Floors v corridors

David Beckworth argues that the U.S. Federal Reserve should stop running a floor system and adopt a corridor system, say like the one that the Bank of Canada currently runs. In this post I'll argue that the Bank of Canada (and other central banks) should drop their corridors in favour of a floor—not the sort of messy floor that the Fed operates mind you, but a nice clean floor.

Floors and corridors are two different ways that a central banker can provide central banking services. Central banking is confusing, so to illustrate the two systems and how I get to my preference for a floor, let's start way back at the beginning.

Banks have historically banded together to form associations, or clearinghouses, a convenient place for bankers to make payments among each other over the course of the business day. To facilitate these payments, clearinghouses have often issued short-term deposits to their members. A deposit provides clearinghouse services. Keeping a small buffer stock of clearinghouse deposits can be useful to a banker in case they need to make unexpected payments to other banks.

Governments and central banks have pretty much monopolized the clearinghouse function. So when a Canadian bank wants to increase its buffer of clearinghouse balances, it has no choice but to select the Bank of Canada's clearing product for that purpose. Monopolization hasn't only occurred in Canada of course, almost every government has taken over their nation's clearinghouse.

One of the closest substitutes to Bank of Canada (BoC) deposits are government t-bills or overnight repo. While neither of these investment products is useful for making clearinghouse payments, they are otherwise identical to BoC deposits in that they are risk-free short-term assets. As long as these competing instruments yield the same interest rate as BoC deposits, a banker needn't worry about trading off yield for clearinghouse services. She can deposit whatever quantity of funds at the Bank of Canada that she deems necessary to prepare for the next day's clearinghouse payments without losing out on a better risk-free interest rate elsewhere.  

But what if these interest rates differ? If t-bills and repo promise to pay 3%, but a Bank of Canada deposit pays an inferior interest rate of 2.5%, then our banker's buffer stock of Bank of Canada deposits is held at the expense of a higher interest elsewhere. In response, she will try to reduce her buffer of deposits as much as possible, say by reallocating bank resources and talent to the task of figuring out how to better time the bank's outgoing payments. If more attention is paid to planning out payments ahead of time, then the bank can skimp on holdings of 2.5%-yielding deposits while increasing its exposure to 3% t-bills.

Why might BoC deposits and t-bills offer different interest rates? We know that any differential between them can't be due to credit risk—both instruments are issued by the government. Now certainly BoC deposits provide valuable clearinghouse services while t-bills don't. And if those services are costly for the Bank of Canada to produce, then the BoC will try to recapture some of its clearinghouse expenses. This means restricting the quantity of deposits to those banks that are willing to pay a sufficiently high fee for clearing services. Or put differently, it means the BoC will only provide deposits to banks that are willing to accept an interest rate that is 0.5% less than the 3% offered on t-bills.

But what if the central bank's true cost of providing additional clearinghouse services is close to zero? If so, the Bank of Canada should avoid any restriction on the supply of deposits. It should provide each bank with whatever amount of deposits it requires without charging a fee. With bankers' demand for clearing services completely sated, the differential between BoC deposits and t-bills will disappear, both trading at 2.5%.

There is good reason to believe that the cost of providing additional clearinghouse services is close to zero. It is no more costly for a central bank to issue a new digital clearinghouse certificate than it is for a Treasury secretary or finance minister to issue a new t-bill. In both cases, all it takes is a few button clicks.

Let's assume that the cost of providing clearinghouses is zero. If the Bank of Canada chooses to  constrain the supply of deposits to the highest bidders, it is forcing banks to overpay for a set of clearinghouse services which should otherwise be provided for free. In which case, the time and labour that our banker will need to divert to figuring out how to skimp on BoC deposit holdings constitutes a misallocation of her bank's resources. If the Bank of Canada provided deposits at their true cost of zero, then her employees' time could be put to a much better use.

As members of the public, we might not care if bankers get shafted. But if our banker has diverted workers from developing helpful new technologies or providing customer service to dealing with the artificially-created problem of skimping on deposits, then the public directly suffers. Any difference between the interest rate on Bank of Canada deposits and competing assets like t-bills results in a loss to our collective welfare.

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Which finally gets us to floors and corridors. In brief, a corridor system is one in which the central bank rations the number of clearinghouse deposits so that they aren't free. In a floor system, unlimited deposits are provided at a price of zero.

When a central bank is running a corridor system, as most of them do, the rate on competing assets like t-bills lies above the interest rate on central bank deposits. Economists describe these systems as corridors because the interest rate at which the central bank lends deposits lies above the interest rate on competing safe assets like t-bills and repo, and with the deposit rate lying at the bottom, a channel or corridor of sorts is formed.

For instance, take the Bank of Canada's corridor, illustrated in the chart below. The BoC lets commercial banks keep funds overnight and earn the "deposit rate" of 0.75%. The overnight rate on competing opportunities—very short-term t-bills and repo—is 1%. The top of the corridor, the bank rate, lies at 1.25%. So the overnight rate snakes through a corridor set by the Bank of Canada's deposit rate at the bottom and the bank rate at the top. (The exception being a short period of time in 2009 and 2010 when it ran a corridor floor).

Let's assume (as we did earlier) that the BoC's cost of providing additional clearinghouse services is basically zero. Given the way the system is set up now, there is a 0.25% rate differential (1%-0.75%) between the deposit rate and the rate on competing asset, specifically overnight repo. This means that the Bank of Canada has capped the quantity of deposits, forcing bankers to pay a fee to obtain clearing services rather than supplying unlimited deposits for free. This in turn means that Canadian bankers are forced to use up time and energy on a wasteful effort to skimp on BoC deposit holdings. All Canadians suffer from this waste.

It might be better for the Bank of Canada (and any other nation that also uses a corridor system) to adopt what is referred to as a floor system. Under a floor system, rates would be equal such that the rate on t-bills and repo lies on the deposit rate floor of 0.75%--that's why economists call it a floor system. The Bank of Canada could do this by removing its artificial limit on the quantity of deposits it issues to commercial banks. Banks would no longer allocate scarce time and labour to the task of skirting the high cost of BoC deposits, devoting these resources to coming up with new and superior banking products. In theory at least, all Canadians would be made a little better off. All the Bank of Canada would have to do is click its 'create new clearinghouse deposits'  button a few times.

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The line of thought I'm invoking in this post is a version of an idea that economists refer to as the optimum quantity of money, or the Friedman rule, first described by Milton Friedman back in the 1960s. Given that a central bank's cost of issuing additional units of money is zero, Friedman thought that any interest rate differential between a monetary asset and an otherwise identical non-monetary asset represents a loss to society. This loss comes in the form of people wasting resources (or incurring shoe leather costs) trying to avoid the monetary asset as much as possible. To be consistent with the zero cost of creating new monetary assets, the rates on the two assets should be equalized. The public could then hold whatever amount of the monetary asset they saw fit, so-called shoe leather costs falling to zero.

In my post, I've applied the Friedman rule to one type of monetary asset: central bank deposits. But it can also be applied to banknotes issued by the central bank. After all, banknotes yield just 0% whereas a t-bill or a risk-free deposit offers a positive interest rates. To avoid holding large amounts of barren cash, people engage in wasteful behaviour like regularly visiting ATMs.

There are several ways to implement the Friedman rule for banknotes. One of the neatest ways would be to run a periodic lottery that rewards a few banknote serial numbers with big winnings, the size of the pot being large enough that the expected return on each banknote as made equivalent to interest rate on deposits. This idea was proposed by Charles Goodhart and Hugh McCulloch separately in 1986.

Robert Lucas once wrote that implementing the Friedman rule was “one of the few legitimate ‘free lunches’ economics has discovered in 200 years of trying.” The odd thing is that almost no central banks have tried to adopt it. On the cash side of things, none of them offer a serial number lottery or any of the other solutions for shrinking the rate differential between banknotes and deposits, say like Miles Kimball's more exotic crawling peg solution. And on the deposit side, floor systems are incredibly rare. The go-to choice among central banks is generally a Friedman-defying corridor system.

One reason behind central bankers' hesitation to implement the Friedman rule is that it would threaten their pot of "fuck you money", a concept I described here. Thanks to the large interest rate gaps between cash and t-bills, and the smaller gap between central bank clearinghouse deposits and t-bills, central banks tend to make large profits. They submit much of their winnings to their political masters. In exchange, the executive branch grants central bankers a significant degree of independence... which they use to geek out on macroeconomics. Because they like to engage in  wonkery and believe that it makes the world a better place, central bankers may be hesitant to implement the Friedman rule lest it threaten their flows of fuck you money, and their sacred independence. 

That may explain why floors are rare. However, they aren't without precedent. To begin with, there is the Fed's floor that Beckworth describes, which it bungled into by accident. At the outset of this post I called it a messy floor, because it leaks (George Selgin and Stephen Williamson have gone into this). The sort of floor that should be emulated isn't the Fed's messy one, but the relatively clean floor that the Reserve Bank of New Zealand operated in 2007 and Canada did from 2009-11 (see chart above). Though these floors were quickly dropped, I don't see why the couldn't (and shouldn't) be re-implemented. As Lucas says, its a free lunch.

Is the Fed breaking the law by paying too much interest?

George Selgin had an interesting post describing how the Fed appears to be breaking the law by paying too much interest to reserve-holders. This is an idea that's cropped up on the blogosphere before, here is David Glasner, for instance.

I agree with George that the the letter of the law is being broken. That's unfortunate. As Section 19(b)(12)(A) of the Federal Reserve Act stipulates, the Fed can only pay interest "at a rate or rates not to exceed the general level of short-term interest rates." With three month treasury bills currently around 0.33% and the fed funds rate at 0.4%, the current interest rate on reserves (IOR) of 0.5% exceeds the legal maximum.

Unlike George, I don't think the Fed deserves criticism over this. If the letter of the law is being broken, the spirit of the law surely isn't.

If there is a spirit residing in the law governing IOR, it's the ghost of Milton Friedman. Since the Fed's inception in 1913, IOR had been effectively set at 0%, far below the general level of short term interest rates. This has acted as a tax on bankers. They have been forced to hold an asset—reserves—that provides a below-market return. Friedman's big idea was to remove this distortionary tax by bringing IOR up to the same level as other short term interest rates. Banks would now be earning the same rate as everyone else. The Fed would only get the authority to set a positive rate on reserves in 2008, long after most modern central banks like the Bank of Canada had implemented Friedman's idea.

Friedman wanted to remove the tax, but he didn't want to introduce a subsidy in its place. To prevent central bank subsidization of banks, the Federal Reserve Act is explicit that IOR should not exceed other short-term interest rates.

In practice, how might the Fed set IOR in a way that subsidizes banks? This is more complicated than it seems. If the Fed sets IOR at 1%, arbitrage dictates that all other short term rates will converge to that same level. After all, why would a financial institution buy a safe short term fixed income product for anything less than 1% if the central bank is fixing the yield of a competing product, reserves, at 1%?

Short-term yields won't converge exactly to IOR. Some will trade a hair above IOR, others a bit below. This is because each short-term fixed income product has its own set of peculiarities and these get built into their yield. For instance, buying federal funds is riskier than parking money at the Fed; in the latter transaction the Fed is your counterparty while in the former it's a bank, So the fed funds rate should trade a bit above IOR. But we wouldn't say that a higher fed funds rate is a sign of a below-market return on reserves, or that this spread represents an implicit tax on reserve owners. The fed funds rate exceeds IOR only because that is how the market has chosen to appraise the risk of owning fed funds.

Conversely, because a treasury bill is ofttimes less risky then parking money at the Fed, its yield should regularly dip below IOR. When it does, no one would say that the Fed is providing an unfair subsidy to reserve holders by paying IOR in excess of the treasury bill rate. The lower treasury bill rate is simply the free market's way of accounting for the superior risk profile of treasury bills relative to reserves.

Nowadays, with IOR at 0.5% and treasury bills yielding 0.33%, the Fed is clearly contradicting the wording of the Federal Reserve Act. IOR has been set at a rate that "exceeds the general level of short-term interest rates." But this by no means implies that the Fed is breaking the spirit of the law. The spirit of the law only tells the Fed not to pay subsidies to banks. As I explained above, the yield differential may simply reflect the market's assessment of the unique risks of various short-term fixed income products, not  a policy of paying subsidies.

To get the ghost of Milton Friedman rolling in his grave, here is how to structure IOR so that it offers a subsidy to banks. The Fed would have to set up a tiered reserve system where a bank's first tier of reserves earns a higher rate than the next tier. To begin with, assume that Fed officials deem that a 0.5% fed funds rate is consistent with a 2% inflation target. The Fed offers to pays interest of 100% on required reserves (I'm exaggerating to make my point) while offering just 0.5% on excess reserves. Banks will hold required reserves up to the maximum and reap an incredibly 100% yearly return. All reserves above that ceiling will either be parked at the Fed to earn 0.5% or lent out in the fed funds market.

Thanks to arbitrage, the 0.5% rate on excess reserves ripples through to other short term rates. Because a bank can always leave excess reserves at the Fed and earn an easy 0.5%, a borrower will have to bid up the fed funds rate and t-bill rates to at least 0.5% in order to coax the marginal lender away from the Fed.

And that's how the Fed would subsidize banks. The "general level" of rates as implied by the rate on fed funds and treasury bills hovers at 0.5% while banks are earning a stunning 100% on a portion of their reserve holdings. It's highway robbery! Milton Friedman would be furious; the distortionary tax he so disliked has been replaced with a distortionary subsidy.

By the way, if you really want to know what tiering and central bank subsidies to banks look like, this is the exact same mechanism the Bank of Japan and Swiss National Bank have introduced to help banks deal with negative interest rates. See here and here.  

So the bit of legalese that says that IOR should not exceed the "general level of short-term interest rates" is really just a poorly chosen set of words meant to describe a very specific idea, namely, a prohibition against setting a tiered reserve policy where the first tier, required reserves, earns more than the second, excess reserves, the ensuing subsidy flowing through to banks.

At the end of the day, what accounts for the current divergence between IOR and the other short term rates? Because the Fed has not set up a tiered reserve policy, there is simply no way that the divergence reflects a subsidization of banks. There is only one remaining explanation. Peculiar developments in the microstructure of the fed funds and t-bills markets have led traders to discount these rates relative to IOR.

So you can rest easy, Milton.

The peculiarities bedeviling the fed funds market are explained by Stephen Williamson here. There are several large entities, the GSEs, that can keep reserves at the Fed but are legally prevented from earning IOR. Anxious to get a better return, they invest in the fed funds market market, but only a limited number of banks have the balance sheet capacity to accept these funds. This oligopoly is able to extract a pound of flesh from the GSEs by lowballing the return they offer, the result being that the fed funds rate lies below IOR.

As for treasury bills, they are unique because, unlike reserves held at the Fed, they are accepted as collateral by a whole assortment of financial intermediaries. Put differently, treasury bills are a better money than reserves. Because the government is loath to issue too many of them, the supply of treasury bills has been kept artificially scarce so that they trade at a premium, a liquidity premium.

George ends his post by appealing to his readers to sue the Fed. I don't think think a lawsuit will bring much justice. If there are to be any legal battles to be fought, better to petition Congress to adjust the wording of the Federal Reserve Act so that it better fits the spirit of the law. We don't want the law to misidentify a situation involving IOR in excess of the "general level of interest rates" as necessarily implying subsidization when microstructure is actually at fault. While Milton Friedman had a lot of reasons to criticize the Fed, this probably wouldn't be one of them.

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.

Freshwater macro, China's silver standard, and the yuan peg

1934 Chinese silver dollar with Sun Yat-sen on the obverse side. The ship may be in freshwater.

I have been hitting my head against the wall these last few weeks trying to understand Chinese monetary policy, a project that I've probably made harder than necessary by starting in the distant past, specifically with the nation's experience during the Great Depression. Taking a reading break, I was surprised to see that Paul Krugman's recent post on the topic of freshwater macro had surprising parallels to my own admittedly esoteric readings on Chinese monetary history.

Unlike most nations, China was on a silver standard during the Great Depression. The consensus view, at least up until it was challenged by the freshwater economists that people Krugman's post, had always been that the silver standard protected China from the first stage of the Great Depression, only to betray the nation by imposing on it a terrible internal devaluation as silver prices rose. This would eventually lead China to forsake the silver standard. This consensus view has been championed by the likes of Milton Friedman and Anna Schwartz in their monumental Monetary History of the United States.

This consensus view is a decidedly non-freshwater take on things as it it depends on features like sticky prices and money illusion to generate its conclusions. After all, given the huge rise in the value of silver, as long as Chinese prices and wages—the reciprocal of the silver price—could adjust smoothly downwards, then the internal devaluation forced on China would be relatively painless. If, however, the necessary adjustment was impeded by rigidities then prices would have been locked at artificially high levels, the result being unsold inventories, unemployment, and a recession.

Just to add some more colour, China's internal devaluation was imposed on it by American President Franklin D. Roosevelt in two fell swoops, first by de-linking the U.S. from gold in 1933 and then by buying up mass quantities of silver starting in 1934. The first step ignited an economic rebound in the U.S. and around the world that helped push up all prices including that of silver. As for the second, Roosevelt was fulfilling a campaign promise to those who supported him in the western states where a strong silver lobby resided thanks to the abundance of silver mines. The price of silver, which had fallen from 60 cents in 1928 to below 30 cents in 1932, quickly rose back above its 1928 levels, as illustrated in the chart below. According to one contemporary account, that of Arthur N. Young, an American financial adviser to the Nationalist government, "China passed from moderate prosperity to deep depression."

As I mentioned at the outset, this consensus view was challenged by the freshwater economists, no less than the freshest of them all, Thomas Sargent (who was once referred to as "distilled water"), in a 1988 paper coauthored with Loren Brandt (RePEc link). New data showed that Chinese GDP rose in 1933 and only declined modestly in 1934, this due to a harvest failure, not a monetary disturbance. So much for a brutal internal devaluation.

According to Sargent and Brandt, it appeared that "that there was little or no Phillips curve tradeoff between inflation and output growth in China." In non econo-speak, deflation.not.bad. They put forth several reasons for this, including a short duration of nominal contracts and village level mechanisms for "haggling and adjusting loan payments in the event of a crop failure." In essence, Chinese prices were very quick to adjust to silver's incredible rise.

Four years later, Friedman responded (without Schwartz) to what he referred to as the freshwater economists' "highly imaginative and theoretically attractive interpretation." (Here's the RePEc link). His point was that foreign trade data, which apparently has a firmer statistical basis than the output data on which Sargent and Brandt depended, revealed that imports had fallen on a real basis from 1931 to 1935, and particularly sharply from 1933 to 1935. So we are back to a story in which, it would seem, the rise in silver did place a significant drag on the Chinese economy, although Friedman grudgingly allowed for the fact that perhaps he may have "overestimated" the real effects of the silver deflation.

So this battle of economic titans leads to a watered-down story in which Roosevelt's silver purchases probably had *some* deleterious effects on China. China would go on to leave the silver standard, although what probably provided the final nudge was a bank run that kicked off in the financial centre of Shanghai in 1934. Depositors steadily withdrew the white metal from their accounts in anticipation of some combination of a devaluation of the currency, exchange controls, and an all-out exit from the silver standard, a process outlined in a 1988 paper by Kevin Chang (and referenced by Friedman). This self-fulfilling mechanism, very similar in nature to the recent run on Greece, may have encouraged the authorities to sever the currency's linkage to silver and put it on a managed fiat standard. The Chinese economy went on to perform very well in 1935 and 1936, although that all ended with the Japanese invasion in 1937.

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As I mentioned at the outset, these events and the way they were perceived by freshwater and non-freshwater economists seem to me to have some relevance to modern Chinese monetary policy. As in 1934, China is to some extent importing made-in-US monetary policy. The yuan is effectively pegged to the U.S. dollar, so any change in the purchasing power of the dollar leads to a concurrent change in the purchasing power of the yuan.

There's an asterisk to this. In 1934, China was a relatively open economy whereas today China makes use of capital controls. By immobilizing wealth, these controls make cross-border arbitrage more difficult, thus providing Chinese monetary authorities with a certain degree of latitude in establishing a made-in-China monetary policy.  But capital controls have become increasingly porous over the years, especially as the effort to internationalize the yuan—which requires more open capital markets—gains momentum. By maintaining the peg and becoming more open, China's monetary policy is getting ever more like it was in 1934.

As best I can tell, the monetary policy that Fed Chair Janet Yellen is exporting to China is getting tighter. One measure of this, albeit an imperfect one, is the incredible rise of the U.S. dollar over the last year. Given its peg, the yuan has gone along for the ride. Another indication of tightness in the U.S. is Scott Sumner's nominal GDP betting market which shows nominal growth expectations for 2015 falling from around 5% to 3.2%. That's quite a decline. On a longer time scale, consider that the Fed has been consistently missing its core PCE price target of 2% since 2009, or that the employment cost index just printed its lowest monthly increase on record.

If Chinese prices are as flexible as Brandt and Sargent claimed they were in 1934, then the tightening of U.S. dollar, like the rise in silver, is no cause for concern for China. But if Chinese prices are to some extent rigid, then we've got a Friedman & Schwartz explanation whereby the importation of Yellen's tight monetary policy could have very real repercussions for the Chinese economy, and for the rest of the world given China's size.

Interestingly, since 2014 Chinese monetary authorities have been widening the band in which the yuan is allowed to trade against the U.S. dollar. And the peg, which authorities had been gently pushing higher since 2005, has been brought to a standstill. The last time the Chinese allowed the peg to stop crawling higher was in 2008 during the credit crisis, a halt that Scott Sumner once went so far as to say saved the world from a depression.

Chinese GDP [edit: GDP growth] continues to fall to multi-decade lows while the monetary authorities consistently undershoot their stated inflation objectives. In pausing the yuan's appreciation, the Chinese authorities could very well be executing something like a Friedman & Schwartz-style exit from the silver standard in order to save their economy from tight U.S. monetary policy. This time it isn't an insane silver buying program that is at fault, but the Fed's odd reticence to reduce rates to anything below 0.25%. Further tightening from Yellen may only provoke more offsetting from the Chinese... unless, of course, the sort of thinking underlying Wallace and Brandt takes hold and Chinese authorities decide to allow domestic prices to take the full brunt of adjustment.

Fedwire transactions and PT vs PY

Milton Friedman's alleged license plate, showing the equation of exchange

The excruciatingly large revisions that U.S. first quarter GDP growth underwent from the BEA's advance estimate (+0.1%, April 30, 2014) to its preliminary estimate (-1.0%, May 29, 2014) and then its final estimate (-2.9%, June 25m, 2014) left me scratching my head. Isn't there a more timely and accurate measure of spending in an economy?

One interesting set of data I like to follow is the Fedwire Fund Service's monthly, quarterly, and yearly statistics. Fedwire, a real time gross settlement interbank payment mechanism run by the Federal Reserve*, is probably the most important financial utility in the U.S., if not the world. Member banks initiate Fedwire payments on their own behalf or on behalf of their clients using the Fedwire common currency: Fed-issued reserves. Whenever you wire a payment to another bank in order to settle a purchase, you're using Fedwire. Since a large percentage of U.S. spending is transacted via Fedwire, why not use this transactions data as a proxy for U.S. spending?

Some might say that using Fedwire data is an old-fashioned approach to measuring spending. Irving Fisher wrote out one of the earliest versions of the equation of exchange, MV=PT, where T measures the "volume of trade" or "real expenditure" and P is the price at which this trade is conducted. Combined together, PT amounts to the sum of all exchanges in an economy. More specifically, Fisher's T included all exchanges of goods where his chosen meaning for a good was broadly defined as any sort of wealth or property. That's a pretty wide net, including everything from lettuce to publicly-traded equities to land.

Practically speaking, Fisher wrote that it was "utterly impossible to secure data for all exchanges" and therefore his statistical approximation of T was limited to the quantities of trade in 44 articles of internal commerce (including pig iron, rice, hogs, boots & shoes), 23 articles of import and 25 of export, sales of equities, railroad freight carried, and letters through the post office. This mishmash of items included everything from wholesale goods to securities to and consumption goods. Using Fedwire transactions to track total spending is very much in the spirit of Fisher, since any sort of transaction can be conducted through the interbank payments system, including financial transactions.

Nowadays we are no longer taught the Fisherian transactions version of the equation of exchange MV=PT but rather the income approach, or MV=PY. What is the difference between the two? Y is a much smaller number than T. This is because it represents GDP, or only those goods and services that are qualified as final, where "final" indicates items bought by a final user. T, on the other hand, includes not only the set of final goods and services Y but also all spending on second hand goods, stocks and bonds, existing homes, transfer payments, and more. Whereas GDP measures final goods in order to avoid double counting, T measures final and intermediate goods, thus counting the same good twice, thrice, or even more if the good changes hands more often than that.

A good illustration of the difference in size between Y and T is to chart them. The total yearly value of Fedwire transactions, which are about as good a measure of PT that we have (but by no means perfect), exceeds nominal GDP (or PY) by a factor of 40 or so, as the chart below shows. Specifically, nominal GDP came in at $17 trillion or so in 2013 whereas the total value of Fedwire transactions clocked in at $713 trillion.

So why do we focus these days on PY and not Fisher's PT? We can find some clues by progressing a little further through the history of economic thought to John Keynes (is it a travesty to omit his middle name?). In his Treatise on Money, Keynes was unimpressed with Fisher's cash transactions standard, as he referred to it, because PT failed to capture the most important human activities:

Human effort and human consumption are the ultimate matters from which alone economic transactions are capable of deriving any significant; and all other forms of expenditure only acquire importance from their having some relationship, sooner or later, to the efforts of producers or to the expenditure of consumers.

Keynes proposed to "break away from the traditional method" of tabulating the total quantity of money "irrespective of the purposes on which it was employed" and focus instead on the narrow range of trade in current consumption and investment output. Keynes's PY measure (the actual variables he chose was PO where O is current output) would be a "more powerful instrument of analysis than their predecessor, when we are considering what kind of monetary and business events will produce what kind of consequences."

And later down the line, Milton Friedman, who renewed the quantity theory tradition in the 1950s and 60s, had this to say about the shift from PT to PY:

Despite the large amount of empirical work done on the transactions equations, notably by Irving Fisher and Carl Snyder ( Fisher 1911 pp 280-318, Fisher 1919, Snyder 1934), the ambiguity of the concept of "transactions" and the "general price level", particularly those arising from the mixture of current and capital transactions—were never satisfactorily resolved. The more recent development of national income accounting has stressed income transactions rather than gross transactions and has explicitly and satisfactorily dealt with the conceptual and statistical problems of distinguishing between changes in prices and changes in quantities. As a result, the quantity theory has more recently tended to be expressed in terms of income rather than of transactions

So there are  evidently problems with PT, but what are the advantages? Assuming we use Fedwire transactions as the proxy for PT (and again, Fedwire is by no means a perfect measure of T, as I'll go on to show later) the data is immediate and unambiguous. It doesn't require hordes of government statisticians to laboriously compile, recompile, and check, but arises from the regular functioning of Fedwire payments mechanism. There are no revisions to the data after the fact. And rather than being limited to periods of time of a month or a quarter, there's no reason we couldn't see Fedwire data on a weekly, daily, or even real time level of granularity if the Fed chose to publish it.

Even Keynes granted the advantages of PT data when he wrote that the "figures are available promptly without the necessity for any special calculation." In Volume II of his Treatise, he took U.S. "bank clearings" data (presumably Fedwire data), and tried to remove those transactions arising from financial activity by excluding New York City, the nation's chief financial centre, thus arriving at a measure of final spending that came closer to PY.

What are the other advantages of PT? While PT counts second-hand and existing sales, might that not be a good thing? Nick Rowe, writing in favour of PT, once made the point that it's "not just new stuff that is harder to sell in a recession; it's old stuff too. New cars and old cars. New houses and old houses. New paintings and old paintings. New furniture and antique furniture. New machine tools and old machine tools. New land and old land." As for the inclusion of financial transactions, anyone who thinks asset price inflation or deflation is an important property of the economy (Austrians and Austrian fellow travelers no doubt) may prefer PT over PY since the latter is mute on the subject.

I'd be interested to hear in the comments the relative merits and demerits of PY and PT. Why don't the CNBC talking heads ever mention Fedwire, whereas they can spend hours debating GDP? Why target nominal GDP, or PY, when we can target PT?

For now, let's explore the Fedwire data a bit more. In the figure below I've charted the total value of Fedwire transactions (PT) for each quarter going back to 1992. I've overlaid nominal GDP (PY) on top of that and set the initial value of each to 100 for the sake of comparison.

It's evident that the relative value of Fedwire transactions has been growing faster than nominal GDP. However, the financial crisis put a far bigger dent in PT than it did PY. Only in the last two quarters has PT been able to break to new levels whereas nominal GDP surpassed its 2008 peak by the second quarter of 2010. Is the financial sector dragging down PT? Or maybe people are spending less on used goods and/or existing homes?

Fedwire data is further split into price and quantity data. Below I've plotted the number of transactions, or T, completed on Fedwire each quarter. On top of that I've overlaid real GDP, or Y. The initial value of real GDP has been set to 16.6 million, or the number of transactions completed on Fedwire in 1992.

After growing at a relatively fast rate until 2007, the number of transactions T being carried out on Fedwire continues to stagnate below peak levels. In fact, last quarter represented the lowest number of transactions since the first quarter of 2012, a decline that coincided with the atrocious first quarter GDP numbers.

Finally, below I've plotted the average value of Fedwire transfer by quarter. On top of that I've overlaid the GDP deflator. To make comparison easier, I've taken the liberty of setting the initial value of the deflator at the 1992 opening value for Fedwire transaction size.

As the chart shows, the average size of Fedwire transfers really took off in 2007, peaked in late 2008 then stagnated until 2013, and has since re-accelerated upwards. In fact, we can attribute the entire rise in the quarterly value of transactions on Fedwire (the second chart) to the growth in transaction size, not the quantity of transactions. Fedwire data is telling us that inflation of the PT sort has finally reemerged.

A few technical notes on the Fedwire data before signing off. As I've already mentioned, Fedwire provides a less-than complete measure of PT. To begin with, it doesn't include cash transactions (GDP does, or at least those that have been reported). This gap arises for the obvious reason that cash transactions aren't conducted over Fedwire. Nor do cheque transactions appear on Fedwire, or at least they do so only indirectly. Check payments are netted against each other and canceled, with only the final amounts owed being settled between banks via Fedwire, these settlements representing just a tiny fraction of the total value of payments that have been conducted by check over any period of time.

The same goes for securities transactions. Fedwire data underestimates the true amount of financial transactions because trades are usually netted against each other by an exchange's clearing house prior to final settlement via Fedwire. The transfer of reserves that enables the system to settle represents a small percent of the total value of trades that have actually occurred.

Another limitation is that Fedwire data doesn't include wire payments that occur on competing payment systems. Fedwire isn't a monopoly, after all, and competes with CHIPS. I believe that once all CHIPS payments have been cleared, final settlement occurs via a transfer of reserves on Fedwire, but this final transfer is a fraction of the size of total CHIPS payments. And finally, payments that occur between customers of the same bank are not represented in the Fedwire data. This is because these sorts of payments can be conducted by a transfer of book entries on the bank's own balance sheet rather than requiring a transfer of reserves.

I'm sure I'm missing other reasons for why Fedwire data undershoots PT, feel free to point them out in the comments. Do Fedwire's limitations cripple its value as an indicator PT? I think there's still some value in looking at these numbers, as long as we're aware of how they might come up short.

Some links:
1. Canadian Large Value Transfer System Data, the Canadian equivalent to Fedwire
2. A paper exploring UK CHAPS data,the British equivalent to Fedwire: Income and Transactions Velocities in the UK

* 'Real time' means that payments are immediate and not subject to delay, while 'gross settlement' indicates that payments are not grouped together for processing but submitted individually upon being entered. Fedwire gets its name from the beginning of the last century, when payments were carried out over the wires, or the telegraph system. 

Milton Friedman and moneyness

Steve Williamson recently posted a joke of sorts:

What's the difference between a New Keynesian, an Old Monetarist, and a New Monetarist? A New Keynesian thinks no assets matter, an Old Monetarist thinks that some of the assets matter, and a New Monetarist thinks all of the assets matter.

While I wouldn't try it around the dinner table, what Steve seems to be referring to here is the question of money. New Keynesians don't have money in their models, Old Monetarists have some narrow aggregate of assets that qualify as M, and New Monetarists like Steve think everything is money-like.*

This is a interesting way to describe their differences, but is it right? In this post I'll argue that these divisions aren't so cut and dry. Surprisingly enough, Milton Friedman, an old-fashioned monetarist, was an occasional exponent of the idea that all assets are to some degree money-like. I like to call this the moneyness view. Typically when people think of money they take an either/or approach in which a few select goods fall into the money category while everything else falls into the non-money category. If we think in terms of moneyness, then money is a characteristic that all goods and assets possess to some degree or another.

One of my favorite examples of the idea of moneyness can be found in William Barnett's Divisia monetary aggregates. Popular monetary aggregates like M1 and M2 are constructed by a simple summation of the various assets that economists have seen fit to place in the bin labeled 'money'. Barnett's approach, on the other hand, is to quantify each asset's contribution to the Divisia monetary aggregate according to the marginal value that markets and investors place on that asset's moneyness, more specifically the value of the monetary services that it throws off. The more marketable an asset is on the margin, the greater its contribution to the Divisia aggregate.

Barnett isolates the monetary services provided by an asset by first removing the marginal value that investors place on that asset's non-monetary services, where non-monetary services might include pecuniary returns, investment yields and consumption yields. The residual that remains after removing these non-monetary components equates to the market's valuation of that given asset's monetary services. Since classical aggregates like M1 glob all assets together without first stripping away their various non-monetary service flows, they effectively combine monetary phenomena with non-monetary phenomena—a clumsy approach, especially when it is the former that we're interested in.

An interesting incident highlighting the differences between these two approaches occurred on September 26, 1983, when Milton Friedman, observing the terrific rise in M2 that year, published an article in Newsweek warning of impending inflation. Barnett simultaneously published an article in Forbes in which he downplayed the threat, largely because his Divisia monetary aggregates did not show the same rise as M2. The cause of this discrepancy was the recent authorization of money market deposit accounts (MMDAs) and NOW accounts in the US. These new "monies" had been piped directly into Friedman's preferred M2, causing the index to show a discrete jump. Barnett's Divisia had incorporated them only after adjusting for their liquidity. Since neither NOW accounts nor MMDAs were terribly liquid at the time—they did not throw off significant monetary services—their addition to Divisia hardly made a difference. As we know now, events would prove Friedman wrong since the large rise in M2 did not cause a new outbreak of inflation.**

However, Friedman was not above taking a moneyness approach to monetary phenomenon. As Barnett points out in his book Getting it Wrong, Friedman himself requested that Barnett's initial Divisia paper, written in 1980, include a reference to a passage in Friedman & Schwartz's famous Monetary History of the United States. In this passage, Friedman & Schwartz discuss the idea of taking a Divisia-style approach to constructing monetary aggregates:

One alternative that we did not consider nonetheless seems to us a promising line of approach. It involves regarding assets as joint products with different degrees of "moneyness" and defining the quantity of money as the weighted sum of the aggregate value of all assets, the weights varying with the degree of "moneyness".

F&S go on to say that this approach

consists of regarding each asset as a joint product having different degrees of "moneyness," and defining the quantity of money as the weighted sum of the aggregate value of all assets, the weights for individual assets varying from zero to unity with a weight of unity assigned to that asset or assets regarded as having the largest quantity of "moneyness" per dollar of aggregate value.

There you have it. The moneyness view didn't emerge suddenly out of the brains of New Monetarists. William Barnett was thinking about this stuff a long time ago, and even an Old Monetarist like Friedman had the idea running in the back of his mind. And if you go back even further than Friedman, you can find the idea in Keynes & Hayek, Mises, and as far back as Henry Thornton, who wrote in the early 1800s. The moneyness idea has a long history.

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* Steve on moneyness: "all assets are to some extent useful in exchange, or as collateral. "Moneyness" is a matter of degree, and it is silly to draw a line between some assets that we call money and others which are not-money."

...and on old monetarists: "Central to Old Monetarism - the Quantity Theory of Money - is the idea that we can define some subset of assets to be "money". Money, according to an Old Monetarist, is the stuff that is used as a medium of exchange, and could include public liabilities (currency and bank reserves) as well as private ones (transactions deposits at financial institutions)."

** See Barnett, Which Road Leads to Stable Money Demand?

1,682 days and all's well

1,682 is the number of days that the Dow Jones Industrial Average has spent rising since hitting rock bottom back in March 6, 2009.

It also happens to be the number of days between the Dow's July 8, 1932 bottom and its March 10, 1937 top. From that very day the Dow would begin to decline, at first slowly, and then dramatically from August to November when it white-knuckled almost 50%, marking one of the fastest bear market declines in history.

Comparisons of our era to 1937 seems apropos. Both eras exhibit near zero interest rates, excess reserves, and a tepid economic recovery characterized by chronic unemployment. Are the same sorts of conditions that caused the 1937 downturn likely to arise 1,682 days into our current bull market?

The classic monetary explanation for 1937 can be found in Friedman & Schwartz's Monetary History. Beginning in August 1936, the Fed announced three successive reserve requirement increases, pushing requirements on checking accounts from 13% to 26% (see chart below). The economy began to decline, albeit after a lag, as banks tried vainly to restore their excess reserve position by reducing lending and selling securities. A portion of the reserve requirement increase was rolled back on April 14, 1938, too late to prevent massive damage being done to the economy. The NBER cycle low was registered in June of that year.

Friedman & Schwartz's second monetary explanation for 1937 has been fleshed out by Douglas Irwin (pdf)(RePEc). In December 1936, FDR began to sterilize foreign inflows of gold and domestic gold production (see next paragraphs for the gritty details). This effectively froze the supply of base money, which had theretofore been increasing at a rate of 15-20% or so a year. Tight money, goes the story, caused the economy to plummet, a decline mitigated by FDR's announcement on February 14, 1938 to partially desterilize (and therefore allow the base to increase again, with limits), further mitigated by an all-out cancellation of the sterilization campaign that April.

Here are the details of how sterilization worked. (If you find the plumbing of central banking tedious, you may prefer to skip to the paragraph that begins with ">>" — I'll bring the 1937 analogy back to 2013 after I'm done with the plumbing). In the 1920s, the supply of base money could be increased in several ways. First, Fed discounting could do the trick, whereby new reserves were lent out upon appropriate collateral. The Fed could also create new reserves and buy either government securities in the open market or bankers acceptances. Lastly, gold was often sold directly to the Fed in exchange for base money. After 1934, all but the last of these four avenues had been closed. Both the Fed's discount rate and its buying rate on acceptances was simply too high to be attractive to banks, and the practice of purchasing government securities on the open market had long since petered out. Only the gold avenue remained.

New legislation in 1934 meant that all domestic gold and foreign gold inflows had to be sold to the Treasury at $35/oz. The Secretary of the Treasury would write the gold seller a cheque drawn on the Treasury's account at the Fed, reducing the Treasury's balance. The Treasury would then print off a gold certificate representing the number of ounces it had purchased, deposit the certificate at the Fed, and have the Fed renew its account balance with brand-spanking new deposits. Put differently, gold certificates were monetized. As the Treasury proceeded to pay wages and other expenses out of its account during the course of business, these new deposits were injected into the banking system.

You'll notice that by 1934 the Treasury, and not the Fed, had become responsible for increasing the base money supply, a situation that may seem odd to us today. As long as the Treasury Secretary continuously bought gold and took gold certificates representing those ounces to the Fed to be monetized, the supply of base money would increase one-for-one as the Treasury drew down its account at the Fed.

The Treasury's decision to sterilize gold inflows in December 1936 meant that although it would continue to purchase gold, it would cease bringing certificates to the Fed to be monetized. The Treasury would pay for each newly mined gold ounce and incoming foreign ounces by first transferring tax revenues and/or the proceeds of bond issuance to its account at the Fed. Only then could it afford to make the payment. Whereas the depositing of gold certificates by the Treasury had resulted in the creation of new base money, neither the transfer of tax revenues nor the proceeds of bond issuance to the Treasury's account would have resulted in the creation of new base.

FDR's sterilization campaign therefore froze the base. Gold was kept "inactive" in Treasury vaults, as Friedman & Schwartz would describe it. The moment the sterilization campaign was reversed (partially in February 1938, and fully in April), certificates were once again monetized, the base began to expand again, and a rebound in stock prices and the broader economy followed not long after.

>> Let's bring this back to the present. Before 2008 the Fed typically increased the supply of base money as it defended its target for the federal funds rate. The tremendous glut of base money created since 2008 and the introduction of interest-on-reserves has given the Fed little to defend, thus shutting the traditional avenue for base money increases. Just as the gold avenue became the only way to increase the base in 1936, quantitative easing has become the only route to get base money into the banking system. With that analogy in mind, FDR's 1936 sterilization campaign very much resembles an end to QE, doesn't it? Both actions freeze of the monetary base. Likewise, last September's decision to avoid tapering is analogous to the 1938 decision to cease sterilization (or to "desterilize") —both of these decisions unfreeze the base.

Who cares if the base is frozen? After all, in 1937 and today, any pause in base creation won't change the fact that there is already a tremendous glut in reserves. A huge pile of snow remains a huge pile, even after it has stopped snowing.

One reason that desterilization and ongoing QE might be effective is because they shape expectations about future monetary policy, and these expectations are acted upon in the present. For instance, say that the market expects the glut of base money to be removed five years in the future. Only then will reserves regain their rare, or "special" status. While a sudden announcement to taper or sterilize will do little to reduce the present glut, it might encourage the market to move up the expected date of the glut's removal by a year or two. Which will only encourage investors in the present to sell assets for soon-to-be rare reserves, causing a deflationary decline in prices. On the other hand, a renewed commitment to QE or desterilization may extend glut-expectations out another few years. This promise of an extended glut period pushes the prospect that reserves might once again be special even further down the road. With the return on base money having been reduced, current holders of the base will react by trying to offload their stash now—thus causing a rise in prices in the present.

If the monetary theories about the 1937 recession are correct, it is no wonder then that 1,682 days into our current bull market investors seem to be so edgy about issues like tapering. Small changes in current purchasing policies may have larger effects on markets than we would otherwise assume thanks to the intentions they convey about future policy.

QE is effective insofar as it is capable of pushing market expectations concerning the future removal of the base money glut ever farther into the future. But once that lift-off point has been pushed so far off into the distant future (say ten years) that the discounted value of going further is trivial, more QE will have minimal impact.

If QE is nearing the end of its usefulness, what happens if we are hit by a negative shock in 2014? Typically when an exogenous shock hits the economy and lowers the expected return on capital, the Fed will quickly reduce the return on base money in order to ensure that it doesn't dominate the return on capital. If the base's return is allowed to dominate, investors will collectively race out of capital into base money, causing a crash in capital markets. The problem we face today is that returns on capital are currently very low and nominal interest rates near zero. Should some event in 2014 cause the expected return on capital to fall below zero, there is little room for the Fed to reduce the return on base money so as to prevent it from dominating the return on capital—especially with interest-on-reserves unable to fall below zero and QE approaching irrelevance. Come the next negative shock, we may be doomed to face an unusually sharp and quick crash in asset prices (like 1937) as the economy desperately tries to adapt to the superior return on base money.

So while I am still somewhat bullish on stocks 1,682 days into the current bull market, I am worried about the potential for contractionary spirals given that we are still at the zero-lower bound. I'm less worried about the Fed implementing something like a 1937-style sterilization campaign. Incoming Fed chair Janet Yellen is well aware of the 1937 event and is unlikely to follow the 1937 playbook. Writes Yellen:

If anything, I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery. That’s just what happened in 1936 when, following two years of robust recovery, the Fed tightened policy because it was worried about large quantities of excess reserves in the banking system. The result? In 1937, the economy plunged back into a deep recession.  -June 30, 2009 [link] 

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Other recent-ish commentary on the 1937 analogy include Paul Krugman, Francois Velde (pdf), Scott Sumner, Lars Christensen, Christina Romer, Charles Calomiris (pdf), Business Insider, and David Glasner.

Milton Friedman and the mania in "copy-paste" cryptocoins

When I last wrote about alternative cryptocoins — the universe of small bitcoin competitors — TerraCoin and PPCoin had just debuted, but by and large the list was a relatively stable one that included Litecoin, Namecoin, Devcoin, and a few non-functioning coins. All of these alt-coins paled in size and breadth to Bitcoin, of course, and as the chart below shows, this dominance continues to be the case.

Since April, what was once a trickle of new alternative cryptocoins has turned into a veritable flood. Nowadays, a new coin is being announced every day, and it isn't rare for two or three to debut on the same afternoon. Almost all of these are "copy-paste" coins. Their creator simply takes the source code of a previous coin (usually Litecoin), alters a few parameters, and then announces its debut on the alternative crypto-currency forum at Bitcointalk.

Most of the changes implemented by new alt-coins are arbitrary. RichCoin, one of the newest coins, sets an 88.88 million upper limit for the number of coin in existence and a block reward of 88 coins, presumably to appeal to the Chinese user (Bitcoin has a 21 million upper limit and block reward of 25). FastCoin targets a block generation rate of twelve seconds, compared to Litecoin's 150 seconds, and Bitcoin's nine minutes. These are little more than cosmetic modifications that involve changing a variable or two in the initial source code.

New issuers usually jazz up their coin with a cheezy logo made in MS Paint, a website, and a silly gimmick, like SexCoin did by proclaiming itself as the coin "for the adult industry". Sometimes their creators forget to erase references to the coin they've copied. YACoin, for instance, launched May 6, was mocked for accidentally including NovaCoin's logo on its client, the coin from which YACoin drew its sourcecode. Apart from amusing errors like these, it seems that creating your own coin these days is as easy as printing up business cards. In fact, this blog post provides a complete guide for coining one's own fiat alt-chain.

Here is a partial list of new coins and issue dates. You can find the definitive list here:

The great alt-coin rush seems to be a fine illustration of Milton Friedman's views on privately-issued inconvertible fiat money. As long as the reigning intrinsically valueless currency like Bitcoin, Litecoin, and others have a positive price, individual issuers will have an incentive to (almost costlessly) copy and paste new clones into existence in an effort to capture the premium.

Wrote Friedman:

So long as the fiduciary currency has a value greater than its cost of production—which under conditions can be compressed close to the cost of the paper on which it is printed—any individual issuer has an incentive to issue additional amounts. A fiduciary currency would thus probably tend through increased issue to degenerate into a commodity currency—into a literal paper standard—there being no stable equilibrium price level short of that at which the money value of currency is no greater than that of the paper it contains. [1960, A Program for Monetary Stability]

A great example of Friedman's dictum is the odd case of Somali shillings, vividly illustrated by William Luther. Though the Somali central bank was destroyed in 1991, shillings continued to circulate. Local businessmen and warlords printed counterfeit shillings and spent them into the local economy until the purchasing power of shillings was driven down to the value of paper, printing, and shipment.

How does the profit incentive work in the case of new alt-coins? Here's how a new issuer makes a profit. Prior to announcing their new coin on Bitcointalk, the issuer "pre-mines" a few million coins for themselves. When the public starts to mine the new coin in earnest and trade it on the forums — a sort of over-the counter-market — the issuers seize the opportunity to sell all the coins that they've premined. More ambitious coin issuers endeavour to have their coin listed on any of the larger formal alt-coin markets like BTC-e or Vircurex, rather than the OTC market. This adds a larger liquidity premium to the coin, thereby improving the price at which the originator can make an exit. The lure of a listing is so tantalizing that NovaCoin, for instance, a coin premiering back in February, initially premined a quantity of coins which it used to payoff BTC-e in order to procure an immediate listing on its exchange (when controversy ensued, this payoff was later rescinded).

Because premining is roundly vilified on the forums, and coin ledgers are public (rendering it fairly easy to determine if a coin has been premined), issuers have resorted to less overt techniques to profit from new issues. Insta-mining is one practice. An issuer and his/her confederates prepare their computers to mine the coin "instantly" upon the coin's public release on Bitcointalk. The ease of mining is set very low for the first few hours, allowing the issuer and his/her friends to snap up a large percentage of coins. Later, when the public begins to participate, the issuer ups the difficulty and sells their booty. In the first twenty-four hours of Feathercoin's existence, for instance, some 2.9 million coins were mined out of a total of 336 million minable coins, far more than would be mined on an average day.

The dozens of coins issued in the last months are largely worthless, or close to it. You can track some of their prices at Cryptsy, an alt-coin exchange. This would seem to bear out Friedman's theory that the price of a competitive fiat currency will inevitably be driven down to zero. Incidentally, that's the same theory I've been adopting in many of my bitcoin posts, and why I (mostly) sold out of the ledger a few months ago.

A major data point seems to disconfirm Friedman's theory. While we've seen a new wave of coins being issued in order to exploit the value differential between cost and market price, these new coins have not been particularly successful in arbitraging away the positive price of the incumbents Bitcoin and Litecoin. When I posted this, Bitcoin's market cap was around $1.1 billion and Litecoin's at around $50 million.

I take two things from this. Either we're still in the short run, and Bitcoin's price will eventually get knocked down to zero.

Alternatively, something else is at work. It could be that cryptocoins are not indistinguishable fiat monies as per Friedman's theory of fiat money but rather are heterogeneous and differentiable. Multiple carbon copies of Bitcoin are simply not enough to arbitrage away the original's value because the earliest mover has superior features compared to late moving clones. To begin with, incumbents like Bitcoin and Litecoin have already attracted a large mining community. The hashing power that the miners bring with them makes the coin more secure against 51% attacks, or forks, than upstart coins that don't have the same degree of mining power. So while the source code for a clone may be identical to the original, the degree of security inherent in each is very different.

Secondly, incumbents will tend to be more marketable. Merchants may have begun to accept them, securities might be denominated in them, and formal exchanges like MtGox offer direct convertibility into US dollars. This liquidity does not emerge in medias reas, or on its own, a fact that puts Bitcoin and Litcoin clones at a disadvantage. Like the security problem above, the liquidity hurdle is difficult to overcome because, chicken-and-egg-like, you can't become liquid or secure without users, but if you're not liquid or secure you don't attract users.

It appears that Milton Friedman is wrong, at least for the time being. Despite the recent onslaught of competing alt-coins, privately-issued fiat currencies like Bitcoin and Litecoin are still worth many millions of dollars. I suppose we'll have to wait another few years to see if Friedman is wrong not just about the short term, but also the long term. Until then, I'll throw in my chips with Friedman. Bitcoin's biggest competitors probably haven't arrived yet.

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Readers may find that George Selgin's Synthetic Commodity Money adds more dimensionality to the fiat/not-fiat distinction. Selgin argues that bitcoin is not fiat money, but belongs to a heretofore undefined category called synthetic commodity money.

Yap stones and the myth of fiat money

At first glance, the large circular discs that circulated on the island of Yap in the South Pacific certainly seem quite odd. Too big to be easily transported, the stones are often seen in photos resting against their owner's houses. So much for velocity. Yap stones have been considered significant enough that they have become a recurring motif in monetary economics. Macroeconomics textbooks, including Baumol & Blinder, Miles & Scott (pdf), Stonecash/Gans/King/Mankiw, Williamson, and Taylor all have stories about Yap stone money.

Why this fascination? Part of it is probably due to the profession's obsession with the categorical divide between "money" and "non-money". In dividing the universe of goods into these two bins, only a few select goods end up in the money bin. That an object so odd and unwieldy as a three meter wide stone could join slim US dollar bills and easily portable silver coins in the category of money is pleasantly counterintuitive  – and economists love the counterintuitive. I'll talk about this divide and on which side to place Yap stones later (see part 3 below).

Another reason that Yap stones attract attention is their seeming "fiat" nature. In serving no useful purpose other than money, Yap stones seem to be historic ancestors to our modern "fiat" central bank money. I'll be discussing this idea in the current post.

The discussion on Yap stones will be split into three parts:

1. Yap stones and the myth of fiat money
2. Yap stones and chartalism
3. Yap stones and moneyness

I recently finished reading The Stone Money of Yap: A Numismatic Survey (pdf) by Cora Lee Gillilland (1975), which provides a historical summarization of all appearances of Yap stone money in the accounts of travelers, administrators, and anthropologists over the centuries. Having little to do over Christmas, I also picked up The island of stone money: Uap of the Carolines (1910) by W.H. Furness. Furness spent a year living on Yap and recorded his observations.

Here are some interesting facts gleaned from Gillilland and Furness which will be useful for all three parts:

1. Yap is an Island in the South Pacific. Denizens of Yap, the Yapese, valued circular stones called rai, or fei. A certain type of mineral called aragonite was prized by the Yapese in making rai. Aragonite, a white limestone that glistens, was only found on the island of Palau some 250 miles away, necessitating a long and arduous journey by canoe with a heavy rock in tow (see map below). The stones were quarried in the mountains of Palau and shaped into discs with holes in the centre. The holes allowed the stones to be carried on long poles, facilitating transportation. The poles can be seen in the photo above.

2. One of the earliest European accounts of these stones (in Gillilland) refers to a trader named Andrew Cheyne, who in 1843 wrote this about his arrival at Yap from Palau with a delegation of Palua traders.

At 9 A.M., the premier and chiefs of Tomal [Yap] came on board to receive their present, sent by Abba Thule [one of the chiefs of Palau], for their king, which consisted of nothing more or less than a round stone, with a hole in the centre, similar to a small upper millstone. These stones are very rare, and consequently highly prized, being only found in the mountains of the Pallou Islands. 

This particular stone was sent to the king of Yap to secure permission for Palau traders to barter with the Yapese for bêche-de-mer, otherwise known as sea cucumber.

3. We know from Gillilland that Yap exchanged not only bêche-de-mer with Palau traders, but also turmeric root. Nor was this the only exchange good. Accounts in the late 1800s describe Yapese traders traveling to Palau and exchanging their labour for the right to quarry stones. They gathered firewood for the Palau, carried, water, and according to one account, constructed the paved streets of the island of Koror in Palau.

4. Early rai were small, usually no more than eight hand spans across according to Gillilland. They were also rare. The difficulty of transporting stones by raft from distant Palau was certainly a limiting factor. The appearance of European traders allowed the Yapese to transport larger stones back from Palau and in greater quantities. There are accounts of stones weighing a ton and spanning over three metres in diameter. The stereotypical Yap stone we are accustomed to seeing in photos like the above are probably post-European stones. Cheyne described the stones as "very rare" in the 1840s, but they numbered 13,281 in 1929 according to a Japanese survey.

5. Other forms of "money" were used on Yap, including pearl shells (yar), pearl shell bead necklaces (gau), ceremonial pestles (ma), and woven mats (mbul).

6. David Sean O'Keefe, an Irish American adventure, cornered the market in Yap stone transportation from 1872 to 1901. The Yapese were allowed to transport the stones they'd mined on Palau on O'Keefe's schooner. Upon arrival at Yap, they were required to pay O'Keepe in copra to have the stones released. Copra is the dried meat of coconuts, and it was useful in lamp oil. Because most Yapese didn't have a copra supply, they could also pay by working on O'Keefe's coconut plantations.

7. Rai had exchange value on Yap. Furness reports that a rai spanning a length of three hands and

of good whiteness and shape ought to purchase fifty 'baskets'; of food - a basket is about eighteen inches long and ten inches deep, and the food is taro roots, husked coconuts, yams, and bananas;- or, it is worth an eighty or a hundred pound pig, or a thousand coconuts, or a pearl shell measuring the length of the hand plus the width of three fingers up the wrist. I exchanged a small short handled axe for a good white rai, fifty centimeters in diameter. For another rai, a little larger, I gave a fifty pound bag of rise... I was told that a well-finished rai, about four feet in diameter, is the price usually paid either to the parents or to the headman of the village as a compensation of the theft of a mispil [a woman].

Gillilland lists rai as capable of purchasing fishing equipment, canoes, and housing materials. There is record of a dance group being paid in rai for their performance. War indemnities and funeral expenses of chiefs were paid in rai, as was the assistance in war of a neutral tribe. Normally a family was self-sufficient in food, but when necessary rai could be used to purchase fish, yams, or taro.

8. Rai needn't be exchanged directly, especially the larger variety. Rather, Yapese were often content to transfer mental ownership of a Yap stone, leaving the stone sitting in place. Wrote Furness:

it is not necessary for its owner to reduce it to possession. After concluding a bargain which involves the price of a rai too large to be conveniently moved, its new owner is quite content to accept the bare acknowledgment of ownership and without so much as a mark to indicate the exchange, the coin remains undisturbed on the former owner's premises.

9. An extreme example of this is provided by Furness. According to local legend, two or three generations before Furness's arrival a large stone in transit was lost at sea during a storm. The claim to this stone continued to have value, even though the stone itself was unrecoverable.

10. According to Furness, the Germans bought control of Yap from the Spanish in 1899. In order to motivate Yapese to work on improving the island's road system, the Germans marked a certain number of rai with black crosses, indicating that the government now claimed these stones. To regain control of their rai, people had to labour on the road system. It was in this way that Yap got its first roads. Gillilland confirms this account, noting only that the intials B.A. (Berzirks-Amt or District Office) was painted on the stones, not a cross.

There are many more facts and anecdotes worth reading about in Gillilland and Furness, as well as this shorter article from the Smithsonian. I'm going to turn away from the anthropological evidence and investigate how economists have used Yap money in their theorizing.

Yap stones used by economists as examples of fiat money

One of the earliest expositions of Yap stones is in Volume II of J.M. Keynes's Treatise on Money (1930). When he mentions the stones, Keynes is in the process of writing about the emergence of "representative" money from commodity money. According to Keynes, a representative money can be either fiat or "managed". Representative money has "relatively little or no intrinsic value apart from the law or practice of the State." As gold had ceased to be used privately in the west, it was increasingly concentrated in the vaults of central banks. Keynes noted that even central banks had ceased transferring gold to each other's vaults, preferring instead to have their gold "ear-marked" – have its ownership changed without changing location. In this context, Keynes mused that money was on the verge of becoming fiat, which he felt was comparable to the status of Yap stones:

The earliest example of "ear-marking" is in the case of the stone money of Rossel Island, which, being too heavy to move without difficulty, could be conveniently dealt with in no other way. One of the largest and most valuable of these stones lay at the bottom of the sea, the boat which was importing it having capsized. But there being no doubt that the stone was there, these civilized islands saw no objection to including it as part of their stock of currency—its lawful owner at any time being, in fact, thereby established as the richest man in the island—or to changing its ownership by "ear-marking". (Pg 292, Vol II)

Note that Keynes's facts are wrong, since it was Yap Island, and not Rossel Island, thousands of miles to the southeast of Yap, that used stone money.

In an article called Money for the New Palgrave, James Tobin also provides an account of Yap Stones, closely mirroring Keynes by comparing the stones to gold:

On the island of Yap debts were settled by changing the ownership of large immovable stone wheels. The practice continued after the sea flooded their site and the stones were invisible at the bottom of a lagoon. (Similarly when gold was international money in the twentieth century title to it often changed while the gold itself, safe in underground vaults, never moved.) (Pg 3)

Tobin either makes an error or an embellishment, since neither Furness nor Gillilland mention the sea flooding the site where stones were held, only that one stone was lost at sea during a storm.

Milton Friedman also jumped into the Yap stone fray in the first two chapters of his book Money Mischief. Like Keynes and Tobin, Friedman compares the earmarking of gold among central banks to the use of transferable claim on the famous submerged Yap stone. In the second chapter of the same book, Friedman goes on to question whether the stones had any nonmonetary value whatsoever:

When most money consisted of silver or gold or some other item that had a nonmonetary use, or of an enforceable promise to pay a specified amount of such an item, the "metallist" fallacy arose that "it is logically essential for money to consist of, or be 'covered' by, some commodity so that the logical source of the exchange value or purchasing power of money is the exchange value or purchasing power of that commodity, considered independently of its monetary role" (Schumpeter 1954, p. 288). The examples of the stone money of Yap, of cigarettes in Germany after World War II, and of paper money currently make clear that this "metallist" view is a fallacy. The usefulness of items for consumption or other nonmonetary purposes may have played a role in their acquiring the status of money (though the example of the stone money of Yap indicates that this has not always been the case). [My emphasis]

Greg Mankiw invokes Keynes's line between commodity and representative money when he writes in his textbook Macroeconomics that "Yap, a small island in the Pacific, once had a type of money that was something between commodity and fiat money."  Yap therefore illustrated an economy with circulating paper redeemable in a commodity on the threshold of becoming an economy in which the circulating paper's claim to the original commodity has been lost. Mankiw also repeats the famous story of the lost Yap stone:

Eventually, it became common practice for the new owner of the fei not to bother to take physical possession of the stone. Instead, the new owner accepted a claim to the fei without moving it. In future bargains, he traded this claim for goods that he wanted. Having physical possession of the stone became less important than having legal claim to it. This practice was put to a test when a valuable stone was lost at sea during a storm. Because the owner lost his money by accident rather than through negligence, everyone agreed that his claim to the fei remained valid. Even generations later, when no one alive had ever seen this stone, the claim to this fei was still valued in exchange.

Gary Smith's textbook Money and Banking (1984) goes even further than Mankiw in attributing to Yap stones not merely intermediate status between fiat and commodity money, but status as a purely fiat money:

The stone money of Yap is superficially a commodity money. And yet is has no real value as a commodity. A Yap stone is eagerly accepted in exchange for useful goods and services solely because its recipients are confident that they will also be able to exchange the stone for goods and services. Its acceptance as a medium of exchange rests on simple faith, nothing more. This is an example of fiat money, something that has little value as a commodity but, because of law or tradition, is accepted as a medium of exchange.

We see modern use of the motif in Willem Buiter in Helicopter Money (2004, pdf). Like Smith, Buiter doesn't bother with the idea that Yap money might be somewhat intermediate between commodity and fiat money:

Some commodity monies have intrinsic, that is, non-monetary, value as a consumption, intermediate or capital good. Gold, salt, cattle and cigarettes are historical examples. I do not consider this kind of intrinsically valuable strong outside money. There is, however, a partial resemblance between the government-issued fiat base money considered in this paper and commodity money that does not have any intrinsic value. Pet rocks, the candy wrappers that are part of many first expositions of Samuelson’s pure consumption loans model (Samuelson (1958)), or the stone money used on the Micronesian island state of Yap are examples.

On the blogosphere, Nick Rowe had this to say about Yap stones a few years ago:

My point is that both Yap stones and cowrie shells (the Yap stones especially) look totally useless except as money. Even if they did have some value apart from their use as money, that "industrial value" would be a small proportion of their value as money.

So as you can see, there is a long line of economists who have attributed a pure fiat nature to Yap stones.

Yap stones not fiat - Dror Goldberg's response

Dror Goldberg penned an interesting paper in 2005 called Famous Myths of Fiat Money. I'm in debt to him for providing some clues to the whereabouts of the above references to Yap stones.

Goldberg defines fiat money as an object that has no intrinsic value and is not convertible into anything. It is neither legal tender, not is its use forced on anyone. Insofar as money can be thought of as having a kernel of fundamental value plus some extra marginal use as a medium of exchange, a fiat money is something without any fundamental value whatsoever. It is a purely speculative object valued only for its exchangeability.

Goldberg points out that most monetary economists believe that their concept of fiat money is not merely fictional but exists in reality. One justification for their belief is the supposed existence of fiat monies in primitive societies. However, in investigating the phenomenon of Yap stones, Goldberg finds that scholars have ignored laws, customs, and religion in according to rai the label "fiat". To begin with, the stones were valued for their aesthetic value:

For Pacific islanders who knew no metals or precious stones, it was reasonable to attach high value to semi-precious stones. Another proof for the high esthetic value is that the largest stones were “entirely beyond price” (Einzig 1966, p.40). Small specimens may have been used in jewelry, but the stones became more popular as big statues in the shape of a full moon (Gillilland 1975, pp.19-20). In fact, these stones were Yap’s version of gold. Just as gold could barely be used for any practical purpose (it is too soft), and one of the few things one could do with it was sit on a throne made of it, the Yap stones were also used as thrones (Gillilland 1975, p.3)

Goldberg also points out that Yap stones had religious value:

One local legend says that the bodies of the islanders’ ancestors, which were half-human and half-divine, have become the oldest stones (Gillilland 1975, p.19). Another legend says that the Fairy Godmother of Yap chose which stones would become money, and the stones’ shape was also approved by her (Christian 1899, p.300). Regardless of the latter legend, it is known that the full moon shape had a religious significance.

Thus to ascribe to Yap stones intrinsic uselessness is to ignore the very real value ascribed to them by the Yapese . While from the perspective of outsiders these stones may seem useless, within the context of the society in which they are used they have a very particular meaning and history.

As for the famous story of the lost stone that Keynes and Mankiw invoke in favor of fiat money, Goldberg points out that the stone in question remained in the possession of an ancestor of the family that had first brought it over from Palau. Thus Keynes, Tobin, and Mankiw are wrong to assume the claim to the lost stone continued to have exchange value, for there is no evidence that it was ever traded outside of the family who originally lost the stone. If the claim had been marked-to-market, would its so-called value have survived? We simply don't know. I suppose a graduate student could fly to Yap and try to locate the claim to the famous missing stone — after all, it should still be valuable if Keynes/Mankiw/Tobin are right. But until then, the story remains dubious.

This leads into the final question in this post.

So why is the existence of theoretical and/or actual fiat money so important to economists?

I suspect the answer to this is because fiat money makes theorizing easier. Goldberg, for instance, points out that the fiat money concept is "useful". He invokes Wallace and Zhu (2004), a quote worth providing in full:

The conception of money as fiat money, an intrinsically useless object, has been used in models for a long time. It was used in the classical-dichotomy model, even though that model was developed and used at a time when actual money was gold or silver. Ignoring the commodity aspect of money was convenient because it produced a simple and strong prediction: allocations are independent of the amount of money.

In other words, in assuming the existence of a fiat money, the analyst can neutralize the monetary sector and work purely with a real economy. This removes a number of thorny issues.

The great economist Alfred Marshall, for instance, noted in his example of an economy that used "shells of some certain extinct fish" as currency, that the simultaneous demand for those shells as useful ornaments would break the proportional relationship between the quantity of the shells and their value. This was the famous quantity theory of money. If it was the case that shells were desired as ornamentation, then an increase in demand for shells as ornaments would have monetary effects while an increase in demand for shells as money would have non-monetary effects. Gone is the useful dichotomy between the real and monetary economies.

Another reason that the myth continues to be sustained is the idea that fiat money saves resources. One of the oldest expressions of this idea comes from David Ricardo in The Principles of Political Economy and Taxation:

A currency is in its most perfect state when it consists wholly of paper money, but of paper money of an equal value with the gold which it professes to represent. The use of paper instead of gold substitutes the cheapest in place of the most expensive medium, and enables the country, without loss to any individual, to exchange all the gold which it before used for this purpose for raw materials, utensils, and food; by the use of which both its wealth and its enjoyments are increased.

This idea rings true in modern general equilibrium economics. Ostroy and Starr (1988) note that in a sequence economy (one which opens and closes, rather than an all-at-one-point-in-time Arrow Debreu economy)

goods are desired as objects of consumption and as carriers of value between trading opportunities. The second demand may interfere with the first. When it does so, the introduction of a fiduciary or fiat money with negligible transactions and storage costs can change the equilibrium allocation to one that is Pareto efficient... Since the opportunity cost of holding real goods in inventory will generally be non-negligible, there is an efficiency gain through the use of fiduciary (bank) or fiat money in place of commodity money. 

In other words, since intrinsically useful goods serving as money also have consumption value, the opportunity cost of using said goods as money is the lost consumption. Replacing these commodity monies with a non-real money good, something inherently valueless like a fiat token, will return a commodity money’s “lost consumption” to the economy, while ensuring that something still exists to perform the function of money. Fiat money is the most efficient solution. Given that in theory fiat money is the theoretically ideal money, it is no doubt tempting to assume the actual existence of such an object, even when the evidence is lacking. Otherwise we would be living in a world with a massive market failure.

Lastly, in observing the rise of central bank money, monetary economists going back to the days of David Ricardo have felt it their duty to create theories of fiat money. But central bank money is not necessarily fiat money. If there is no actual fiat money in the real world, why have economists spent so much time modeling a world as if it contained such an item? There needs to be fiat money to justify the effort.