From ancient electrum to modern currency baskets (with a quick detour through symmetallism)

Electrum coins [source]

First proposed by economist Alfred Marshall in the late 19th century as an alternative metallic standard to the gold, silver and bimetallic standards, symmetallism was widely debated at the time but never adopted. Marshall's idea amounted to fusing together fixed quantities of silver and gold in the same coin rather than striking separate gold and/or silver coins. Symmetallism is actually one of the world's oldest monetary standards. In the seventh century B.C., the kingdom of Lydia struck the first coins out of electrum, a naturally occurring mix of gold and silver. Electrum coins are captured in the above photo.

While symmetallism is an archaic concept, it has at least some relevance to today's world. Modern currencies that are pegged to the dollar (like the Hong Kong dollar) act very much like currencies on a gold standard, the dollar filling in for the role of gold. A shift from a dollar peg to one involving a basket of other currencies amounts to the adoption of a modern version of Marshall's symmetallic standard, the euro/yen/etc playing the role of electrum.

The most recent of these shifts has occurred with China, which late last year said it would be measuring the renminbi against a trade-weighted basket of 13 currencies rather than just the U.S. dollar. Thus many of the same issues that were at stake back at the turn of the 19th century when Marshall dreamt up the idea of symmetallism are relevant today.

So what exactly is symmetallism? In the late 1800s, the dominant monetary debate concerned the relative merits of the gold standard and its alternatives, the best known of which was a bimetallic standard. The western world, which was mostly on a gold standard back then, had experienced a steady deflation in prices since 1875. This "cross of gold" was damaging to debtors; they had to settle with a higher real quantity of currency. The reintroduction of silver as legal tender would mean that debts could be paid off with a lower real amount of resources. No wonder the debtor class was a strong proponent of bimetallism.

There was more to the debate than mere class interests. As long as prices and wages were rigid, insufficient supplies of gold in the face of strong gold demand might aggravate business cycle downturns. For this reason, leading economists of the day like Alfred Marshall, Leon Walras, and Irving Fisher mostly agreed that a bimetallic standard was superior to either a silver standard or a gold standard. (And a hundred or so years later, Milton Friedman would come to the same conclusion.)

The advantage of a bimetallic standard is that the price level is held hostage to not just one precious metal but two; silver and gold. This means that bimetallism is likely to be less fickle than a monometallic standard. As Irving Fisher said: "Bimetallism spreads the effect of any single fluctuation over the combined gold and silver markets."  Thus if the late 1800s standard had been moved from a gold basis to a bimetallic one, the stock of monetary material would have grown to include silver, thus 'venting' deflationary pressures.

Despite these benefits, everyone admitted that classical bimetallism had a major weakness; eventually it ran into Gresham's law. Under bimetallism, the mint advertised how many coins that it would fabricate out of pound of silver or gold, in effect setting a rate between the two metals. If the mint's rate differed too much from the market rate, no one would bring the undervalued metal (say silver) to the mint, preferring to hoard it or export it overseas where it was properly valued. The result would be small denomination silver coin shortages, which complicated trade. What had started out as a bimetallic standard thus degenerated into an unofficial gold standard (or a silver one) so that once again the nation's price level was held hostage to just one metal.

The genius of Alfred Marshall's symmetallic standard was that it salvaged the benefits of a bimetallic standard from Gresham's law. Instead of defining the pound as either a fixed quantity of gold or silver, the pound was to be defined as a fixed quantity of gold twinned with a fixed quantity of silver, or as electrum. Thus a £1 note or token coin would be exchangeable at the Bank of England not for, say, 113 grains of gold, but for 56 grains of gold together with twenty or so times as many grains of silver. The number of silver and gold grains in each pound would be fixed indefinitely when the standard was introduced.

Because symmetallism fuses gold and silver into super-commodity, the monetary authority no longer sets the price ratio between the two metals. Gresham's law, which afflicts any bimetallic system when one of the two metals is artificially undervalued, was no longer free to operate. At the same time, the quantity of metal recruited into monetary purposes was much larger and more diverse than under a monometallic standard, thus reducing the effect of fluctuations in the precious metals market on aggregate demand.

While symmetallism was an elegant solution, Alfred Marshall was lukewarm to his own idea, noting that "it is with great diffidence that I suggest an alternative bimetallic scheme." To achieve a stable price level, Marshall preferred a complete separation of the unit of account, the pound, from the media of exchange, notes and coins. This was called a tabular standard, a system earlier proposed by William Stanley Jevons. The idea went nowhere, however; the only nation I know that has implemented such a standard is Chile. As for Fisher, he proposed his own compensated dollar standard plan, which I described here.

The urgency to adopt a new standard diminished as gold discoveries in South Africa and the Yukon spurred production higher, thus reducing deflationary pressures. None of these exotic plans—Marshall's symmetallism, Jevons tabular standard, or Fisher's compensated dollar—would ever be adopted. Rather, the world kept on limping forward under various forms of the gold standard. This standard would be progressively modified through the years in order to conserve on the necessity for gold, first by removing gold coin from circulation and substituting convertibility into gold bars (a gold bullion standard) and then having one (or two) nations take on the task of maintaining gold convertibility while the remaining nations pegged to that nation's currency (a gold exchange standard).

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Let's bring this back to the present. In the same way that conditions in the gold market caused deflation among gold standard countries in the late 1800s, the huge rise in the U.S. dollar over the last few years has tightened monetary conditions in all those nations that peg their currency to the dollar. To cope, many of these countries have devalued their currencies, a development that Lars Christensen has called an 'unraveling of the dollar bloc.'

A more lasting alternative to re-rating a U.S. dollar peg might be to create a fiat version of electrum; mix the U.S. dollar with other currencies like the euro and yen to create a currency basket and peg to this basket. China, which has been the most important member of the dollar bloc, has turned to the modern version of symmetallism by placing less emphasis on pegging to the U.S. dollar and more emphasis on measuring the yuan against a trade-weighted basket of currencies. This means that where before China had a strictly made-in-the U.S. monetary policy, its price level is now determined by more diverse forces. Better to put your eggs in two or three baskets than just one.

Bahrain, Oman, Qatar, Saudi Arabia and United Arab Emirates are also members of the dollar bloc. Kuwait, however, links its dinar to a basket of currencies, a policy it adopted in 2007 to cope with the inflationary fallout from the weakening U.S. dollar. In an FT article from April entitled Kuwaiti currency basket yield benefits, the point is made that Kuwait has enjoyed a more flexible monetary policy than its neighbours over the recent period of U.S. dollar strength. Look for the other GCC countries to mull over Kuwaiti-style electrum if the U.S. dollar, currently in holding pattern, starts to rise again.

Modern day electrum can get downright exotic. Jeffrey Frankel, for instance, has suggested including commodities among the basket of fiat currencies, specifically oil in the case of the GCC nations. Such a basket would allow oil producing countries to better weather commodity shocks than if they remained on their dollar pegs. If you want to pursue these ideas further, wander over to Lars Christensen's blog where Frankel's peg the export price plan is a regular subject of conversation.

A 21st century gold standard

Imagine waking up in the morning and checking the hockey scores, news, the weather, and how much the central bank has adjusted the gold content of the dollar overnight. This is what a 21st century gold standard would look like.

Central banks that have operated old fashioned gold standards don't modify the gold price. Rather, they maintain a gold window through which they redeem a constant amount of central bank notes and deposits with gold, say $1200 per ounce of gold, or equivalently $1 with 0.36 grains. And that price stays fixed forever.

Because gold is a volatile commodity, linking a nation's unit of account to it can be hazardous. When a mine unexpectedly shuts down in some remote part of the world, the necessary price adjustments to accommodate the sudden shortage must be born by all those economies that use a gold-based unit of account in the form of deflation. Alternatively, if a new technology for mining gold is discovered, the reduction in the real price of gold is felt by gold-based economies via inflation.

Here's a modern fix that still includes gold. Rather than redeeming dollar bills and deposits with a permanently fixed quantity of gold, a central bank redeems dollars with whatever amount of gold approximates a fixed basket of consumer goods. This means that your dollar might be exchangeable for 0.34 grains one day at the gold window, or 0.41 the next. Regardless, it will always purchase the same consumer basket.

Under a variable gold dollar scheme the shuttering of a large gold mine won't have any effect on the general price level. As the price of gold begins to skyrocket, consumer prices--the reciprocal of a gold-linked dollar--will start to plummet. The central bank offsets this shock by simply redefining the dollar to contain less gold grains than before. With each grain in the dollar more valuable but the dollar containing fewer grains of the yellow metal, the dollar's intrinsic value remains constant. This shelters the general price level from deflation.

This was Irving Fisher's 1911 compensated dollar plan  (see chapter 13 of the Purchasing Power of Money), the idea being to 'compensate' for changes in gold's purchasing power by modifying the gold content of the dollar. A 1% increase in consumer prices was to be counterbalanced by a ~1% increase in the number of gold grains the dollar, and vice versa. Fisher referred to this fluctuating definition as the 'virtual dollar':

From A Compensated Dollar, 1913

Fisher acknowledged that 'embarrassing' speculation was one of the faults of the system. Say the government's consumer price report is to be published tomorrow and everyone knows ahead of time that the number will show that prices are rising too slow. And therefore, the public expects that the central bank will have to increase its gold buying price tomorrow, or, put differently, devalue the virtual dollar so it is worth fewer ounces of gold. As such, everyone will rush to exchange dollars for gold at the gold window ahead of the announcement and sell back the gold tomorrow at the higher price. The central bank becomes a patsy.

Fisher's suggested fix  was to introduce transaction costs, namely by setting a wide difference between the price at which the central bank bought and sold gold. This would make it too expensive buy gold one day and sell it the next. This wasn't a perfect fix because if the price of gold had to be adjusted by a large margin the next day in order to keep prices even, say because a financial crisis had hit, then even with transaction costs it would still be profitable to game the system.

A more modern fix would be to adjust the gold content of the virtual dollar in real-time in order to remove the window of opportunity for profitable speculation. Given that consumer prices are not reported in real-time, how can the central bank arrive at the proper real-time gold price? David Glasner once suggested targeting the expectation. Rather than aiming at an inflation target, the central bank targets a real-time market-based indicator of inflation expectations, say the TIPS spread. So if inflation expectations rise above a target of 2% for a few moments, a central bank algorithm rapidly reduces its gold buying price until expectations fall back to target. Conversely, if expectations suddenly dip below target, over the next few seconds the algorithm will quickly ratchet down the content of gold in the dollar to whatever quantity is sufficient to restore the target (i.e. it increases the price of gold).

Gold purists will complain that this is a gold standard in name only. And they wouldn't be entirely wrong. Instead of defining the dollar in terms of gold, a compensated dollar scheme could just as well define it as a varying quantity of S&P 500 ETF units, euros, 10-year Treasury bonds, or any other asset. No matter what instrument is being used, the principles of the system would be the same.

A compensated dollar scheme isn't just a historical curiosity; it may have some relevance in our current low-interest rate environment. Lars Christensen and Nick Rowe have pointed out that one advantage of Fisher's plan is that it isn't plagued by the zero lower bound problem. Our current system depends on an interest rate as its main tool for controlling prices. But once the interest rate that a central bank pays on deposits has fallen below 0%, the public begins to convert all negative-yielding deposits into 0% yielding cash. At this point, any further attempt to fight a deflation with rate cuts is not possible. The central banker's ability to regulate the purchasing power of money has broken down.*

Under a Fisher scheme the tool that is used to control purchasing power is the price of gold, or the gold content of the virtual dollar, not an interest rate. And since the price of gold can rise or fall forever (or alternatively, a dollars gold content can always grow or fall), the scheme never loses its potency.

Ok, that is not entirely correct. In the same way that our modern system can be crippled under a certain set of circumstances (negative rates and a run into cash), a Fisherian compensated dollar plan had its own Achilles heel. If gold coins circulate along with paper money and deposits, then every time the central bank reduces the gold content of the virtual dollar in order to offset deflation it will have to simultaneously call in and remint every coin in circulation in order to keep the gold content of the coinage in line with notes and deposits. This series of recoinages would be a hugely inconvenient and expensive.

If the central bank puts off the necessary recoinage, a compensated dollar scheme can get downright dangerous. Say that consumer prices are falling too fast (i.e. the dollar is getting too valuable) such that the central banker has to compensate by reducing the gold content of the virtual dollar from 0.36 grains to 0.18 grains (I only choose such a large drop because it is convenient to do the math). Put differently, it needs to double the gold price to $2800/oz from $1400. Since the central bank chooses to avoid a recoinage, circulating gold coins still contain 0.36 grains.

The public will start to engage in an arbitrage trade at the expense of the central bank that goes like this: melt down a coin with 0.36 grains and bring the gold bullion to the central bank to have it minted into two coins, each with 0.36 grains (remember, the central bank promises to turn 0.18 grains into a dollar, whether that be a dollar bill, a dollar deposit, or a dollar coin, and vice versa). Next, melt down those two coins and take the resulting 0.72 grains to the mint to be turned into four coins. An individual now owns 1.44 grains, each coin with 0.36 grains. Wash and repeat. To combat this gaming of the system the government will declare the melting-down of  coin illegal, but preventing people from running garage-based smelters would be pretty much impossible. The inevitable conclusion is that the public increases their stash of gold exponentially until the central bank goes bankrupt.

This means that a central bank on a compensated dollar that issues gold coins along with notes/deposits will never be able to fight off a deflation. After all, if it follows its rule and reduces the gold content of the virtual dollar below the coin lower bound, or the number of grains of gold in coin, the central bank implodes. This is the same sort of deflationary impotence that a modern rate-setting central bank faces in the context of the zero lower bound to interest rates.

In our modern system, one way to get rid of the zero lower bound is to ban cash, or at least stop printing it. Likewise, in Fisher's system, getting rid of gold coins (or at least closing the mint and letting existing coin stay in circulation) would remove the coin lower bound and restore the potency of a central bank. Fisher himself was amenable to the idea of removing coins altogether. In today's world, the drawbacks of a compensated dollar plan are less salient as gold coins have by-and-large given way to notes and small base metal tokens.

In addition to evading the lower bound problem, a compensated dollar plan would also be better than a string of perpetually useless quantitative easing programs. The problem with quantitative easing is that commitments to purchase, while substantial in size, are not made at any particular price, and therefore private investors can easily trade against the purchases and nullify their effect. The result is that the market price of assets purchased will be pretty much the same whether QE is implemented or not. Engaging in QE is sort of like trying to change the direction of the wind by waving a flag, or, as Miles Kimball once said, moving the economy with a giant fan. A compensated dollar plan directly modifies the price of gold, or, alternatively, the gold content of the dollar, and therefore has an immediate and unambiguous effect on purchasing power. If central bankers adopted Fisher's plan, no one would ever accuse them of powerlessness again.

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*Technically, interest rates need never lose their potency if Miles Kimball's crawling peg plan is adopted. See here.

There won't be a drachma-induced recovery

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I catch both Lars Christensen and Brad DeLong making the claim that an introduction of the drachma will work wonders for Greece. Lars, for instance, says that:

However, Grexit will also remove the monetary straitjacket, which has had caused an enormous amount of economic hardship in Greece since 2008. The removal of this straitjacket will cause a significant easing of Greek monetary conditions, which in my view very likely will cause a sharp rise in nominal GDP in Greece in the coming years.

I hate to rain on the party, but even if a drachma is introduced and it collapses in value there won't necessarily be a drachma-induced recovery. Greece is currently in a straitjacket because its monetary standard -- the system for measuring and conveying economic value -- is a euro standard. Think of the euro as being akin to the metric system, a standard for measuring weights and distances, or dots per inch, a standard for measuring print resolution. An introduction of drachmas banknotes into circulation is simply not a sufficient condition to create the sort of effects that Brad and Lars want. To get their recovery, Brad and Lars need an all out monetary standard switch. But as long a Greek prices continue to be expressed in euros, drachmas will simply swim within the existing euro standard fish bowl. All sorts of mountains must be crossed before the penultimate switch of standards. This isn't "snap of the fingers" territory.

Drachma as another bitcoin

To better understand the destiny of a new drachma, its nice to have an example. Lucky for us, we can find one in the recent emergence of one of the world's newest currencies, bitcoin. Now Lars assumes that a collapse in the drachma will have all sorts of beneficial effects on the Greek economy. But does the world economy roar when bitcoin plunges? No, and here's why.

While merchants accept bitcoin as payment, they haven't accepted it as a standard. Sticker prices continue to be set in units like dollars, yen, pounds, etc., Bitcoin swims within the existing fiat standard. To accommodate those who want to pay in bitcoin, merchants will typically use the last-second bitcoin-to-dollar exchange rate (taken from foreign exchange markets) as the basis for the bitcoin price of their goods. Which means that as bitcoin plunges in value, the amount of bitcoin that retailers ask for their stuff is immediately adjusted upwards by a concomitant amount.

This is important because implicit in Brad and Lars's drachma recovery story is a certain degree of price stickiness. As the fundamental value of the standard unit plunges, sticker prices are slow to adjust upwards. Knowing that sticker prices will at some point start to catch up, people spend their currency now before it loses value, thus stoking an economic boom as merchants' inventories are drawn down. This sticky price effect is entirely lacking in bitcoin. Given a sickening collapse in bitcoin, those who own the stuff have no reason to spend it on before it loses value. After all, the amount of bitcoin that retailers require is adjusted every second, so prices in terms of bitcoin don't stay sticky. A bitcoin collapse therefore has no real effects on the world economy.

Applying this lesson to Greece, there's no guarantee that a decline in the drachma will boost the Greek economy. The appearance in circulation of drachma banknotes needn't mean that sticker prices will be set in drachmas. To determine how many drachmas Greeks must pay for an item, retailers may simply refer to its euro sticker prices and convert that amount into drachma by glancing at the last-second drachma-to-euro exchange rate. If so, then just as bitcoin prices are not sticky, neither will drachma prices. Without the requisite stickiness, a collapse in drachmas will not have the real effects that Lars and Brad want. Only a collapse in the euro, the monetary standard, will harness the sticky price effect the two implicitly invoke. But that effectively means Greece remains in its monetary straitjacket, despite having debuted a drachma.

Hurdles to switching

I've talked about the network externalities involved in switching standards before. Take an incumbent standard and a new standard. Even if the quality gap between the novel standard and the inferior incumbent is quite high, the costs of coordinating everyone onto the new standard may be too onerous for adoption to occur. Hysteresis, or lock in, is the result.

Switching to a drachma standard requires that a strong third party step in to overcome these network externalities. They need to punish, or credibly threaten to punish, those who refuse to comply. The Greek government, which has already demonstrated an inability to execute on basic tasks like tax collection, could very well lack the resources that are necessary to adequately perform the tasks of a third party.

Further militating against a drachma standard is its massive quality gap. A monetary standard should be as nuisance-free as possible. Merchants do not want to be adjusting their prices every day, and customers want to know that the blender they saw on a store's shelves on Tuesday will be worth the same amount when they go back on Wednesday. If sticker prices must be adjusted hourly, or even by the minute, the amount of time and mental space that people must allocate to calculation and measurement will displace other more meaningful activities. Like bitcoin, the drachma would probably be a one of the world's most volatile currencies; the incumbent euro one of its steadiest. So rather than improving on the euro standard, a drachma standard would represent a regression in quality.

Given that a strong government must spend a significant amount of resources getting its population to adopt a better standard, it's hard to imagine that a weak government will ever be able to foist an inferior standard on its population without facing a backlash. So contrary to Lars and Brad, there is no guarantee that issuing drachmas offers an ultimate salvation. In the end, there's probably very little difference between a Greece that introduces a drachma or one that doesn't, since either way the incumbent euro standard will likely stick around.


Note: This is very similar to my previous post on the topic. I've introduced the bitcoin analogy, which I think helps drive home the point, and also brought the quality gap to the forefront. 

Nick Rowe comments here.

Who signs a country's banknotes?

2010 Bank of England note signed by Andrew Bailey, former Chief Cashier of the Bank.

A few years ago, Peter Stella and Åke Lönnberg conducted a study that classified national banknotes by the signatories on that note's face. They found some interesting results. Of the world's 177 banknotes with signatures (10 had no signature whatsoever), the majority (119) were signed by central bank officials only. Just four countries issue notes upon which the sole signature was that of an official in the finance ministry: Singapore, Bhutan, Samoa, and (drum roll) the United States.

Stella and Lönnberg hypothesize that the signature(s) on a banknote indicate the degree to which the issuing central bank's is financially integrated with its government. The lack of a signature from a nation's finance ministry might be a symbol of a more independent relationship between the two, the central bank's balance sheet being somewhat hived off from the government's balance sheet and vice versa. The presence of a finance minister's signature would indicate the reverse, that both the treasury and central bank's balance sheets might be best thought of as one amalgamated entity.

The nature of this arrangement is significant because if something disastrous were to happen to an independent central bank's financial health, say its assets were destroyed and all hope of profits dashed for eternity, the central banker should not necessarily expect support from his/her government. Lacking in resources, monetary policy could go off the rails. (Why would it go off the rails? Here I go into more detail).

On the other hand, should it be established by law that a government is to backstop its central bank, that same disaster would pose a smaller threat to monetary policy since the nation's finance minister, his John Hancock affixed to the nation's notes, would presumably come to the central bank's rescue.

These ideas are similar to Chris Sims's classification of type F and type E central banks (alternative link). One of the features of type F banks (like the Fed) is that "there is no doubt that potential central bank balance sheet problems are nothing more than a type of fiscal liability for the treasury." On the other hand, with type E banks (like the ECB) "it is not obvious that a treasury would automatically see central bank balance sheet problems as its own liability."

So is it the case that the Federal Reserve is actually more fused with the U.S. Treasury than other central banks are? One reading of the Federal Reserve Act might indicate yes. Section 16.1 stipulates that Federal Reserve notes are ultimately obligations of the US government:

Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues.

The language in the above phrase would seem to indicate that should the Fed find itself incapable of exercising monetary policy (Stella and Lönnberg  use the term policy insolvency), the US government is obliged to step in and make good on the Fed's promises, however those promises might be construed. The fact that Treasury Secretary Jacob Lew's signature appears on all paper notes, as does that of U.S. Treasurer Rosa Gumataotao Rios, can perhaps be taken as an indication of this guarantee.

Bank of Canada notes, on the other hand, are signed by the Governor of the BoC and his deputy. Finance Minister Flaherty's signature is nowhere in sight. This jives well with a quick reading of the Bank of Canada Act, which stipulates that though notes are a first claim on the assets of the Bank of Canada, the government itself accepts no ultimate obligation to make good on banknotes. In theory, should the Bank of Canada cease to earn a profit from now to eternity, Canadian monetary policy could go haywire—American monetary policy, backstopped by the Treasury, less so.

Other central banks go even further in formalizing this separation. In Lithuania, for instance, the law states that: "The State of Lithuania shall not be liable for the obligations of the Bank of Lithuania, and the Bank of Lithuania shall not be liable for the obligations of the State of Lithuania." Should Leituvos Bankas hit a rough patch, so will its monetary policy.

Stella and Lönnberg correlate the rise of independent central banking with a movement away from the printing of finance minister signatures on notes. For instance, the sole signature on Euro banknotes is that of the President of the ECB, Mario Draghi. Two of the currencies replaced by the Euro, the Irish punt and the Luxembourg franc, which had carried signatures of finance department officials, no longer exist, symbolic evidence of the Euro project's dedication to central bank independence.

Sims uses the ECB as an exemplar of type E central banks because "the very fact that there is a host of fiscal authorities that would have to coordinate in order to provide backup were the ECB to develop balance sheet problems suggests that such backup is at least more uncertain than in the US." For evidence, he points to the fact that the Fed carries just 1.9% of its balance sheet in capital and reserves while the ECB holds 6.7%.

Stella and Lönnberg hint at the prevalence of a "rather singular U.S. view of central bank and treasury relations." My interpretation of this is that most conversations about central banking are inherently conversations about the the world's dominant monetary superpower, the Federal Reserve. This is surely evident in the blogosphere, where we mostly talk as-if we were Bernanke, not Carney or Poloz or Ingves (Lars Christensen is a rare counter-example who is fluent in multiple "languages"). In the same way that all Americans only understand English while all foreigners are conversant in English and their native tongue, non-American commentators like me can't talk solely in terms of our own central bank (in my case the Bank of Canada) lest we fall out of the conversation. The Fed becomes our focal point.

Yet among central banks, the Fed is an odd duck, since the wording in the Federal Reserve Act and the signature on its notes would indicate a more well-integrated financial relationship between central bank and treasury than most. The upshot is that popular conceptions of the central banking nexus will often be wrong as they will be couched in terms of the U.S.'s integrated viewpoint, whereas most of the world's central banks are not structured in the same way as the U.S. A deterioration of the Fed's balance sheet would likely be neutral with respect to monetary policy, but for many of the world's nations this simply isn't the case.

On a totally unrelated side note, I found it interesting that Bank of England notes stand out as being signed by the Chief cashier of the Bank, not the governor. When the BoE opened its doors for business in 1694, the banknotes it issued were written on blank sheets of paper, often for unusual quantities (standardized round numbers were not introduced till the 1700s). The bank's directors and its governor, usually well-established bankers who simultaneously ran their family business, were not responsible for the BoE's day-to-day operations, this being devolved to the bank's cashiers who were given the repetitive task of signing each note by hand. Even when the ability to print signatures directly on to notes was developed in the 1800s, the practice of affixing the cashier's signature continued, despite the fact that mechanical process would make it easy for the higher-ranked governor to get his name on each note.

So while Mark Carney's route from the BoC to the BoE got him a higher salary, more prestige, and posher digs, in one respect his standing has deteriorated: there are no longer millions of bits of paper circulating with his name on them. Chief cashier Chris Salmon has that distinction.

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PS: You should try and read all of Peter Stella's papers. They are excellent. He blogs here.

More monetary lunacy from Mugabe

In a recent speech leading up to an end-of-month national election, Zimbabwe's President Robert Mugabe hinted at the possibility of introducing a gold-backed Zimbabwe dollar.

This is from the Mail & Guardian:

Then there is the business about the Zim dollar, that one issue that makes every Zimbabwean wake up in a cold sweat, and one that every candidate should really avoid. We cannot use the US dollar forever, he [Mugabe] begins. We will have to look at ways of bringing back our currency, sometime in the future. There are uncomfortable murmurs. Mugabe appears to be thinking out loud. "Should we, should we not?" he asks himself. "What if we back our currency with all our gold? Wouldn't it be strong enough? Maybe not now, of course, but sometime in the future. Maybe we will talk to [Gideon] Gono, the Reserve Bank governor."

I'm sure the memories of the hyperinflation are too fresh in the minds of Zimbabweans for them to buy into the folly of letting the insane duo of Mugabe and his central banker, Gideon Gono, once again have their own printing press, even if that press is to be constrained by gold convertibility. Let's take a quick glance through the 2007 Reserve Bank of Zimbabwe (RBZ) annual report [link] for a refresher of what the two of them got up to the last time around. By then in the midst of a severe hyperinflation, the RBZ's 2007 report kicks off with a boilerplate disavowal of any responsibility for the plunge in the Zim dollar's purchasing power, blaming it on "supply side constraints, speculative activities, and adverse expectations."

The report goes on to describe a dizzying number of "support" programs set up by the RBZ. These include in no particular order:

A) Farm Mechanization Program: to provide farmers with the funds to purchase tractors, combines, plows, and sprayers.
B) Agricultural Sector Productivity Enhancement Facility: to provide low cost funds to support producers of beef, pigs, and poultry
C) Parastatals Reorientation Program: aid to suffering government-owned businesses including Cold Storage Co of Zimbabwe, Tel One, and Net One.
D) Basic Commodities Supply-Side Intervention Facility: targeted financial support to ensure a quick return of basic goods to supermarket shelves
E) Tourism Development Facility: funds for hotels, lodges, and tour operators
F) Seed Development Program: funding to procure maize, soybean, and sorghum seed
G) National Cattle Herd Restocking Program: the purchase of breeding cattle for onlending to farmers
H) Rural Business Facility: funds for rural retailers including hardware shops, wholesalers, and butchers.
I) and more...

A large quantity of the support provided via these RBZ programs went straight to Gono and Mugabe's friends and allies. Coincidentally, it would seem that Gono, while RBZ governor, has become one of the biggest chicken farmers in Zimbabwe, recently boasting in the press that he expects to be Africa's first chicken-farming billionaire. Even if Gono didn't fund his farming dreams by diverting funds from RBZ agricultural support programs to himself, his suppliers, or purchasers, the conflict of interest presented by Gono's twin roles as chicken farmer and chicken farm financier is breathtaking. It would be like putting Jamie Dimon in charge of the Fed, without requiring Dimon to resign from and sell his shares in JP Morgan.

Most of the RBZ's special lending programs, as well as the direct financing of the government carried out by the RBZ, were granted at rates far cheaper than the market rate. Whenever a central bank keeps its rate perpetually below the market rate, hyperinflation is the inevitable result. But in Gono and Mugabe's Alice in Wonderland world, their so-called support programs weren't the cause of the hyperinflation, but rather the cure to hyperinflation. How did the pair square this very odd circle? Here is Gono explaining the Farm Mechanization Program:

Many may wonder why Your Central Bank gets involved in some of these activities which, on the face of it, appear to be outside our core mandate of inflation fighting. Your Excellency, inflation remains our number one enemy and core business. Thirty three percent (33%) of that inflation relates to Food and Food items alone. It follows therefore that our attempts to boost agricultural productivity in collaboration with Government and other stakeholders is actually an ancillary and incidental part of our core business.

According to Gononomics, inflation is not something created by a central bank but an external enemy that must be fought. The RBZ's cheap loans to the farm sector didn't set off inflation, but rather they improved productivity and reduced food prices, thereby reining in inflation. Reality, of course, had something stern to say about this. The Zim dollar continued to plunge in value, eventually hitting zero a year after Gono's speech. Gono and Mugabe were appropriately stripped of their printing press by the course of events, and that is how the situation should stay.

I'll deal with a few reasons that might be put forward for the resurrection of the Zim dollar, and why these reasons are not sufficient to counterbalance the danger of giving our two hyperinflationistas their own currency.

1) First, many people complain of a "small change" problem in Zimbabwe. A paucity of US dollar coins in circulation means that it is difficult for someone purchasing, say, $1.85 worth of food with $2.00 to get back 15c in change. While we in the West might consider change to be an inconvenience -- it is heavy and clinks around -- in a country like Zimbabwe where the average daily income is only a few dollars, the lack of coinage is a major problem.

This is hardly an issue that needs to be solved by a new Gono dollar, though. One route that Zimbabwean shopkeepers have taken to make things easier is to provide change in by the form of gum, candy, or other small items. This isn't an ideal solution, but it is a start of sorts. Private bus owners give change in the form of coupons that can be redeemed for transportation at some later date. These coupons don't appear to be highly liquid, though. The South African five rand coin has been recruited to serve the role of a 50 cent piece, regardless of the actual exchange rate between rand and US dollars. This is fine for now, but as the USD-ZAR exchange rate changes over time, the use of rand coins as change in US dollar transactions may become computationally burdensome.

A better solution would be to allow private Zimbabwean banks to coin or print 10c, 25c, and 50c tokens/coupons that, when brought back to the issuing bank, might be converted into their dollar equivalent. This would require the regulatory blessing of the RBZ. The RBZ, unfortunately, seems to be extremely jealous of those who would print or coin currency. In a bizarre story from this spring, two "prophets" claimed to be able to create US dollars from scratch, those in their audience reportedly receiving "miracle money" in their pockets. Gono immediately investigated the duo, eventually clearing them of any wrongdoing. If so-called miracle money receives such scrutiny from the RBZ, one can be sure that bank-produced small change would have to jump through incredibly high hoops before being permitted.

Lars Christensen has also discussed the small change problem in Zimbabwe, noting the potential for e-money to fill the gap. I won't go into any depth on this possibility since Lars has covered it in some detail.

2) A second purported reason for introducing a new Zim dollar is to provide for the lender of last resort. Since the RBZ can't print US dollars willy nilly, Zimbabwe banks can't turn to their nation's central bank when they need liquidity support.

We've grown so used to the idea of a lender of last resort that we rarely stop to consider that such a lender is not a necessary feature of an economy. Panama has been effectively dollarized since 1904 and for that entire time has been without a lender of last resort. Panamanian banks have adapted by holding relatively high levels of liquid assets as self-insurance [link]. Bank failures have been small and infrequent, with the only major crisis event being related to the Manuel Noriega incident in the late 1980s. [link]

Like Panamanian banks, Zimbabwean banks will adapt to the lack of lender of last resort by modifying their own banking practices to ensure that their balance sheets are sufficiently flexible to deal with liquidity crisis.

In sum, Zimbabwe's currency situation is better than it has been in years and will only improve as technologies and practices evolve to deal with the small change problem, and as banks position themselves to deal with potential liquidity shortfalls. A Mugabe/Gono attempt to bring back the Zim dollar, whether it be gold-backed or not, is thoroughly unnecessary. Should the duo succeed in linking a new currency to gold, it is probable that they'll quickly close the gold window in order to get back to their old ways,  a scenario that no one wants. With any luck, Zimbabweans will throw the scoundrels out onto the street come election time. Mugabe and Gono certainly deserve it.

Don't shackle Target2

Like Guntram Wolff over at the Bruegel blog, I hope that the much-rumoured capital controls on Cypriot deposits don't get enacted. So far the Euro authorities seem to have done everything right, albeit in a slow and circuitous manner. Insolvent banks are being closed, uninsured depositors, unsecured creditors, and shareholders are being bailed in, and solvent banks are slated to reopen.

Wolff's main concern is that capital controls threaten the very meaning of a monetary union:

With capital restrictions, the value of a euro in Cyprus is no longer worth the same as a euro held by any other bank in the eurozone. A euro in Nicosia cannot be used to buy goods in Frankfurt without limits. Effectively, it means that a Cypriot euro is not a euro any more.

Enact capital controls and we'd see the emergence of an entirely new currency trading pair CYP€:onshore€, with Cypriot euros trading at a discount. The discount would emerge since the ability of CYP€ to buy things outside of the island of Cyprus is limited. It would be a less liquid euro than "mainland" euro, and therefore would get penalized with a liquidity discount.

A Eurosystem in which euros are heterogeneous would technically be workable. For an analogy, look at China. The Chinese yuan has several different prices. Mainland yuan (CNY) typically trades at a discount to yuan in Hong Kong(CNH) and yuan in Taiwan (CNT). I've cribbed a chart below that shows the spread. Chinese capital restrictions prevent arbitrage forces from reducing the gap. Foreigners would prefer to buy cheaper CNY than more expensive CNH and CNT, but they can't because restrictions on capital inflows into China prevent them from doing so. Chinese companies would like to borrow in Hong Kong rather than China since they'd be borrowing high-value CNH and repatriating it, thereby lowering their cost of funding. But capital outflows are also limited.*

Source: HSBC Global Research

Just like capital controls prevent the closing of the CNY-CNH spread, the introduction of European capital controls would lead to the emergence of the CYP€-€ spread. What are the dangers of Europe adopting a Chinese model of multiple prices for the same currency?

As Wolff points out, the Eurosystem already has a tool to deal with flight from banks: the ECB's incredibly powerful Target2 clearing system. When Cypriot banks reopen and depositors start to transfer deposits to Germany, Target2 will accommodate these flows by stepping between the two banking systems, simultaneously acting as a creditor to Cyprus and a debtor to Germany. Like any lender of last resort, Target2 will be vigorous in lending, providing whatever assistance is required to Cypriot banks facing liquidity shortfalls.**

The great thing about Target2 is that its mere presence has the ability to prevent a bank run from ever being kick-started. If Cypriot depositors know at the outset that the incredibly powerful Target2 will accommodate their fears, why should they be fearful? Target2 is like Chuck Norris, as Nick Rowe and Lars Christensen would say. Its mere presence is enough to create powerful self-fulfilling counter-effects.

Cyprus wants to soften potential deposit flight with capital controls rather than leaving Target2 to do all the work. One wonders if these controls would help at all. Controls are porous, and investors will find cunning ways to get around them.

Worse is the precedent this sets. If capital controls are used as a substitute for Target2, the Euro risks losing a major stabilizing force come the next crisis. Say that it is 2016 and doubts spring up concerning Finland's banking system. If Finnish depositors know that Target2 will accommodate all deposit outflows from solvent Finnish banks, then they realize that they have nothing to fear, and the panic will subside on its own accord. But if Finnish depositors think that Cyprus-style capital controls will be put in place to prevent deposit outflows, the panic will only be exacerbated as people try to withdraw money from Finland before capital controls cause FIN€ to trade at a discount. Anyone who gets through the gate before it closes can't lose, so everyone tries to get through the gate. This effect is perverse, since the very rumour of capital controls leads to their actual adoption. With capital controls, a European bank panic is self-fulfilling—with Target2, that same panic is self-correcting.

Leave Target2 free to be the regulator of European liquidity flows—don't use capital controls. Haven't we already learnt this lesson? It was Draghi's speech about Euro convertibility from last summer that helped reduce yield spreads and stop the intra-European bank run. Gavyn Davies read that speech as a reaffirmation of unlimited Target2 power, and so did I.*** Never shackle Target2.
_______________________

* The Chinese are moving to less capital controls. Spreads are already declining, and at some point the CNY-CNH/CNT differential will be no more. 

** The provision of these LOLR services is subject to Cypriot banks providing collateral. But the winding up of insolvent Cypriot banks and the haircutting of depositors *should* have insured that the remaining quantity of Cypriot banking liabilities have been pruned so that they equal the quantity of remaining collateral.

*** See this comment as well as my first Never Shackle Target2 post.

Rudolph Havenstein, independent central banker during the Weimar inflation

Lars Christensen's excellent post about the necessity of having a monetary constitution includes an interesting point about central bank independence:

We want central banks to stop the ad hoc’ism. In fact we don’t even like independent central banks – as we don’t want to give them the opportunity to mess up things.

Central bank independence has become the standard approach to structuring the nexus between government service-provider and central bank liquidity-provider over the last fifty years. I think a degree of independence makes a lot of sense. Running a monopoly clearing house (which is really what a central bank is) while simultaneously operating other businesses and charities (which is what a government does) presents a tremendous conflict of interest.

For instance, imagine that General Electric was granted a monopoly to operate the U.S. clearing system. Wouldn't we worry that GE might use that clearing system to support its appliance or turbine manufacturing businesses? It might, for instance, require that those borrowing clearing balances submit GE securities as collateral but not those of GE's competitors, thereby giving GE an unfair financing advantage. Or why not have the clearing house give GE an interest free loan? Member banks can't leave the clearing house for another—it's a monopoly, after all—so there are no counterbalancing forces to discipline GE should it choose to abuse its clearing house duties.

A government is no less conflicted than GE in running a nation's monopoly clearing house. In recognition of this, we hive off central banks from government by establishing strict central bank acts and operating procedures.

But as Lars points out, we shouldn't make an idol out of central banking. Without a monetary constitution, independent central banks can screw up royally. The German Reichsbank from 1921-1923, which I wrote about in How To Stop a Hyperinflation, is a great example of this.

With prices rising at around 100% a year, Rudolph Havenstein, the President of the Reichsbank, was discounting bills at a mere five percent up until July 1922. By April 1923, Havenstein had increased the discount rate to 18%, and in September to 90%, yet by then prices were doubling every two days. Businessmen only had to take out a loan from the Reichsbank, buy and hold goods, stocks, gold, or US dollars, and when the loan was due, sell whatever had been bought for devalued reichsmarks in order to settle the loan. Even with the loan costing 90% per annum, returns on these assets were so many multiples higher that the profits on this trade were huge.

Havenstein and the board of the Reichsbank had adopted a theory that the mark was depreciating due to external circumstances. According to Laidler (1998), this theory went something like this. An adverse balance of payments (due in part to reparations requirements) was causing the reichsmark to fall in international markets. This resulted in higher local wages and prices, which created a shortage of money. The Reichsbank was only resolving the shortage by passively meeting the demand for credit. Conveniently, this theory absolved the bank's low interest rates of any responsibility for the inflation.

By the fall of 1923 Germans had had enough and voted in a government who promised monetary reform. But the government ran into a problem—they couldn't get control over Havenstein. Hjalmar Schacht notes in his autobiography Confessions of "The Old Wizard" that Havenstein was not on good terms with the government and despite indications that it wished Havenstein to retire, the Reichsbank President had resisted.

Havenstein was able to dig his heels in because in May 1922, the Reichsbank's Autonomy Law had come into effect. This law effectively enshrined the Reichsbank's independence from the government and installed Havenstein for life. Germans were effectively held hostage to a 66-year old independent central banker who refused to acknowledge his responsibility to raise interest rates in order to stop a hyperinflation. Its options limited, the government decided to try hacking around the Reichsbank by creating an entirely new currency, the rentenmark. Schacht was asked to run the bank that issued these notes, the Rentenbank. Liaquat Ahamed explains this unusual situation as it stood in mid-November:

Saddled with Von Havenstein, Stresemann had simply bypassed him by creating the independent Currency Commissionership outside of the Reichsbank [to manage the Rentenbank]. And so, when the new currency was introduced on November 15, 1923, Germany found itself in the curious position of having two official currencies—the old Reichsmark and the new Rentenmark—circulating side by side, issued by two uniquely parallel central banks. At one end of town was Schacht, operating from his converted broom closet; at the other, Von Havenstein, holed up and increasingly isolated and irrelevant in the Reichsbank’s imposing red sandstone building on Jagerstrasse. Although the Reichsbank had now stopped providing money to the government, its printing presses still continued to roll out trillions of Reichsmarks to private businesses. (Lords of Finance, Chapter 10)

As I wrote in my previous article, what stopped the reichsmark inflation cold by the end of November 1923 was not the debut of Schacht's rentenmarks on November 15 but an abrupt change in the Reichsbank's policy. This rapid reversal could only happen because of the sickness and sudden death of Havenstein on November 20th from a heart attack. Hjalmar Schacht immediately exerted his presence. He ceased the Reichsbank's acceptance of notgeld and tightened credit, thereby halting the mark's slide by the end of November, a week after Havenstein's death.

The point of this story is that independent central banking is not a panacea. Yes, it's probably a good idea to set limits in order to minimize the potential for conflicts of interest between government and the monopoly clearing house. But if an independent central banker is left to follow whatever ad hoc rule (or lack thereof), the consequences can be disastrous. A monetary constitution of the sort that Lars describes is one way to solve this problem. Even better is to open up the clearing house business to competition and choice. That way irresponsible central bankers can be disciplined by the same forces that discipline irresponsible grocers, farmers, salesman, and the rest of us great unwashed—just cease doing business with them.

TIPS: How to decompose the liquidity premium from the inflation-risk premium

Lars Christensen talks about the idea of setting a floor under inflation-linked bonds in order keep inflation expectations at some minimum level. It`s an interesting idea. Here is my comment:

Interesting idea, Lars. One problem here is that the TIPS spread (I’ll use US lingo if you don’t mind) measures not only expected inflation but also the relative illiquidity of TIPS relative to Treasuries. It measures, in part, a liquidity premium.

TIPS might fall to the central bank’s minimum buying price not because inflation expectations have fallen, but because the liquidity of TIPS relative to Treasuries has declined. This change in liquidity could be purely incidental. ie. it could be due to some unimportant technical change unique to Treasury markets. The result would be that the central bank buys up TIPS because it believes inflation expectations have fallen, when in actuality it is the liquidity premium that has changed. According to your rule, the money supply automatically increases, though perhaps it shouldn’t have.

In short, you have to find some way to decompose that portion of the spread between TIPS and Treasuries that is due to the liquidity premium and that which is due to inflation expectations.

It there were publicly traded “liquidity-options” on TIPS, you’d be able price the value of the liquidity premium and use that to back out that portion of the TIPS spread due purely to inflation expectations. Then you could apply your rule more precisely.

In a 2009 speech, FRBNY President William Dudley talks about the illiquidity premium and inflation-risk premium of TIPS here.

Thinking in terms of stocks: From Fisher to Fischer

In an older post, Scott Sumner had an interesting comment:

The most recent inflation rate in Greece is 1.7%, whereas Spain has 1.9% inflation. I don’t know about you, but I find those figures to be astounding. That’s not deflation, and yet Tyler’s clearly right that they are being buffeted by powerful deflationary forces. I’d make several observations:

1. This shows the poverty of our language. Economics lacks a term for falling NGDP, even though falling NGDP is arguably the single most important concept in all of macro, indeed the cause of the Great Depression. So we call it “deflation” which is actually an entirely different concept. I wouldn’t be the first to find connections between the poverty of our language and the poverty of our thinking.

You say hot potato, he says endogenous

David Glasner finally chimed in on the subject of endogenous money. I pretty much agreed with everything he said on the topic of bank money endogeneity. Basically, the financial system adjusts to a reduced demand  for bank money by destroying that money rather than keeping it in circulation and forcing all prices to adjust. The process by which this occurs is an arbitrage process. This is the classical theory of money that Glasner describes in his book Free Banking and Monetary Reform, and it applies equally to the modern banking system since banks make their deposits convertible into central bank money.

David said something interesting:

So while I think that bank money is endogenous, I don’t believe that the quantity of base money or currency is endogenous in the sense that the central bank is powerless to control the price level.

I was curious about his claims that modern central bank (CB) money is not endogeneous and left some comments on his post trying to drill down on this issue. It seems to me that, much like old-fashioned gold standard CBs and modern private banks, many modern inflation-targeting CBs also have effective convertibility regimes, ie. they are governed by the redemption principle. This regime allows for arbitrage. In other words, David's classical theory of money applies just as well to modern CB money as it does to competitively-supplied banking money and central bank liabilities convertible into gold.

As Nick Rowe points out here (and my post here), modern inflation-targeting central banks including the Bank of Canada, Australian Reserve Bank, and others, are not so different from old-fashioned gold standard CBs, the only difference being that rather than offering convertibility at a fixed rate into gold, modern CBs offer convertibility at  a floating rate into bonds (Nick calls this a CPI standard, I see it as floating rate bond-convertibility, same thing in the end). In between changes to that floating rate, those with access to the CBs "conversion window" - effectively those who can conduct open market operations with the CB - can engage in arbitrage between the external, or secondary market for bonds, and the private price set at the conversion window. This arbitrage mechanism withdraws money from the system or adds to it. Its existence renders modern CB money endogenous (or at least more endogenous than before). Using less exact terminology, once issued, modern (inflation-targeting) CB money never becomes a hot-potato. Increases in the public's demand for CB money draws it out of the system via open market operations while decreases in this demand push that money back into the CB via the same.

That being said, CB money can easily become hot-potato money. Should an inflation-targeting CB foresake its inflation targeting regime and cease offering daily withdrawal/deposit mechanisms (ie open market purchases and sales) priced using some sort of consistent rule, its liabilities have effectively become hot-potato, or exogenous. The modern Federal Reserve, which no longer targets the Federal funds rate by withdrawing/adding to reserves using open market purchases/sales of bonds, is a good example of this. There is no formal process which by the mountain of excess reserve balances might be withdrawn should the demand to hold them collapse, we only have indications from Ben Bernanke that some sort of draining process will occur. Over the last four years, the Fed has surely become a more "hot potato" central bank than the BoC, for instance. Thus David's classical theory surely applies more to the BoC than the Fed, although I'm not sure where he stands on this.

This hot potato vs not issue also came up at Lars Christensen's blog. I pointed out to him that I don't think that the distinction is a core one - its just a matter of how liabilities are structured.

I think we can agree that corporate stock is a hot-potato asset. Once issued, it circulates endlessly. Stocks can also be highly liquid -companies can issue new stock to buy services and many sorts of assets rather than using cash.

But if the corporation agrees to repurchase all its stock at $100 and sell unlimited stock at $105, then that stock is no longer hot-potato. Should the firm issue excess stock to buy services, that stock will quickly be returned for $100.

So much like stock, I’d say that central bank money is not necessarily either exogenous (hot potato) or endogenous. Like the stock example above, it depends on how the asset itself is structured and what options it provides its holders. 

So we're not talking about foundational differences here.

Lastly, while Nick Rowe's post From Gold Standard to CPI Standard is becoming one of my all time favorite Rowe posts, we like it for very different reasons, I think. Nick wanted to use the progression to show that if the old system was reserve-constrained, so is the current one. I'm using it to show that if the old system didn't emit hot potato money, neither does the new one.

Addendum: David Glasner follows up Nick Rowe’s Gold Standard, and Mine

Market monetarists and endogenous money

Lars Christensen had some interesting comments and responses on market monetarism.

I pushed him on how far market monetarists departed from traditional monetarists in admitting that money creation was endogenous, not exogenous. ie. determined by the central bank. If this is indeed the case, than the market monetarists stand nearer to the middle of the historic currency vs. banking school divide than Milton Friedman did. The latter would be considered a pure currency school theorist. Same with Mises and the traditional Austrians, although the Austrian free-bankers are surely not currency school theorists.

The fact that market monetarists, according to Christensen, are willing to think about money endogenously, just as the banking school theorists did, is a healthy improvement.

Japan, Productivity Norm, and Deflation

Lars Christensen teaches me some interesting things about Japan and deflation in Did Japan have a “productivity norm”?

See also an older post here titled Japan’s deflation story is not really a horror story.

This involves George Selgin's idea of the productivity norm. See Less than Zero (pdf).

I notice that Paul Krugman has also chimed in on Japan, charting GDP per working age citizen rather than GDP so as to adjust for demographics.

*Update: Lars has responded to the Krugman post here, and includes another chart. As I pointed out in the comments, I am not entirely convinced by his chart because he computes it on a per capita basis, not a per worker basis. Krugman's chart measures the ratio of Japan's per worker GDP to that of the US, which is a more powerful way to visually tell the tale. Unfortunately the time axis's resolution is by the decade in Krugman's chart, which gives no granularity, and he only includes the US.

So I made my own chart.

I think it's worth noting that, in regards to Lars's post, Japan's relative per worker GDP bottomed in 1999 and began to rise, which was before quantitative easing began in 2001. 

As for Krugman, my chart doesn't show the same large rise in Japanese per worker GDP relative to the US in the 2000s that his chart shows. It was more of a pause. But I am using World Bank data, and Krugman is using something else. Note also how Japan has done far better than Germany, France, and Italy.

**Update: Krugman has another post, More On Japan (Wonkish).

Moneyness and liquidity options

Lars Christensen had an interesting post on moneyness and the Divisia indexes. He recommended an old paper of Steve Horowitz's which I read some time ago and have always respected. See A Subjectivist Approach to the Demand for Money.

Essentially, you can't believe in the concept of moneyness and also believe in the effort to count money through indexes like M1, M2, or even the Divisia indexes. The two efforts contradict each other. The best way to get a market indication of moneyness, or liquidity, is through the introduction of liquidity options. My comment follows:

If moneyness is a subjective concept, and I think it is, then trying to sum up various money assets into a Divisia index is problematic. That’s because an asset that appears to be high on one person’s subjective moneyness scale will be low on another’s, the result being that it is impossible to create objective categories for moneyness.

Ultimately, the best way to determine moneyness is to back out the market’s assessment of an asset’s liquidity premium. The best way to do this is to introduce liquidity options on various assets and see how the market prices these options. Anyways, this is science fiction for now since liquidity options don’t exist.


Previous posts on liquidity options.