A free market case for CBDC?

Central bank digital currency, or CBDC, is a form of highly-liquid digital debt that most governments have, till now, held back from issuing. But there is a growing push to change this. Free market economists are generally not big fans of CBDC. They see it as government encroachment on the banking sector.

In this post I'm going to push back on the free market consensus.

(This post was inspired after reading posts by Tyler Cowen and Scott Sumner).

Look, we're always going to have a government. Right? And that government is going to have to raise funds somehow in order to keep the lights on. The question is, how? Should it issue 30-day Treasury bills? Fifty-year bonds? Perpetual debt? Paper currency? Why not issue currency-ish debt instruments in digital form?

Let's start with a parable. Imagine a world in which the government has only ever issued 30-year bonds. But next month it wants to shift some of its borrowing from the 30-year bond range to the 10-year range. Government officials believe that this will reduce the government's interest costs and diversify government sources of funding.

Seems like a good idea, no?

But wait. The grocery industry has historically relied on funding itself with 10-year bonds. Till now, it hasn't had to compete with the government for the attention ten-year bond investors. Grocery store owners are furious over the impending decision. We could have difficulties funding ourselves! they fret. We might have to cut back on selling food!

Meanwhile, the restaurant industry in our imaginary world prefers to fund itself by issuing 30-year bonds. If the government raises more money in the 10-year end of the debt market and less in the 30-year end of the spectrum, restaurants will face less competition for investor attention. Go for it! say restaurant owners.

Which sector should the government choose to favor, grocery stores or restaurants? The choice seems entirely arbitrary. Government shouldn't be picking winners or losers, right? Civil servants should choose the most cost-effective form of financing.

The same argument goes for CBDC.

Bonds, bills, and CBDC are all just forms of transferable government debt.* But instead of having a fixed maturity like a bond, CBDC never matures. And whereas the interest rate on a bond is fixed and its price floats, the interest rate on CBDC is periodically adjusted while its price is fixed to $1. Either way, the government can use these instruments for funding projects and investments.

(For the rest of this post I'll use the terms CBDC and fixed-value floating-rate perpetual debt interchangeably.)

For whatever reason, modern governments choose not to fund themselves in the fixed-value floating-rate corner of the debt market.** No industry benefits more from this than banks. Individuals and businesses who want to buy fixed-value floating-rate perpetual debt have only one option available to them: bank-issued deposits. Regulations prevent all other industries from participating in this end of the debt market. So these non-banks have to turn to the 3-month to 30-year segment of the debt market where they must face the full brunt of government competition.

The presence of government competition means that non-banks' funding costs will be more onerous than otherwise. Conversely, banks' funding costs will be less onerous given a lack of government competition.

I don't see any compelling reason for why the government should avoid one end of the debt market and, in the process, favor the banking industry over other industries. I mean, if the government can cost-effectively issue CBDC in a way that reduces its overall interest obligations, then that's a win for taxpayers, no? It shouldn't go with an option that hurts taxpayers because it wants to help out a certain sector, should it?

The argument could be made that the banking industry is far more important than other industries because it does a lot of lending, and if lending slows then everyone loses. 

If the banking sector really deserves to be subsidized, why doesn't the government just pay the subsidy in a more transparent way, say by taking money directly from the pockets of individuals and non-banks and giving it to banks? 

Also, banks aren't the economy's only lenders. There are many non-bank lenders too. Sure, if a government were to issue CBDC, banks would now face more competition in the fixed-price floating-rate corner of the debt market, and perhaps would choose to lend less. But at the same time the government would be issuing less 30-year bonds, or 10-year bonds, or treasury bills. Non-bank lenders that issue debt in these ends of the debt market would face less competition than before, and might lend more.

In the end, it's a wash. One industry's loss is another's gain.

So let governments issue CBDC and compete for the attention of the fixed-price floating-rate investor, just like they already compete for the attention of the 30-year bond investor. This would remove an inefficient distortion, namely a subsidy to banks and a penalty on non-banks. This seems to be the free market position, no?

---

*It could be argued that one type of debt is a currency, and can be transferred from you to me, while the other isn't. But I don't buy that. Both types of debt are liquid. They can be bought and sold on exchanges. Or they can be transferred bilaterally. With bonds, a bilateral transfer can be conducted by conveying an old style physical bearer bonds, or by transferring a bond to a recipient using Treasury Direct.

**The government does issue banknotes, which are sort of like perpetual floating-rate debt, where the decision has been made to keep the rate at 0%. And it does issue reserves to the banking sector. But the quantity of banknotes and reserves is quite small relative to overall government borrowing.

Paying interest on cash

Freigeld, or stamp scrip, is designed to pay negative interest, but it can be re-purposed to pay positive interest.

Remember when global interest rates were plunging to zero and all everyone wanted to talk about was how to set a negative interest rate on cash? Now that interest rates around the world are rising again, here's that same idea in reverse: what about finally paying positive interest rates on cash? I'm going to explore three ways of doing this. As for why we'd want to pay interest on cash, I'll leave that question till the end.

-------

The first way to pay interest on cash is to use stamping. Each Friday, the owner of a bill—say a $50 note—can bring it in to a bank to be officially stamped. The stamp represents an interest payment due to the owner. When the owner is ready to collect his interest, he deposits the note at the bank. For example, say that 52 weeks have passed and 52 stamps are present on the $50 note. If the interest rate on cash is 5%, then the banknote owner is due to receive $2.50 in interest.

Alternatively the note owner can collect the interest by spending the $50 note, say at a local grocery store. The checkout clerk will count the number of stamps, or interest due, and tack that on to the face value of the note. With 52 stamps, the owner of a $50 note should be able to buy $52.50 worth of groceries, not $50. After all, the store has the right to bring the $50 note to its bank and collect the $2.50 in interest for itself.

Stamped currency seems like a pretty big hassle to me. The clerk behind the counter must count out the stamps on the note by hand, and the owner of the note has to trek back and forth to the bank each week to get the stamp affixed. Instead, imagine that each banknote has a magnetic strip that records how long the bill had been in circulation. This would remove some of these hassles. Weekly trips to the bank for stamping would no longer be necessary, and a note reader installed at a bank or retailer would automatically record how much interest was due, precluding painstaking counting of stamps.

"They use this magnetic strip to track you." says Byers to Agent Scully, The X-Files

Apart from stoking conspiracy theories, there's still a major problem with a magnetic strip scheme. Because each note has entered circulation at a different time, each is entitled to a varying amounts of interest. And this means that banknotes are no longer fungible. Fungibility—the ability to cleanly interchange all members of a population—is one of the features of money that makes it so easy to use. Remove it and money becomes complicated, each piece requiring a unique and costly effort to ascertain its value.

-------

Our second way of paying interest on money doesn't destroy the fungibility of banknotes. The central bank needs to sever the traditional 1:1 peg between deposit money and cash, and then have cash slowly appreciate in value relative to deposits.

For instance, a central bank might start by setting an exchange rate of $1 note = $1 deposit on January 1, but on January 2 it adjusts this rate so $1 note is equal to $1.0001 deposits, and on January 3 adjust this rate to $1:$1.0002, etc. So the cash in your wallet is benefiting from capital gains. By December 31, the exchange rate will be around $1 note to $1.0365. Anyone who has held a banknote for the full year can deposit it and will have earned 3.65 cents in interest, or 3.65%. 

The major drawback with this scheme is the calculational burden imposed on the population by breaking the convenient 1:1 peg between cash and deposits. Assuming that retailers price their wares in terms of deposits, anyone who wants to pay in cash will have to make a currency conversion using that day's exchange rate. For instance, if the central bank's peg is currently being set at $1 note = $1.50 in deposits, then a popsicle that is priced at $1 will require—hmmm... let me check my calculator—$0.667 in cash. Phones will make this exchange rate calculation easy, but it is still likely to be a bit of a nuisance.

There are other hassles too. Would a capital gains tax have to be paid on the appreciation of one's cash? How would existing long-term contracts deal with the divergence? For instance, if my employer is paying me $50,000 per year, obviously I'd prefer this sum be denominated in steadily appreciating cash rather than constant deposits, and she will prefer the latter. What becomes the standard unit of account?

------

The last way to pay interest (at least as far as I know) is to run lotteries based on banknote serial numbers, an idea independently proposed by Hu McCulloch and Charles Goodhart back in 1986.

It's surprisingly easy to get banknotes to pay interest. Run a lottery based on note serial numbers. Hu McCulloch dreamt this scheme up in 1986, but no central bank has ever tried it. Source: https://t.co/pUUf1liuhH pic.twitter.com/5mil9B62FN

— JP Koning (@jp_koning) January 14, 2018

Central banks would periodically hold draws entitling the winning serial numbers to large cash prizes. For example, if there was $100 billion in banknotes in circulation, the central bank could set the interest rate on cash at 5% by offering prizes over the course of the year amounting to 5% of $100 billion, or $5 billion.

This technique of paying interest on cash solves the fungibility problem that plagues the earlier stamping technique. Every note has the same chance of winning the lottery, and non-fungible winners are immediately withdrawn. And unlike the crawling peg idea, banknotes and deposits remain equal to each other so burdensome exchange rate calculations don't need to me made.

However, it introduces the threat of bank runs. The day before the big lottery is set to occur, everyone will withdraw deposits for cash so that they can compete in the draw. To prevent a bank run, it may be necessary to randomize the date of the big lottery so that no one knows when to withdraw notes, an idea proposed by Tyler Cowen. Another way to preclude bank runs is to have a regular stream of small weekly lotteries rather than one or two big ones each year.

Another drawback to note lotteries is the cost that is imposed on society by having everyone constantly checking serial numbers. As Brian Romanchuk points out, employees who are working behind their employer's tills may be tempted to switch out winning notes with losers. Employers may protect themselves by setting up scanning hardware to read in serial numbers as banknotes enter the tills, maintaining their own internal database of cash inventories so that winners can quickly be isolated and returned. But all of that is costly. Would it be worth it?

Interestingly, there is some precedent for these sorts of lotteries. In Taiwan, receipts are eligible for a receipt lottery, a neat way to incentivize people to avoid under-the-table transactions (ht Gwern). Lotteries can also be useful in attracting depositors, as outlined in this Freakonomics podcast (ht Ryan). George Selgin and William Lastrapes have gone into the idea of lottery-linked money in some detail:

Though the suggestion may appear far fetched, in many countries lotteries are presently being used with considerable success to market bank deposits. According to Mauro Guillen and Adrian Tschoegl (2002), “lottery-linked” deposit accounts have been especially popular with poorer persons, including many who might otherwise remain “outside the banking system.” ... In two popular Argentine schemes, for instance, depositors receive one ticket or chance of winning for every $200 or $250 on deposit (ibid., p. 221). Lottery-linked banknotes, in contrast, would themselves serve as tickets, allowing persons to play for as little as the value of the lowest note denomination, and with no apparent cost to themselves save that of occasionally inspecting their note holdings.

--------

Some readers may recognize these three techniques for paying interest on cash as the inverse of the three go-to ways of applying negative interest rates to cash being discussed a few years ago. For instance, one of the most well-known ways of imposing negative interest rates on owners of cash is to apply a Silvio Gesell style stamp scheme (see picture at top), whereby a currency owner must buy a stamp and affix it to the note in order to renew the validity of their currency each month. (I once discussed Alberta's experiment with Gesell's "shrinking money" here). Without the appropriate number of stamps, the note is illegitimate. In my first example above, Gesell's stamp tax has been re-engineered into a stamp subsidy. As for the magnetic strip modification, this is Marvin Goodfriend's 1999 update of Gesell, flipped around to award interest rather than docking it.

Miles Kimball has written extensively on escaping the zero lower bound to interest rates by setting a crawling peg on currency. But just as Kimball's crawling peg can impose a negative interest rate on banknotes, it can be used to pay interest, as I described above. Indeed, Miles (along with Ruchir Agarwal) frequently mention this possibility in his blog posts and papers (see this pdf).

Finally, remember Greg Mankiw's controversial 2009 article on imposing negative interest rates by serial number? He wrote:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

Mankiw's idea is just the reverse of Goodhart and McCulloch's earlier lottery idea, the lottery replaced by with a demonetization.

-------

So why pay interest on currency? I can think of two reasons. One is based on fairness, the other on efficiency.

The decision to avoid paying the market rate of interest on currency amounts to a tax on currency users. Who pays this tax? Cash is often the only means for the poor, new immigrants, and unbanked to participate in the economy. So the tax falls on those who can least afford it. This hardly seems fair. By conducting note lotteries or stamping notes, those consigned to the cash economy can get at least the same return on banknotes as the well-off banked receive on deposits.

Now hold up JP, some you will be saying at this point. What about criminals? Yep, the other group of people who suffer from the lack of interest on banknotes are criminals and tax evaders. Rewarding them with interest hardly seems appropriate. One would hope that if central banks did adopt a mechanism for rewarding currency with interest, it would be capable of screening out bad actors. For instance, criminals may be leery of collecting their interest or lottery prize if making a claim at a bank means potentially being unmasked. Another way to set up the screen would be to pay interest or prizes on small denominations like $1-$10 notes, and not on $20s and above. Since criminal organizations prefer high denomination notes due to their compactness, they wouldn't benefit from interest.

As for the efficiency argument, this is nothing but the famous Friedman rule that I described in my previous post. All taxes impose a deadweight loss on society. When a good or service is taxed, people produce and consume less of it than the would otherwise choose, tax revenues not quite compensating for this loss. From a policy maker's perspective, the goal is to reduce deadweight loss as much as possible by selecting the best taxes.

In the case of cash, the deadweight loss comes from people holding less of it than they would otherwise prefer, incurring so-called shoe leather costs as they walk to the bank and back to avoid holding too much of the stuff. If a 0% return on cash is an inefficient form of taxation relative to other alternatives types of taxes, then it would be better for the government to just pay interest on the stuff and recoup the lost revenues elsewhere, say through consumption taxes or income taxes.

Central banks shouldn't ignore their duty to provide anonymity

Cross section of a banknote with a cotton paper core surrounded by two layers of polymer [Source]

 
Central bankers are at their most comfortable when engaging in technical debates over the finer points of monetary policy. But over the next few years they may be forced out of their comfort zone into a thorny philosophical debate over anonymity and financial censorship. They are poorly equipped for such a debate.

When central bankers monopolized the issuance of banknotes in the 1800s and early 1900s, little did they know that a hundred years later anonymity would become an important public good. And because banknotes are the only generally-accepted way for law-abiding citizens to make uncensored anonymous payments, central bankers effectively became—by accident rather than design—the sole purveyors of these vital services.*

Banknotes are anonymous because it is very difficult to link banknotes to identities, say by monitoring usage of notes via a note's serial number. As for 'uncensored', this means that banknotes are available for anyone to use—i.e. they are highly resistant to censorship. There are no gateways involved, no need to get permission ahead of time by opening an account or installing some sort of proprietary software or hardware, and no way for the issuer to halt a payment while it is being made.

If you glance through the research papers that central banks typically publish, they're almost all on monetary policy. And why not? A stable medium of exchange is one of the most important services provided by a central bank, so they need to do their homework. But if you try to find research on the topics of anonymity and censorship resistance, good luck. What this tells me is that central bankers know very little about the unique set of services they are providing to the cash-using public, despite being the world's only suppliers. Not only have they blundered into their role of monopoly provider of anonymity and uncensored payments, they are trying their best to pretend the role isn't theirs.

Take for instance the European Central Bank's decision to stop printing the €500 note, which was motivated by the desire to cut down on crime. No doubt a significant chunk of €500 notes are used by criminals, but the ECB seems to have made no effort to quantify the anonymity services lost by the tax-paying non-criminal public. Because the ECB has never officially admitted its role as Europe's sole provider of uncensored payments anonymity, it lacks the sorts of datasets and institutional wisdom that are necessary for formally approaching problems about anonymity and censorship-resistance. So while their decision about the €500 wasn't necessarily wrong, it was surely uninformed.

-----

Related to all this is Tyler Cowen's recent article criticizing central banks that take an active role in developing their own cryptocurrencies. His critique includes the Fedcoin idea, or a public cryptocurrency available to anyone that is pegged by the central bank to the national unit of account. Cowen says that this "new and potentially risky responsibility" might tax central bankers' resources. The problem with this is that the responsibility of delivering anonymous and censorship resistant cash is an old one. In this context blockchain technology isn't anything special, it's just another technology among many that central bankers might use to upgrade the quality of the public services that they are already providing.

Banknote technology has been constantly improving over the decades. For instance, anti-counterfeiting technology began with serial numbers and elaborate engravings on notes in the 18th and 19th centuries. Even after banknote production was monopolized by governments, improvements continued into the 20th and 21st centuries with security threads, watermarks, holography, raised images, clear windows, latent images, microprinting, and luminescent ink. The substrate on which notes are printed has evolved from cotton and/or linen to polymer, or a hybrid of the two (see image at top). If central bankers had applied Cowen's advice to avoid new technology, banknotes would still be printed on cotton and lack modern anti-counterfeiting devices.

So think of encoding banknotes onto a public blockchain—the Fedcoin idea—as just another change in substrates. In the same way that the anonymity and censorship resistance embedded on a cotton substrate was replicated on a polymer one, why not test out the idea of replicating these features on a blockchain? Along with anonymity and censorship resistance, a public blockchain would capture the decentralization of banknote systems, and thus their robustness in the face of disasters, a feature I wrote about here.**

The advantage to digitally delivering these services rather than physically delivering them on polymer or cotton is that a payment no longer requires face-to-face meetings; it can occur over the internet. This would constitute a dramatic upgrade to the quality and breadth of the anonymity and censorship resistance services that are currently being provided by our central bank monopolists.

-----

With the emergence of bitcoin and the slowly percolating Fedcoin debate, central bankers are thinking for the first time in ages about designing cash-like systems from scratch. And since these systems may eventually replace the physical stuff, central bankers will have to accept the fact that they are the only providers of anonymity and censorship resistant payments services, and that maybe they should get their act together and think hard about the value of these services to the public. A great start can be found in former Fed policy maker Narayana Kocherlakota's Monetary Mystery Tour, which ends with the exhortation: "Need more economists working on these issues!"

Bringing this back to Cowen's article, I don't agree that central bankers should refuse to test the idea of a central bank-issued cryptocurrency because this represents a new and risky technology. That would be shirking their duty as a monopolist provider of the unique services embedded in paper cash. Central bankers should only say no to Fedcoin because they've done a rigourous cost-benefit calculus that takes into account the social value of anonymity and censorship resistance to the public, and that effort has resulted in a conclusion that the status quo—the provision of these public services on a polymer or cotton substrate—is the best option. 

Having blundered into their role as monopoly provider of anonymous payments, here's hoping that the cryptocurrency revolution means that central bank's finally take that role more seriously. If they don't, maybe they should just give up their monopoly.

---

*Can bitcoin serve as a suitable replacement for cash? Unlike cash, bitcoin can't be used to make anonymous payments. Bitcoin payments are pseudonymous—so they don't quite make it over the line. The other problem is that bitcoin is not pegged to national units of account. Thanks to its terrific volatility, bitcoin has failed emerged as a genuine medium of exchange, so it can't take on the responsibility of providing law-abiding citizens with a generally-accepted anonymous and censorship-resistant medium for making payments.
**I am by no means wedded to blockchains as a way to digitally capture anonymity,censorship resistance, and robustness. There are other ways to go about this that do not involve blockchains.

Bitcoin's bootstraps

by Paul Conrad

When we talk about bitcoin, one thing we need to ask ourselves is this: can worthless things circulate and be accepted in trade? If so, how? And can this state of affairs continue indefinitely?

An intrinsically useless, unbacked, and costless fiat object might be accepted in trade, but only if it already has a positive price. A history of positive prices will generate sufficient expectations among potential acceptors that they will be able to trade that object on tomorrow. But how might our fiat object earn a positive price to begin with? If we reply that early adopters expected it to be widely accepted by others in trade, how did these early adopters ever form these expectations if that object didn't already have a positive price? We're dealing with a problem of circularity. There is no way to "break into" a dynamic that might generate a positive value for a fiat object. So logically, worthless things cannot trade in the market at a positive value.

However, fiat objects like dollars and yen do seem to have a positive value. Two types of economists, Austrians and MMTers, recognize the circularity dilemma that emerges when trying to explain the positive price of a useless fiat object. Both solve the circularity problem in different ways.

Austrians say that when early adopters first acquired the fiat object, it was not yet intrinsically useless, unbacked, or costless. Thanks to its original commodity nature, or perhaps its status as a backed financial asset, it already traded at a positive price. Even if that character is lost, the object suddenly becoming a fiat one, it may still be widely accepted in trade on the basis of people's memory of its pre-fiat price. Thus the circle can be broken into, and worthless bits of paper can legitimately have a positive value in trade. This is Ludwig von Mises's famous regression theorem.

MMTers solve the circularity problem by bringing in the tax authority. As long as some agency like the government imposes an obligation on people to pay taxes with these fiat objects, that will be enough to drive their positive value.

I should point out that I don't think we actually face a circularity problem with modern central banknotes since they aren't worthless bits of paper but rather exist as a liability of their issuer. But we do run into the problem with bitcoin. Here we have an unbacked, intrinsically useless, stateless fiat object trading at $950 or so, not to mention a legion of copycat coins trading at various positive prices. [1]

Austrians are all over the board on bitcoin. Because their solution to the circularity problem is to invoke the legacy commodity value of a fiat object, bitcoin poses some theoretical hurdles for them since it is by no means clear whether bitcoin ever had an original commodity value. Bob Murphy for one argues here that bitcoin may have earned its first foothold thanks to non-pecuniary ideological reasons. However, there seems to be no consensus among Austrians on that point. MMTers seem to genuinely dislike bitcoin since their preferred tax obligation story can't bear the load of explaining bitcoin's price. Here is L. Randall Wray who says that bitcoin is a test of the "infinite regress view of money", then gleefully points to its falling price as evidence that the taxed backed theory is the dominant theory (it later rebounded).

Let's move on from MMTers and Austrians. George Selgin recently came up with an interesting way to explain how bitcoin might have earned its all important original positive price:

Records show that a just a few persons took part in most early Bitcoin transfers, and especially in the larger-volume ones. My guess is that they all knew each other, and that those trades were more-or-less fictitious, with large values being traded and then traded back again, with the intent of enhancing the prominence of the positive-value equilibrium by drawing attention away from the much larger set of inactive Bitcoin markets. Bitcoin’s inventors, I’m now almost certain, were making conspicuous leaps onto their own bandwagon, so as to encourage others to do so, whether to express themselves or to profit by doing so. In short, a clever marketing strategy, including a little strategic sleight-of-hand, can substitute for history in putting a positive sign on the expected value of an otherwise useless potential exchange medium.

Here we have neat way to break into the circle. Have a group of insiders trade the fiat object amongst each other in order to generate an artificial history of positive prices, at which point outsiders will be willing to accept it in trade based on the expectation that others will repurchase it from them later.

Making "conspicuous leaps onto one's own bandwagon," as Selgin calls it, is a well worn tactic. In stock markets, the term wash trading refers to the illegal practice whereby an individual or group of schemers trade an illiquid, often worthless, stock back and forth among different accounts. The goal is to give the illusion of activity, thereby attracting innocent traders who would otherwise pass up the stock. A more colourful term for this is "painting the tape", which refers to the old ticker tape of yore.

Another way to paint the tape is to high close a stock. Using this technique, a trader or group of traders will buy a stock in the closing seconds of the day, pushing its price up. Since media outlets tend to focus on a stock's daily closing price, and stock charts depend on the daily close, high closing may be a cost effective strategy for traders to create and benefit from the positive price momentum that news of a high closing price engenders.

Auction markets, say in livestock or art, are sometimes populated with confederates—those who work in conjunction with a seller to provide fictitious bids so as to drive some object's price, say a dubious piece of abstract art, or a lame horse, far higher than it would otherwise be worth. Should the confederate's bid be the only bid, the worst that happens is that the schemers get their own painting or horse back, upon which they can try the same trick over again in the next auction. If their bidding excites someone else to add a bid, then they've succeeded in earning something for nothing.

In any case, all of these techniques can push a worthless object's price above zero, at which point that object may have generated enough of a history of positive prices that it will be valued by enough outsiders that it will join the mass of non-fiat objects in circulation. From nothing, our worthless item it has pulled itself up by its own bootstraps.

Which explains bitcoin's incredible volatility. A bootstrapped object can just as easily let go of its own straps and fall back to zero. Without some real use or backing, there's nothing to catch it on the way to $0. And at $0, there's no guarantee of re-bootstrapping bitcoin back to some positive price. As such, Bitcoin users justifiably expect incredible returns from bitcoin holdings in order to bear the risk of a zero-value equilibrium. Expected hyperdeflation is the carrot that must be proffered up for risky cryptocoins to be held. When those expectations of price appreciation aren't met, a large crash in the current price (relative to its future expected price) is necessary in order to tempt the next crop of speculators to hold it again. Thus bitcoin's pattern of incredible rises, or hyperdeflation, followed by 50% flash crashes, followed by the next round of hyperdeflation.

So if unbacked, useless, and costless objects can be imbued with a positive price via Selgin's painting-the-tape story, why isn't everyone doing it? But they are! Attracted by the potential for large gains, plenty of people are creating alt-coins, as I wrote here and here. In theory, their combined greediness should have the effect of swamping the market with fiat objects, driving their price towards the cost of production. The idea here is similar to the Somali shilling story, in which continual counterfeiting of old fiat shilling notes drove their price down to the cost of production, namely the costs of paper, printing, and shipment.

This hasn't happened yet with bitcoin, which is hovering at around $950. In my old post Milton Friedman and the mania in "copy-paste" cryptocoins, I hypothesized that the seeming inability of competitors to drive bitcoin prices down had something to do with the unassailable benefits that bitcoin enjoys as being the first mover, including superior security and liquidity. Tyler Cowen has some interesting thoughts on this. Bitcoin has a market cap of about $20 billion. As long as Bitcoin's entrenched advantages are so supreme that it would cost $20 billion to create a competitor, then there's no profit in tackling its niche. Cowen, however, thinks that the cost of mimicking bitcoin is far less than this. Rather than being in equilibrium, the cryptocurrency market is currently working itself via a process of "supply-side arbitrage" to a new equilibrium at which bitcoin will be worth far less.

On this same topic, Nick Rowe suggests that a BackedCoin might be one of the competitors capable of carrying of this feat. I agree with Cowen and Rowe —that's why I mostly sold out of bitcoin last year, and why I plan to eventually sell my litecoin. Of course, I'm the dummy who sold BTC back at $100, so my opinions should be taken with a grain of salt.

Where will the competition come from? Robert Sams makes a good argument for why bitcoin knock offs like litecoin, sexcoin, etc., though costless to produce, can't easily compete with bitcoin itself. The mining power that goes into maintaining the integrity of the various blockchains is in scarce supply. Merchants will always congregate to the blockchain with the most security, since that will be the coin that guarantees that the threat of double-spending is the smallest. While clones can be created with a few key strokes, good security can't be bought. Thus bitcoin's price can't be competed down to $0ish by alt-coins.

I think I buy Sams's point. However, he couches his argument within the existing universe of bitcoin and its clones. I'd make the argument that the crypto phenomena through which "supply-side arbitrage" will be carried out could be something entirely different than bitcoin, say Ripple or something we haven't yet seen. Ripple for one isn't constrained by the supply of existing mining power, or hashing, since the Ripple blockchain is maintained via consensus, not by hashing miners. Is this type of security cheaper? I'm no techie, so I won't speculate. But it is something different. And though it may take a while, at some point new and different will also be cheaper.

Another bonus of the Ripple system is that the crypto currency it creates are not bootstrapped assets, they are redeemable IOUs (let's not confuse Ripple IOUs and XRP!). In Rowe's UnbackedCoin vs BackedCoin world, Ripple IOUs are the equivalent of BackedCoin. It is their backing that should protect the exchange value of Ripple IOU from the threat of competition. This very same backing frees them from the hyperdeflation-crash-hyperdeflation patten that bootstrapped coins tend to display, stability being a desirable feature among  those who want to hold an inventory of media of exchange. As long as Ripple IOUs are just as transferable & secure as bitcoin and other alt-coins, this stability will be the edge that pushes them above the crypto competition.

So in sum, worthless assets can be kickstarted into circulation, say by a group of confederates who paint the tape in a way to attract outsiders. The riskiness of these bootstrapped assets requires that they yield incredibly high returns, or constant price appreciation. However, this state of affairs can't last forever since others will be eager to issue their own competing fiat objects, including superior non-volatile competitors. If I'm right, in the future bitcoin will be a smaller part of the cryptocoin world than it it now, whereas stable-value non-bootsrapped crypto assets, like Ripple IOUs, will be a larger part of that world.

---

[1] Bitcoin may not be entirely intrinsically worthless. I have floated the idea before that bitcoin has commodity value as a symbol of geek cred.

Separating the functions of money—the case of Medieval coinage

Florentine florin

Last year Scott Sumner introduced the econ blogosphere to what he likes to call the medium-of-account function of money, or MOA, defined as the sign in which an economy's sticker prices and debts are expressed. Here and here are recent posts of his on the subject.

I think Scott's posts on this subject have added a lot of depth to the interblog monetary debates. However, I've never been a big fan of Scott's terminology. As I've pointed out before, what Scott calls MOA, most modern economists would call the unit-of-account function of money. Older economists like Jevons and Keynes[1] referred to the unit-of-account as the money-of-account, and modern economic historians also prefer money-of-account. Terminological differences aside, in today's post I want to focus on what I'll call from here on in the unit-of-account function of money.

Scott's UOA posts often emphasize the idea of separating the unit-of-account function from the medium-of-exchange. This isn't a new approach. Back in the 1980s, a trend in monetary economics began whereby economists began to dissociate the various bundled functions of money into constituent components. In fact, a few contributors to the modern econ blogosphere were participants in what was then called "New Monetary Economics", or NME, including Tyler Cowen, Bill Woolsey (pdf), Scott, and Lawrence White (pdf). White, it should be noted, was a critic. Cowen doesn't blog much about NME these days, his last post on the subject was in 2011, but I'm sure every time he goes to a restaurant he can't help but wonder what the world might be like if the menu prices were in different units than the media he expected to pay with. Here is an old Cowen paper (with Krozner) on NME that is worth reading, as well as the bibliography which serves as a good jumping off point to understand more about NME.

But let's turn to an actual example. The separation of the medium-of-exchange from the unit-of-account envisioned by NME isn't mere speculation. Indeed, such a separation has been very much the norm over the last thousand years or so. The medieval monetary system operated with what was essentially a number of heterogeneous media of exchange and an independent unit of account.

Medieval Europe was politically fragmented and many different mints issued coins. Einaudi (pdf) tells us that some 22 gold coins and 29 silver coins (most of them foreign) circulated in the Duchy of Milan alone in the 18th century. This does not include the many varieties of copper coins that would also have been current. Weber (pdf) describes Basel in the 1400s, which had a heterogeneous coinage acquired through trade that included florin and ducats from Italy, and German rhinegulden, along with the local silver penny.

Because most of these coins had different metallic content, and the market value of coins was determined to a large extent by the quantity of metal therein, would this not have caused a terrific amount of confusion? Silver and gold traded at a constantly fluctuating ratios, contributing to the calculational morass. How could shopkeepers and shoppers keep track of the prices at which transactions were to be consummated with such an incredible variety of ever changing units?

The answer is that prices were expressed in terms of a universal unit of account. The name for this unit was the pound, or in French, the livre. The pound (and livre) were further divisible into 20 shillings (sous) and each shilling into 12 pence (deniers). A pound was therefore divisible into 240 pence. Prices and debts were recorded not in terms of individual circulating coins, but in terms of this pound unit of account. Indeed, pound coins never actually existed in Medieval Europe, the pound being a purely abstract accounting unit.

According to Einaudi, local mint officials maintained a list of coin ratings whereby each coin in local circulation was rated at a certain amount of £/s/d. Officials determined the rating by assaying the quantity of gold or silver in each coin. Thus a shopkeeper need only list the price for, say, a horse in terms of the universal unit of account, say 1 pound 6 shillings. A buyer need only look at the 1£ 6s sticker price, determine what sorts of coins he had in his pocket, refer to their public ratings, and compute the proper number of coins to hand over as payment.

Over time, the precious metals content of coins would deteriorate as people 'sweated' coins, filed them, clipped them, or bathed them in aquafortis [2]. The price ratio of gold to silver would often change subject to the whims of market demand as well as mine supply. Sometimes a sovereign might call in an existing issue of coins and reissue them with more or less precious metals therein. When the metallic content of a given coin was changed, or when the market silver-to-gold ratio fluctuated, local mint officials would quickly account for this change by re-rating the altered coin in terms of the £/s/d unit of account.

The advantage to shopkeepers with this system is that they needn't update their sticker prices. After all, via constant re-ratings, the prices of coins were made to fluctuate around the unit of account. For example, if the Spanish doubloon was re-rated due to a debasement in its gold content, our horse-seller could keep his 1 pound 6 shilling price constant, and need simply ask for more doubloons [3]. In this way, the chaos of the medieval coinage system was rendered orderly by a universal £/s/d unit of account.

There is one important issue I haven't dealt with. What defined the medieval pound unit of account? Anyone who's read my old post will know that this question boils down to this—what was the medieval medium of account? The unit of account is always defined in terms of something else, a medium of account, and it is this MOA (which is different from Sumner's MOA) that anchors the price level.

Although city states never minted pounds (and only rarely shillings), they did mint their own pennies. Weber (pdf)(RePEc) and Spufford hypothesize that these pennies served as a foundation, or "link" coin. The penny unit of account was set equal to the penny coin, either spontaneously or via enactment, and thereafter any alteration in the silver quantity of the penny link coin modified the unit of account.

To illustrate, if the sovereign reduced the amount of silver in the local penny, the penny's linkage to the unit of account meant that the penny-as-unit of account now contained a smaller quantity of silver. The pound unit of account (a multiple of 240 pennies) by definition now also contained less silver. So a debasement of the link penny coin meant that all £/s/d sticker prices would need to be raised by shopkeepers if they desired to preserve real purchasing power [4]. In modern days, we call this inflation. Nor was princely debasement of the link coin the sole cause of medieval unit-of-account inflation. After many years of passing from hand to hand, link coin's naturally wore out, and therefore a steady inflation in prices resulted.

A debasement in a foreign penny circulating locally, however, would have no effect on the local unit of account, insofar as the foreign penny didn't serve as the link coin. Rather, a debasement of a foreign penny would result in that particular coin being re-rated in terms of the unit of account. £/s/d sticker prices would stay constant.

In some cases, however, foreign pennies were the link coin, so changes to the silver content of the local penny would have no effect on the price level. Inflation or deflation were imposed exogenously. Even more interesting, in a few rare cases the precious metal content of a famous coin of a previous era that no longer existed was used as the link coin. Monetary historians such as Munro call these "ghost monies". The advantage of having a ghost link coin rather than a current coin is that the unit-of-account could now stay constant over time, preserving the real value of debts and contracts.

To sum up, the medieval unit of account, as we already know, was £/s/d. We also know that there was no single medium of exchange, but a chaotic mix of coin media of exchange. The MOA was a single "index" coin, usually the locally-coined penny, but at other times a foreign coin or an antiquated "ghost coin". While link coins would come and go over the centuries, the £/s/d unit of account stayed constant.

At what point in history did the unit of account and medium of exchange finally fuse together? Weber (pdf) hypothesizes that the Industrial Revolution brought with it improvements in the quality of coin production. Milled edges prevented filing and clipping. The introduction of steam driven coining reduced minting costs and made it more feasible to replace worn coins. These technological improvements meant that it was now possible for coins to serve as stable units of account. The best evidence that Weber finds for this is the appearance of "value marks", or numbers, on the faces of coins. Medieval coins did not carry numbers on them, only the faces and names of the various personages responsible for their issue. The blank nature of these coins allowed the market to determine their exchange rates in terms of the unit of account. The appearance of value marks in the 19th century indicated that the coinage was now of a high enough quality that a separate unit of account was rendered unnecessary. It was now possible to inscribe the unit of account directly on the coin's face.

As a result of these developments, the modern day individual is incapable of imagining a split between the unit-of-account and the media-of-exchange. But this complex institution is something that our ancestors dealt with on a daily basis. Understanding the medieval monetary system is a great way for us to throw off the cobwebs and understand the difference between media-of-exchange and unit-of-account. After all, who knows what future monetary systems might have in store for us — perhaps another divergence between the two functions? It also crystallizes how important the unit-of-account function is. Whoever controls the unit-of-account controls prices, and therefore monetary policy.

---

[1] The first line of Keynes's Treatise on Money is: "Money-of-account, namely that in which Debts and Prices and General Purchasing Power are expressed, is the primary concept of a Theory of Money.
[2] Sweating coins involved putting many coins in a sack, shaking the sack, and removing the fine metal grains that shaking had dislodged from the coins. Aquafortis is nitric acid, or HNO3.
[3] The doubloons re-rating due to lower metallic content was called a "crying down" the value of the coin. If the doubloon had been reminted to contain more gold,  its value would have been "cried up". [Editor's Note: this is wrong|
[4] When the link coin's metallic content was debased, this was referred to in the medieval literature as an 'augmentation' or 'enhancement' of prices. When link coin's metallic content was rebased (increased), this was referred to as 'diminution', or 'abatement'. 

Update: By coincidence, Nick Rowe has simultaneously posted on the separation of the functions of money.

No need to ban cash to avoid the zero-lower bound problem

Tyler Cowen and Scott Sumner discuss the idea of abolishing central bank-issued cash. The existence of cash can create problems for monetary policy. Say a central bank wants to reduce the rate it pays on central bank deposits to below zero. If it did so, everyone would immediately convert deposits into cash, since owning 0% yielding paper notes is better than owning an instrument that pays a penalty rate. There appears to be a zero-lower bound to the interest rate on deposits. Ban cash and you might remove that bound.

Tyler points out that the alternative to an outright ban is to put a Silvio Gesell-style tax on cash that brings a bank note's yield to something below 0%. This way, no one will prefer cash to negative yielding deposits. But as he points out, this is slightly "goofy" since it requires serial numbers and scans on all paper notes.

There is a simple alternative that doesn't require a ban, nor does it require that all cash carry sensors, serial numbers, or whatnot. Instead, the central bank can reduce the convenience of cash by constricting the denominations of currency it issues. The Federal Reserve currently prints notes in denominations of $1, $5, $10, $20, $50 and $100. Say that the Fed reduces the rate it pays on deposits to -2%. Households, small businesses, large corporations, and banks flock to turn in all their deposits for bills. The kicker is, the Fed will only provide them with cash in $5s.

This imposes a real burden on people because it is more expensive to hold $5s than it is $100s. Banks keep their cash in vaults, but these vaults have been designed to store thousands of $100s, not hundreds of thousands of $5s. Given this inconvenience, deposit holders will be less willing to flee -2% interest rates by moving to cash. Gone is the zero-lower bound problem.

I pointed out here that one problem with this policy is that the entire cash-using sector, particular criminals, might Euroize. Rather than hold, say, thirty US$5 bills, or US$150 in -2% deposits people might choose to hold one €100 bill. This decline in the dollar's "brand" would in turn hurt seignorage earned by the Fed.

In any case, the core issue here is how to reduce the attractiveness of central bank liabilities in a world in which central banks issue two types - cash and deposits. Reducing interest rates on deposits below 0% works only as long as you simultaneously hurt the convenience of cash by doing something like only issuing $5s (or putting a Gesell tax on cash). Alternatively,one can reduce the attractiveness of both notes and deposits in one fell swoop by doing what Scott Sumner advocates: promise to reduce the future purchasing power of all central bank liabilities. I'm on the fence about policy implications of all of this. I'm a macroeconomic agnostic, for the time being at least. But I think the zero-low bound problem is probably an over-exaggerated problem.

Updates: Bill Woolsey has an excellent post on this debate. Other things that can be done to avoid the zero-lower bound apart from taxing or banning cash include ceasing redemptions of deposits for cash. Banks can threaten holders of cash to deposit it now or deposit it later at a discount. Bill also notes that if the quality of bank notes is reduced by making them junior claims on bank assets, then senior claims like deposits can easily yield negative amounts without causing a rush to cash.

The Euro isn't a glove, it's a Chinese finger trap

Tyler Cowen posts on Is there an easy way out of the eurozone? He notes it would be harder than Robert Barro thinks.

I agree. My comment:

Barro’s is the Euro-as-glove argument. You can slip it on, and slip it off just as easily.

I like the Euro-as-Chinese-finger-trap argument. Once you’re in, you aren’t going to get out of it.*

*Germany can’t leave it easily, because it is owed some E500b by the ECB via the Target2 settlement system. Leave it and lose it. The PIIGS can’t leave, because as Tyler points out, a bank run will immediately result. And if they dodge the run, they surely won’t be able to dodge euroization: citizens will spontaneously disengorge any newly-created liras/drachmas/etc in favour of the already-circulating and vastly superior Euro.

ECB, NCBs, and arbitrage yet again

Tyler Cowen posts again on the theory that banks are using the ECB's new and broader facilities for arbitrage by buying risky sovereign debt, thereby driving interest rates down.

There is another explanation for the fall in rates, see my comment below:

The new ECB collateral rules dramatically increase the quantity of assets that banks can submit to the ECB in order to get ECB clearing balances. Bank loans are now allowed, so are lower quality ABS. This means that it is less likely that the national governments will have to guarantee local bank debt. This was a real problem in Greece and Ireland, for instance, for the local banks had run out of assets to submit to the ECB. Instead, banks were creating debts amongst each other and having the government guarantee these debts, before submitting them to the ECB as collateral.

Since private non-marketable debt can now be submitted to the ECB, governments will no longer be required to covertly bail out their banks by guaranteeing intra-bank debts. That means that euro government debt is now a lot safer, and explains why yields are falling. So you can use an ECB arbitrage theory to explain the data, but there are alternatives.

Interfluidity also chimes in on The Eurozone’s policy breakthrough? My comment below:

I think the ECB’s policy change is designed to stop the intra-European bank run currently in effect, and not to support various governments. The arbitrage bit that Cowen is writing about is either a red herring or simply incidental.

Because of the Eoro area clearing & settlement mechanism, banks subject to capital flight need to submit collateral to their NCB on a continuing basis to deal with a bank run.

By lending settlement balances for three years and, more importantly, accepting lower quality ABS and bank loans as collateral, the ECB is committing NCBs to averting all degrees of bank runs from member banks. Hopefully this flexing of its muscles is enough to stop the run.


See this older blog post too.

Asset shortages, scarcity of safe collateral

Have commented on a few blogs that bring up the meme of collateral shortages.

Commodity money: It's back! (and it sucks) at Macromania
Is the Fed our savior in financial regulation? at Marginal Revolution
Why the Global Shortage of Safe Assets Matters at Macro and Other Market Musings

The idea of a scarcity of shortage of safe assets is nonsensical to me.

I just don't think this can be a real issue. If the quantity of "safe assets" somehow collapses, then the prices of remaining "safe assets" will rise to meet the market's demand for safe collateral and stores of value. You can't have shortages in financial markets. Do you think you can?

and

The idea that there can be a shortage of good collateralizable financial assets sounds fishy to me. Prices for those assets will simply rise until their price is sufficient to meet the demand for good collateral. The same with an excess demand for money - prices will simply fall to meet that demand.

ECB and NCBs again

Tyler Cowen has another post on the ECB financing sovereign governments via loans... It is finally being recognized that the eurozone made a major policy breakthrough:

My thoughts:

I don’t think the key here is arbitrage and government monetary financing. It’s about a slow bank run that has been enveloping Southern Europe for a few years now. The mechanism which governs intra-Euro payments requires Greek/Italian etc banks to “solve” for the bank run by submitting collateral to their national central bank in return for settlement balances. Much of this is done overnight or on a weekly basis. By establishing 3 year operations, the ECB is telling the banks and the rest of the world that they will continue to meet the demands of anyone running on the Southern European banks for the next 3 years. That sort of commitment to the system might be large enough to stop the bank run.

It’s similiar to how, in the old days, banks suffering bank runs would often bring out all their cash and gold from the vaults and put it on display behind the bank teller so that depositors, seeing the actual backing assets, would turn away. The ECB is putting its cash on display.

Relevant link: see this older post

LOLR, ECB, and "too complicated for people to complain about"

Interesting post on Marginal Revolution, What is the difference between LOLR to banks and LOLR to governments?

Cowen: “Is this transfer of the subsidy to the sovereign a bug or a feature of the plan? Perhaps this is how the EU/ECB, viewed for a moment as a consolidated entity, will circumvent EU law to finance troubled governments. Is it possible that by changing collateral requirements they can alter the flow of funds to governments in a discretionary, ever-changing, and relatively non-politicized fashion? Does this satisfy the “too complicated for people to complain about” provision?”

Reply:

Good post. It is probably a feature, not a bug, and it is surely “too complicated for people to complain about,” at least for now.

This isn’t a new thing, though. The ECB has been lightening up collateral requirements for a few years now, presumably in part to finance weak governments through the back door. Remember when the ECB broke its rules and began accepting BBBminus-rated collateral?

Relevant Link:
Peter Garber, Deutsche Bank. The Mechanics of Intra Euro Capital Flight