. Renegotiating wages or salaries can be an
extremely costly business, as well as a time-consuming one.

“Menu costs” can account for prices being sticky even when the nature of underlying
changes in supply or demand conditions is well understood. Suppose, for example,
that a restaurant’s popularity is growing at a steady and known rate. That fact still
wouldn’t justify having new menus printed every day, or every hour, or perhaps even
every week. But add the possibility that a perceived increase in demand may not last,
and the restaurateur has that much more reason to delay ordering new menus: after
all, if demand subsides again, the new menus may cost more than turning a few
customers away would have. (The menus might also annoy customers who would
dislike not being able to anticipate what their meal will cost.) Now imagine an
employer asking his workers to take a wage rate cut because business was slack last
quarter. Get the idea? If not, there’s a vast body of writings you can refer to for more
examples and evidence.

These days it is common for economists who insist on the “stickiness” of the price
level to be referred to, or to refer to themselves, as “New Keynesians.” But the label
is misleading. Although John Maynard Keynes had plenty of innovative ideas, the
idea that prices aren’t perfectly flexible wasn’t one of them. Instead, by 1936, when
Keynes published his General Theory, the idea that prices aren’t fully flexible was
old-hat: no economists worth his or her salt thought otherwise.[1] The assumption
that prices are fully flexible, or “continuously market clearing,” is in contrast a
relatively recent innovation, having first become prominent in the 1980s with the rise
of the “New Classical” school of economists, who subscribe to it, not on empirical
grounds, but because they confuse the economists’ construct of an all-knowing
central auctioneer, who adjusts prices costlessly and continually to their market-
clearing levels, with the means by which prices are determined and changed in real
Let New Classical economists ruminate on the challenge of justifying any particular
monetary regime in a world of perfectly flexible prices. The rest of us needn’t
bother. Instead, we can accept the reality of “sticky” prices, and let that reality
inform our conclusions concerning which sorts of monetary regimes are more likely,
and which ones less likely, to avoid temporary surpluses and shortages of money and
their harmful consequences.

What consequences are those? The question is best answered by first recognizing the
crucial economic insight that a shortage of money must have as its counterpart a
surplus of goods and services and vice versa. When money, the means of exchange,
is in short supply, exchange itself, meaning spending of all sorts, suffers, leaving
sellers disappointed. In contrast, when money is superabundant, spending grows
excessively, depleting inventories and creating shortages. Yet these are only the most
obvious consequences of monetary disequilibrium. Other consequences follow from
the fact that, owing to different prices’ varying degrees of stickiness, the process of
moving from a defunct level of equilibrium prices to a new one necessarily involves
some temporary distortion of relative price signals, and associated economic
waste. A price system has work enough to do in coming to grips with ongoing
changes in consumer tastes and technology, among many other non-monetary
factors that influence supply and demand for particular goods and services, without
also having to reckon with monetary disturbances that call for scaling all prices up or
down. The more it must cope with the need to re-scale prices, the less capable it
becomes at fine-tuning them to reflect changing conditions within particular

Hyperinflations offer an extreme case in point, for during them sellers often resort to
“indexing” local-currency prices to the local currency’s exchange rate with respect to
some relatively stable foreign currency. That is, they cease referring altogether to the
specific conditions in the markets for particular goods, and settle instead for keeping
their prices roughly consistent with rapidly changing monetary conditions. In light
of this tendency it’s hardly surprising that hyperinflations lead to all sorts of waste, if
not to the utter collapse of the economies they afflict. If relative prices can become so
distorted during hyperinflations as to cease entirely to be meaningful indicators of
goods’ and services’ relative scarcity, it’s also true that the usefulness of price signals
in promoting the efficient use of scarce resources declines to a more modest extent
during less severe bouts of monetary disequilibrium.

What sort of monetary policy or regime best avoids the costs of having too much or
too little money? In an earlier post, I’ve suggested that keeping the supply of money
in line with the demand for it, without depending on help in the shape of
adjustments to the price level, is mainly a matter of achieving a steady and
predictable overall flow of spending. But why spending? Why not maintain a stable
price level, or a stable and predictable rate of inflation? If, as I’ve claimed, changes
in the general level of prices are an economy’s way of coping, however imperfectly,
with monetary shortages and surpluses, then surely an economy in which the price
level remains constant, or roughly so, must be one in which such surpluses and
shortages aren’t occurring. Right?

No, actually. Despite everything I’ve said here, monetary order, instead of going
hand-in-hand with a stable level of prices or rate of inflation, is sometimes best
achieved by tolerating price level or inflation rate changes. A paradox? Not
really. But as this post is already too long, I must put off explaining why until next
[1] For details see Leland Yeager’s essay, “New Keynesians and Old Monetarists,”
reprinted in The Fluttering Veil.

Part 4: Stable Prices or Stable

Changes in the general level of prices are capable, as we’ve seen, of eliminating
shortages or surpluses of money, by adding to or subtracting from the purchasing
power of existing money holdings. But because such changes place an extra burden
on the price system, increasing the likelihood that individual prices will fail to
accurately reflect the true scarcity of different goods and services at any moment, the
less they have to be relied upon, the better. A better alternative, if only it can
somehow be achieved, or at least approximated, is a monetary system that adjusts
the stock of money in response to changes in the demand for money balances,
thereby reducing the need for changes in the general level of prices.

Please note that saying this is not saying that we need to have a centrally-planned
money supply, let alone one that’s managed by a committee that’s unconstrained by
any explicit rules or commitments. Whether such a committee would in fact come
closer to the ideal I’m defending than some alternative arrangement is a crucial
question we must come to later on. For now I will merely observe that, although it’s
true that unconstrained central monetary planners might manage the money stock
according to some ideal, that’s only so because there’s nothing that such planners
might not do.

The claim that an ideal monetary regime is one that reduces the extent to which
changes in the general level of prices are required to keep the quantity of money
supplied in agreement with the quantity demanded might be understood to imply
that what’s needed to avoid monetary troubles is a monetary system that
avoids allchanges to the general level of prices, or one that allows that level to change
only at a steady and predictable rate. We might trust a committee of central bankers
to adopt such a policy. But then again, we could also insist on it, by eliminating their
discretionary powers in favor of having them abide by a strict stable price level (or
inflation rate) mandate.

Monetary and Non-Monetary Causes of Price-Level Movements

But things aren’t quite so simple. For while changes in the general price level are
often both unnecessary and undesirable, they aren’t always so. Whether they’re
desirable or not depends on the reason for the change.

This often overlooked point is best brought home with the help of the famous
“equation of exchange,” MV = Py. Here, M is the money stock, V is its “velocity” of
circulation, P is the price level, and y is the economy’s real output of goods and
services. Since output is a flow, the equation necessarily refers to an interval of
time. Velocity can then be understood as representing how often a typical unit of
money is traded for output during that interval. If the interval is a year, then both Py
and MV stand for the money value of output produced during that year or,
alternatively, for that years’ total spending.

From this equation, it’s apparent that changes in the general price level may be due
to any one of three underlying causes: a change in the money stock, a change in
money’s velocity, or a change in real output.

Once upon a time, economists (or some of them, at least) distinguished between
changes in the price level made necessary by developments in the “goods” side of the
economy, that is, by changes in real output that occur independently of changes in
the flow of spending, and those made necessary by changes in that flow, that is, in
either the stock of money or its velocity. Deflation — a decline in the equilibrium
price level — might, for example, be due to a decline in the stock of money, or in its
velocity, either of which would mean less spending on output. But it could also be
due to a greater abundance of goods that, with spending unchanged, must command
lower prices. It turns out that, while the first sort of deflation is something to be
regretted, and therefore something that an ideal monetary system should avoid, the
second isn’t. What’s more, attempts to avoid the second, supply-driven sort of
deflation can actually end up doing harm. The same goes for attempts to keep prices
from rising when the underlying cause is, not increased spending, but reduced real
output of goods and services. In short, what a good monetary system ought to avoid
is, not fluctuations in the general price level or inflation rate per se, but fluctuations
in the level or growth rate of total spending.

Prices Adjust Readily to Changes in Costs

But what about those “sticky” prices? Aren’t they a reason to avoid any need for
changes in the price level, and not just those changes made necessary by underlying
changes in spending? It turns out that they aren’t, for a number of reasons.[1]

First of all, whether a price is “sticky” or not depends on why it has to adjust. When,
for example, there’s a general decline in spending, sellers have all sorts of reasons to
resist lowering their prices. If the decline might be temporary, sellers would be wise
to wait and see before incurring price-adjustment costs. Also, sellers will generally
not profit by lowering their prices until their own costs have also been lowered,
creating what Leland Yeager calls a “who goes first” problem. Because the costs that
must themselves adjust downwards in order for sellers to have a strong motive to
follow suit include very sticky labor costs, the general price level may take a long time
“groping” its way (another Yeager expression) to its new, equilibrium level. In the
meantime, goods and services, being overpriced, go unsold.

When downward pressure on prices comes from an increase in the supply of goods,
and especially when the increase reflects productivity gains, the situation is utterly
different. For gains in productivity are another name for falling unit costs of
production; and for competing sellers to reduce their products’ prices in response to
reduced costs is relatively easy. It is, indeed, something of a no-brainer, because it
promises to bring a greater market share, with no loss in per-unit profits. Heck,
companies devote all sorts of effort to being able to lower their costs precisely so that
they can take advantage of such opportunities to profitably lower their prices. By the
same token, there is little reason for sellers to resist raising prices in response to
adverse supply shocks. The widespread practice of “mark-up pricing” supplies ample
proof of these claims. Macroeconomic theories and models (and their are plenty of
them, alas) that simply assign a certain “stickiness” parameter to prices, without
allowing for the possibility that they respond more readily to some underlying
changes than to others, lead policymakers astray by overlooking this important fact.

A Changing Price Level May be Less “Noisy” Than a Constant One

Because prices tend to respond relatively quickly to productivity gains and setbacks,
there’s little to be gained by employing monetary policy to prevent their movements
related to such gains or setbacks. On the contrary: there’s much to lose, because
productivity gains and losses tend to be uneven across firms and industries, making
any resulting change to the general price level a mere average of quite different
changes to different equilibrium prices. Economists’ tendency — and it hard to avoid
— to conflate a “general” movement in prices, in the sense of a change in
their average level, with a general movement in the across-the-board sense, is in this
regard a source of great mischief. A policy aimed at avoiding what is merely a change
in the average, stemming from productivity innovations, increases instead of
reducing the overall burden of price adjustment, introducing that much more “noise”
into the price system.

Nor is it the case that a general decline or increase in prices stemming from
productivity gains or setbacks itself conveys a noisy signal. On the contrary: if things
are generally getting cheaper to produce, a falling price level conveys that fact of
reality in the most straightforward manner possible. Likewise, if productivity suffers
— if there is a war or a harvest failure or OPEC-inspired restriction in oil output or
some other calamity — what better way to let people know, and to encourage them to
act economically, than by letting prices generally go up? Would it really help matters
if, instead of doing that, the monetary powers-that-be decided to shrink the money
stock, and thereby MV, for the sake of keeping the price level constant? Yet that is
what a policy of strict price-level stability would require.

Reflection on such scenarios ought to be enough to make even the most die-hard
champion of price-level or inflation targeting reconsider. But in case it isn’t, allow
me to take still another tack, by observing that, when policymakers speak of
stabilizing the price level or the rate of inflation, they mean stabilizing some measure
of the level of output prices, such as the Consumer Price Index, or the GDP deflator,
or the current Fed favorite, the PCE (“Personal Consumption Expenditure”) price-
index. So long as changes in total spending (“aggregate demand”) are the only source
of changes in the overall level of prices, those changes will tend to affect input as well
as output prices, so policies that stabilize output prices will also tend to stabilize
input prices. General changes in productivity, in contrast, necessarily imply changes
in the relation of input to output prices: general productivity gains (meaning gains in
numerous industries that outweigh setbacks in others) mean that output
prices must decline relative to input prices; while general productivity setbacks mean
that output prices must increase relative to input prices. In such cases, to stabilize
output prices is to destabilize input prices, and vice versa.

So, which? Appeal to menu costs supplies a ready answer: if a burden of price
adjustment there must be, let the burden fall on the least sticky prices. Since “input”
prices include wages and salaries, that alone makes a policy that would impose the
burden on them a poor choice, and a dangerous one at that. As we’ve seen, it means
adding insult to injury during productivity setbacks, when wage earners would have
to take cuts (or settle for smaller or less frequent raises). It also increases the risk of
productivity gains being associated with asset-price bubbles, because those gains will
inspire corresponding boosts to aggregate demand which, in the presence of sticky
input prices, can cause profits to swell temporarily. Unless the temporary nature of
the extraordinary profits is recognized, asset prices will be bid up, but only for as
long as it takes for costs to clamber their way upwards in response to the overall
increase in spending.

What About Debtor-Creditor Transfers?

But if the price level is allowed to vary, and to vary unexpectedly, doesn’t that mean
that the terms of fixed-interest rate contracts will be distorted, with creditors gaining
at debtors expense when prices decline, and the opposite happening when they rise?

Usually it does; but, when price-level movements reflect underlying changes in

productivity, it doesn’t. That’s because productivity changes tend to be associated
with like changes in “neutral” or “full information” interest rates. Suppose that, with
each of us anticipating a real return on capital of four percent, and zero inflation, I’d
happily lend you, and you’d happily borrow, $1000 at four percent interest. The
anticipated real interest rate is of course also four percent. Now suppose that
productivity rises unexpectedly, raising the actual real return on capital by two
percentage points, to six percent rather than four percent. In that case, other things
equal, were I able to go back and renegotiate the contract, I’d want to earn a real rate
of six percent, to reflect the higher opportunity cost of lending. You, on the other
hand, can also employ your borrowings more productively, or are otherwise going to
be able (as one of the beneficiaries of the all-around gain in productivity) to bear a
greater real interest-rate burden, other things equal, and so should be willing to pay
the higher rate.

Of course, we can’t go back in time and renegotiate the loan. So what’s the next best
thing? It is to let the productivity gains be reflected in proportionately lower output
prices — that is, in a two percent decline in the the price level over the course of the
loan period — and thus in an increase, of two percentage points, in the real interest
rate corresponding to the four percent nominal rate we negotiated.

The same reasoning applies, mutatis mutandis, to the case of unexpected, adverse
changes in productivity. Only the argument for letting the price level change in this
case, so that an unexpected increase in prices itself compensates for the unexpected
decline in productivity, is even more compelling. Why is that? Because, as we’ve
seen, to keep the price level from rising when productivity declines, the authorities
would have to shrink the flow of spending. Ask yourself whether doing that will
make life easier or harder for debtors with fixed nominal debt contracts, and you’ll
see my point.

Next: The Supply of Money


[1] What follows is a brief summary of arguments I develop at greater length in my

1997 IEA pamphlet, Less Than Zero. In that pamphlet I specifically make the case
for a rate of deflation equal to an economies (varying) rate of total factor productivity
growth. But the arguments may just as well be read as supplying grounds for
preferring a varying yet generally positive inflation rate to a constant rate.

Part 5: The Supply of Money

In previous installments of this primer I’ve tried to convince you, first, that monetary
policy is ultimately about keeping the available quantity of money from differing
substantially, if only temporarily, from the quantity demanded and, second, that
doing this boils down in practice to having a money stock that adjusts so as to
maintain a steadily-growing level of overall spending on goods and services.

If we’re to pick the right arrangements for achieving this goal, we’d better have a
good understanding of the determinants of an economy’s money stock, and of how
that stock can be made to expand or contract just enough to keep total spending
stable. Although I eventually plan to talk about monetary arrangements that might
make maintaining a steady flow of spending a lot easier than our present system
does, for now I’m going to stick to discussing how the same goal might be achieved,
at least in principle, in our present monetary system or, more precisely, in the system
we had until the subprime crisis of 2008. (A later post will discuss how things have
changed since the crisis.) This means talking about the Fed’s “instruments of
monetary control,” which include devices for regulating the total quantity of bank
reserves and circulating Federal Reserve notes, and also for regulating the quantity of
bank deposits and other forms of privately-created money that will be supported by
any given quantity of bank reserves.

Money Proper and Money Substitutes

In trying to explain how these instruments of monetary control work, I’m tempted, if
only for the time being, to revert to some old-fashioned terminology that, whatever
its other shortcomings, seems more useful than modern terms are for shedding light
upon the nature of money creation. Nowadays economists use the term “money” to
refer to anything that’s a generally-accepted medium of exchange. Hence the
manifold measures of the U.S. money stock — M1, M2, M3, MZM, and so forth — all
of which include various sorts of bank deposits. To refer specifically to the dollars
that the Fed itself creates, including both bank reserves and Federal Reserve notes
circulating outside of the banking system, they use the terms “high-powered money,”
or “base money,” or “the monetary base.”

In the old days, in contrast, economists — or many of them, in any event [1] — liked
to distinguish between what they considered money in the strict sense of the term, or
“money proper,” and “money substitutes.” Both money proper and money
substitutes serve as generally accepted means of exchange. The difference is that,
while “money substitutes” consist of various kinds of instantly-redeemable IOUs or
promises to pay, “money proper” refers to the stuff that the promises promise, that
is, what a bank customer expects to get in exchange for the substitutes if he or she
asks the bank to pay up.

A century ago, when the terms were still current, in most industrialized economies
“money proper” consisted of gold coins, while paper banknotes and demand deposits
that were redeemable in gold were mere money substitutes. Today the same
terminology might be used to distinguish the irredeemable currency supplied directly
by the Fed from the redeemable exchange media created by commercial banks and
other private financial firms. According to it, and thanks to a few twists of fate, paper
Federal Reserve notes are now “money proper,” while bank deposits, and checkable
deposits especially, are “money substitutes.” Note that “money proper” in this
context isn’t quite the same thing as what modern economists call “high-powered” or
“base” money, because the last includes bank reserves, which aren’t actually “money”
at all: they are, true enough, means of payment so far as banks themselves are
concerned, but so far as the general public is concerned, it’s bank deposits, rather
than the bank reserves that stand behind those deposits, that serve as money.

Real Money as “Raw Material” for Banks

Why drag-in the old-fashioned distinction between money proper and money
substitutes? Because it serves to remind us that even today the “money” that
commercial banks and other private-market financial firms produce is in an
important respect not the real McCoy at all, but ersatz (if often more convenient)
stuff that serves in place of it, and does so only because the firms that supply it, not
only make it very convenient to use (e.g., by swiping a debit card), but at the same
time offer its users something akin to money-back (which is to say, a “money
proper”-back) guarantees. It’s owing to such guarantees — that is, to the fact that
bank deposits are, or are supposed to be, readily redeemable in central bank notes —
that bank deposits usually command the same value as the “money proper” for which
they’re a stand-in. Today, of course, those guarantees are for most depositors further
reinforced by the presence of deposit insurance, as well as by the knowledge that
government authorities consider some banks “too big to fail.” But such government
guarantees don’t allow banks to manage without reserves: they only reduce the
likelihood that a bank’s panicking customers will all rush at once to exchange its
money substitutes for “real” money.

The understanding that bank deposits and such derive their value at least partly from
the fact that banks are prepared to convert them into “money proper” in turn helps
us to appreciate how private financial institutions’ ability to create money substitutes
depends on their access to “real” (that is, central-bank-created) money. It depends,
in the first place, on the amount of such “real” money that these firms keep on hand,
either in the shape of actual central bank currency (“vault cash”) or in that of deposit
balances they maintain at the central bank that are themselves readily convertible
into central bank notes, and, in the second place, on their ability to borrow “real”
money either from other private firms or from the central bank itself should their
own inventories of it run out. One might even go so far as to think of “real” money
(central bank notes and deposit balances) as a crucial “raw material” from which
money substitutes (various sorts of bank deposits) are made.

The importance of these insights for a proper understanding of central banks’ devices
for monetary control becomes instantly apparent once one realizes that, by
regulating the actual quantity of its outstanding notes and deposit balances, together
with the terms upon which it is willing to make more of the last available on credit to
private sector financial firms, a central bank is able to control, not just the quantity of
circulating paper money, but the quantity of money substitutes created by the private
sector. Indeed, since the quantity of circulating currency tends to grow along with
the extent of commercial-bank deposit creation, that quantity itself ultimately
depends on the quantity of reserves that central banks make available to private
financial firms.

Open-Market Operations

It follows from this that the most obvious way in which a modern central bank can
regulate an economy’s total money stock is by adjusting the available quantity of
bank reserves and circulating currency. Central banks can most readily do that by
adjusting the total size of their balance sheets, which they do by either acquiring or
selling assets. For example, if the Fed wants to increase the stock of bank reserves
by, say, $100 billion (admittedly a mere trifle, these days), it has only to purchase
$100-billion worth of Treasury securities or other assets from dealers in the
secondary or “open” market.[2] To pay for the securities, the Fed wires funds into
the sellers’ bank accounts, instantly increasing the total quantity of bank reserves by
the same amount. The banks that receive the new reserves will then have more “raw
material” on hand to support their own and, eventually, other financial firms’
creation of various kinds of money substitutes. Just how this happens–and
especially how it is that each dollar in fresh reserves can ultimately inspire the
creation of several dollars-worth of substitutes, will be among the subjects of
our next installment.

To shrink the money supply, on the other hand, the Fed has only to sell-off some of
its securities, or to let them “roll” off its balance sheet as they mature, instead of
replacing them. When the Fed sells $100 billion in securities, the sellers have their
banks wire funds to the Fed for the amounts they purchase, essentially instructing
the Fed to deduct the wired amounts from their banks’ reserve balances with it.

Although changes in the size of the Fed’s balance sheet — that is, in its total assets
and liabilities — often involve like changes in the quantity of high-powered or base
money (currency and bank reserves), and corresponding changes in the total money
stock, this isn’t always so. Although banks’ reserve balances and outstanding Federal
Reserve notes make up the bulk of the Federal Reserve System’s total liabilities,
those liabilities also include deposit balances of the U.S. Treasury, of foreign central
banks, and of some GSEs. Because these other Fed customers are, unlike banks, not
in the business of creating money substitutes, their share of the Fed’s total liabilities
doesn’t contribute, as the banks’ share does, to the creation of such substitutes. It’s
possible, therefore, for the quantity of base money, and of various monetary
aggregates, to change independently of any overall change in the size of the Fed’s
balance sheet. An increase in the share of Federal Reserve deposit balances
belonging to ordinary U.S. banks, rather than to the Treasury, foreign central banks,
or GSEs, will, for example, lead to an increase in the total money stock, other things
unchanged, while a decline in that share will reduce it.

Repurchase Agreements

Outright Fed security purchases or sales are only one of two sorts of “open-market
operations” the Fed resorts to to change the total size of its balance sheet. The other
involves so-called “repurchase agreements” — “repos” for short. A security
repurchase agreement is literally a sale of a security that’s coupled with an agreement
to buy the security back for a specific price and at a specific time. (A “reverse” repo is
thus a purchase combined with an agreement to resell.) However in practice repos
(and reverse repos) are practically equivalent to securitized loans, where the security
that’s temporarily “sold” serves as collateral to secure a loan from the purchaser to
the buyer of an amount equal to the purchase price, and the difference between that
price and the later, “repurchase” price is the interest on the loan. The self-reversing
nature of the Fed’s repos and reverse repos, many of which are “overnight” rather
than “term” agreements (that is, ones providing for repurchase a day after the
original purchase) has caused the Fed to prefer them as a means for achieving
temporary adjustments to the money stock, while treating outright security
purchases as a way of providing for permanent monetary expansion, and especially
for secular growth in the demand for Federal Reserve notes. Since the crisis,
however, the Fed has come to treat repos, and particularly overnight reverse repos
(ON RRPs) with Money Market Mutual Funds and GSEs, as a means for securing
long-term monetary control.[3]

As I’ve said, by altering the size of its own balance sheet, and especially by altering
the available quantity of bank reserves, the Fed is able, not only to influence its own
direct contribution to the money stock, consisting of the quantity of Federal Reserve
notes circulating within U.S. borders, but to influence the availability of “raw
material” that banks must have in order to “manufacture” readily transferable
deposits and other “substitutes” for cash. But while comparing a bank to a factory is
helpful up to a point, we mustn’t take the comparison too seriously. For while it’s
true that banks can only create and manage deposits provided they have access to
reserves, including vault cash, the connection between reserve “input” and deposit
“output” is rather different from what goes on in any factory. Indeed, it’s different
because it depends, not just on what any single bank can “make” out of a fresh
increment of reserves, but on what the banking industry as a whole can make from it,
which turns out to be something else again.

Explaining the relation between the Fed’s creation (or destruction) of bank reserves
and banks’ creation (or destruction) of deposits takes a little effort, not in the least
because doing so means confronting the different ways in which economists on one
hand and bankers and banking consultants on the other look at the process, and
deciding whether the difference is due to substantive disagreement, or mere
semantics. Since that’s going to take more than one or two paragraphs, and this post
is already long, I’ll take it up next time.


[1] Ludwig von Mises and Irving Fisher are two of the more prominent economists
who employed this terminology, which can be traced to the early-to-mid 19th century
writings of members of the British Banking School.

[2] Unlike some other central banks, the Fed is prohibited from purchasing Treasury
securities from the government. Instead, it purchases securities already outstanding
from a group of designated “primary dealers.” The financial losses of two such
dealers — Bear Stearns and Lehman Brothers — figured prominently in the recent
financial crisis.

[3] In particular, the Fed has used ON RPPs to encourage MMMFs and GSE’s to lend
to (or park funds with) it, and to thereby reduce the quantity of Federal Reserve
dollars available to banks. The Fed is thus able to reward non-banks for holding
(instead of lending or investing) cash, despite the fact that they can’t keep interest-
bearing balances with it. By simultaneously raising both the interest rate it pays on
bank reserves and the ON RPP rate, as it did in mid-December 2015, the Fed is able
to engage in monetary “tightening” without having to reduce the overall size of its
balance sheet. I will have more to say about this and other post-crisis changes in the
way the Fed conducts monetary policy in a later post.

Part 6: The Reserve-Deposit

In my last post in this series, I observed that an economy’s “base” money serves as
the “raw material” that commercial banks and other private-market financial
intermediaries employ in “producing” deposits of various kinds that can themselves
serve as means of exchange.
If they could do so profitably, these private intermediaries would, by making their
substitutes more attractive than base money itself, collectively gain possession of
every dollar of base money in existence. In some past monetary arrangements, most
notably that of Scotland before 1845, banks came very close to achieving this ideal,
thanks to the their freedom to supply their customers with circulating paper
banknotes as well as with deposits, and to the fact that between them these two
substitutes could serve every purpose coins might serve, and do so more conveniently
than coins themselves.

All save a handful of commercial banks today are, in contrast, able to supply deposits
only, so that only base money itself can serve as currency, that is, circulating money.
The extent to which national money stocks have been “privatized,” in the sense of
being made up mainly of private IOUs of various kinds rather than officially-supplied
base money, has been correspondingly limited, as has the extent to which private
money holdings have served as a source of funding for bank loans.

When banks and other private-market intermediaries acquire base money, they do
so, not for the sake of holding on to it, as they might were they mere warehouses, but
in order to lend or otherwise invest it. More precisely, they do so in order to lend or
invest most of the base money that comes their way, while keeping some on hand for
the sake of either meeting their customers’ requests for currency, or for settling
accounts with other banks, as they must do at the end of each business day, if not
more frequently. While banks’ own substitutes for base money may serve in place of
base money for all sorts of transactions among non-banks, those substitutes won’t
suffice for settling banks’ dues to one another, for every bank is anxious to grab for
itself as large a share of the market for money balances as possible, while
contributing as little as possible to the shares possessed by rival banks.

Bankers have also learned, through hard experience, that by accumulating the IOUs
of other banks, and thereby allowing other banks to accumulate their own IOUs in
turn, they expose themselves to grave risks, which risks are best avoided by taking
part in regular interbank settlements. Because even the most carefully-managed
banks cannot perfectly control or predict the value of their net dues at the end of any
particular settlement period, all would tend to equip themselves with a modest
cushion of cash reserves even if they did not have to do so for the sake of stocking
their ATM’s or accommodating their customers’ over-the-counter requests for cash.

Because banks typically receive fresh inflows of reserves every day, as a result of
ordinary deposits, loan repayments, or maturing securities, a responsible banker,
once having set-aside a reasonable cushion of reserves, has only to see to it that the
lending and investment that his or her bank engages in just suffices to employ those
inflows, in order to succeed in keeping it sufficiently liquid. Greater reserve inflows,
if judged likely to be persistent, will inspire increased lending or investment, while
reduced ones will have the opposite effect. The bankers’ general goal is to keep funds
that come the bank’s way profitably employed, while holding on to just so many
reserves as are needed to accommodate fluctuations of net reserve drains around,
and therefore often above, their long-run (zero) mean. More precisely, bankers’ strive
to keep reserves on hand sufficient to reduce the probability of losses exceeding
available reserves to a (usually modest) level, reflecting both the opportunity of
holding reserves, which is to say the interest that might be earned on other assets,
and the costs involved in making-up for reserve shortages, by borrowing from other
banks or otherwise.

Throughout the history of banking, and despite laws that have suppressed
commercial banknotes while often imposing minimum (but never maximum) reserve
ratios on banks, bank reserves have generally constituted a very modest part of
banks’ total assets, and therefore a modest amount compared to their their total
liabilities. Indeed, bank reserves have generally been but a small fraction of banks’
readily redeemable or “demandable” liabilities. England’s early”goldsmith” banks are
supposed to have held reserves equal to only a third of their demandable liabilities —
a remarkably low figure, given the circumstances; at the other extreme, Scottish
banks at the height of that nation’s pre-1845 “free banking” episode often managed
quite well with gold or silver reserves equal to between one and two percent of their
outstanding notes and demand deposits. Modern banks, even prior to the recent
crisis, have generally had to keep somewhat higher reserve ratios than their pre-1845
Scottish counterparts, mainly owing to the fact, mentioned above, that they must
stock their cash machines and tills with base money, instead of being able to do so
using their own circulating banknotes.

Between 1997 and 2005, for instance, U.S. depository institutions’ reserves ranged,
with rare exceptions, between 11 and 14 percent of their demand deposits (see figure
below). Put another way, for every dollar of base money “raw material” they
acquired, U.S. commercial banks were able to “manufacture” (that is, to create and
administer) just under 10 dollars of demand deposits. That figure, the inverse of the
banking system reserve ratio, is what’s known as the reserve-deposit “multiplier.”

Depository Institutions’ (Demand Deposit) Reserve Ratio, 1997-2005

The multiplier’s significance to monetary policy is, or used to be, straightforward: it
indicated the quantity of additional bank deposits that monetary authorities could
expect to see banks produce in response to any increment of new bank reserves
supplied them by means of either open-market operations or direct central bank
loans. If, around 2000 (when the reserve-demand deposit multiplier was about 14),
the Fed wanted to see bank’s demand deposits increase by, say, $10 billion, it had
only to see to it that they acquired $(10/14) billion in fresh reserves, which meant
creating a somewhat larger quantity of new base dollars — the difference serving to
make up for the tendency of some of any newly created bank reserves to be converted
into currency. The ratio of the total amount of new money, including both currency
and bank deposits, generated in response to any new increment of base money, to
that increment of base money itself, is known as the “base money multiplier.”

Since the recent crisis, all sorts of nonsense has been written about the “death” of the
reserve-deposit and base-money multipliers, and even (in some cases) about how we
ought to be glad to say “good riddance” to it. I say “nonsense” because, first of all, the
multipliers in question, being mere quotients arrived at using values that are
themselves certainly very much alive cannot themselves have “died,” and because the
working of these multipliers does not, as some authorities suppose, depend on the
particular operating procedures central banks employ. Finally, although it’s true that,
until the recent crisis, economists were inclined, with good reason, to take the
stability of the reserve-deposit and base-money multipliers for granted, it doesn’t
follow that they (or good ones, at least) ever regarded these values as constants, as
opposed to variables the values of which depended on various determinants which
were themselves capable of changing.

What certainly has happened since the crisis is, not that the reserve-deposit and
base-money multipliers have died, but that their determinants have changed enough
to cause them to plummet. U.S. bank reserves, for example, have (as seen in the next
picture) gone from being equal to a bit more than a tenth of demand deposits to
being about twice the value of such deposits! The base-money (M2) multiplier,
shown further below, has, at the same time, fallen to below half its pre-crisis level,
from about 8 to 3.5 or so (not long ago it was less than 3).
The Reserve Demand-Deposit Multiplier Since 2005

The Base-Money M2 Multiplier since 2005

These are remarkable changes, to be sure. But they are hardly inexplicable. Banks’
willingness to accumulate reserves depends, as I’ve already noted, on the cost of
holding reserves, which itself depends on the interest yield of reserves compared to
that of other assets banks might hold instead. Before the crisis, bank reserves earned
no interest at all. On the other hand, banks had all sorts of ways in which to employ
funds profitably, especially by lending to businesses both big and small.
Consequently, banks held only modest reserves, and bank reserve and base-money
multipliers were correspondingly large.

The crisis brought with it several changes that are more than capable of accounting
for the multipliers’ collapse. The recession itself has, first of all, resulted in a general
reduction in both nominal and real interest rates on loans and securities, to the point
where some Treasury securities are now earning negative inflation-adjusted returns.
Regulators have in turn responded to the crisis by cracking-down on all sorts of bank
lending, making it costly, if not impossible, for banks, and smaller banks especially,
to make many of the higher-return loans, including small business loans, they would
have been able to make, and to make profitably, before the crisis. (More here.) U.S.
bank regulators have also begun to enforce Basel III’s new “Liquidity Coverage Ratio”
rules, compelling banks to increase the ratio of liquid assets, meaning reserves and
Treasury securities, to less-liquid ones on their balance sheets. Finally, since October
2008, the Fed has been paying interest on bank reserves, at rates generally exceeding
the yield on Treasury securities, thereby giving them reason to favor cash reserves
over government securities for all their liquidity needs.

Whatever their cause, today’s very low money multiplier values mean that
commercial banks have ceased to contribute as they once did to the productive
employment of scarce savings. Instead, those savings have been shunted to the Fed,
and to other central banks, which use them to purchase government securities, and
also for other purposes, but never, with rare exceptions (and with good reason), to
fund potentially productive enterprises. Although discussions of monetary policy
since the crisis have mainly had to do with the quantity of money, and central banks’
efforts to expand that quantity so as to stimulate spending, the effects of the crisis,
and of governments’ response to it, on the quality of money, and especially on the
investments its holders have been funding, deserve at least as much attention.
Part 7: Monetary Control,
It’s high time that I got ‘round to the subject of “monetary control,” meaning the
various procedures and devices the Fed and other central banks employ in their
attempts to regulate the overall availability of liquid assets, and through it the
general course of spending, prices, and employment, in the economies they oversee.

In addressing this important subject, I’m especially anxious to disabuse my readers

of the popular, but mistaken, belief — and it is popular, not only among non-experts,
but also among economists — that monetary control is mainly, if not entirely, a
matter of central banks’ “setting” one or more interest rates. As I hope to show,
although there is a grain of truth to this perspective, a grain is all the truth there is to
it. The deeper truth is that “monetary control” is fundamentally about controlling the
quantity of (hang on to your hats) … money! In particular, it is about altering the
supply of (and, in recent years, the demand for) “base” money, meaning (once again)
the sum of outstanding Federal Reserve notes and depository institutions’ deposit
balances at the Fed.

Although radical changes to the Fed’s monetary control procedures since the recent
crisis don’t alter this fundamental truth about monetary control, they do make it
impractical to address the Fed’s control procedures both before and since the crisis
within the space of a single blog entry. Instead, I plan to limit myself here to
describing monetary control as the Fed exercised it in the years leading to the
crisis. I’ll then devote a separate post to describing how the Fed’s methods of
monetary control have changed since then, and why the changes matter.

The Mechanics of “Old-Fashioned” Monetary Control

In those good-old pre-crisis times, the Fed’s chief monetary control challenge was
one of adjusting the available quantity of base money, and of bank’s deposit balances
at the Fed especially, sufficiently to sustain or sponsor general levels of lending and
spending consistent with its ultimate employment and inflation objectives. If, for
example, the FOMC determined that the Fed had to encourage lending and spending
beyond already projected levels if it was to avoid a decline in inflation, a rise in
unemployment, or a combination of both, it would proceed to increase depository
institutions’ reserve balances, with the intent of encouraging those institutions to
put their new reserves to work by lending (or otherwise investing) them. Although
the lending of unwanted reserves doesn’t reduce the total amount of reserves
available to the banking system, it does lead to a buildup of bank deposits as those
unwanted reserves get passed around from bank to bank, hot-potato fashion. As
deposits expand, so do banks’ reserve needs, owing partly (in the U.S.) to the
presence of minimum legal reserve requirements. Excess reserves therefore decline.
Once there are no longer any excess reserves, or rather once there is no excess
beyond what banks choose to retain for their own prudential reasons, lending and
deposit creation stop.

Such is the usual working-out of the much-disparaged, but nevertheless real, reserve-
deposit multiplier. As I explained in the last post in this series, although the
multiplier isn’t constant — and although it can under certain circumstances decline
dramatically, even assuming values less than one — these possibilities don’t suffice to
deprive the general notion of its usefulness, no matter how often some authorities
claim otherwise.

Regardless of other possibilities, for present purposes we can take the existence of a
multiplier, in the strict sense of the term, and of some official estimate of the value of
this multiplier, for granted. The question then is, how, given such an estimate, does
(or did) the Fed determine just how much base money it needed to create, or perhaps
destroy, to keep overall credit conditions roughly consistent with its ultimate
macroeconomic goals? It’s here that the “setting” of interest rates, or rather, of one
particular interest rate, comes into play.

The particular rate in question is the “federal funds rate,” so called because it is the
rate depository institutions charge one another for overnight loans of “federal funds,”
which is just another name for deposit balances kept at the Fed. Why overnight
loans? In the course of a business day, a bank’s customers make and receive all sorts
of payments, mainly to and from customers of other banks. These days, most of these
payments are handled electronically, and so consist of electronic debits from and
credits to banks’ reserve accounts at the Fed. Although the Fed allows banks to
overdraw their accounts during the day, it requires them to have sufficient balances
to end each day with non-zero balances sufficient to meet their reserve requirements,
or else pay a penalty. So banks that end up short of reserves borrow “fed funds”
overnight, at the “federal funds rate,” from others that have more than they require.

Notice that the “federal funds rate” I just described is a private-market rate, the level
of which is determined by the forces of reserve (or “federal funds”) supply and
demand. What the Fed “sets” is not the actual federal funds rate, but the “target”
federal funds rate. That is, it determines and then announces a desired federal funds
rate, to which it aspires to make the actual fed funds rate conform using its various
monetary control devices.

Importantly, the target federal funds rate (or target ffr, for short) is only a means
toward an end, and not a monetary policy end in itself. The Fed sets a target ffr, and
then tries to hit that target, not because it regards some particular fed funds rate as
“better” in itself than other rates, but because it believes that, by supplying banks
with reserve balances consistent with that rate, it will also provide them with a
quantity of reserves consistent with achieving its ultimate macroeconomic objectives.
The fed funds rate is, in monetary economists’ jargon, merely a policy “instrument,”
and not a policy “objective.” Were a chosen rate target to prove incompatible with
achieving the Fed’s declared inflation or employment objectives, the target, rather
than those objectives, would have to be abandoned in favor of a more suitable one. (I
am, of course, describing the theory, and not necessarily Fed practice.)

But why target the federal funds rate? The basic idea here is that changes in
depository institutions’ demand for reserve balances are a rough indicator of changes
in the overall demand for money balances and, perhaps, for liquid assets generally.
So, other things equal, an increase in the ffr not itself inspired by any change in the
Federal Reserve policy can be taken to reflect an increased demand for liquidity
which, unless the Fed does something, will lead to some decline in spending,
inflation, and (eventually) employment. Rather than wait to see whether these things
transpire, an ffr-targeting Fed would respond by increasing the available quantity of
federal funds just enough to offset the increased demand for them. If the fed funds
rate is indeed a good instrument, and the Fed has chosen the appropriate target rate,
then the Fed’s actions will allow it to do a better job achieving its ultimate goals than
it could if it merely kept an eye on those goal variables themselves.

Open Market Operations

To increase or reduce the available supply of federal funds, the Fed increases or
reduces its open-market purchases of Treasury securities. (Bear in mind, again, that
I’m here describing standard Fed operating procedures before the recent crisis.) Such
“open-market operations” are conducted by the New York Fed, and directed by the
manager of that bank’s System Open Market Account (SOMA). The SOMA manager
arranges frequent (usually daily) auctions by which it either adds to or reduces its
purchases of Treasury securities, depending on the FOMC’s chosen federal funds rate
target and its understanding of how the demand for reserve balances is likely to
evolve in the near future. The other auction participants consist of a score or so of
designated large banks and non-bank broker-dealers known as “primary dealers.”
When the Fed purchases securities, it pays for them by crediting dealers’ Fed deposit
balances (if the dealers are themselves banks) or by crediting the balances of the
dealers’ banks, thereby increasing the aggregate supply of federal funds by the
amount of the purchase. When it sells securities, it debits dealer and dealer-affiliated
bank reserve balances by the amounts dealers have offered to pay for them, reducing
total system reserves by that amount.

Because keeping the actual fed funds rate near its target often means adjusting the
supply of federal funds to meet temporary rather than persistent changes in the
demand for such, the Fed undertakes both “permanent” and “temporary” open-
market operations, where the former involve “outright” security purchases or (more
rarely) sales, and the latter involve purchases or sales accompanied by “repurchase
agreements” or “repos.” (For convenience’s sake, the term “repo” is in practice used
to describe a complete sale and repurchase transaction.) For example, the Fed may
purchase securities from dealers on the condition that they agree to repurchase those
securities a day later, thereby increasing the supply of reserves for a single night only.
(The opposite operation, where the Fed sells securities with the understanding that it
will buy them back the next day, is called an “overnight reverse repo.”) Practically
speaking, repos are collateralized loans, except in name, where the securities being
purchased are the loan collateral, and the difference between their purchase and
their repurchase price constitutes the interest on the loan which, expressed in annual
percentage terms, is known as the “repo rate.”

The obvious advantage of repos, and of shorter-term repos especially, is that, because
they are self-reversing, a central bank that relies extensively on them can for the
most part avoid resorting to open-market sales when it wishes to reduce the supply
of federal funds. Instead, it merely has to refrain from “rolling over” or otherwise
replacing some of its maturing repos.

Sustainable and Unsustainable Interest Rate Targets

Having described the basic mechanics of open-market operations, and how such
operations can allow the Fed to keep the federal funds rate on target, I don’t wish to
give the impression that achieving that goal is easy. On the contrary: it’s often
difficult, and sometimes downright impossible!

For one thing, just what scale, schedule, or types of open-market operations will
serve best to help the Fed achieve its target is never certain. Instead, considerable
guesswork is involved, including (as I’ve mentioned) guesswork concerning
impending changes in depository institution’s demand for liquidity. Ordinarily such
changes are small and fairly predictable; but occasionally, and especially when a
crisis strikes, they are both unexpected and large.

But that’s the least of it. The main challenge the Fed faces consists of picking the
right funds rate target in the first place. For if it picks the wrong one, it’s attempts to
make the actual funds rate stay on target are bound to fail. To put the matter more
precisely, given some ultimate inflation target, there is at any time a unique federal
funds rate consistent with that target. Call that the “equilibrium” federal funds
rate.** If the Fed sets its ffr target below the equilibrium rate, it will find itself
engaging in endless open-market purchases so long as it insists on cleaving to that
That’s the case because pushing the ffr below its equilibrium value means, not just
accommodating changes in banks’ reserve needs, thereby preserving desirable levels
of lending and spending, but supplying them with reserves beyond those needs.
Consequently the banks, in ridding themselves of the unwanted reserves, will cause
purchasing of all sorts, or “aggregate demand,” to increase beyond levels consistent
with the Fed’s objectives. Since the demand for loans of all kinds, including that for
overnight loans of federal funds, itself tends to increase along with the demand for
other things, the funds rate will once again tend to rise above target, instigating
another round of open-market purchases, and so on. Eventually one of two things
must happen: either the Fed, realizing that sticking to its chosen rate target will
cause it to overshoot its long-run inflation goal, will revise that target upwards, or the
Fed, in insisting on trying to do the impossible, will end up causing run-away
inflation. Persistent attempts to push the fed funds rate below its equilibrium value
will, in other words, backfire: eventually interest rates, instead of falling, will end up
increasing in response to an increasing inflation rate. A Fed attempting to target an
above-equilibrium ffr will find itself facing the opposite predicament: unless it
adjusts its target downwards, a deflationary crisis, involving falling rather than rising
interest rates, will unfold.

The public would be wise to keep these possibilities in mind whenever it’s tempted to
complain that the Fed is “setting” interest rates “too high” or “too low.” The public
may be right, in the sense that the FOMC needs to adjust the fed funds target if it’s to
keep inflation under control. On the other hand, if what the public is really asking is
that the Fed try to force rates above or below their equilibrium values, it should
consider itself lucky if the FOMC refuses to listen.

A Steamship Analogy

I hope I’ve already said enough to drive home the fact that there was, prior to the
crisis at least, only a grain of truth to the common belief that the Fed “sets” interest
rates. It is, of course, true that the Fed can influence the prevailing level of interest
rates through its ability to alter both the actual and the expected rate of inflation. But
apart from that, and allowing that the Fed has long-run inflation goals that it’s
determined to achieve, it’s more correct to say that the Fed’s monetary policy actions
are themselves “set” or dictated to it by market-determined equilibrium rates of
interest, than that the Fed “sets” interest rates.

But in case the point still isn’t clear, an analogy may perhaps help. Suppose that the
captain of a steamship wishes to maintain a sea speed of 19 knots. To do so, he (I said
it was a steamship, didn’t I?) sends instructions, using the ship’s engine-order
telegraph, to the engineer, signaling “full ahead,” “half ahead,” “slow ahead,” “dead
slow ahead,” “stand by,” “dead slow astern,” “slow astern,” and so on, depending on
how fast, and in what direction, he wants the propellers to turn. The engine room in
turn acknowledges the order, and then conveys it to the boiler room, where the
firemen are responsible for getting steam up, or letting it down, by stoking more or
less coal into the boilers. But engine speed is only part of the equation: there’s also
the current to consider, variations in which require compensating changes in engine
speed if the desired sea speed is to be maintained.

Now for the analogy: the captain of our steamship is like the FOMC; its engineer is
like the manager of the New York Fed’s System Open Market Account, and the ship’s
telegraph is like…a telephone. The instructions “full ahead,” “half ahead,” “stand by,”
“half astern,” and so forth, are the counterparts of such FOMC rate-target
adjustments as “lower by 50 basis points,” “lower by 25 basis points,” “stand pat,”
“raise by 25 basis points,” etc. Coal being stoked into the ship’s boilers is like fed
funds being auctioned off. Changes in the current are the counterpart of changes in
the demand for federal funds that occur independently of changes in Fed
policy. Finally, the engine speed consistent at any moment with the desired ship’s
speed of 19 knots is analogous to the “equilibrium” federal funds rate. Just as a
responsible ship’s captain must ultimately let the sea itself determine the commands
he sends below, so too must a responsible FOMC allow market forces dictate how it
“sets” its fed funds target.


Such was monetary control before the crisis. Since then, much has changed, at least
superficially; so we must revisit the subject with those changes in mind. But first, I
must explain how these changes came about, which means saying something about
how the S.S. Fed managed to steam its way straight into a disaster.


**I resist calling it the “natural” rate, because that term is mostly associated with the
work of the great Swedish economist Knut Wicksell, who meant by it the rate of
interest consistent with a constant price level or zero inflation, rather than with any
constant but positive inflation rate. The difference between my “equilibrium” rate
and Wicksell’s “natural” rate is simply policymakers’ preferred long-run inflation rate
target. Note also that I say nothing here about the Fed’s employment goals. That’s
because, to the extent that such goals are defined precisely rather than vaguely, they
may also be incompatible, not only with the Fed’s long-run inflation objectives, but
with the avoidance of accelerating inflation or deflation.

Part 8: Money in the Latest

Great Muddle
In the first, 1922 edition of Money, his own now-classic primer on monetary
economics, the great Dennis Robertson included a chapter he called “Money in the
Great Muddle,” about the blow World War I dealt to England’s once (relatively) rock-
solid monetary system, and to other monetary arrangements worldwide. To Money’s
fourth (1947) edition, Robertson added a new chapter concerning the Great
Depression and its monetary aftermath, calling it “Money in the Second Great

So it is with a bow to Sir Dennis — and a rueful awareness of the likelihood of still
other muddles to come — that I have chosen the title for my own primer’s assessment
of monetary policy surrounding the upheaval known as the Great Recession.

A primer on American monetary policy is, needless to say, no place for a detailed
account of the the causes of that calamity. It ought, nonetheless, to say something
about the part that monetary policy, and the Fed’s monetary policy decisions in
particular, played in it.

Some Preliminaries

To get a handle on the Fed’s contribution to the crisis, one must be willing to do what
all too many commentators on monetary policy seem incapable of doing, to wit: set
aside the temptation to treat central banks as being congenitally prone to create too
much money, or predisposed to create too little. The sad truth is that central banks
are perfectly capable of creating too much money on some occasions, and too little on
others, and that it isn’t at all unusual for them to sway intemperately from one off-
kilter stance to the other, with scarcely a pause in between.

But that’s not all. One must also be willing to set aside the more dispassionate belief
that, so long as the rate of consumer price inflation is stable and modest, monetary
policy is neither excessively easy nor excessively tight. Popular as that belief is, even
among many monetary economists and policymakers, it is also, I’m sorry to say,
facile. Among other things, it confuses the behavior of consumer or final-output
prices, which is what the more popular price-indexes measure, with that of the
“general” price level, and therefore neglects the possibility that changes in the rate of
CPI or PCE inflation may actually signify, not excessive or deficient money growth,
but changes in unit production costs, that is, in the price of output relative to that of
inputs, including labor.

When the PCE index goes up, for example, that could mean that excessive money
creation has caused the demand for output to increase relative to a stable supply. But
it could also mean that unit output costs have risen. The same goes for “core” PCE
index, which excludes food and energy prices. A falling PCE index could, on the other
hand, mean either that the demand for final goods has shrunk relative to an
unchanging supply, or that final goods, having become less expensive to produce, are
also becoming more abundant, so that the same amount of spending buys more of

Suppose, to offer a concrete case, that in a heavily agricultural economy a series of

harvest failures leads to higher prices. Only a blockhead would insist that the
monetary authorities there must have created too much money, and that it would
help matters for them to draw in the money-creation reins enough to get prices back
down to where they might have been had the harvest been good. Likewise, were the
harvest exceptionally good, only a blockhead would insist on having the money stock
boosted to prevent prices from falling — as if the decline were not a perfectly
accurate reflection of the fact that goods had become cheaper. What goes for crop
prices in an agricultural economy goes as well for prices of goods-in-general in a
more diverse one. For that reason there’s at least an inkling of blockheadedness
involved in the popular view that a stable and low inflation rate necessarily means
that monetary policy is on track.

Fortunately there is also, as I’ve suggested elsewhere in this primer, a perfectly good
alternative to treating departures of inflation from some stable and modest level as
an indicator of excessive or deficient money. The alternative is to treat departures of
the growth rate of overall spending on final goods from some stable and modest level
as such an indicator. Unlike an increase in the rate of inflation, an increase in the
growth rate of spending is an unambiguous symptom of an increase in
the demandfor goods, while a decline in the growth rate of spending is an
unambiguous symptom of a slowing down of the progress of demand. There’s every
reason to welcome adjustments to monetary policy aimed at preventing such
fluctuations in aggregate demand; but there is no good reason for central bank
actions that render aggregate demand less stable for the sake of maintaining a stable
rate of inflation.

Policy was Too Easy, then Too Tight

With these preliminaries in mind, we’re in a position to consider the Fed’s part in the
Great Recession, and especially whether it contributed to that event by making
money too easy or too tight. The answer, I hope to convince you, is that the Great
Recession is one of those instances in which the Fed erred first in one direction, and
then in the other. Between 2003 and 2007, it poured fuel on the subprime fire by
maintaining an excessively easy monetary policy stance. Then, in 2007-8, it lurched
from an easy to a tight stance, and from there to an exceedingly tight stance, which
was only partially corrected by its later forays into Quantitative Easing.
The evidence supporting these claims consists, first of all, of the behavior of total
spending on final goods before, during, and after the crisis and, second, of a
comparison of the Fed’s policy rates (or market rates closely reflecting those policy
rates) during the same periods with corresponding estimates of the “natural” rate of
interest. An excessively loose monetary stance will be reflected in unusually rapid
spending growth and below-natural policy rates, whereas an excessively tight stance
will be reflected in slower-than-usual spending growth and above-natural policy
rates. Notice, again (for the point can’t be repeated too often), that these criteria
don’t exclude the possibility that policy may be loose (or tight) even though the
inflation rate isn’t rising (or falling), and even though the Fed’s policy rates appear
high (or low) in an absolute sense, relative to past levels.

So, how did spending behaving during the late muddle? Nominal GDP and domestic
final sales are two popular measures of total spending on output, each of which has
its champions. The measures tend to be closely correlated; for simplicity’s sake, and
also because I think it in some respects at least the better measure, I’ll look at
domestic final sales. Here is a chart showing the growth rate of such sales along with
the core PCE inflation rate from 1986 through this year; as usual the shaded vertical
lines stand for NBER recessions:

As you can see, both the recent and previous busts have involved substantial declines
in spending growth, with an outright reduction in spending this last time
around. They’ve also followed periods of above-average spending growth. In
particular, according to our spending metric, money was easy at the height of the
subprime boom, and not just tight but exceedingly tight during the bust. Since then it
has remained on the tight side, relative to the historical trend, whereas the absolute
decline in spending during the downturn actually called for some faster-than-usual
growth afterwards to restore spending to its pre-bust level, or at least within spitting
distance of it.

The coincidence of changes in the growth rate of spending and business cycles is, it
bears saying, not mathematically inevitable: although booms and busts are just other
names for upward and downward movements in the growth rate of real output (“y,”
in the textbook algebra) around its trend, the fact that these movements accompany
similar changes in spending (“Py”) reflects, not a mathematical necessity, but a more
important, causal connection. It means that, instead of merely causing prices to
increase, as a naive Quantity Theory of Money would have it (and as does tend to
happen in the long run) more rapid spending tends to result in more real activity.
That asset (as opposed to output) prices are likewise more closely correlated with
spending than with inflation is also both easy to establish and not at all surprising
once one realizes the connection between exceptionally vigorous spending and
exceptional (though ultimately transitory) profits.

Natural Rate Estimates Tell the Same Story

And interest rates? Here the relevant comparison is, again, between the Federal
Reserve’s policy rate — that is, the rate it “targeted,” and thereby kept at least roughly
under its control — and estimates of that rate’s neutral or “natural” values. A
convenient proxy for the first of these (in part because we have a consistent series for
it) is the “effective” federal fund’s rate (ffr), which is the rate banks and other
financial institutions actually charge one another for overnight loans. For the
effective ffr’s “natural” counterpart, we have estimates by Vasco Cúrdia, of the
Federal Reserve Bank of San Francisco. Because natural rate estimates are
notoriously unreliable, the chart below shows Cúrdia’s median estimates (solid black
line) as well as the upper and lower boundaries (dotted lines) of the 90% probability
range for other possibly correct estimates. Finally, because these are estimates of the
real (inflation-adjusted) natural short-term rate, I compare them to the effective
funds rate minus the core PCE inflation rate. (Using core CPI instead makes virtually
no difference):
The story told by this chart is remarkably similar to that told by the preceding one, to
wit, that booms have generally been associated with loose monetary policy, signified
here by below-natural policy rates, while busts have been associated with tight
monetary policy, or above-natural policy rates. In particular, policy appears to have
gone from relatively tight to relatively loose some time during 2004, and to have
remained loose throughout the remainder of the subprime boom. Then toward the
end of 2007, it went from too loose to too tight, where it has remained throughout
most of the period since. Just as remarkably, these conclusions hold for all but 10
percent of Cúrdia’s alternative natural rate estimates.

Having presented all this evidence, I hope I may be forgiven for daring to draw from
it two simple lessons for monetary policy, namely: (1) that a stable inflation rate is no
guarantee of overall economic stability, and (2) that such stability is best achieved
having the Fed endeavor to maintain, not a steady rate of inflation, but a steady
annual growth rate of final sales, or some similar spending measure, of something
like 5 percent.[1]

Now for some caveats. I have argued that an excessively loose Fed policy stance
contributed to the subprime boom, and that an excessively tight stance contributed
to the subsequent crash and recession. That’s “contributed to,” not “caused.” I am not
blaming the Fed for the subprime crisis. I understand very well that that crisis was
the result of many factors, some of which may have been more important than the
Fed’s actions.

I’ve also said nothing about the particular arguments and beliefs that informed the
Fed’s conduct, or about the particular actions it took or devices it employed in order
to give effect to what, in retrospect at least, appears to have been first an overly loose,
and then an overly tight, stance. For some of the details, I refer readers to this paper
written with David Beckworth and Berrak Bahadir, and to some of my previous Alt-
Mposts, including this one, this one, this one, and this one.

Finally, I’ve said nothing about how in the course of the recent crisis the Fed
abandoned, and perhaps was compelled to abandon, its traditional methods of
monetary control. How and why that happened, and the new means of monetary
control that the Fed has been employing ever since, will be the subjects of this
primer’s next instalment.

Part 9: Monetary Control,

Having considered the Fed’s pre-crisis approach to monetary control, with its
emphasis on interest-rate targets reached with the help of open-market operations,
we must now come to grips with the quite different methods it has been employing
since, and how the switch to them came about.

The story of that switch must surely rank among the great tragicomedies of monetary
history, for despite what many Fed officials have suggested, the Fed wasn’t forced to
abandon conventional interest rate targeting for reasons entirely beyond its control.
Instead, it was compelled to give-up old-fashioned rate targeting in part because of
its own, obstinate refusal to practice such targeting responsibly.

Explaining what happened isn’t easy, so brace up!

The Futility of “Unnatural” Monetary Policy

As should be evident by now, the Fed’s ability to achieve any given federal funds rate
target depends on that target’s consistency with the underlying, “natural” funds rate.
If, for example, the Fed pours fresh reserves into the banking system, by means of
open-market security purchases, to combat a tendency for the effective funds rate to
climb above its target, where that target is itself below the “natural” funds rate, its
effort will eventually fail, because the fresh reserves will sponsor increased bank
lending and investment, which will in turn increase spending on, and prices of, goods
and services. The demand for credit will likewise increase, as people must borrow
more to finance purchases of more costly goods. Rates will therefore tend to go up
after all.

The Fed might try to keep rates from increasing through further rounds of reserve
creation. But it would only end up repeating the same process: like a dog chasing its
own tail, the Fed would be engaged in a hopeless quest. And should it persist through
further rounds, or (what’s worse) accelerate its rate of reserve creation, it will only
succeed in causing an equally persistent, if not accelerating, rate of inflation. Because
persistent inflation must eventually translate into heightened inflation expectations,
interest rates, instead of being lowered, will end up becoming higher than they would
have been if the Fed hadn’t fought the increase at all. Anyone who recalls, or has
studied, what happened to U.S. interest rates during the 1970s, knows what I’m
talking about.

Any Fed attempt to enforce an excessively high rate target is also bound to be self-
defeating, for similar reasons. The artificially high target target will mean excessively
tight money, which will in turn cause lending, spending, and prices to decline, other
things equal. The slackening of demand for goods and services will have as its
counterpart a like slackening of demand for credit that will defeat the Fed’s efforts by
pushing rates down again. Unless the Fed changes its strategy, market interest rates,
instead of staying put, will end up falling even lower as deflation and expectations of
its persistence take root.

Black October
It was this last scenario that played out during the last half of 2008. Because it did so
against the background of an ongoing decline in real, natural interest rates, the result
was that the equilibrium, nominal federal funds rate was driven to zero, and perhaps
even into negative territory, compelling the Fed to completely abandon its
conventional methods of monetary control.

Although the Fed lowered its federal funds rate target aggressively between the fall of
2007, when it stood at 5.25%, and early May of 2008, once the target was down to 2
percent, it resisted making any further cuts. More importantly, it refrained from
making such net open-market purchases as it traditionally relied upon to assist in
achieving a lowered rate target by adding to the supply of bank reserves. Instead, as
part of its effort to keep the funds rate at 2 percent, the Fed auctioned-off Treasury
securities to compensate for, or “sterilize,” its emergency lending programs,
subtracting as many reserves from the banks that bought those Treasuries as its
emergency loans were supplying to other, more troubled banks.

When, starting in September 2008, the Fed ramped-up its emergency lending, it no
longer had enough Treasuries on hand to keep its balance sheet from ballooning. It
remained determined nonetheless to resist any monetary loosening. As alternative
ways to keep its emergency lending from adding to the general availability of
credit, it first arranged to have the government accumulate deposits with it, and
then started paying banks to do the same. Instead of keeping a lid on the monetary
base, in other words, the Fed tried to keep money tight by reducing the reserve-
deposit multiplier.

But if the Fed’s aim was to keep the effective funds rate from falling below 2 percent,
its efforts were in vain. As the chart below shows, as market conditions worsened, the
effective Fed funds rate (blue line) did in fact fall below the Fed’s target (red), from
which it then tended to drift further and further.
Disinflation Takes its Toll

Instead of helping to counter the tendency of market rates to decline (for longer-term
interest rates were also falling at this time), the Fed’s insistence on maintaining what,
in retrospect at least, was an excessively tight stance, reinforced that tendency, by
putting a brake on lending and spending, and by contributing thereby to falling
inflation expectations. By mid-2008 and the end of that year, according to the
University of Michigan’s survey of consumers’ year-ahead inflation expectations, the
expected rate of inflation (green line) had fallen from over 4.5 percent to just 2
percent, which meant that, even had there been no downward decline in real natural
rates during that time, nominal natural rates would have declined considerably.

Although, as the chart also shows, the Fed did finally cut its rate target again — twice
— in October, those cuts were essentially meaningless, because they weren’t
accompanied by any increase in the Fed’s open-market purchases. Instead, the only
reserves the Fed was creating continued to be those it created as a consequence of its
emergency lending. As James Hamilton observed at the time,
the [fed funds] target itself has become largely irrelevant as an instrument of
monetary policy… . There’s surely no benefit whatever to trying to achieve an even
lower value for the effective fed funds rate. On the contrary, what we would really like
to see at the moment is an increase in the short-term T-bill rate and traded fed funds
rate, the current low rates being symptomatic of a greatly depressed economy, high
risk premia, and prospect for deflation.

What we need is some near-term inflation, for which the relevant instrument is not
the fed funds rate but instead quantitative expansion of the Fed’s balance sheet. …I
would urge the Fed to be buying outstanding long-term U.S. Treasuries and short-
term foreign securities outright in unsterilized purchases, with the goal of achieving
an expansion of currency held by the public, depreciation of the currency, and
arresting the commodity price declines.

But the last thing we should expect to do us any good would be further cuts in the fed
funds target

You tell it, brother!

Nor did the Fed relax its efforts to prevent the reserves it did create from
contributing to the overall volume of bank lending, overnight or otherwise. Indeed, it
was while the Fed was making its last “symbolic” changes to its fund rate target that
the reserves being piled-up by the Treasury as part of its multiplier-shrinking
Supplementary Finance Program reached their peak of just under $560 billion.

Why the sham? Why didn’t the Fed really ease its policy stance aggressively, as it
would have had it set and seriously pursued rate targets consistent with underlying
market conditions? It’s here that tragedy meets comedy: Fed officials believed that,
instead of countering declining inflation expectations, further easing would, by
pouring more funds into the overnight market, only serve to further reduce the
effective funds rate, eventually lowering it to its zero lower bound. Once it got there,
the officials feared, the Fed could lower it no further, and so would find itself out of
depression-fighting ammunition.
The Fed’s reasoning, so far as it went, was sound enough: the initial consequence of
Fed easing would include an increase in the supply of overnight funds, and a
corresponding tendency for the effective funds rate to decline still further. The
problem was that this reasoning didn’t go nearly far enough. Fed officials failed to
consider how traditional easing — meaning not just more aggressive cuts in the fed
funds target, but cuts backed-up by more aggressive open-market purchases — would
eventually boost both actual and expected levels of spending, and how, by doing so, it
would end up buoying rates instead of suppressing them. Just as a rising tide lifts all
boats, a general increase in spending, and especially an increase in the expected
growth rate of spending, lifts demand schedules in all markets, including markets for
all sorts of loans.

The Fed was, nonetheless, determined to keep a lid on bank lending, overnight or
otherwise. When it could no longer do that by sterilizing its emergency lending, it
turned, as we’ve seen, to other measures, including paying interest on bank reserves
to discourage banks from lending them out.

From Floor to Ceiling…

Fed officials originally hoped that the interest rate on reserves, and particularly on
excess reserves, would serve as a floor on the effective federal funds, because banks
would have no reason to lend reserves overnight for less than they could earn by
holding on to them: the rate would therefore serve to keep the effective funds rate
from reaching its zero lower bound, even if it proved incapable of keeping that rate
from falling below the Fed’s target.

But that expectation also turned out to be mistaken: because some Government
Sponsored Enterprises, including Fannie Mae, Freddie Mac, and the Federal Home
Loan Banks, kept deposits at the Fed, but weren’t eligible for interest payments on
those deposits, they were happy to lend their Fed balances to banks overnight at
rates below what the banks were earning on their own balances, and the banks were
no less happy to oblige them. As the total volume of reserves continued to grow, first
in response to further Fed emergency lending, and then in consequence of several
rounds of Quantitative Easing, it also became unnecessary for banks themselves to
borrow reserves unless they could profit by doing so on the difference between the
rate they earned on deposits and the rate they paid on them. The result of all this was
that, instead of serving as a floor on the effective funds rate, the interest rate paid on
excess reserves ended up becoming a ceiling!

Moreover, the logic underpinning the Fed’s desire to put an above-zero floor on the
effective federal funds rate was tortured. To see why, suppose there had been no
GSEs with Fed account balances. In that case, no bank would have lent funds
overnight for less than the interest rate on reserves, so that the rate would indeed
have constituted a floor of sorts. But what difference would that have made? In what
sense, apart from a trivial one, would it have solved the so-called “zero lower bound”
problem? Yes, it meant that Fed easing no longer posed the risk of driving the fed
funds rate to zero, even in the short run. But it did so only by assuring that such
easing would cease to have any repercussions, save that of adding to banks’ excess
reserves, as soon as the effective funds rate ceased to exceed its new, positive floor. It
was as if, out of concern for would-be jumpers, the designers of a skyscraper decided
to construct a broad veranda around their building’s second floor, so as to prevent
the jumpers from ever hitting the ground.

In any case, the Fed quickly discovered that the interest rate on excess reserves
established an upper bound to the effective fed funds rate, while its official rate
target, which still hovered well above the effective rate, had become perfectly
meaningless. Before the year was over, it formally abandoned that single-valued
target. A brave new era of monetary control thus began.

…and from Target to Range

As the old saw goes, if life hands you a lemon, make lemonade. So far as the Fed’s
monetary control efforts were concerned, the months starting with Black October
were one great lemon harvest. The lemonade followed, sure enough, in the shape of
the Fed’s switch from setting a single-value federal funds rate target that it could no
longer strike to announcing a fed funds target “range” it couldn’t miss, with the rate
of interest on excess reserves serving as the range’s upper bound, and zero as its
lower one.
Considering how narrow the range was, the Fed’s new approach may not seem all
that radically different from traditional rate targeting. But the appearance is
deceiving: in fact, the switch marked a sea change in the Fed’s methods of monetary

How so? So long as the Fed took it seriously, the old ffr target operated as a signal to
the Fed’s open-market desk, instructing the manager on the required adjustments to
the course of the Fed’s open-market purchase. Changes to the funds target were, in
other words, a mere headliner to the main, open-market events. By December 2008,
that was no longer the case. The Fed’s new fed-funds target range, instead of giving
the open-market desk its marching orders, was one in which the effective federal
funds rate was bound to fall, no matter what the open-market desk in New York was
up to. To both alter the target range, and guarantee that the effective funds rate still
fell within it, the Fed had only to alter the interest rate it paid on bank reserves. In its
new guise, interest rate targeting, to still call it that, had become entirely divorced
from open-market operations, and hence from any actual adjustments to the supply
of currency or bank reserves.

In changing the rate of interest on excess reserves, and hence the funds rate target
range, the Fed was, to be sure, still exercising monetary control of a sort. But it was a
very different and untested sort of monetary control that worked, not by altering the
supply of base money, and especially of bank reserves, but by influencing the reserve-
deposit multiplier. Other things equal, a higher rate of interest on excess reserves
would encourage banks to maintain higher reserve ratios, and this would be a form of
monetary tightening. But just how much tightening any given increase in the rate
would inspire was hard to say. Nor did the Fed quickly put its new mechanism to the
test. Instead, it left its original fed funds target range, with its 25 basis point upper
and 0 lower bounds, unchanged until December 2015.

Quantitative Easing

As I’ve said, in replacing its traditional federal funds target with a new target range,
the Fed severed the traditional connection between funds rate targeting on the one
hand and open-market operations on the other. But that didn’t mean that it ceased to
engage in open-market operations, including long-term ones involving outright asset
purchases. On the contrary: the Fed’s abandonment of conventional interest-rate
targeting coincided with the first of several rounds of what Fed officials referred to as
“Large Scale Asset Purchases,” and what the rest of the world calls “Quantitative

Despite the torrents of ink that have been devoted to theories rationalizing or
otherwise assessing the workings of Quantitative Easing, in essence this
“unconventional” monetary policy is nothing more than a name for central bank
open-market purchases undertaken without reference to a particular fed funds rate
target, that is, purchases that are not aimed at moving the effective fed funds rate to
some specific level. Instead of picking a rate target and instructing the open-market
desk to buy as many securities as it takes to hit the target, the Fed plans to buy some
particular quantity of securities — hence “quantitative” easing.

According to the conventional reckoning, the Fed has engaged in three rounds of
quantitative easing, since known as QE1, QE2, and QE3. QE1, which ran from
December 2008 to June 2010, added $2.1 trillion, mainly in Mortgage-Backed
Securities (MBS), to the Fed’s balance sheet. For QE2, which ran from November
2010 until June 2011, the Fed bought $600-billion worth of Treasury securities. QE3,
finally, began in September 2012, and consisted of an open-ended program of
securities purchases, starting with $40 billion in MBS per month, and supplemented,
beginning in December 2012, with monthly purchases of another $45 billion in long-
term Treasury securities. In all, between December 2008 and October 2014 the Fed
purchased securities worth not quite $4 trillion, or about 4.5 times its total assets
just prior to the crisis.

That Quantitative Easing had nothing to do with interest targeting was made
especially evident by the fact that the Fed left its original federal funds target rate
range of 0 to 25 basis points unchanged throughout all three rounds of Quantitative
Easing, the last of which officially ended in October 2014. The first change in the
target range, and thus the first test of the Fed’s new approach to interest-rate
targeting, came more than a year later, in mid December 2015, when the Fed
announced a new rate range of 25 to 50 basis points. Another year passed before the
Fed hiked the range for a second time, to 50 to 75 basis points, where it remains as of
this writing.

Overnight Reverse Repos

The upper bound of the fed funds target range is, as we’ve seen, simply equal to the
interest rate the Fed pays on banks excess reserve balances; so to raise that the
Federal Reserve Board has simply to approve and announce a new rate. Raising the
lower bound above zero is another matter altogether. To do this, the Fed introduced
still another novel monetary control instrument, consisting of a revamped Overnight
Reverse Repo (ON-RRP) program it had been tinkering with since the spring of 2014.

As I explained in Part 3 of this primer, repos, or repurchase agreements, had long

been part of the Fed’s open-market operations. But prior to the crisis the Fed made
such agreements only with the small number of Primary Dealers it usually dealt with,
and for the purpose of making such temporary adjustments to the supply of bank
reserves as were needed to achieve its fed funds target. To temporarily increase
banks’ reserves, it might agree to purchase securities from one or more dealers,
under the condition that they repurchase them the next day. To temporarily
withdraw reserves from the banking system, it could instead resort to overnight
“reverse” repos, selling securities to one or more dealers, while promising to
repurchase the same securities the next day.

The post-crisis ON-RRP differed both in its scope and in its purpose. Instead of being
limited to a score or so of Primary Dealers, it involved a much larger number of
counterparties, including Fannie and Freddie, four of the nation’s eleven Federal
Home Loan Banks, and 94 money market mutual funds. For the purpose of
implementing the Fed’s new system of monetary control, however, it was the
inclusion of the GSEs that mattered. For those institutions now had a new way to
earn interest on their idle Federal Reserve deposit balances. Instead of lending them
to banks overnight, in return for some share of the interest banks were earning on
their own Fed balances, they could instead take part in the Fed’s overnight securities
sales, profiting on the difference between the Fed’s sale price and the price it agreed
to pay to repurchase the securities a day latter. So long as they could take part in the
Fed’s overnight repos, the GSEs had no reason to lend funds to banks overnight for
less than the repos’ implicit interest return. The Fed’s new repo facility thus allowed
it to set an above-zero lower bound on its federal funds rate target range, starting
with the 25 basis point lower bound it announced in December 2015, which it
doubled in December 2016.

So there you have it. Although we continue, as in the past, to identify monetary
tightening or loosening with the Fed’s determination to raise or lower “interest
rates,” since 2008 both the interest rates involved, and the Fed’s way of altering
them, have changed dramatically. Instead of endeavoring to influence a market-
determinedfederal funds rate by reducing or increasing the supply of bank reserves,
the Fed now adjusts a pair of rates determined solely by its own administrative
decrees, while conducting open-market operations without any particular reference
to these rate adjustments. Sometimes, a wise Frenchman might say, the more things
stay the same, the more they change.

Part 10: Discretion, or a

A Class Camping Trip

Forget about monetary policy for a moment or two, and imagine, instead, that you’re
back in 6th grade. You and your classmates are about to go on a camping trip,
involving some strenuous hiking, and lasting several days.

Somehow, your teacher must see to it that all of you are kept well fed. To do so, she
plans to appoint one of you Class Quartermaster. The school’s budget is limited, and
rations can get heavy, so there will only be so much food to go around — so many
hotdogs, baked beans, scrambled eggs, peanut butter sandwiches, and granola bars.
The Quartermaster’s job will be to make sure it all gets divvied-up fairly and
The catch is that your classmates are a motley bunch. Pete Smith, the football team
captain, is even taller than the teacher, and otherwise built like an old oak tree. His
body goes through fuel like a small steam locomotive. Mary Beth Johnson, on the
other hand, looks like a gust of wind might carry her off, and eats so little that she
doesn’t mind Peter grabbing her grilled cheese sandwich on tomato soup day. The
rest generally fall between those two extremes. But just how several days of hiking
will affect all their needs is anybody’s guess.

Still the food has got to be rationed somehow. And the class must decide
how before a drawing of straws determines who will be Quartermaster. Will it be
Jane “Goody Two Shoes” Miller, the teachers’ pet, or Wesley “The Weasel” Jones,
who, though never caught red-handed, is widely suspected of cheating on his tests?
Or could it — perish the thought! — turn out to be the ravenous Pete Smith himself?
Whatever the choice, the class will have to live with it once the straw poll has been

After some discussion, the class decides to vote for one of two options for rationing
the food. The first is to simply let the Quartermaster dole out food according to his or
her best judgement. That option will allow the limited provisions to be used as
efficiently as possible, with Pete Smith getting the bigger helpings he needs, and
Mary Beth getting less, assuming that less suffices. The second option is to insist that
the Quartermaster give equal rations to everyone, big, small, or in-between. That’s
bound to be inefficient, of course. Still, it can easily beat having Wesley or Peter

So, which option will you vote for? If you settle for the first, you favor a
“discretionary” rationing policy; if the second, you favor a rationing “rule” over

The Lesser of Evils

The point of the camping trip story is that neither of the two alternatives — rules or
discretion — is obviously better than the other, let alone perfect. Instead, the task you
and your classmates faced was that of selecting the lesser of two evils.
The long-standing debate between proponents of monetary rules on one hand, and
defenders of monetary discretion on the other, should likewise be understood as a
debate concerning the lesser of evils, that is, the least-bad choice among inevitably
imperfect alternatives. Only a fool would want to force monetary authorities to cling
to a rule that could only serve to rule-out better policy choices. But real-world
monetary authorities are capable of screwing-up for all sorts of reasons too. Just as
our Class Quartermaster might misjudge his or her classmates’ caloric needs, they
might misjudge an economy’s need for monetary accommodation. And just as the
Quartermaster might be inclined to favor particular students, or the teacher, over
others, so too might monetary authorities cater to special interests, including the
government, instead of doing what’s best for the public taken as a whole.

For these reasons one can’t just dismiss the case for a monetary rule by observing
how unhindered monetary authorities might improve upon it. Yet such dismissals
are encountered surprisingly often, especially (though here their presence is perhaps
a little less surprising) in the statements and writings of monetary authorities
themselves. Not long ago, for instance, Fed Chair Janet Yellen responded to the
suggestion that the FOMC follow a monetary rule by observing, with supporting
figures and charts, that “rules often do not take into account important
considerations and information.” Following one mechanically, she said, “could have
adverse consequences for the economy.” Of course Yellen’s claim is correct. But
whoever denied it? Certainly no proponent of monetary rules ever did. The argument
for a monetary rule isn’t that sticking to such a rule will never have adverse
consequences. It’s that the adverse consequences of sticking to a rule may be less
serious than those of relying upon the discretionary choices of fallible monetary

Limited Knowledge

Let’s have a closer look at some reasons why unfettered monetary authorities can’t
avoid making mistakes. The most fundamental reason is that, despite all the
statistics and other information available to them, monetary authorities generally
lack the knowledge required to choose the best possible policy stance.
In a previous Alt-M article, summarizing the limited-knowledge case for monetary
rules, CMFA Senior Fellow Gerald O’Driscoll explains that much of the information
required to determine the optimal course for monetary policy at any time “is
dispersed among the millions of actors in society.” Like any rule of thumb, a
monetary policy rule compensates for this unavoidable lack of knowledge concerning
actual and developing circumstances by leaning on past experience. Although critics
of monetary rules sometimes suggest that, unless a perfect monetary rule can be
devised, discretion is necessary, the truth, O’Driscoll observes,

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?

While O’Driscoll’s version of the limited-knowledge argument for a monetary rule

draws on Friedrich Hayek’s famous essay, “The Use of Knowledge in Society,” the
arguments of Milton Friedman — perhaps the best-known proponent of monetary
rules — are (as O’Driscoll notes elsewhere) similar in spirit. So far as Friedman was
concerned the main challenge facing monetary policymakers was that of keeping
their own actions “from being a major source of economic disturbances.”
He considered a monetary rule the best means for meeting this challenge, in part
because such a rule would make monetary policy more predictable, thereby avoiding
unsettling policy surprises and the uncertainty that the very possibility of such
surprises engenders.

Friedman believed, furthermore, that discretionary policymakers’ attempts to

improve upon a rule were likely to backfire, not only because they lacked needed
knowledge of existing circumstances, but because of the “long and variable lags” that
stood between their decisions and those decisions’ ultimate effects on spending,
inflation, and employment. A decision to ease monetary policy today, based on
information suggesting that money is or may be getting tight, could end up making
money too loose months from now, when the decision has had its greatest impact on
the money stock, because the demand for money has since subsided. The problem is
especially likely during recoveries, when central bankers are loathe to stop
administering monetary medicine until their patient displays robust health. The
opposite problem — of money becoming excessively tight in the midst of a crash — is
also common, because central banks often come to realize that their policies have
been too loose, and therefore decide to tighten, just as asset prices that had been
bolstered by their formerly loose stance are set to come crashing down.

Political Pressure

Even if they could command the necessary knowledge, monetary authorities might
fail to choose the best policies for political, bureaucratic, or psychological reasons.

Among such unwelcome influences, political pressure reigns supreme. No matter

how nominally “independent” they may be, central banks are creatures of legislation,
and as such depend on government support for whatever powers they possess. They
who give, can take away; so central bankers can never altogether avoid having to set-
aside their preferred policies for the sake of mollifying those government officials
who are in a position to punish them or their institution.

That even nominally independent central banks have often acted as if they were mere
backscratchers of fiscal authorities, especially by taking part in inflationary wartime
finance, is only the most obvious example of their tendency to set-aside sound
monetary policy for the sake of accommodating their sponsoring governments’ fiscal
needs. That tendency surprising, given that fiscal accommodation of governments
was the very raison d’être of all early central banks. The Fed is no exception to this
rule: it helped to finance every one of this country’s major post-1913 military
conflicts, though doing so meant tolerating high rates of inflation.

Nor has the Fed been immune to peacetime political pressure, especially from
Presidents. That during the 1971 Presidential election President Nixon pressured
then Fed Chairman Arthur Burns to ease policy to boost his prospects for re-election,
despite mounting inflation, is notorious, thanks mainly to the Nixon Tapes, which
leave no room for doubt concerning what took place. But Burns’ conduct, far from
being exceptional, was of a piece with the by then well-established understanding of
the Fed’s limited “independence within government” as Burns’ predecessor, William
McChesney Martin, described it. In essence, Martin was saying that, although the
Fed was independent, it could remain so only if it occasionally did whatever the
government wanted it to do!

In short, although it’s tempting to assume that an “independent” central bank is one
that’s not operating under the sway of government officials, the truth is that, so long
as central bankers enjoy discretionary powers, government officials will try to
influence their decisions, and will succeed in doing so at least to some extent. To
truly insulate monetary policy from short-run political influences, something beyond
central bank independence is needed, that can rule-out any tendency for central
bankers to pander to their own overseers — something like an inviolable monetary

Other Sources of Bad Discretionary Policy

Even when central bankers aren’t caving-in to pressure from politicians, their choices
can reflect considerations apart from those that ought to inform their policies. Being
bureaucrats, they are no less inclined than other bureaucrats to take advantage of
opportunities to increase their institutions’ budgets, even when doing so isn’t
consistent with their assigned objectives. And being like politicians themselves to
some extent, when faced with an emergency they often can’t resist acting according
to the “politician’s syllogism,” to wit:

 We must do something.

 This is something.

 Therefore, we must do this.

It’s well established, to offer an analogy, that doctors tend to over-prescribe both
drugs and tests, and also to have patients admitted to hospitals more often than is in
their patients’ own interest, because existing insurance arrangements are such that,
by doing those things (“something”) they can both earn more and reduce their risk of
being sued for malpractice. Although central bankers can’t be sued for malpractice
(alas), they have their own reasons for insisting on doing “something” whenever one
of their patients — entire economies — so much as sneezes.
The same central bankers are, on the other hand, all too inclined to refrain from
taking action to address troubles brewing in an economy that seems all-too-healthy.
Besides coming up with “independence within government,” Martin also memorably
compared a responsible central banker to a chaperone whose unenviable
responsibilities included that of having “the punch bowl removed just when the party
was really warming.” Unfortunately the quip has gained notoriety mainly as a
description of what discretionary central bankers often fail to do.

There are plenty of other reasons why central bankers might misuse their
discretionary powers, including various psychological biases to which they might be
prone. Drawing on the field of behavioral economics, Mark Calabria, the
Cato’s former Director of Financial Regulation Studies, has discussed several of these
potential biases; so has Andrew Haldane, the Bank of England’s Chief Economist.
Status-Quo bias, Myopia bias, Hubris biases, and Groupthink, are just a few of the
afflictions they consider. Just how serious these afflictions are in practice is an open
question. But the likelihood that central bankers suffer from at least some of them
supplies that much more reason for entertaining the possibility that the right sort of
monetary rule might outperform monetary discretion.

The Time-Inconsistency Twist

The case for a monetary rule, as I’ve summarized it so far, rests on the claim that
central bankers may lack either the information required, or the inclination, to
pursue the best possible monetary policies. But according to a now-famous paper by
Finn Kydland and Edward Prescott, even omniscient altruists, left to manage the
money supply as they think best, might be bested by a monetary rule. That’s so
because of what Kydland and Prescott call the “time-inconsistent” nature of optimal
monetary policy, which can prevent even well-intentioned and well-informed central
bankers from carrying-out their preferred plans.

To illustrate the problem, Kydland and Prescott imagine a case in which inflation,
deflation, and unemployment are all considered undesirable. An unexpected burst of
money creation can, however, make everyone better off by temporarily reducing
unemployment, albeit at the cost of a one-time increase in the price level.
So what’s the best policy? Suppose that a committee of benevolent central bankers
promises to keep inflation at zero, and that the public believes it. The very fact that
the public doesn’t expect any inflation will then tempt the central bankers to take
advantage of “surprise” inflation to lower unemployment, since doing so results in a
one-time gain. The temptation in question is what makes the announced policy

Were the public naive enough to go on believing the central bankers’ promises no
matter how often these were broken, the central bankers’ best strategy would be to
trick them again and again, thereby achieving a permanently lower unemployment
rate, albeit at the (perhaps worthwhile) cost of a higher inflation rate. But
hoodwinking the public, even for its own good, isn’t so simple. The public will
eventually come to anticipate the central bankers’ inflationary strategy, assuming it
isn’t smart enough to divine it from the get-go. Either way, instead of allowing them
to make everyone better off than they might by sticking to zero inflation, the
discretion the central bankers exercise ends up trapping them in a high-inflation
equilibrium, with no employment gains at all, because they find that they must either
continue to live up to the public’s positive inflation expectations, or surprise them
with a non-inflationary policy that will lead, for some time, to higher-than-necessary

Is it possible for our central bankers to avoid the trap that Kydland and Prescott
describe? It is, but to avoid it they must renounce their discretionary powers, and
instead commit the central bank to a strictly-enforced zero inflation rule. Unlike
central bankers’ mere promises, an unbreakable rule will necessarily be “time
consistent.” Consequently the public has no reason to anticipate any deviation from
it. Just as Ulysses was only able to resist the Sirens’ call by having himself lashed to
the mast, our altruistic central bankers are only able to avoid being drawn into an
inflationary equilibrium by renouncing their freedom to “fine tune” monetary policy.

Flexible and Inflexible Rules

Showing that a monetary rule might outperform discretionary central banking is one
thing; identifying a particular rule that’s likely to do so is another. Indeed, it’s fair to
say that, of countless monetary rules that have been proposed at one time or another,
the vast majority would eventually have led to some extremely undesirable outcomes,
if not to outright disaster.

Take, for example, the “k-percent” money supply growth rule that Milton Friedman
once favored — a rule according to which some simple monetary aggregate
(Friedman tended to prefer M2) was set to grow at a modest but unchanging rate.
Such a rule could work reasonably well only so long as there were no major changes
in people’s real demand for the money assets in question. If that demand increased at
a steady pace of 5 percent each year, a 5 percent growth rule would just meet the
public’s needs, keeping spending stable. But in practice the rate at which the demand
for any fixed set of monetary assets — for M1, or M2, or M3, or whatever — grows is
likely to change over time, and perhaps dramatically — as financial innovations and
other changes alter different asset’s relative attractiveness. Speaking generally, Janet
Yellen was entirely correct in observing some months ago that “sensible
implementation of policy rules requires adjustments to take such changes into
account, as a failure to do so would result in poor monetary policy decisions and poor
economic outcomes.”

But, valid as it is, Yellen’s observation doesn’t mean that we must, after all, fall back
on discretion as our only hope for getting monetary policy (almost) right. Instead, it’s
possible to design monetary rules that themselves take account of changing
conditions. The most well-known example of such a “flexible” monetary rule is the
so-called “Taylor Rule,” named after Stanford Economist John B. Taylor, in which
the central bank sets a federal funds rate target that is constantly adjusted in
response to deviations of inflation and output from their desired and “potential”
levels, respectively. Taylor himself has argued that, had it stuck to his rule (as it did,
more-or-less, from the mid-1980s until 2000 or so), the Fed might have avoided a
good part of the calamitous boom-bust cycle of 2002-2009. But the more important
and general point is one that Athanasios Orphanides and John Williams emphasized
at the start of the crisis, to wit: that it is after all “possible to design a simple policy
rule that can deliver reasonably good macroeconomic performance even in an
environment of considerable uncertainty regarding expectations formation and
natural rate uncertainty.”
Furthermore, having a monetary rule, however rigid or flexible the rule may be,
doesn’t necessarily mean having one written in stone: provisions can be made for a
rule’s periodic reconsideration and revision, according to a regular schedule, or in
response to designated circumstances, and following agreed-upon procedures. One
can, in other words, combine a monetary rule in the ordinary sense of the term with a
“meta” monetary rule for revising the rule over time. In short, to think clearly about
the relative merits of rules and discretion, its important to realize that there are
many weigh stations between the extremes of an inflexible and unalterable rule on
one hand and unalloyed monetary discretion on the other.

A Stable Spending Rule

If discovering a reliable monetary rule has been harder in practice than it appears to
be in theory, that’s largely because of confusion regarding the appropriate,
ultimate objectives of monetary policy. Keynesians have, on the one hand, tended to
insist on a “full employment” objective, while (old-school) monetarists have, on the
other, insisted on the need for low (if not zero) and steady inflation. Some monetary
rules, like Taylor’s, attempt to strike a compromise between these positions.

If you ask me, such compromises, for all their practical merits, still have economists
barking up the wrong tree. The belief that inflation and deflation are necessarily bad,
and the related belief that a constant (if not necessarily zero) inflation rate is better
than a varying rate, are both widely subscribed to, even among professional
economists. Those beliefs are nevertheless mistaken: as I’ve suggested in previous
chapters of this primer, and as I’ve argued at some length elsewhere, there are good
reasons, and plenty of them, for letting the inflation rate vary along with an
economy’s productivity, so that in more-productive times prices rise less quickly, and
perhaps even decline, than in less productive ones.

The goals of “full employment” and its close counterparts, including “potential”
output, also leave much to be desired as guides to sound monetary policy, in part
because they’re nebulous, but also because theory tells us that even if they weren’t so,
attending to them alone wouldn’t suffice to “pin down” monetary policy in the sense
of establishing a uniquely desirable path for either the money supply itself or the
price level. Instead, many such paths might be equally capable of keeping
employment and output close to their “full” or “potential” levels.

So, what should monetary policy aim for? I’ve said it before, and I’ll say it again: it’s
aim should be the stable growth of total spending in the economy. Let spending grow
at a steady rate, roughly equal to the rate of growth of the labor force, and the
inflation rate will vary only as productivity varies, which is what it ought to do. At the
same time, employment, though perhaps less than “full” according to some other
criteria, will not be so on account of any lack of spending, and will therefore not be so
in any way warranting further doses of monetary medicine.

While devising a monetary rule that strikes a correct balance between the supposed
“wrongs” of price level movements on one hand and less than “full” employment on
the other may ultimately prove as intractable a problem as squaring the circle,
devising one that’s consistent with preserving a stable level of spending is,
comparatively speaking, child’s play. The challenge consists of getting both
Keynesians and Monetarists, as well as others, to agree that stability of spending,
rather than any particular values of inflation or unemployment, ought to be the
ultimate objective of monetary policy.

Part 11: Last-Resort Lending

So far, throughout this primer, I’ve claimed that central banks have one overarching
task to perform: their job, I said, is to “regulate the overall availability of liquid
assets, and through it the general course of spending, prices, and employment, in the
economies they oversee.” I’ve also shown how, prior to the recent crisis, the Fed
pursued this task, sometimes competently, and sometimes ineptly, by means of
“open-market operations,” meaning routine purchases (and occasional sales) of
short-term Treasury securities.

But this picture isn’t complete, because it says nothing about central banks’ role as
“lenders of last resort.” It overlooks, in other words, the part they play as institutions
to which particular private-market firms, and banks especially, can turn for support
when they find themselves short of cash, and can’t borrow it from private sources.

For many, the “lender of last resort” role of central banks is an indispensable
complement to their task of regulating the overall course of spending. Unless central
banks play that distinct role, it is said, financial panics will occasionally play havoc
with nations’ monetary systems.

Eventually I plan to challenge this way of thinking. But first we must consider the
reasoning behind it.

h4>The Conventional Theory of Panics

The conventional view rests on the belief that fractional-reserve banking systems are
inherently fragile. That’s so, the argument goes, because, unless it’s squelched at
once, disquiet about any one bank or small group of banks will spread rapidly and
indiscriminately to others. The tendency is only natural, since most people don’t
know exactly what their banks have been up to. For that reason, upon hearing that
any bank is in trouble, people have reason to fear that their own banks may also be in
hot water.

Because it’s better to be safe than sorry, worried depositors will try to get their
money back, and — since banks have only limited cash reserves — the sooner the
better. So fear of bank failures leads to widespread bank runs. Unless besieged banks
can borrow enough cash to cover panicking customers’ withdrawals, the runs will
ruin them. Yet the more widespread the panic, the harder it is for affected banks to
secure private-market credit; if it spreads widely enough, the whole banking system
can end-up going belly-up.

An alert lender of last resort can avoid that catastrophic outcome, while also keeping
sound banks afloat, by throwing a lifeline, consisting of a standing offer of emergency
support, to any solvent bank that’s threatened by a run. Ideally, the standing offer
alone should suffice to bolster depositors’ confidence, so that in practice there
needn’t be all that much actual emergency central bank lending after all.[1]

It’s a Wonderful Theory

A striking feature of this common understanding is its depiction of a gossamer-like
banking system, so frail that the merest whiff of trouble is enough to bring it crashing
down. At very least, the depiction suggests that any banking system lacking a
trustworthy lender of last resort, or its equivalent, is bound to be periodically ravaged
by financial panics.

And therein lies a problem. For however much it may appeal to one’s intuition, the
conventional theory of banking panics is simply not consistent with the historical
record. Among other things, that record shows

 that banks seldom fail simply because panicking depositors rush to get their
money out. Instead, runs are almost always “information based,” with depositors
rushing to get money out of banks that got themselves in hot water beforehand;

 that individual bank runs and failures generally aren’t “contagious.” Although
trouble at one bank can lead to runs on banks that are affiliated with the first
bank, or ones that are known to be among that bank’s important creditors, panic
seldom if ever spreads to other banks that would otherwise be unscathed by the
first bank’s failure;

 that, while isolated bank failures, including failures of important banks, have
occurred in all historical banking systems, system-wide banking crises have
generally been relatively rare events, though they have been much more common
in some banking systems than in others;

 that the lack of a central bank or other lender of last resort is not a good predictor
of whether a banking system will be especially crisis-prone; and

 that the lack of heavy-handed banking regulations is also a poor predictor of the
frequency of banking crises. Instead, some heavily-regulated banking systems
have endured crisis after crisis, while some of the least regulated systems have
been famously crisis-free.

That the conventional theory of banking panics is not easily reconciled with historical
experience may help to explain why its proponents often illustrate it, as Ben
Bernanke did in the first of a series of lectures he gave on the subprime crisis, not by
instancing some real-world bank run, but by referring to the run on the Bailey Bros.
Building & Loan in “It’s a Wonderful Life”! In the movie, although George Bailey’s
bank is fundamentally sound, it suffers a run when word gets out that Bailey’s
absent-minded Uncle Billy mislaid $8000 of the otherwise solvent bank’s cash.

The Richmond Fed’s Tim Sablik likewise treats Frank Capra’s Christmas-movie bank
run as exhibit A in his account of what transpired during the 2007-8 financial crisis:

George Bailey is en route to his honeymoon when he sees a crowd gathered outside
his family business …. He finds that the people are depositors looking to pull their
money out because they fear that the Building and Loan might fail before they get the
chance. His bank is in the midst of a run.

Bailey tries, unsuccessfully, to explain to the members of the crowd that their
deposits aren’t all sitting in a vault at the bank — they have been loaned out to other
individuals and businesses in town. If they are just patient, they will get their money
back in time. In financial terms, he’s telling them that the Building and Loan is
solvent but temporarily illiquid. The crowd is not convinced, however, and Bailey
ends up using the money he had saved for his honeymoon to supplement the
Building and Loan’s cash holdings and meet depositor demand…

As the movie hints at, the liquidity risk that banks face arises, at least to some extent,
from the services they provide. At their core, banks serve as intermediaries between
savers and borrowers. Banks take on short-maturity, liquid liabilities like deposits to
make loans, which have a longer maturity and are less liquid. This maturity and
liquidity transformation allows banks to take advantage of the interest rate spread
between their short-term liabilities and their long-term assets to earn a profit. But it
means banks cannot quickly convert their assets into something liquid like cash to
meet a sudden increase in demand on their liability side. Banks typically hold some
cash in reserve in order to meet small fluctuations in demand, but not enough to
fulfill all obligations at once.

There you have it: banks by their very nature are vulnerable to runs. Hence
banking systems are inherently vulnerable to crises. Hence crises like that of 2007-8.
Hence the need for a lender of last resort (or something equivalent, like government
deposit insurance) to keep perfectly sound banks from being gutted by panic-stricken

But is that really all there is too it? Were the runs of 2007-8 triggered by nothing
more than some minor banking peccadilloes, if not by mere unfounded fears? Not by
any stretch! For starters, the most destructive runs that took place during the 2007-8
crisis were runs, not on ordinary (commercial) banks, or thrifts (like George Bailey’s
outfit), but on non-bank financial intermediaries, a.k.a. “shadow banks,” including
big investment banks such as Bear Stearns and Lehman Brothers, and money-market
mutual funds, such as Reserve Primary Fund.

Far from having been random or inspired by shear panic, all of these runs were
clearly information based: Bear and Lehman were both highly leveraged and heavily
exposed to subprime mortgage losses when the market for such mortgages collapsed,
while Reserve Primary — the money market fund that suffered most in the crisis —
was heavily invested in Lehman Brother’s commercial paper.

As for genuine bank runs, there were just five of them in all, and every one was
triggered by well-founded news that the banks involved —
Countrywide, IndyMac, Washington Mutual, Wachovia, and Citigroup — had
suffered heavy losses in connection with risky mortgage lending. Indeed, with the
possible exception of Wachovia, the banks were almost certainly insolvent when the
runs on them began. To suggest that these banks were as innocent of improprieties,
and as little deserving of failure, as the fictitious Bailey Bros. Building and Loan, is
worse than misleading: it’s grotesque.

Not having been random, the runs of 2007-8 also weren’t contagious. The short-term
funds siphoned from failing investment banks and money market funds went
elsewhere. Relatively safe “Treasuries only” money market funds, for example,
gained at riskier funds’ expense. The same thing happened in banking: for every
bank that was perceived to be in trouble, many others were understood to be sound.
Instead of being removed, as paper currency, from the banking system, deposits
migrated from weaker to stronger banks, such as JP Morgan, Wells Fargo, and
BB&T. While a few bad apples tried to fend-off runs, in part by seeking public
support, other banks struggled to cope with unexpected cash inflows.

Yet because the runs were front-page news, and the corresponding redeposits
weren’t, it was easy for many to believe that a general panic had taken hold. That
sound and unsound banks alike were forced to accept TARP bailout money only
reinforced this wrong impression. Evidently we have traveled far from the quaint
hamlet of Bedford Falls, where George Bailey’s bank nearly went belly-up.

Nor were we ever really there. During the Great Depression, for example, most of the
banks that failed, including those that faced runs, were rural banks that suffered
heavy losses as fallen crop prices and land values caused farmers to default on their
loans. Few if any unquestionably solvent banks failed, and bank run contagions, with
panic spreading from unsound to sound banks, were far less common than is often
supposed. Even the widespread cash withdrawals of February and early March, 1933,
which led FDR to proclaim a national bank holiday, weren’t proof of any general loss
of confidence in banks. Instead, they reflected growing fears that FDR planned to
devalue the dollar upon taking office. Those fears in turn led bank depositors to cash
in their deposits for Federal Reserve notes, in order to convert those notes into gold.
What looked like distrust of commercial banks’ ability to keep their promises was
really distrust of the U.S. government’s ability to keep its promises.

Regulate, Have Crisis, Repeat

If bank runs are mainly a threat to under-diversified or badly-managed banks, it’s no

less the case that banking crises, in which relatively large numbers of banks all find
themselves in hot water at the same time, are mainly a problem in badly-regulated
banking systems. To find proof of this claim, one only has to compare the records,
both recent and historical, of different banking systems. Do that and you’ll see that,
while some systems have been especially vulnerable to crises, others have been
relatively crisis free. Any theory of banking crisis that can’t account for these varying
experiences is one that ought not to be trusted.

But just how can one account for the different experiences? The conventional theory
of panics implies that the more crisis-prone systems must have lacked a lender of last
resort or deposit insurance (which also serves to discourage runs) or both. It may
also be tempting to assume that they lacked substantial restrictions upon the
activities banks could engage in, the interest rates they could charge and offer, the
places where they could do business, and other aspects of the banking business.

Wrong; and wrong again. Central banks, deposit insurance, and relatively heavy-
handed prudential regulations aren’t the things that distinguished history’s relatively
robust banking systems from their crisis-prone counterparts. On the
contrary: central bank misconduct, the perverse incentives created by both explicit
and implicit deposit guarantees, and misguided restrictions on banking activities
including barriers to branch banking, portfolio restrictions, and mandated business
structures,have been among the more important causes of banking-system
instability. Some of the most famously stable banking systems of the past, on the
other hand, lacked either central banks or deposit insurance, and placed relatively
few limits on what banks were allowed to do.

Northern Exposures

It would take a treatise to review the whole, gruesome history of financial crises for
the sake of revealing how unnecessary and ill-considered, if not corrupt, regulations
of all sorts contributed to every one of them.[2] For our little primer we must instead
settle for four especially revealing case studies: those of the U.S. and Canada on the
one hand and of England and Scotland on the other. The banking systems of
Scotland between 1772 and 1845 and Canada from 1870 to 1914 and again from
1919 until 1935 were remarkably free of both crises and government interference. In
comparison, the neighboring banking systems of England and the United States were
both more heavily regulated and more frequently stricken by crises.

To first return again to the Great Depression, in the U.S. between 1930 and 1933,
some 9000 mostly rural banks failed. That impressive record of failure could never
have occurred had it not been for laws that prevented almost all U.S. banks from
opening branch offices, either in their home states or elsewhere. The result was a
tremendous number of mostly tiny and severely under-diversified banks.
Canada’s banks, in contrast, were allowed to establish nationwide branch networks.
Consequently, not a single Canadian bank failed during the 1930s, despite the fact
that Canada had no central bank until 1935, and no deposit insurance until 1967, and
also despite the fact that Canada’s depression was especially severe. The few U.S.
states that allowed branch banking also had significantly lower bank failure rates.

Comparing the performance of the Canadian and U.S. banking systems between
1870 and 1914 tells a similar story. Although the U.S. didn’t yet have a central bank,
and so was at least free of that particular source of financial instability (yes, you read
that last clause correctly), thanks to other kinds of government intervention in
banking, and especially to barriers to branch banking and to banks’ ability to issue
circulating notes put in place during the Civil War, the U.S. system was shaken by
one financial crisis after another. Yet during the same period Canada, which also had
no central bank, but which didn’t subject its commercial banks to such
restrictions, avoided serious banking crises.

Although naturally different in its details, the Scotland-vs.-England story is

remarkably similar in its broadest brushstrokes. Scotland’s banks, like Canada’s,
were generally left alone, while in England privileges were heaped upon the Bank of
England, leaving other banks enfeebled and at its mercy. In particular, between 1709
and 1826, the so-called “six partner rule” allowed only small partnerships to issue
banknotes, effectively granting the Bank of England a monopoly of public or “joint
stock” banking. In an 1826 Parliamentary speech Robert Jenkinson, the 2nd Lord
Liverpool, described the system as one having “not one recommendation to stand
on.” It was, he continued, a system

of the fullest liberty as to what was rotten and bad; but of the most complete
restriction, as to all that was good. By it, a cobbler or a cheesemonger, without any
proof of his ability to meet them, might issue his notes, unrestricted by any check
whatever; while, on the other hand, more than six persons, however respectable,
were not permitted to become partners in a bank, with whose notes the whole
business of a country might be transacted. Altogether, this system was one so absurd,
both in theory and practice, that it would not appear to deserve the slightest support,
if it was attentively considered, even for a single moment.
Liverpool made these remarks in the wake of the financial panic that struck Great
Britain in 1825, putting roughly 10 percent of the note-issuing cobblers and
cheesemongers of England and Wales out of business. Yet in Scotland, where the six-
partner rule didn’t apply, that same panic caused nary a ripple.

Although Scotland and Canada offer the most well-known instances of relatively
unregulated and stable banking systems, other free banking experiences also lend at
least some support to the thesis that those governments that governed their banks
least often governed them pretty darn well.

Bagehot Bowdlerized

The aforementioned Panic of 1825 was one of the first instances, if not the first
instance, in which the Bank of England served as a “lender of last resort,” albeit too
late to avert the crisis. It was that intervention by the Bank, as well as the lending it
did during the Overend-Gurney crisis of 1866, that inspired Walter Bagehot to
formulate, in his 1873 book Lombard Street, his now-famous “classical” rule of last-
resort lending, to wit: that when faced with a crisis, the Bank of England should lend
freely, while taking care to charge a relatively high rate for its loans, and to secure
them by pledging “good banking securities.”

Nowadays central bankers like to credit Bagehot for the modern understanding that
every nation, or perhaps every group of nations, must have a central bank that serves
as a lender of last resort to rescue it from crises. Were that actually Bagehot’s view,
he might be grateful for the recognition if only he could hear it. In fact he’s more
likely to be spinning in his grave.

How come? Because far from having been a fan of the Bank of England, or (by
implication) of central banks more generally, Bagehot, like Lord Liverpool,
considered the Bank of England’s monopoly privileges the fundamental cause of
British financial instability. Contrasting England’s “one reserve” system, which was a
byproduct of the Bank of England’s privileged status, with a “natural,” “many-
reserve” system, like the Scottish system (especially before the Bank Act of 1845
thoughtlessly placed English-style limits on Scottish banks’ freedom to issue notes),
Bagehot unequivocally preferred the latter. That is, he preferred a system in which no
bank was so exalted as to be capable of serving as a lender of last resort, because he
was quite certain that such a system had no need for a lender of last resort!

Why, then, did Bagehot bother to offer his famous formula for last-resort lending?
Simply: because he saw no hope, in 1873, of having the Bank of England stripped of
its destructive privileges. “I know it will be said, ” he wrote in the concluding
passages of Lombard Street,

that in this work I have pointed out a deep malady, and only suggested a superficial
remedy. I have tediously insisted that the natural system of banking is that of many
banks keeping their own cash reserve, with the penalty of failure before them if they
neglect it. I have shown that our system is that of a single bank keeping the whole
reserve under no effectual penalty of failure. And yet I propose to retain that system,
and only attempt to mend and palliate it.

I can only reply that I propose to retain this system because I am quite sure that it is
of no manner of use proposing to alter it… . You might as well, or better, try to alter
the English monarchy and substitute a republic.

Perhaps today’s Bagehot-loving central bankers didn’t read those last pages. Or
perhaps they read them, but preferred to forget them.

The Flexible Open-Market Alternative

If Great Britain was stuck with the Bank of England by 1873, as Bagehot believed,
then we are no less stuck with the Fed, at least for the foreseable future. And unless
we can tame it properly, we may also be stuck with its “unnatural” capacity to
destabilize the U.S. financial system, in part by being all-too-willing to rescue banks
and other financial firms that have behaved recklessly, even to the point of becoming

Consequently, getting the Fed to follow Bagehot’s classical last-resort lending rules
may, for the time being, be our best hope for securing financial stability. But doing
that is a lot easier said than done. For despite all the lip-service central bankers pay
to Bagehot’s rules, they tend to honor those rules more in the breach than in the
observance. One need only consider the relatively recent history of the Fed’s last-
resort lending operations, especially before 2003 (when it finally began setting a
“penalty” discount rate) and during the subprime crisis, to uncover one flagrant
violation Bagehot’s basic principles after another.

There is, I believe, a better way to make the Fed abide by Bagehot’s rules for last-
resort lending. Paradoxically, it would do away altogether with conventional central
bank lending to troubled banks, and also with the conventional distinction between a
central banks’ monetary policy operations and its emergency lending. Instead, it
would make emergency lending an incidental and automatic extension of the Fed’s
routine monetary policy operations, and specifically of what I call “flexible” open-
market operations, or “Flexible OMOs,” for short.

The basic idea is simple. Under the Fed’s conventional pre-crisis set-up, only a score
or so of so-called “primary dealers” took direct part in its routine open-market
operations aimed at regulating the total supply of money and credit in the economy.
Also, those operations were — again, traditionally — limited to purchases and sales of
short-term U.S. Treasury securities. Consequently, access to the Fed’s routine
liquidity auctions was very strictly limited. A bank in need of last-resort liquidity,
that was not a primary dealer, or even a primary dealer lacking short-term Treasury
securities, would have to go elsewhere, meaning either to some private-market
lender or to the Fed’s discount window, where to borrow from the latter was to risk
being “stigmatized” as a bank that might well be in trouble.

“Flexible” open-market operations would instead allow any bank that might qualify
for a Fed discount-window loan to take part, along with non-bank primary dealers, in
its open-market credit auctions. It would also allow the Fed’s expanded set of
counterparties to bid for credit at those auctions using, not just Treasury securities,
but any of the marketable securities that presently qualify as collateral for discount-
window loans, with the same margins or “haircuts” applied to relatively risky
collateral as would be applied were they used as collateral for discount-window
loans. A “product-mix” auction, such as that the Bank of England has been using in
its “Indexed Long-Term Repo Operations,” would allow multiple bids made using
different kinds of securities to be efficiently dealt with, so that credit gets to the
parties willing to pay the most for it.
So, instead of having a discount-window for emergency loans, not to mention
various ad-hoc lending programs, in addition to routine liquidity auctions for the
conduct of “ordinary” monetary policy, the Fed would supply liquid funds through
routine auctions only, while making the auctions sufficiently “flexible”to allow any
illiquid financial institute with “good banking securities” to successfully bid for such
funds. Thanks to this set up, the Fed would no longer have to concern itself with
emergency lending as such. Its job would simply be to get the total amount of
liquidity right, while leaving it to the competitive auction process to put that liquidity
where it commands the highest value. In other words, it really would have no other
duty save that of regulating “the overall availability of liquid assets, and through it
the general course of spending, prices, and employment.”


[1]Deposit insurance can serve a function similar to that of having an alert lender of
last resort. Most banking systems today rely on a combination of insurance and last-
resort lending.

Diamond and Dybig’s famous 1983 model — one of the most influential works among
modern economic writings — is in essence a clever, formal presentation of the
conventional wisdom, in which deposit insurance is treated as a solution to the
problem of banking panics. For critical appraisals of Diamond and Dybvig see Kevin
Dowd, “Models of Banking Instability,” and chapter 6 of Lawrence White’s The
Theory of Monetary Institutions.

[2]Although that badly-needed treatise has yet to be written, considerable chunks of

the relevant record are covered in Charles W. Calomiris and Stephen Haber’s 2014
excellent work, Fragile by Design: The Political Origins of Banking Crises and
Scarce Credit. I offer a much briefer survey of relevant evidence, including evidence
of the harmful consequences of governments’ involvement in the regulation and
monopolization of paper currency, in chapter 3 of Money: Free and Unfree. I express
my (mostly minor) differences with Calomiris and Haber here.
Part 12: Monetary
This primer is supposed to introduce readers to the workings of the present U.S.
monetary system. So it’s only natural that it should take established monetary
arrangements for granted, including an official, “fiat” dollar currency managed by the
Federal Reserve System.

And while I haven’t hesitated to point out shortcomings in the Fed’s management of
the dollar, and have even dared to suggest some ways in which that management
might be improved upon, I haven’t questioned the fact that, whether it does so
competently or not, the Fed is indeed ultimately “in charge” of the U.S. monetary
system. That is, I’ve assumed, that the U.S. dollar is the only important domestic
currency unit, and that the total quantity of dollar-denominated exchange media, the
behavior of the general level of prices, U.S. dollar exchange rates, and the periodic
flow of domestic dollar-denominated payments, remain under the discretionary
control of the FOMC.

Monetary Policy, Broadly Understood

But while a monetary policy primer must generally deal with existing monetary
arrangements, it doesn’t follow that it should overlook others altogether. “Policy,”
according to Webster, is “a high-level overall plan embracing the general goals and
acceptable procedures especially of a governmental body.” And though, within the set
of possible plans, the most readily-implemented ones take existing institutional
arrangements for granted, there are always other, more radical options that involve
either replacing established arrangements or confronting them with rival ones with
which they must compete.

Radical policy alternatives are, inevitably, controversial ones as well; so a primer is

hardly the place for any detailed consideration, let alone a defense, of any of them.
Instead, we must settle for a quick glance at several especially prominent or
intriguing possibilities, all of which involve moving away from the present,
discretionary system and towards a more-or-less “automatic” alternative.

Back to Gold?

Among various proposals for reforming the present U.S. dollar, none are more
controversial than those for re-instating an official gold standard, meaning an
arrangements in which official paper U.S. dollars are once again made fully
convertible into a fixed quantity of gold, as they had been until 1933. The proposal is
controversial in no small part because, so far as many economists are concerned, the
historic gold standard was itself a disastrous failure, the passing of which calls, not
for tears of regret, but for cries of “good riddance!”

How to account, then, for the gold standard’s enduring appeal, especially among
conservatives and libertarians? Part of the answer is that, whatever its shortcomings,
a gold standard has the indisputable merit of serving to automatically stabilize the
long-run purchasing power of any money tied to it. That property, far from being
mysterious, stems from the simple fact that under a gold standard the profitability of
gold prospecting and mining increases, other things equal, as prices generally fall,
and declines as prices generally rise. Consequently although the general level of
prices can fluctuate, it tends to revert over time to a fixed mean.

Another part of the answer is that the gold standard’s critics often exaggerate its
shortcomings, especially relative to those of actual (as opposed to idealized) fiat
standards. On a blackboard, of course, a fiat standard can readily be shown to
outperform a gold standard in the long-run perhaps, but certainly in the short-run.
But that’s true only because, on a blackboard, a fiat standard can be made to do
whatever the chalk-wielder likes. In practice, on the other hand, fiat standards can
and often do behave very badly indeed. What self-respecting economist, right now,
would relish the opportunity to lecture a roomful of Venezuelans on the theoretical
advantages of irredeemable paper money?

Moreover, while the international gold “exchange” standard that was cobbled
together after World War I was a disaster waiting to happen, the prewar “classical”
gold standard’s commerce-invigorating combination of generally fixed exchange
rates and reasonable (if less than perfect) price-level stability has never been
matched since.

But the most important reason why gold still commands such a following is, if you
ask me, more prosaic: it’s simply that, for those who distrust bureaucratic control,
whether of money alone or of economic activity more generally, the gold standard is
simply the most salient alternative. Gold was the last, the most universally embraced,
and the most successful of all commodity standards, as well as the one that coincided
with a period of remarkable economic progress concerning which even John
Maynard Keynes — that arch critic of the “barbarous” gold standard — waxed

What an extraordinary episode in the economic progress of man that age was which
came to an end in August, 1914! The greater part of the population, it is true, worked
hard and lived at a low standard of comfort… But escape was possible, for any man of
capacity or character at all exceeding the average, into the middle and upper classes, for
whom life offered, at a low cost and with the least trouble, conveniences, comforts, and
amenities beyond the compass of the richest and most powerful monarchs of other ages.
The inhabitant of London could order by telephone, sipping his morning tea in bed, the
various products of the whole earth, in such quantity as he might see fit, and reasonably
expect their early delivery upon his doorstep; he could at the same moment and by the
same means adventure his wealth in the natural resources and new enterprises of any
quarter of the world, and share, without exertion or even trouble, in their prospective
fruits and advantages… He could secure forthwith, if he wished it, cheap and comfortable
means of transit to any country or climate without passport or other formality, could
dispatch his servant to the neighboring office of a bank or such supply of the precious
metals as might seem convenient, and could then proceed abroad to foreign quarters,
without knowledge of their religion, language, or customs, bearing coined wealth upon
his person, and would consider himself greatly aggrieved and much surprised at the least
interference. But, most important of all, he regarded this state of affairs as normal,
certain, and permanent, except in the direction of further improvement, and any
deviation from it as aberrant, scandalous, and avoidable.

Nostalgia versus Expediency

But however much one may regret the passing of the classical gold standard, it
doesn’t follow that we can do no better than to try and restore it. “In commerce,” the
great William Stanley Jevons famously said, “bygones are forever bygones”; and what
Jevons says of commerce goes for money as well. Gold may have served as a
relatively successful monetary standard in the past. But it doesn’t follow that there’s
anything sacrosanct about gold today, or that a gold standard is still the best of all
possible options for fundamental monetary reform.

On the contrary: an official attempt to once again make paper dollars convertible into
gold today would be a step no less arbitrary or “constructivist” (in F.A. Hayek’s sense
of the term), than an attempt to make them convertible into silver, palladium, or
Japanese yen. To be sure, gold has a nostalgic appeal lacking in the rest. But allowing
that consideration to be decisive would be like deciding to replace an aging fleet of jet
aircraft, not with newer jets, but with as many propeller-driven biplanes. Don’t get
me wrong: I’m not saying that gold convertibility couldn’t possibly be a good idea.
I’m just saying that it wouldn’t qualify as a great idea simply by virtue of its historical
preeminence. The only real test ought to be whether a revived gold standard would
deliver better results than any equally practical (and not merely theoretical)

Finally, even if no new system could beat a restored classical gold standard, it doesn’t
follow that such a restoration is possible. If getting one nation alone to return to gold
is bound to be extremely difficult, getting a large number of advanced nations to do
so simultaneously, so as to have a truly “classical” set-up like the one that existed
before 1914, would be a truly Herculean challenge.

Furthermore, official gold standards can survive only if citizens trust their
governments and central banks to generally keep promises to trade gold for paper.
Such trust, having been dealt a severe blow by World War I, died a slow and painful
death in the decades that followed it. A new gold standard commitment by the Fed,
or by any other central bank, today, is bound to run afoul of this reality, especially by
becoming the object of attacks by skeptical speculators. If history is any guide, sooner
or later those attacks would force even the most well-meaning central bankers to
break their gold-standard promises all over again, though perhaps not on time to
avoid leaving their economies in shambles.

Self-Regulating Fiat Money

If trying to revive the classical gold standard, or something close to it, is like trying to
piece Humpty-Dumpty back together, that doesn’t mean that we have no choice but
to settle for a paper dollar managed by a committee of fallible (and occasionally
fumbling) bureaucrats. In particular, the difficulties inherent in trying to tame the
dollar by once again making it convertible into a scarce commodity can be avoided by
relying instead on a quantity-based monetary rule. Because such a rule provides for
automatic adjustments in the quantity of standard money without allowing people to
convert that money into something else, it can’t fall victim to a speculative attack,
and is that much more likely to endure.

As we’ve already reviewed some general arguments in favor of having a monetary

rule, there’s no need to review those arguments again here. Instead, I’d like to
consider a radical variation on the old theme, consisting of a quantity rule that’s
enforced, not by a committee, either voluntarily or with the help of sanctions
imposed whenever the rule is breached, but by means of some sort of automatic, fail-
safe mechanism.

The general idea is one Milton Friedman entertained for many years. “We don’t need
the Fed,” he said (in one of many similar interviews he gave in the 1990s). “I have, for
many years, been in favor of replacing the Fed with a computer” programmed to
“print out a specified number of paper dollars…month after month, week after week,
year after year.”

Although the constant (“k-percent”) money growth rate rule that Friedman once
favored has itself fallen out of fashion, his idea for a computer-driven money supply
couldn’t be more à la mode. Computers are, for one thing, capable of doing a lot
more than they were back in the 90s. And even in the 90s they might have been
capable of managing the money supply so as to maintain, not a stable growth rate for
B or M1 or M2 or some other monetary aggregate, but a stable level of
nominal spending. The smooth growth of spending would in turn supply, for
reasons we’ve considered previously, robust protection against severe economic

Indeed, while it’s easy to imagine a circumstance in which a constant money growth
rule could turn out to be a recipe for macroeconomic chaos, it’s darn difficult to
imagine a situation in which there’d be much to gain, and little to lose, by sacrificing
a stable and customary overall growth rate of spending growth for some other
monetary policy objective. A bout of exceptionally rapid spending? A fine way to
boost asset prices, no doubt, until one considers the inevitable denouement! Slower
spending than usual? Tell it to your average businessman, or employee! Those
(mainly Fed insiders) who rail against what they like to characterize as “inflexible”
rules (as if a “rule” could be anything but inflexible!) forget — or pretend not to know
— that while some rules would indeed prevent the Fed from having the flexibility to
do the right thing, others would mainly serve to deny it the flexibility to
do wrongthings. A stable spending rule, including one that’s “rigidly” enforced by a
computer, though it would rule out many bad monetary policy options, would also
“rule in” the good ones.

NGDP Futures

Scott Sumner has come up with an alternative plan for targeting nominal spending,
which relies not on a computer but on trading in futures to keep spending on target.
The plan, called “NGDP Futures Targeting ,” starts with the Fed settling on an NGDP
growth-rate target — say, 4 percent — and then offering to enter into NGDP futures
contracts, with payoffs depending on the future level of NGDP, to anyone who
expects it to either exceed or fall short of target. Traders who expect NGDP to come
in above target will go long on the futures, while those expecting it to fall short will go

How, then, does the Fed manage to actually achieve its target? The answer becomes
evident when one considers the link between the futures contracts it enters into for
its monetary policy operations. When the Fed sells futures to investors who are
betting on excessive NGDP growth, it is withdrawing base dollars from the economy,
just as it might by engaging in open-market asset sales. In contrast, when it buys
contracts from short sellers, it expands the monetary base. In other words, the very
persons who are betting that the Fed will miss its target are also driving it to adjust
its policy in a direction calculated to make them lose their bets! As a means for
further reinforcing this built-in feedback mechanism, Sumner would also have the
Fed engage in “parallel” open-market operations for each NGDP contract purchase or
sale. In short, by offering to “peg” the price of its futures by engaging in as many
contracts as it takes to keep the price on target, the Fed essentially stands ready to
expand or contract the monetary base by whatever it takes to keep expected NGDP
on target.

That, at least, must suffice for the barest of summaries of a plan that has since
appeared in several, subtly-distinct versions, each of which has spawned its share of
subtle (and not-so-subtle) controversy, with some critics claiming that Sumner’s
scheme, or some versions of it, unworkable. Do those critics have a point? Perhaps
they do, but that’s not our concern. We’re here neither to praise nor to bury, but only
to have a gander at, this and other intriguing future possibilities for monetary policy.

Bitcoin and All That

Of these possibilities none are more intriguing than those held out by so-called
cryptocurrencies, including Bitcoin and its various “altcoin” offshoots. As I observed
some years ago (and as Tim Sablik explains in this Richmond Fed piece), when it was
just starting to gain economists’ attention, Bitcoin has properties in common with
both gold and other commodity monies on the one hand and deliberately managed
fiat monies on the other. Like gold, Bitcoin is unalterably scarce: just as there is only
so much gold on the planet, whether mined or as-yet unmined, there are only so
many bitcoins to be had — 21 million, to be precise — of which not quite 17 million
have been mined as of this writing. And like gold mining, bitcoin “mining,” which
involves the use of computer-power to solve a mathematical puzzle, is costly. Since
bitcoin “miners” compete for the privilege of being responsible for some share of any
periods’ bitcoin output, the marginal resource costs of mining a batch (or “block”) of
bitcoin tends to equal the market value of the coins produced.
Yet unlike gold, and like a fiat money, both the maximum possible output of bitcoin
and the number of coins mined in any given period is controlled, not by mother
nature, but by a protocol programmed into Bitcoin’s open-source software. The
protocol adjusts the difficulty of the puzzle bitcoin miners must solve so as to keep
total bitcoin output on a predetermined schedule, according to which bitcoin output
gradually tapers off, asymptotically approaching, but never quite reaching, its 21
million coin limit. The decentralized nature of Bitcoin’s software means that no one
is either “in charge” of the protocol or capable of altering it. A majority of miners can,
however, agree to form themselves into a new branch network or “fork” that uses a
modified copy of Bitcoin’s original protocol, as happened on August 1, 2017, when
“Bitcoin Cash” split-off from what became known thereafter as “Bitcoin Core.”
Although the fork created as many new “Bitcoin Cash” coins as there had been
Bitcoin Core coins beforehand, it left the Bitcoin Core protocol itself unchanged.

Bitcoin’s odd blend of commodity- and fiat-money properties led me to dub it a

“synthetic commodity money” some years ago. But the exciting thing about Bitcoin
and its various spinoffs and rivals isn’t merely that they comprise a distinct sort of
basic money, but that their combination of commodity- and fiat-money features is
capable, in principle at least, of combining the best properties, while avoiding the
worst, of each of those more traditional alternatives.

One of the more common complaints against a commodity standard is that it exposes
the value of money to shocks stemming from either new commodity discoveries or
from changes in the non-monetary demand for the standard commodity. Bitcoin and
other such “synthetic” commodity monies are, on the other hand, not subject to
similar shocks, because the amount miners can extract is strictly pre-programmed,
and because they have no non-monetary (e.g. ornamental or industrial) value.

The big beef against fiat money, on the other hand, is that its quantity can be altered
by the authorities placed in charge of it, not only for the sake of promoting economic
stability, but for other reasons, if not arbitrarily.

It doesn’t follow, of course, that any old cryptocurrency would be a hands-down

winner in a race against any established fiat money. Despite its ultimate limit of 21
million coins and skyrocketing transactions fees, Bitcoin might still seem a safer
gamble than, say, the Venezuelan Bolivar. But would it really supply a better or more
durable monetary standard than the present U.S. dollar?

But the question isn’t whether Bitcoin can beat the present fiat dollar. It’s whether
the basic technology pioneered by Bitcoin might allow some other self-regulating
cryptocurrency to do so. Besides giving rise to its own “Cash” spinoff, Bitcoin has
already spawned dozens of “altcoin” rivals, with others yet to come. It’s at least
conceivable some one or more of these might harbor such properties as would make
it a worthy opponent to the present dollar, if not something clearly superior.
Consider, if you will, the immense variety of ordinary commodities that either have
served as money in the past, or that might have done so, from cowrie shells and
tobacco to silver, gold, and even (as more than one prominent economist once
proposed) common bricks. Each had its merits and its drawbacks; and every one of
them was imperfect. But now consider that the cryptocurrency revolution presents us
with a whole new universe of new, albeit synthetic, options to draw upon, each of
which has been deliberately endowed with properties calculated to make it an
attractive medium of exchange. Call me an optimist, but it seems to me only natural
to suppose that one of these innovative products might someday prove just the thing
to give even the best discretion-wielding central bankers a run for their (that is, our)

Choice in Currencies

For an upstart currency to make inroads on an established fiat money requires, at

very least, that established and would-be monies compete on a reasonably level
playing field. That means having rules and regulations that make it relatively easy for
persons to either partly or entirely “opt out” of an official currency network, and to
“opt in” to one or more alternative networks. I say “relatively easy” because it’s
inevitably costly to switch from one currency network to another, and especially so
when the switch is from a bigger network to a smaller one. A level playing field
therefore means, not one where rivals are necessarily well-matched, but one where
the game isn’t rigged in the home team’s favor. In other words, the laws should
not themselves favor official money over other alternatives.
It was with that intent in mind that F.A. Hayek, in making his now-famous 1976 case
for “Choice in Currency,” called upon

all the members of the European Economic Community, or, better still, all the
governments of the Atlantic Community, to bind themselves mutually not to place any
restrictions on the free use within their territories of one another’s — or any other —
currencies, including their purchase and sale at any price the parties decide upon, or on
their use as accounting units in which to keep books.

“There is no reason whatever,” Hayek went on to argue,

why people should not be free to make contracts, including ordinary purchases and sales,
in any kind of money they choose, or why they should be obliged to sell against any
particular kind of money. There could be no more effective check against the abuse of
money by the government than if people were free to refuse any money they distrusted
and to prefer money in which they had confidence. Nor could there be a stronger
inducement to governments to ensure the stability of their money than the knowledge
that, so long as they kept the supply below the demand for it, that demand would tend to
grow. Therefore, let us deprive governments (or their monetary authorities) of all power
to protect their money against competition: if they can no longer conceal that their
money is becoming bad, they will have to restrict the issue.

Although Hayek’s advice seems perfectly reasonable, putting it into practice turns
out to be a lot harder than he seemed to think, and not just because governments’
would rather keep currency playing fields slanted their way. Consider the case of
Bitcoin. In March 2014, the IRS classified it and other cryptocurrencies as capital
assets (“intangible property”) rather than as currency, making any trade involving
them the basis for either a short- or a long-term capital gains tax, depending on how
long the coins were held before being disposed of. As the folks in the Coin Center (a
non-profit cryptocurrency advocacy group) explain, this tax treatment puts
cryptocurrencies at a disadvantage, not just relative to the U.S. dollar, but relative to
official foreign currencies, which enjoy an exemption when it comes to relatively
small transactions:

Say you buy 100 euros for 100 dollars because you’re spending the week in France.
Before you get to France, the exchange rate of the Euro rises so that the €100 you bought
are now worth $105. When you buy a baguette with your euros, you experience a gain,
but the tax code has a de minimis exemption for personal foreign currency transactions,
so you don’t have to report this gain on your taxes. As long as your gains per transaction
are $200 or less, you’re good to go.

Such an exemption does not exist for non-currency property transactions. This means
that every time you buy a cup of coffee, or an MP3 download, or anything else with
bitcoin, it counts as a taxable event. If you’ve experienced a gain because the price of
Bitcoin has appreciated between the time you acquired the bitcoin and the time you used
it, you have to report it to the IRS at the end of the year, no matter how small the gain.
Obviously this creates a lot of friction and discourages the use of Bitcoin or any
cryptocurrency as an everyday payment method.

The obvious solution, the Coin Center goes on to suggest, is “to simply create a de
minimis exemption for cryptocurrency the way it exists for foreign currency.” But
hold on: to really achieve Hayek’s ideal, it won’t do to level the capital gains tax
portion of the currency playing field for cryptocurrencies only, rather than
for all potential, unofficial dollar substitutes. But then, just what shouldn’t count as
such a potential substitute? Surely gold qualifies. But why not silver, or cigarettes,
or… the point, as we know from experience, is that all sorts of things are “potential”
exchange media, and therefore potential currencies. So, to really allow them all to
compete on equal terms, one would at very least have to exempt all of them — from
taxes to which official dollar trades aren’t subject.

In short, Hayek’s ideal is just that: something to have governments strive for, rather
than something they can be expected to fully achieve in practice.

What’s more, Hayek was far too optimistic regarding the likely consequence of
making it easier for people to choose among rival currencies. “Make it merely legal”
for them to switch to something else, he wrote, “and people will be very quick indeed
to refuse to use the national currency once it depreciates noticeably.” But would
they? Unlike, say, shoes or soda water, money is a “network” good, meaning that one
of the most important, if not the most important, determinant of the attractiveness of
any particular money is the size of the network of persons prepared to accept it. You
might think gold an ideal monetary commodity, and I might hold that Bitcoin is to
the dollar what sliced bread is to bread of the old-fashioned sort. Yet when it comes
to going shopping, what either of us must first consider is, not what sort of
money welike, but what the shopkeepers are prepared to take in exchange for their

It follows that, even if official and unofficial currencies really could have a level
playing field to compete on, that field would still be one on which official money
would generally enjoy a huge “home team” advantage. For this reason, the mere fact
that an official currency is depreciating “noticeably” isn’t enough to incite people to
abandon it in droves. Instead, it might take a very substantial rate of depreciation, or
some like cataclysm, to bring about rapid change. Cataclysms aside, upstart
currencies are more likely to have to start by clawing their way into established
currency markets one painful inch at a time, though with each becoming easier than
the last as their own, initially tiny networks begin to blossom.

Free Banking

The alternatives I’ve considered so far have all consisted either of potential
replacements for the U.S. dollar or of novel means for regulating the stock of official
(that is, Fed-created) U.S. dollars themselves. Emphasizing such alternatives makes
sense, after all, in a primer concerned with “monetary policy,” where the most
fundamental choices are those concerning what type or types of basic money to
employ, and how best to regulate the supply of basic money, assuming that it doesn’t
adequately regulate itself.

But what about alternatives consisting of banks’ readily convertible IOUs, like most
bank deposits today that, by virtue of their instant convertibility into official dollars,
are very close substitutes for them? Because such bank-created substitutes
necessarily “piggy back” on the basic monies into which they can be converted, their
presence can’t generally make up for misbehavior or mismanagement of the quantity
of basic money itself, and might even aggravate that misbehavior. A fiat money stock
that’s allowed to grow so rapidly that it would result in a 20 percent annual rate of
inflation in a pure fiat money system will, for example, produce the exact same rate
of inflation in an economy in which payments are made exclusively by means of bank
IOUs backed by a fixed fractional reserve of the same basic money.

Moreover there’s nothing at all radical about having banks supply such alternatives,
at least to a limited extent. Today and for some time past bank deposits of various
kinds have served, with the aid of checks and, more recently, debit cards, as close
substitutes for official monies, to the point of being far more extensively employed in
exchange than official monies themselves.

It would, nevertheless, be wrong to suppose that there’s no scope for a potential

beneficial radical reform involving bank-supplied alternatives to basic money. On the
contrary: plenty of scope exists for expanding the role of such alternatives,
particularly by doing away with long-standing restrictions on commercial banks’
ability to challenge central banks’ monopoly of circulating (or hand-to-hand)
payments media.

Once upon a time commercial banks routinely issued their own circulating paper
notes; indeed, until the latter half of the 19th century bank notes were the most
important liability on banks’ balance sheets, which were far more commonly
employed in making payments than either checks or coins. Nor did central bank
notes, which themselves started out as mere IOUs redeemable in gold or silver, only
to be transformed into inconvertible fiat money later on, come to generally displace
notes of commercial banks until the last decades of the 19th century, and the opening
ones of the 20th, when the proliferation of central banks typically went hand-in-hand
with laws forcing commercial banks out of the paper currency business.

Received opinion has it that commercial bank notes had to go because central bank
currency was better. But now and then received opinion is nothing but hokum, and
this happens to be one of those instances. Had central bank notes been better than
their commercial counterparts, it shouldn’t have been necessary for governments to
suppress the latter. Instead, the mere availability of official alternatives should have
sounded the death knell of the commercial stuff. Yet instead of that having been the
case, in every instance the commercial bank notes had to be snuffed-out, leaving
people no choice but to employ official paper money. Nor did the commercial bank
currency go down without a fight, in which prominent economists often took part,
with many of the most prominent (and most better ones, if I may say so) challenging
governments’ efforts to establish official currency monopolies, and championing the
alternative of free trade in banking, or “free banking,” for short.

Strictly speaking, “free banking” means more than just allowing ordinary banks to
issue paper currency. It also means leaving them free of other restrictions, including
restrictions upon their ability to establish branch networks, lend to whomever they
wish, charge whatever rates they wish, and hold whatever levels of cash reserves and
capital they wish to. Freedom of note issue is only the most controversial of these
many aspects of freedom in banking, in part because allowing it would make it
possible for the public to rely exclusively on privately-supplied exchange media, with
official dollars playing their part only behind the scenes, as bank reserves.
Furthermore, in times past, when official money consisted, not of any central bank’s
inconvertible “liabilities,” but of gold or silver coin, not having to rely on a central
bank as a source of paper money meant not having to have a central bank at all !

Could a monetary system lacking a central bank possibly have been any good? Darn

Of all relatively modern monetary systems, none have earned more kudos than the
two that most closely approximated the free-banking ideal, namely, the systems of
Scotland between the latter 18th century and 1845 and Canada from 1870 and 1914.
In both of these, bank-supplied notes and deposits commanded such a high degree of
confidence that gold and silver coin hardly circulated. The public’s disdain for
precious metal money in turn allowed Scottish and Canadian banks to operate on
reserve cushions that were slim even by today’s standards. That in turn made
Scottish and Canadian banks highly efficient intermediaries, with almost all of their
clients’ savings going to fund relatively productive bank loans and investments. Yet
despite this high degree of efficiency, bank runs were extremely rare in both systems,
while banking crises, involving simultaneous problems at many banks at once, were
almost unheard of.
Why, in that case, does free banking, and especially the idea of letting banks issue
their own currency, seem so far-fetched today?

Partly it’s because the Fed and other central banks, upon which we’re now all too
inclined to turn to for information about monetary history, have underplayed such
success stories as those of Scotland and Canada whilst sugarcoating their own
records. But in the U.S. case it’s also due to confusion about the meaning of “free
banking.” Whereas that phrase can refer to genuinely free banking systems like those
of Scotland and Canada, it can also refer to any of the systems established through
so-called “Free Banking” laws passed by eighteen states between 1837 and 1860.
Despite their names the later laws didn’t come close to allowing genuine freedom in
banking. Instead, they all imposed important restrictions upon the banks established
under them, including the requirements that those banks refrain from establishing
branches, and that they back their notes entirely with specific securities — usually
consisting of state government bonds. In several instances such restrictions, far from
guaranteeing the soundness of the banks that were forced to abide by them, led to
notorious abuses and failures, including episodes of “wildcat” banking. All in all, the
misnamed “Free Banking” era proved to be one of the most unfortunate chapters in
U.S. monetary history, because of the direct damage done by bank failures, of course,
but also because those failures gave freedom in banking a bad name it didn’t deserve.

But what relevance has free (that is, genuinely free) banking today? It’s relevant, first
of all, because an understanding of its workings suggests that freedom in banking
isn’t necessarily inimical to soundness in banking, and that the wrong sort of
regulations can in fact be worse than no regulations at all. It also suggests that, even
if we are determined to rely on a fiat-money issuing Fed as our ultimate source of
monetary control, we need not rely upon them to supply hand-to-hand currency.
Instead, we might let commercial banks back into that business, while limiting the
Fed’s ordinary involvement in the market for money to the “wholesale” part of that
market — that is, to supplying banks with reserves. Commercial banks that could
issue their own notes would presumably also be free to experiment with other forms
of non-deposit money, including “smart” stored value cards, that might eventually
replace paper money altogether, except on rare occasions when people lost
confidence in the private stuff. I dare say, indeed, that had commercial banks been
left in charge of supplying currency all along, paper money would some time ago
have gone the way of horses, buggies, spittoons, and slide-rules. What else save a
bunch of government monopolists could have managed to keep such low-tech stuff as
paper currency in play for so long?

Should We, Can We, “End the Fed”?

While in times past free banking was an alternative to central banking, that’s no
longer so. Today’s commercial bank deposits are claims, not to gold or silver coin,
but to central bank issued fiat money; and were commercial banks able to supply
their own notes or stored value cards to take the place of central bank notes in
payments that don’t involve drawing upon bank deposits, those notes and cards
would also represent claims to central bank money.

In short, so long as we stick to the present fiat dollar standard, instead of replacing it
with either a natural or a synthetic commodity standard, no amount of freedom in
commercial banking will suffice to render the Fed entirely otiose. No wonder that,
when former U.S. Representative Ron Paul and his many devotees campaign to “End
the Fed,” they have in mind, not just letting bulldozers loose on the Eccles Building,
but once again making official dollars claims to some fixed quantity of gold.

Whether one is a hard-core libertarian or not, it’s interesting to ponder the extent to
which the Fed’s role might be reduced, with the help of various more-or-less radical
reforms, without either abandoning the present, inconvertible U.S. dollar or
sacrificing its integrity.

We’ve already considered how a carefully-programmed computer, or having the Fed

peg the price of NGDP futures, could render the FOMC redundant — in so far at least
as that body’s challenge can be boiled down to one of maintaining a stable level of
overall spending. We’ve also seen how letting commercial banks issue circulating
currency would make it unnecessary for the Fed to be in the currency business,
though it would still require keeping plenty of Federal Reserve notes on hand in case
a banking panic should break out. Finally, in an earlier chapter we’ve seen how
allowing “flexible” open-market operations could make it unnecessary for the Fed to
ever make any direct loans to troubled financial institutions.
Yet these are far from being the only possibilities for having a leaner, if not a meaner,
Fed. The Fed’s reduced involvement in currency provision and last-resort lending
would mean a corresponding decline in the importance of the regional Fed banks,
apart from the New York Fed, which handles the system’s open-market operations.
The Fed’s involvement in check clearing could also be reduced, by returning that
activity to the private sector, which handled it perfectly well until the Fed muscled its
way in after 1913. Finally, most of the vast army of economists and other staff
personnel presently employed at the Fed, who even now are mainly busy performing
tasks that have nothing much to do with fulfilling the Fed’s mandate, could be made
to seek more productive employment elsewhere.

In short, sticking to a fiat dollar doesn’t rule out reforms that would dramatically
reduce the Fed’s role in the monetary system. Instead of the present, Leviathan Fed,
one might have what might be called a “Nightwatchman” Fed, capable of doing those
things that any responsible fiat money issuing central bank ought to do, but
incapable of doing many of the things that irresponsible central banks do all too

A Concluding Plea for Open-Mindedness

By surveying some more radical options for monetary reform, I don’t pretend to have
made a compelling case for any of them. My only goal has been to suggest that all
sorts of alternatives exist, and that each of them has its merits. Will any of them
really help? Is one better than the rest? Are there others not mentioned that deserve
our consideration? The correct answer to all these questions, and others like them, is
“Maybe.” In other words, such alternatives are, or ought to be, worth thinking about,
even if some might ultimately be judged unattractive. Allowing ourselves to think
outside the established monetary policy box can never do us any harm. Nothing
could be more dangerous, on the other hand, than for all of us to assume that,
despite its obvious faults, ours happens to be the best of all possible monetary