Alphabet soup

It's that time of the economic cycle. Financial writers are flocking to the phrase alphabet soup again. This was a phrase we all adopted in 2008 to describe the hodge podge of credit facilities created by the Federal Reserve to deal with the credit crisis. Twelve years later, alphabet soup applies just as well to the Fed's response to the coronavirus crisis.

As in 2008 the Fed is currently trying to get funding into as many nooks & crannies of the credit system as it can. The easiest way to do this would be for the central bank to create a slew of new deposits and either lend them directly to corporations (and other counterparties like municipalities) or buy up already-issued corporate bonds and other debt instruments.

But things aren't that easy. The Fed's money is taking a somewhat tortuous route into credit markets.

Like 2008, the Fed has reacted to the crisis by incorporating a bunch of special purpose vehicles, or SPVs. An SPV is a subsidiary or corporation that is legally distinct from the Fed, but controlled by it. The Fed has then been lending fresh money to the SPV. And then the SPV on-lends this money to corporations, or buys up their bonds and other debt instruments.

To illustrate, take the Fed's newly unveiled Primary Market Corporate Credit Facility (PMCCF). The Fed is using this facility to lend to an SPV, this SPV in turn purchasing bonds directly from corporate issuers, like Walmart. The hope is that by providing Walmart with direct access to Fed credit, the retailer will be better able to maintain business operations during the pandemic.

Why doesn't the Fed just directly purchase Walmart bonds?

About all the Federal Reserve can legally buy are Treasury bills and other safe government securities. The Federal Reserve Act prohibits the central bank from purchasing Walmart bonds or any other type of corporate debt.

But a Fed-created SPV isn't really subject to the same set of rules as the Fed, right? If it is legally remote enough from the Fed, an SPV can "lawfully" buy all the Walmart bonds that the Fed can't, no? That's basically the strategy that the Fed took in 2008, and it is taking it again.

But that SPV still needs to be funded. Luckily for the Fed, Section 13(3) of the Federal Reserve Act allows it to exercise broad lending powers in an emergency. So the Fed invokes 13(3), lends funds to the SPV, and then has the SPV buy Walmart debt. Voila, the Fed has purchased Walmart bonds without actually buying Walmart bonds. All the legal i's have been dotted, the t's crossed.

The SPV structure isn't just a legal hack. It also allows the Fed to protect itself.

Each of the five or six SPVs that have been created over the last two weeks is backed up by the U.S. government. This means that if the SPV's loans or bond portfolio falls in value, the central bank needn't worry. The Federal government will promise to make it whole.

Take the aforementioned Primary Market Corporate Credit Facility, or PMCCF. The Treasury has currently invested $10 billion in the SPV to which the PMCCF will lend. So if the Fed buys $10 billion in Walmart bonds via the SPV, and Walmart goes bankrupt and its bonds become worthless, the Fed still gets $10 billion back. It's the Treasury that loses its investment, not the Fed. The SPV structure is a tidy way to formalize the Treasury's support.

To get more context about this protection, let's compare the PMCCF to another facility created by the Fed, the Primary Dealer Credit Facility, or PDCF. The goal of the PDCF is to get funds to primary dealers, large financial institutions that make markets in all sorts of assets including the all-important US government securities market.

To create the PDCF, the Fed has also invoked Section 13(3) of the Federal Reserve Act. The Fed's interactions with primary dealers are limited by law to buying and selling government-issued assets. The central bank can't lend to dealers, certainly not on the basis of exotic sorts of collateral. But the emergency powers embedded in Section 13(3) allow the Fed it to open a broad lending channel to primary dealers.

Unlike the rest of the alphabet soup of facilities that invoke Section 13(3), the Primary Dealer Credit Facility is not set up as an SPV, nor does it enjoy $10 billion in protection from the U.S. Treasury. I have it on good authority that the Fed doesn't believe that a firewall is necessary. A strict process is already in place to vet primary dealers. Furthermore, the Fed has an ongoing relationship with dealers because they mediate all central bank purchases and sales of government securities.

But the Fed knows very little about the counterparties that it will lend to under the other facilities it has created, like the PMCCF. To make up for this extra risk, it wants to get some protection from the Treasury should those counterparties fail.

And in a nutshell, that's why the Fed has taken such a circuitous route to get funds into the credit system.

The bigger picture is that you've got a very old set of laws embodied in the Federal Reserve Act. Many of these rules were designed back in 1913 when America was still mostly a farming economy. Debts were almost always short-term back then, usually in the form of a bill of exchange, a debt instrument that doesn't really exist anymore. Heck, a whole section of the Act is about discounting "agricultural paper". That section probably hasn't been invoked in fifty years.

Meanwhile, a massively complex financial system has evolved over the last century. All sorts of new exotic credit instruments have emerged, say like asset-backed commercial paper. Farming, once a dominant sector, now accounts for a tiny part of the US economy. In a modern crisis like the one we are in, Federal officials believe that they need to be able to deal in these new types of securities. And reach new industries. Because the Act is mostly designed for a previous era, Fed lawyers have had to drill a strange new path to the credit markets via Section 13(3), SPVs, and Treasury support.   

I'm going to leave off now. Readers will obviously have a lot of unanswered questions.  

• Should the Fed be lending such a massive amount of money to such a wide variety of borrowers? (I don't have a good answer).
• Why is the Money Market Mutual Fund Liquidity Facility called the MMLF and not the MMMFLF? (Nathan Tankus deals with this and much more in his two part overview of what the Fed has done up till now).
• Aren't the Treasury backstops a waste of ammo? (George Selgin has a good explanation about why they exist, and I am inclined to agree with him. They're not a gimmick.)
• Aren't the SMCCF and PMCCF unprecedented? (Yes, they are. These facilities fund SPVs that either lend directly to corporations or buy corporate bonds in secondary markets. The Fed never went this far in 2008). Are they a good idea? (In a recent blog post, Stephen Cecchetti  & Kermit Schoenholtz argue that they aren't.)
• Shouldn't the Fed limit its support to buying bonds in the secondary market rather than lending directly to corporations? (Narayana Kocherlakota says no. He is opposed to the PMCCF, but likes the SMCCF. George Selgin and I don't see much difference between the SMCCF and PMCCF.)

Money in an economy without banks

by Alex Schaefer

 
Most of the world's money is currently in the form of deposits created by banks. After the 2008 credit crisis, which instilled a strong suspicion of banks among the public, it became fashionable to ask what money would look like in an economy without these organizations. Burn them to the ground or shutter them, what would take their place? One vision is to pursue pure centralization: have the state monopolize all money creation, say by providing universally-available accounts at the nation's central bank. Positive Money is an example of this. Another alternative, by way of Satoshi Nakamoto, is to pursue radical decentralization: replace bank IOUs with digital commodity money in the form of bitcoin and other private cryptocoins.

I'm going to provide a few historical examples that sketch out a third option for replacing banks; bills of exchange. A system underpinned by bills of exchange is capable of converting illiquid personal IOUs into money using a distributed method of credit verification, as opposed to a centralized method patched through a banking organization. Unlike bitcoin, however, these are IOUs, not mere bits of digital ledger-space. While few people these days are familiar with the bill of exchange, in its hey day this instrument was responsible for executing a large chunk of the Western world's transactions. 

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The first story is of cheques, an instrument that while not precisely a bill of exchange gets pretty close. Last week in my homage to the cheque I brought up the Irish bank strike of 1970, described by Antoin Murphy (from whom I steal the title of this blog post). When the nation's banks shuttered their windows for half the year, Irish citizens re-purposed uncleared cheques as personal IOUs, these cheques circulating as a cash substitute. The system was decentralized in that banking institutions no longer served as creators of the medium for making payments; instead, everyone became their own unique money issuer. As Tim Harford recently wrote, pubs and corner shops were able to vouch for the creditworthiness (or not) of each cheque.

Irish cheque money only circulated for six months. After the banks reopened in November 1970, mounds of cheques were cleared & settled and the system returned to normal. Luckily, we have historical examples that lasted much longer than this.

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Let's go back in time to Antwerp in the late 1400s. The institution of banking had been present in Europe for a few centuries, but according to Meir Kohn (who I get much of this material from) it began to go into decline at the end of the 15th century as waves of bank failures broke out across the continent, due in part to coin shortages. In Antwerp, the authorities went so far as to ban the practice of banking in 1489. In lieu of bank deposits, coins could of course be used to make payments, but this would have been a step backward since deposit banking had emerged, in part, to solve the problems related to coins, specifically the fact that they are expensive to store, awkward to transport, and heterogeneous, some coins containing more precious metals than others.

Similar to the Irish five hundred years later, Antwerp's financiers adapted to the death of bank money by innovating a decentralized alternative. Where the Irish chose cheques as their payments instrument, Antwerp settled on a related paper-based order called the bill of exchange. A bill of exchange was a popular way to remit money in medieval times. Say you were a citizen of Florence and you needed to get 20 gold coins to a relative in Venice. Rather than incur the cost and danger of transporting the coins yourself, you might try and strike a deal with a merchant who had offices—and gold—in both cities. By paying the merchant some gold in Florence, your home city, he would issue you a bill of exchange. This bill ordered his colleague in Venice to pay out 20 gold coins to whoever happened to be the bill bearer. You'd then send the bill to your relative in Venice, and he'd bring it into the office and collect the money. The merchant would earn a commission on the deal. No actual gold would travel between the two cities, just a secure and light paper instrument. It was a fantastic technology for saving on the costs of shipping and handling heavy coins.

While bills of exchange started out as remittance instruments, they were later used by merchants as a form of credit. A merchant might want to sell some wool to a manufacturer who in turn required three months to convert the wool into cloth and sell it. To finance the purchase of wool, the manufacturer could always turn to a banker. Absent a banker, the merchant himself might provide the manufacturer with a loan by drawing up a bill of exchange. On its face this bill contained written instructions ordering the manufacturer to pay x coins three months hence to the bearer of the bill. The merchant would keep it in his desk, and when the requisite amount of time had passed he would bring the bill to the manufacturer and collect on his debt, earning interest in the meantime.

The common denominator of a bill of exchange, whether used as a remittance or as credit, is that a private citizen has issued their own personal IOU, to be redeemed for cash after some time has passed. Then Antwerp happened.

In its original form, a bill of exchange could only be used by a small group of people, the initial drawer of the bill, the payor, and the payee. Antwerp's financiers took the bill of exchange and converted it into a fully transferable instrument, or money. They pried open the closed circuit so that if merchant A owned a bill of exchange that was to be paid out in coin by merchant B next month, merchant A could in the meantime transfer this IOU to merchant C as payment, and merchant C could transfer it to merchant D, and D to E etc. These transfers, or assignments, could occur without asking the original debtor, merchant B, for permission. This would have dramatically increased the liquidity of bills of exchange, allowing them to fill the vacuum left in Antwerp by the banning of bank deposits,

To further protect anyone who received a bill of exchange in payment, Kohn tells us that these instruments were granted currency status by Antwerp's merchants. As I wrote here, this meant that even if the bill of exchange had been stolen from merchant B and paid to merchant C (who had innocently accepted it), merchant B could not sue merchant C to get the bill back. This legal upgrade would have further promoted the liquidity of bills of exchange, since merchants needn't bother setting up burdensome verification processes to ensure that bills of exchange presented to them were not stolen. In the eyes of merchant law, all bills of exchange were considered "clean."

There was still one last barrier to creating a truly decentralized medium of exchange; how to overcome stranger danger. Say that you and I are acquaintances and I owe you $20. I tell you I'm going to settle my debt by giving you an IOU issued by another party. Banks are a great way to solve the stranger problem, since everyone will agree to settle debts using the IOUs of a well-known and trusted intermediary like a bank. But say instead I offer you a $20 bill of exchange that I've received from a friend. If you know that person you'll probably accept the deal, but in an economy like Antwerp's with thousands and thousands of actors, you might not know the name of the debtor written on the bill. And without enough knowledge to accept the credit, you'd have probably refused it.

According to Kohn, the final innovation developed in Antwerp solved the stranger problem—the ability to endorse a bill of exchange. I simply signed my name to the back of $20 bill of exchange, or endorsed it, and handed it to you. By signing it, I was agreeing to accept the debt as my own. So if the original debtor failed to pay you for the bill when it came due, you could flip the bill over and pursue the first name on the list of endorsees—me—for payment. And since you knew and trusted me, it was now possible for you to evaluate the credibility of a $20 bill of exchange that had originally been issued by a stranger. Bills could in turn be re-endorsed on by others, a long chain of transactions being made before the bill finally expired. Indeed, Henry Dunning Macleod once remarked that bills might sometimes have "150 indorsements on them before they became due."

From Antwerp, the practice of using negotiable bill of exchange would spread to the rest of Europe, in particular Britain. Below is an example of a bill of exchange from 1815 that ordered Pickford's, an English canal company, to pay £72  11s 1d to Richard Vann. You can see first hand how the stranger problem is solved. The bill has multiple endorsements on its reverse side (pictured below), including that of Richard Vann, William Alcock, T S Marriott, William Whittles, Jones & Mann, Thomas Whalley & Sons, James Mitchell and Richard Williams. To see the front side of the bill, click through to the original link:

Source

Not only did this chain of cosigning individuals solve the stranger problem. It also created an incredibly safe instrument. Bills of exchange were effectively secured not only by the original person whose name was inscribed on the front, Vann, but by all the others who had cosigned the back; Alcock, Marriott, Whittles, etc. The odds of everyone on the list failing would have been quite low. It was an ingenious system.

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Another interesting anecdote on bills of exchange comes from the county of Lancashire in north west England in the 1800s. By then, banknotes had long since been invented and were a popular payments medium in England. Typically issued by small private "country banks," banknotes were a centralized payments technology insofar as their value depended on the good credit of one issuer, the bank. Inhabitants of Lancashire were particularly suspicious of these instruments which explains why there were almost no note-issuing banks in the county. T.S. Ashton speculates that this wariness was due to the 1788 failure of Blackburn-based Livesay, Hargreaves and Co, a banknote issuer: "generations after, when proposals were made for local notes, men's minds turned back to the events of 1788."

In the absence of a system of banks providing transferable deposits or notes, bill of exchange circulated in Lancashire, even dominated, so much so that they were often "covered with endorsements" and become famous for their dirty appearance. Indeed as late as the 1820s, Ashton tells us that some "nine-tenths of the business of Manchester was done in bills, and only one-tenth in gold or Bank of England paper." Bills were used even in small denominations, say to pay piece workers. This is surprising because bills of exchange had typically been used by merchants and wholesalers, and therefore tended to be issued in large denominations.

Alas, according to Ashton the Lancashire bill of exchange was done in by the increase in stamp duties, which effectively made it more cost-effective to use bank-issued forms of payment that didn't require a stamp.

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Just a few random thoughts in closing.

While Ireland, Lancashire, and Antwerp all provide a sketch of an alternative, distributed form of converting personal IOUs into money, do we really need a replacement for banks? While the U.S. banking system certainly had its difficulties in 2008, Canadian banks skated smoothly through the crisis. Maybe banks only need a face lift.

Even if we need to burn the suckers down, a paper-based backup like bills of exchange or cheque just won't cut it—we need digital money. But is it possible to digitally replicate the features of a bill of exchange? And even if an online bills of exchange system could be built, we live in an age where money transmitting is a highly regulated industry—how legal would it be for individuals to take over the role of money creator, transmitter, and verifier? (I once thought that Ripple was the answer to digitally replicating bills of exchange. But they decided to serve banks instead. Maybe Trustlines fits the *ahem* bill?)   

An homage to the cheque (or check)

The check used to buy Alaska (source)

I recently read an FP article about the odd persistence of the cheque as a way to make payments. According to the author, even though cheques are slow and cumbersome, people are willing to live with these drawbacks because they like the ability to write messages in the memo field. Competing electronic payments options (in Canada at least) don't have the ability to write memos.  

Why do people still use checks? It's the memo field, apparently: https://t.co/ui0D0oTHEI pic.twitter.com/lkpEr9ZpEk

— JP Koning (@jp_koning) June 21, 2017

As someone pointed out to me on Twitter, in the U.S. the cheque's memo field is more than just a place for writing personal reminders. According to the law in certain states, when you disagree with your creditor about how much is owed—say the contractor who is building your deck has spent too much on materials—by writing out a cheque for less than the agreed amount and including "paid in full" in the memo line, the debt is extinguished the moment the contractor cashes it.  

What follows are some other neat things about cheques that don't get much attention.

People tend to think of cheques as a mere set of instructions issued to a banker on how to move bank deposits. To transfer deposits, we could always just walk into a bank and do this in person, but we prefer to save time and energy by issuing the instructions on paper.

But a cheque is more than just a substitute for a set of in-person verbal instruction. By inscribing these instructions onto a long-lived medium, we've created an entirely distinct financial instrument, something akin to a debt or a derivative. As long as a cheque exists, it derives its value from the underlying deposits that are expected to be delivered by the issuer.

Normally we take for granted that a $1000 cheque is worth $1000. But this isn't always the case. For instance, if the cheque writer decides to spend a $1000 cheque that has been post-dated for three months—i.e. the underlying cash can not be collected till then—the receiver will typically only accept said cheque at a discount to face value, say $960. After all, the receiver needs to be compensated for the interest they will have to forego in holding that cheque for the three months to encashment, not to mention incurring the risk that the cheque writer fails in the interim.

We don't normally think of cheques as a form of debt or financing, but after India's demonetization an interesting example of this practice was brought to light. This fascinating story describes how small-scale enterprises in Varinasi accept post-dated cheques as payment and then bring them to a battawala—or "one who deducts"—for discounting. The battawala sets his commission, or discount, based on the creditworthiness of the cheque issuer. The ability to sell post-dated cheques allows these businesses to finance expense such as salaries and inventories. A second article describes a battawala market that "opens from 3-7 p.m. every day at Chowk, the heart of the business district," where several thousand battawallas sit and trade post-dated bearer cheques for cash.

North America also has a post-dated cheque market of sorts. Payday lenders, which offer short-term lending to those who can't get it from banks, only issue loans on the provision of a post-dated cheque. They accept these cheques at large discount to face, so that a $350 cheque can only buy, say, a $300 loan.

In addition to being a form of debt, cheques are also a type of money. I don't mean in the sense that cheques allow for the transfer of underlying bank deposits; rather, an uncashed cheque can itself be transferred between many different parties as a medium of exchange. This is something that younger people who only use credit cards and P2P options may not know, but if the issuer of the cheque writes "to bearer" in the pay to field, then literally anyone who is 'bearing' or holding that cheque can bring it into the bank to be cashed. Given that it grants universal access to underlying cash, a $100 bearer cheque might be transferred three or four time over the course of a few days, resulting in $300 worth of transactions being consummated rather than just $100. In the first of the two articles I linked to above, for instance, the owner of a small sari business says that it isn't uncommon for a bearer cheque to change hands as many as five times. 

Just a head's up. Even if you indicate the name of the recipient in the pay to field of a cheque you've written, say to John Doe, he can still use it as a medium for paying someone else rather than cashing it... without you even knowing. By endorsing the back of the cheque with his signature, John Doe converts it into a bearer cheque. This is called blank endorsement. Anyone he gives it to can now either bring it in to be cashed or continue passing it off in a long chain of transactions. In the U.S., these sort of cheques are called third-party checks, although banks tend to be a little leery about accepting them these days.

The use of cheques-as-money is promoted by laws that, like banknotes, grant them currency status. I touched on this distinction last week, but here it is again. Say that person A is carrying some sort of financial instrument in their pocket and it is stolen. The thief uses it to buy something from person B, who accepts it without knowing it to be stolen property. If the financial instrument has not been granted currency status by the law, then person B will be liable to give it back to person A. If, however, the instrument is currency, then even if the police are able to locate the stolen instrument in person B's possession, person B does not have to give up the stolen cheque to person A. We call these special instruments negotiable instruments.

Instruments like cash and cheques that have been granted currency status, or are negotiable, have a big advantage over those that haven't. Because they won't be on the hook for returning stolen negotiable instruments, shopkeepers and others can accept these instruments without having to set up costly verification procedures. This means these instruments will tend to be more liquid than those that are non-negotiable.   

A neat result of the transferability of cheques is that cheque payment systems are incredibly robust in the face of disasters and banking system shutdowns. Any direct transfer a bank deposit, say using a debit card or some other form of electronic fund transfer, requires that the parties to a payment to establish a  communications channel with their respective banks. If there is a problem with either of the banks, the merchant, or the connection itself, then the transfer can't go through. With a cheque however, there is no need to communicate with one's banker. A cheque is created entirely without the bank's say-so. Anyone is allowed to receive that cheque, it being their choice to either cash it or pass it along. Which means that if the banking system is on the fritz, cheque payments can proceed.

The most famous example of this robustness is the Irish banking strike of 1970. With the entire banking system shut, for six months post-dated cheques circulated as the main form of money. In a well-known paper, Antoin Murphy recounts how pub owners acted as evaluators of the credit quality of each cheque, an episode I once wrote about here.

Another nice property of cheques is that, like cash, they can be used by the unbanked. If someone receives a cheque, they can go to the issuer's bank and cash it, even if they don't have a bank account. Alternatively, they can simply endorse the back of the cheque and spend it on as a medium of exchange.

This combination of negotiability, robustness, openness, and decentralization means that long before bitcoin and the cryptocoin revolution, we already had a decentralized payments system that allowed pretty much everyone to participate and, indeed, fabricate their own personal money instruments!

Was there ever a more versatile payments instrument than the cheque? Because you can write on them, a whole language of cheques has emerged, allowing for significant customization. By putting crossings on cheques, like this...

...the cheque writer is indicating that the only way to redeem it is by depositing it, not cashing it. This means that the final user of the cheque will be easy to trace, since they will be associated with a bank account. Affix the words non-negotiable within the cross on the front of the cheque and it loses its special status as currency. Should it be stolen and passed off to an innocent third-party, the victim can now directly pursue the third-party for restitution. To even further limit the power of subsequent users to use the cheque as money, the writer can indicate the account to which the cheque must be deposited.

This language of checks can be used not only by those that have originated the cheque, but also by those that receive it in payment. On the back of any check, any number of endorsements can be written, effectively allowing for the conversion of someone else's payment instructions into your own unique medium of exchange.    

In summary, while the popularity of the cheque has certainly been declining over the last few decade, it is still hanging in there—and that's because it seem to be providing some unique services that haven't yet been replicated by cheaper, digital alternatives. While those in the fintech space often smirk at cheques at as an outdated payments option inevitably doomed to extinction, they might be better served trying to replicate some of these features instead.

On currency

David Birch recently grumbled about people's sloppy use of the term legal tender, and I agree with him. As Birch points out, what many of us don't realize is that shopkeepers have every right to refuse to accept legal tender such as coins and notes. This is because legal tender laws only apply to debts, not to day-to-day transactions. If someone has borrowed some money from you, for instance, then legal tender laws dictate a certain set of media that you cannot refuse to accept to settle that debt. These laws have been designed to protect your debtor from a situation in which you demand payment in a rare medium of exchange, say dinosaur bones, effectively driving them into bankruptcy.

Conversely, they also protect you the lender from being paid in an inconvenient settlement medium. In Canada, for instance, a five cent coin is legal tender, but only up to $5. If your debtor wants to pay off a $10,000 debt using a truckload of nickels, you can invoke legal tender laws and tell them to screw off—give me something more convenient.

Joining in with Birch in the grumbling, I'd argue that people make just as many errors with the term currency as they do with legal tender. When we use the word currency, we typically mean a grab bag of paper money, coins, deposits, and cryptocurrencies, or we use it to describe national units of account such as dollars, yen, pounds, pesos, ringgits, bitcoin, etc. But the word currency shouldn't be used so sloppily. 

Henry Dunning Macleod, a monetary theorist who wrote in the 1800s, has an interesting discussion of the etymology of the word. Macleod was a unique character in his own right. Trained as a commercial lawyer, he signed up as director of the Royal British Bank which failed in 1856 due to questionable loans and self dealing. Macleod went on to write a number of large tomes on monetary theory,  history, and law, including the Elements of Economic, on which I am drawing from for this post. Perhaps his main contribution to economics is the coining of the term Gresham's law, according to George Selgin.

From Macleod we learn that currency used to be used an adjective, not a noun. Certain types of goods or instruments were considered to be "current" in the eyes of the law and common business practice. They were said to have "currency," but were not themselves currency. Here is a clip from his book:

Meaning of 'currency'—money, unlike goods, is 'current.' If stolen and spent, new owner has the right to keep it. pic.twitter.com/mnWcWTtzTb

— JP Koning (@jp_koning) December 28, 2015

Let's break this down. Property that had been granted currency had a different legal status from property that didn't. Let's assume that a good has been stolen and sold by the thief to a third party, a shopkeeper, who innocently accepts it not knowing that it has been stolen. For most forms of property the original owner could sue the third party and get the stolen article back. But not if that good is one of the few to be considered by society to have currency, wrote Macleod. When an article is said to have currency, or to be current, the original owner cannot chase the third party to recover stolen property. So in our example, our shopkeeper gets to keep the stolen good, even if its stolen nature has been proven in court.

Coins had always been current according to mercantile practice, but if you read through Macleod you'll see that over the course of the 1700s, British common law jurists granted currency status to a series of new financial instruments, including banknotes, bills of exchange, stock certificates, exchequer bills, bonds, and more. (I went into this here.) What this illustrates is that an item didn't have to be money to have currency (e.g. bonds were considered to be current), nor did it have to be government-issued to be current (banknotes and bills of exchange were privately-issued).

Granting currency-status to a select group of instruments provided them with some useful mercantile properties. Consider first the converse: when the law did not grant currency to a certain good, any transfer of that good came with strings attached. For instance, if you tried to pawn off an expensive gold ring on a shopkeeper, the possession of that ring in your pocket would not be sufficient for the shopkeeper to establish title. If the ring had been stolen, and he/she accepted it, the shopkeeper might be forced to give it back to its original owner, leaving the shopkeeper out of pocket. So they would be wary at the outset about accepting the ring from you, perhaps requiring a time-consuming verification process before agreeing to the deal.

On the other hand, the shopkeeper would not hesitate to accept a gold coin. Because coins were current according to the law, anyone who received them in trade would not have had to worry about returning them to an angry victim down the line, and therefore could avoid the necessity of setting up a costly verification procedure. This would have encouraged trade in these instruments, rendering them much more liquid than items that weren't current.

According to Macleod, it was only after these early court cases that people started to directly refer to banknotes, coin, yen, dong, pounds, krona, and the like as currency-the-noun, a linguistic switch which Macleod angrily blamed on Yankee "barbarism":

"It is quite usual to say that such an opinion or such a report is Current: and we speak of the Currency of such an opinion or such a report... But who ever dreamt of calling the report or the opinion itself Currency?... To call Money itself Currency, because it is current, is as absurd as to call a wheel a rotation, because it rotates...Such as it is, however, this Yankeeim is far too firmly fixed in common use to be abolished."

It is interesting to note that while not all instruments that had currency were money (i.e. bonds), likewise not all money was granted currency status. According to Macleod, bank deposits did not have currency because, unlike banknotes and coins, deposits could not be dropped in the streets, stolen, lost or transferred to someone else by manual delivery. If you think about it, each movement of a bank deposit requires direct contact with the banking system in order to process the transfer. This effectively weeds out transfers of lost or stolen property, especially in Macleod's day where banking was conducted in person at a branch. Since anyone receiving bank deposits in payment needn't worry about a deposit being dubious, there was no need for the law to grant currency status to deposits.

All of this still has relevance today. Take the case of private cryptocurrencies, ICOs, and central bank digital currencies (CBDC). Because law makers have not been very clear about their legal status, bitcoin and other forms of crypto don't have currency, at least not in the Macleodian sense of the term. This means that a storekeeper who accepts bitcoin (or a future Fedcoin) may also be taking on the liability to give said coins back if they are proven to be stolen. And this lack of currency-status can only handicap a cyptocoin's ability to freely circulate.

If this post achieves anything, it's to illustrate that a special amnesty was once granted to a small set of financial instruments. This amnesty used to be referred to as currency. While we don't have to go back to the old practice of using of the word currency to refer to this special amnesty, we should at least be aware that this amnesty is still present and relevant.

What makes money special, the lawyer's edition (with a guest appearance by bitcoin)

Juan Galt recently introduced me to one of bitcoin's biggest problems. Bitcoin is not money, at least not according to the law.

Economists like to say that money is unique because it is a medium of exchange, store of value, and unit of account. Lawyers and judges have a different story to tell about money's uniqueness. Unlike goods, money can't be 'followed.' When a good is exchanged, its entire history goes with it. This history may be checkered. Say that a car has been stolen at some point in its past and then sold, and the police discover this fact. The current owner—though having purchased the car innocently—is required to return it to its rightful owner. The law 'follows' goods.

With money things are different. Each time a monetary instrument is transferred, its history is wiped clean. As long as the recipient accepts the money in good faith, the original owner of stolen dollars cannot make a claim for those dollars.

This peculiar legal treatment of money, dubbed money's liability limitation by Steve Randy Waldman, ensures fungibility. When all members of a population can be perfectly substituted for each other, than we say that they are fungible. If each monetary unit's unique history becomes a datum that merchants must take into account before selling a good, then fungibility no longer prevails. One unit may be worth more than another because its history is more pristine.

Fungibility is important because it promotes the smooth functioning of a monetary system. If merchants have to analyze each piece of money they are offered to ascertain its legitimacy, long lineups will develop. Exchange grinds to a halt.

So why not extend the status enjoyed by current forms of money to bitcoin? What follows is a quick tour through the history of how jurists have rationalized the legal treatment of other forms of money, including coins, banknotes, and bills of exchange. This should provide us with enough grist to analyze bitcoin's current legal status.

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Let's start with coins. The basic principle of nemo dat quod non habet governs property; no one can give away that which they do not have. According to early common law jurists, coins were exempt from nemo dat because they couldn't be followed. The inability to follow coins arose from the fact that they were homogeneous. In the words of the jurists of the day, 'money has no earmark.' Whereas one pig could be differentiated from another thanks to the practice of earmarking—cutting out a distinct piece from a pig's ear—coins could not be earmarked, and therefore could not be differentiated.

Thus there was no way for a victim to lay claim to lost or stolen coins. With no way to prove that the coins in the accused's pockets had not already been there, mixed coins could not be sufficiently distinguished to establish title. James Fox, for instance, cites a 1614 case in which a gambler, Warde, "thrusts" his coins into the stack of another gambler, Aeyre, perhaps hoping to get a tell from of his opponent. Aeyre refuses to give the coins back. The judge upholds Aeyre's rights to the entire stash since money has no earmark, and therefore nemo dat does not apply. Once mixed, who ever possesses the pile of coins has the best title.

Interestingly, the only way to preserve ownership of coins in the medieval era was to keep them in a bag. Since they could now be identified by the distinctiveness of their container, like any other good they were subject to nemo dat. Had Aeyre's coins been bagged, he could have easily mixed them with Warde's without losing title to them.

The fact that coins had no earmark meant that each piece's distinct past was irrelevant. While this was awkward for poor Aeyre, society was made better off by this decision. Coins became much more fungible than they otherwise would have been, and this would have dramatically promoted their use in trade, greasing the wheels of commerce in general.

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Let's move on to paper credit, namely bills of exchange and banknotes. While bills of exchange developed in the 12th or 13th century, the first notes would not have appeared in England until the 17th century. Though English common law was useful for land disputes, it had not yet developed the expertise to deal with commercial disputes. Indeed, common lawyers' expertise with commercial matters was so limited that Josiah Child, an English trader, complained that he could only make his lawyers understand "one half of our case, we being amongst them as in a Foreign Country."

Rather than resorting to common law, problems arising from the usage of negotiable instruments like bills were governed by lex mercatoria, or merchant's law, a private form of commercial law or custom that had been developed by European merchants over the preceding centuries. Market courts, operated by the merchants themselves, guaranteed a decision the day after a complaint, a necessity given the mobile nature of commercial life.

According to Lowry, the close-knitted nature of the merchant class began to unravel by the end of the seventeenth century, making merchant law less enforceable. As commercial cases were increasingly brought to common law courts, jurists had to decide how to treat these new financial innovations.

Lex mercatoria had always accepted the principle that, as in the case of coins, bills of exchange could not be followed. Since those who accepted bills of exchange didn't have worry about whether they had been stolen or not, this would have made trade in bills of exchange extremely fluid. However, the stance taken by lex mercatoria was an anathema to common law logic. Unlike coins, which couldn't be followed due to their lack of earmark, both bills of exchange and banknotes did have earmarks. Whereas coins were issued in uniform denominations, bills of exchange were usually made out in non-standard ones, say $101.50, making for easy identification. Bills were also signed by a unique debtor and a range of consignees. As for banknotes, these had serial numbers on them. Without the homogeneity of coins, there seemed to be no way to save the these relatively new financial instruments from the harsh strictures of common law nemo dat. Goods they were to be, not money.

It was Lord Mansfield, an English jurist, who took on the task of incorporating lex mercatoria into English common law (Adam Back notes a similar case in Scotland). Take Miller v Race, Mansfield's definitive ruling on banknotes in 1758. The note in question had been issued by the Bank of England "to William Finney or bearer on demand" and subsequently mailed to a third party by Finney. Along the way it was stolen and used to buy room and board at an inn, the innkeeper Miller innocently accepting the note. Finney, upon learning of the robbery, asked Race, an employee at the Bank of England, to stop payment of the note, upon which Miller the innkeeper sued Race. If the bill was treated as a regular good, then Finney would have prevailed. However, Mansfield ruled that despite the note having been stolen, Miller had the best title and was allowed to keep it.

In justifying his ruling, Mansfield dismissed as "quaint" the old earmark principle for not following money. Instead, he appealed to the common mercantile practice of the day. Banknotes, wrote Mansfield, are:

not goods, nor securities, nor documents for debts, nor are so esteemed; but are treated as money, as cash, in the ordinary course and transactions of business, by the general consent of mankind, which gives them the credit and currency of money to all intents and purposes. The are as much money as guineas themselves are, or any other current coins that is used in common payment as money or cash. 

The true reason that money cannot be followed, said Mansfield, is upon "the currency of it; it can not be recovered after it has passed in currency." Thus had Finney sued the robber before he had spent the stolen note, he would have succeeded in claiming title since the note had not yet passed into currency. But once Miller accepted it, the note was "in currency" and thus out of nemo dat's reach. In subsequent rulings, Mansfield extended this same protection to bills of exchange, cheques, bonds, and exchequer bills. Any contrary decision would "incommode" trade and commerce, wrote Mansfield. Thus the customs of merchants were transcribed into common law.

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So both lex mercatoria and the common law tradition that superseded it accepted the principle that in order to protect commerce, highly liquid instruments should not be subject to nemo dat.  Given this precedent, why not extend this same broad amnesty to modern monetary innovations like bitcoin, Fedcoin, or other digital bearer tokens?

One reason could be that bitcoin hasn't proven itself yet. Whereas bills of exchange and banknotes had been widely accepted for decades, even centuries prior to Mansfield's ruling, bitcoin is less than a decade old. It fails the my-grandmother-uses-it-test or, in Mansfield's words, lacks the "general consent of mankind." People seem more intent on hoarding the stuff than trading it around in the "ordinary course of business." Unfortunately there is a chicken-and-egg dynamic at play here; how can bitcoin gain enough consent to be granted amnesty by the law if it needs amnesty to gain consent in the first place?

Lacking common law amnesty from nemo dat, an alternative would be to modify bitcoin so that it is completely anonymous. Although it is true that the real world identity of a bitcoin owner remains unknown, the blockchain itself is a publicly-distributed ledger that reveals the history of every single bitcoin. Removing the ability to see the ledger's history would restore true anonymity. In the same way that coins were originally exempt from nemo dat because they were physically impossible to follow, modern law would not be able to trace any given bitcoin because there would be no means to do so. Anonymity in turn guarantees fungibility, without which mass market adoption might never happen. My understanding is that extensions such as Zerocoin or Zerocash would be able to achieve this sort of true anonymity.

The third route is to roll with the punches and accept non-fungibility. If merchants must search each bitcoin's past, they will innovate solutions to cope. One innovation would be to set up a system for grading bitcoin so as to save on transaction time. Tokens that pass a test of authenticity would be accepted at par whereas low grade bitcoin, that which has a soiled history, would pass at a large discount to pure bitcoin. I believe that a few bitcoin grading services have emerged, including Mint Exchange, which sells freshly-mined bitcoin (which are unburdened by a history) at a premium to regular bitcoin.

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Let's explore the third route a bit more. There is precedent for non-fungible monetary systems. During the so-called Wildcat banking era in the early to mid 1800s, U.S. privately-issued banknotes of the same denomination (say $1) were often  accepted at varying discounts to par. A $10 note from a the Bank of Talahassee might only be worth 98% that of a $10 note from the Bank of Fargo.

While banking regulations prevented note-issuing banks from establishing branches beyond state borders, nothing kept their notes from circulating outside of their home state. However, for notes to be settled in gold, they had to be returned to the issuing bank. Given the large distances involved and lack of transportation infrastructure, this could be an expensive process. To recoup this cost a merchant would typically accept local notes at par while applying discounts to non-local notes. The discount acted as a fee that covered the merchant's transportation costs. And since each bank's brand of notes involved different transportation costs, there were a bewildering number of discounts.

To solve the non-fungibility problem, a new profession emerged, that of a banknote analyst. In addition to providing merchants with information on how to spot counterfeit bank notes, an analyst would publish a weekly banknote reporter that advertised the market price of each banknote that circulated in a particular city, say Philadelphia. Gary Gorton provides a visual feel for what one looks like. Philadelphian merchants who subscribed would, upon being proffered a particular note by a customer, consult their reporter and apply the proper discount. I've explained in more depth how this process worked here and here.

While a Wildcat-era sorting mechanism for bitcoins would help merchants cope with the fungibility problem, any sort of grading process would also impose an extra set of costs on the bitcoin system, making it less competitive with banknotes and deposits. The lack of uniformity of U.S. banknotes was recognized to be enough of a problem that the 1864 National Banking Acts required all banks to accept notes at par (it would have been better to allow banks to establish branches across state lines, of course. See George Selgin here).

Uniformity would certainly be the most efficient solution for bitcoin, but lacking a central authority that can enforce par acceptance, bitcoin may have to endure a period of non-fungibility before the law deems the cryptocurrency popular enough to earn amnesty from nemo dat. That's a low bar to set, but if bitcoin is as good as its proponents say, it should be a bar that can be limbo-ed.


Sources:

S. Todd Lowry: "Lord Mansfield and the Law Merchant: Law and Economics in the Eighteenth Century" (1973) [link]
Benjamin Geva: "The Payment Order of Antiquity and the Middle Ages" (2011)
Kenneth Reid: "Banknotes and their Vindication in Eighteenth-Century Scotland" (2013) [link]
David Fox: "Banks v Whetston" in Landmark Cases in Property Law (2015)
Tim Swanson: Unable to dynamically match supply with demand (2015)
Nick Szabo: From Contracts to Money (2006)

Chopmarks and other distributed verification methods

A 1795 Spanish dollar, minted in Mexico, with several chopmarks

One of the most interesting things about bitcoin, ripple, and other cryptocurrencies is how they are maintained by a dispersed user base rather than some central issuing authority. These users (miners in the case of bitcoin, nodes for ripple) ensure that each "coin" is a legitimate member of the total population of cryptocoins comprising that particular ledger. They are what stand between good coin and bad coin.

I've run into two historical cases of a dispersed method of policing of the quality of exchange media: the endorsement of bills of exchange and the chopmarking of silver coins. It may be worthwhile to explore these two cases.

The Watchdog role

The watchdog or verification function is an important one, especially in anonymous trade where the unlikelihood of a repeat meeting between buyer and seller increases the incentives to be dishonest and pass off lousy coin. Not-so-liquid goods, say sofas, are insulated from the bad coin problem. Due to physical characteristics that impede their liquidity, sofas tend to be sold from fixed locations, or shops. Because a merchant is shackled to his shop and thus unable to preserve his anonymity, any attempt to pass off bad sofas will hurt his business reputation. In the end, only good sofas get stocked by the merchant.

Unfortunately for him, the merchant faces the danger that his much more mobile customers may try and sell him bad coin. The merchant can always threaten them with an embargo should they fob off a fake, but his customers will simply avoid his penalty by shopping at a competing merchant the next time they want a sofa.

In the case of paper money and coinage, the merchant is somewhat protected from the bad coin problem by difficult-to-counterfeit designs printed on the bill or engraved on a coin's face by the issuing authority. In the case of bank money, he is protected by the owners of the credit card networks who approve the legitimacy of a card prior to consummation of trade. These are centralized watchdog systems. What is interesting is that a number of decentralized, or dispersed systems have evolved in times past to offer further protection, including the use of chopmarks:

Chopmarking

In the 16th C, Spanish silver dollars, or pieces of eight, began to appear in China. These coins were minted in Spanish-controlled Mexico, shipped by Spanish vessels to the Philippines where they were exchanged for Chinese goods like porcelain and spices, and finally brought to China by Chinese and other foreign merchants.

Minted on the reverse side with a Christian cross and the obverse side with a Spanish coat of arms, and covered over with Latin characters, the patterning of the Spanish dollar would have meant little to the typical Chinese consumer or merchant. In fact, any pattern would have done just as well since silver was traditionally not accepted at its face value in China, but by its weight (this contrasts to the west, where Spanish dollars were typically accepted at face value). This may have been partly due to the fact that silver ingots, or sycee, had circulated in China long before the piece of eight ever made an appearance, with each city having its own particular standard. Because these sycee circulated according to weight, prior to consummating a trade, merchants would use a set of scales, or dotchin, to determine the value of each ingot.

While anyone with a set of scales could easily ascertain the weight of a particular coin, the difficult part would have been determining the purity of that coin. Counterfeit Spanish dollars were not uncommon, after all, but not everyone would have had the skills to detect them. This is where chopmarking came in handy. Merchants and professional money exchangers, or shroffs, would assay a coin to verify its silver content. The theory goes that once the coin had passed their purity test, a shroff would stamp that coin with his own peculiar chopmark—a Chinese character, an emblem, symbol, or a pseudo character.

Numismaticist Bruce Smith describes the reason for chopping thusly:

I think the chop was only a guarantee that it was acceptable silver. It didn't really matter if the coin was genuine or not. As long as it had the right weight and right fineness as far as they could tell. I mean they were only looking at it by eye and by sound. If it looked like the silver was good and it sounded good [the ‘ring’] and the weight was acceptable then it was okay.

According to Frank Rose, a numismatist who published an early text on chop marks, certain merchants chopmarked every legitimate coin that came into their possession and would readily take back any coin bearing one of their earlier marks. So by chopmarking a coin, a merchant would have been taking on a liability of his own, almost as if he had issued a redeemable paper note or a deposit.

In any case, foreign coins often became so covered in chop marks during the course of trade that their initial design became unrecognizable, as the coin below shows.

1807 Spanish dollar with chopmarks

The genius of this system is that a naive Chinese consumer could safely accept a coin knowing that as long as it was chopped it had successfully passed the smell test of professional appraisers--and the more chops the better. Chopping, like bitcoin mining, transformed a virgin coin into the native exchange medium, with chopmarks serving as a way for disparate users to verify a coin's membership in the set of good silver pieces.

Endorsing

Another interesting form of dispersed verification was the system of bills of exchange, especially the system that developed in Lancashire, a county in northern England. A bill of exchange was a paper contract between two sides in a transaction. It was created or 'drawn' up by the person who provided goods or services, the 'drawer'. The counterparty who had taken position of goods stood as the 'acceptor' and by signing the bill, promised to render up a certain amount of coins to the drawer, usually three months hence. The drawer kept the bill in his desk until three months had passed upon which he presented it to the acceptor, got his gold, and the two parted ways.

A bill of exchange, 1843 [link]

In the early 1700s, English commercial law began to accept the practice of transferring debts, or negotiability. Rather than the drawer keeping the note in desk, he could transfer it to a third party. The drawer would typically do so in exchange for some good or service, and would go about this by endorsing it, or signing his own signature on the back. By endorsing the bill, the drawer had become a co-signatory.

When the bill was due the third party could call on the original acceptor for payment, even though the original agreement had been between the drawer and the acceptor. Should the third party find the acceptor unable to pay the gold upon maturity, he could make a claim on the endorser for full payment. Alternatively, the third party could in turn endorse the bill on to someone else, who could it turn endorse it to someone else, etc. turning what had been an illiquid bill into a highly liquid and potent medium of exchange.

This is exactly what happened in Lancashire, according to this paper by T.S. Ashton. Not only were bills used by large scale industry, but according to Ashton they were used in small transactions too. While coin was generally reserved for the payment of wages, those a little higher in economic status than hired workers, small-capitalist spinners and small time manufacturers with an apprentice or two, were induced to accept payment in Lancashire bills. According to Henry Thornton, who Ashton quotes, all payments at Liverpool and Manchester - then part of Lancashire - were carried out either in coin or bills of exchange. Henry Dunning Macleod describes bills "which had sometimes 150 indorsements on them before they became due."

The practice of endorsement was hugely advantageous for the general populace, for as Ashton points out:

"Since each successive holder endorsed it, the more it circulated the greater the number of guarantors of its ultimate payment in cash. Even if some of the parties to it should be men of doubtful credit it might still circulate, for it was unlikely that they would go down simultaneously."

So in the same way that multiple chop marks and blockchain confirmations ensure that a coin is a good one, multiple endorsements converted an IOU into a member of the population of verified IOUs, and therefore suitable for broad circulation. In the end, what bitcoin and the other cryptocoins is certainly novel, but we have seen parts of this story before.

Deep money, the coexistence puzzle, and the legal restrictions hypothesis

WWI Liberty bonds, which according to Neil Wallace circulated alongside Federal Reserve notes [source]

What follows are some thoughts on the coexistence puzzle as well as the folks who find it interesting.

There is plenty of hyperbole over the difference between freshwater and saltwater economists, but one peculiarity that surely distinguishes a freshwater economist from his saltier cousin is that they tend to be interested in the underlying motivations guiding monetary exchange, the so-called microfoundations of money. (Saltwater economists tend to be content with broad assumptions about monetary phenomena). Representatives of the microfounded approach, which includes the blogosphere's own David Andolfatto as well as Stephen Williamson—who has anointed his approach New Monetarism—like to refer to their models as "deep models of money".

One of the classic questions that continues to interest deep money types is the so-called coexistence puzzle. Zero-yielding financial assets like central bank-issued banknotes are "dominated" in terms of rate of return by interest-yielding financial assets created by governments. The puzzle that needs explaining is why these dominated instruments can continue to coexist with the instruments that do the dominating.

A quick answer is that a lower-yielding asset can coexist with the higher-yielding asset because the first is more liquid than the second. In an uncertain world, the stream of liquidity services that an asset provides over its lifetime is a valuable service. An asset that provides a little less income can still be demanded in the marketplace as long as it provides a little more liquidity. Deep money folks would say that my answer is a bit shallow. It avoids exploring both the qualities of the assets being used and the frictions that characterize the world in which those assets trade that might render one asset more liquid than the next.

Let's explore the setup of the coexistence problem in more detail. In a 1982 paper, deep money pioneer Neil Wallace defined the problem thusly; if the government were to issue small denomination bearer bonds, say in units of $5, $10, and $20, and these instruments were to yield interest, just like their larger denomination relatives, why would anyone carry 0% Federal Reserve notes in their wallets when they might own an interest-yielding replica instead? These two instruments shouldn't coexist—cash should be driven out of existence or, if they are to coexist, then bearer bonds should yield no more than the 0% rate on cash.

One aspect of the problem, Wallace noted, was that for some obscure reason, governments typically choose not to issue small denomination bearer bonds. The large denomination size of t-bills and t-bonds inhibits their use in trade, thus preventing at the outset any sort of direct competition between government bonds and zero-yielding cash.

However, Wallace pointed out that this doesn't explain why private issuers don't simply buy high denomination government bonds and create their own government bond-backed small denomination bearer notes. If they did so, Wallace believed that two things might happen. These private issuers, by virtue of paying interest on their notes (more specifically by issuing bearer bonds at a discount to face value and allowing them to appreciate in price till maturity, much like treasury bills) would drive inferior 0% yielding banknotes out of existence so that only interest-bearing notes circulate.

Alternatively, the public would allow privately-issued bearer bonds to circulate at par with existing currency. Par acceptance would mean that private bearer bonds no longer paid interest in the form of a steadily rising price. However, Wallace stumbled upon an interesting side effect of par acceptance: nominal rates on government bonds would have to fall to zero. Why? According to Wallace, arbitrage dictates that as long as the rate on long term government bonds is above zero, competing private issuers will flock to buy those term bonds with which to back their 0% bearer notes, putting upward pressure on bond prices and downward pressure on yields. It makes sense for banks to do so because they earn the spread between the 0% notes that they issue and the interest-yielding bonds they purchase. According to Wallace, the arbitrage window will only be shut when banks have driven long term rates close enough to zero that the the opportunity for excess profits disappears. In a free market, the term structure of interest rates disappears. All we have is a flat yield curve.

Here is Wallace: "Thus, my prediction of the effects of imposing laissez-faire takes the form of an either/or statement; either nominal interest rates go to zero or existing government currency becomes worthless."

Of course in the world we live interest-yielding bearer currencies have not kicked out 0% notes nor have private notes driven long term bond rates to zero. Wallace attributed this to various legal restrictions against banks from entering the small denomination bearer bond line of business. Take away these legal restrictions and he believed that his conclusions followed.

Even if we removed these legal restrictions, I'm not convinced by Wallace's arguments. Given free competition in note markets, I don't think that positive-yielding small denomination bearer bonds (issued either by a private bank or a government) must necessarily drive cash into exile, not do I think their coexistence means that the term structure of interest rates must be flat.

To start with, the necessity of calculating interest payments throws a wrench in the smooth transfer of a bearer asset, a point made by Larry White. Say that the bearer bonds are printed with a $10 face value but sold by the government at a discount to face so that their price appreciates over time until maturity, the capital gain being a stand-in for interest payments. Should someone wish to use their unmatured bearer bond to pay for something, they will have to calculate how much of a discount to face to apply to the bond. Such a calculation imposes a burden on the transactors since it will take time to crunch the numbers or require a costly technology to speed up the process. As White has noted, a $20 note held for one week at 5% interest would yield less than 2 cents. Is it really worth it for a banknote user to take the time and trouble to compute and collect such a small amount?

The interest rate feature of bearer bonds also precludes the simple summations that round numbers allow. An owner of a $10, $5, and $20 bearer bond doesn't have $35 in purchasing power. Rather, discounting the bonds will show that their purchasing power is composed of inconvenient sums like $9.33, $4.89, and $19.60. This makes it harder to know how much purchasing power is in one's wallet prior to going to market, thereby inhibiting the usefulness of bearer bonds as a liquid medium. Carrying around 0% currency which trades at its face value allows for certainty of purchasing power, a feature that may more than compensate for lack of a pecuniary yield.

Even worse, having inconvenient non-round bonds in one's wallet or till makes the process of obtaining or providing change a nightmare. If you buy a $10 bottle of wine with an unmatured bearer bond worth $11.56, what are the odds that the cashier will have a $1.56 bearer bond to give you as change? 0% cash may not offer interest payments, but at least the standardized even denominations in which it is available (combined with small change) allow for hassle-free transactions.

Lastly, all transactions in bearer bonds face capital gains taxes. That means on each exchange, the owner of bearer bonds must fish back into their records to find the original price at which they received the bond, determine the price at which it was sold, compute the profit, and then submit all this information to the tax authority. Payments made with 0% banknotes are not taxed, saving those who choose to transact with banknotes time and energy.

So in a nutshell, the previous factors may explain why interest-yielding small denomination bearer bonds will always be less liquid relative to 0% yielding cash, thus preventing the former from kicking the latter out of circulation.

If Wallace's first point is wrong and the payment of interest on banknotes doesn't drive existing 0% cash out of existence, what about his second prediction? Assuming that privately issued bearer bonds are accepted at par, what prevents profit-hungry banks from issuing 0% bankotes and accumulating interest-bearing bonds, eventually arbitraging bond rates down to zero?

As I've already illustrated, interest yielding instruments (especially large and ungainly ones like t-bills) will always be less liquid than cash. This gives rise to an un-arbitrageable wedge between the yield on cash and that on bonds, or a liquidity premium. Note-issuing private banks eager to earn more spread income may be able to temporarily push rates down through bond purchases. However, at these lower bond rates the marginal bond investor will be dissatisfied. They are now holding an asset that offers the same inferior liquidity return as before but less interest. These investors will sell their bonds, in the process pushing interest rate right back up to so that bonds once gain offer an attractive return on the margin. In short, bond-buying banks can't push long term bond rates down to zero because the rest of the liquidity-buying public won't let them.

But if long term rates won't budge when banks buy them, doesn't that mean that banks can continuously earn excess profits by perpetually issuing 0% notes and purchasing risk-free long term bonds? Free dollar bills left on the floor are, after all, the biggest no-no in economics. This ignores the fact that even if rates don't fall to zero, other costs will rise instead as banks compete to enjoy the spread. Larry White refers to this as non-price competition. It might include any number of costly strategies used to attract note-holders, including longer bank operating hours, more tellers, increased advertising expenses to make notes more trusted, and special engraving of notes to make one's bills more attractive relative to the competitions'. Thse mounting costs will soon counterbalance the fat spread income, thereby reducing the window for excess profits.

So contra Wallace, laissez faire doesn't reduce the risk-free bond yield curve to a flat line. Because liquidity differentials between bonds and notes will continue to exist free market or not, bond rates will always have to provide a sufficiently high nominal interest rate in order to attract holders.

What makes Wallace's conclusion about the yield curve in a free market interesting is its pleasing counter-intuitiveness. Many of the theories that deep money people come up with have this same quality, including one of my favorites: the irrelevance of open market operations, or what some call Wallace Neutrality. Stephen Williamson's odd theory that central bank's need to fight inflation by lowering rates, not increasing them, is in this same tradition, although in this case I think he's probably wrong.

Empirical evidence is the best way to test deep money theories. In the case of Wallace's legal restrictions theory, reality is not kind. For instance, we know that in the 18th and 19th centuries Scottish banks were not burdened by legal restrictions on the issue of notes, yet the Scottish yield curve was not a flat one. Indeed, interest bearing bills-of-exchange circulated freely with notes. Despite dominating notes, bills of exchange did not drive them to oblivion. Makinen and Woodward report on the coexistence of small-denomination interest-paying "bons" in 1920s France with the franc currency, and Wallace himself points to evidence that Liberty bonds circulated concurrently with Fed cash during WWI. (I should note that David Andolfatto is skeptical of these instances since they are commonly associated with periods of fiscal distress.)

As for some of the more modern deep money efforts like Stephen Williamson's, reality remains a hard customer. One wonders how Rudolph Havenstein's tight interest policy would have created the Wiemar hyperinflation, for instance. While I'm being tough on the deep money folk, I want to sign off on a positive note. Figuring out the underlying nature of monetary exchange is no doubt an important endeavor. Anyone who wants to learn more about monetary phenomena and central banking should probably be reading what the deep money people have to say.

Real or unreal: Sorting out the various real bills doctrines

In the comments section of my post on Adam Smith and the Ayr Bank, frequent commenter John S. brought up the real bills doctrine. The phrase real bills doctrine gets thrown around a lot on the internet. To muddy the waters, there are several versions of the doctrine. In this post I hope to dehomogenize the various versions in order to add some clarity.

1. Lloyd Mints's version

We may as well start with Lloyd Mints's version, since he coined the phrase real bills doctrine back in 1945 on his way to denouncing the doctrine. Mints taught at the University of Chicago and mentored Milton Friedman. [1] Here is Mints:

The real-bills doctrine runs to the effect that restriction of bank earning assets to real bills of exchange will automatically limit, in the most desirable manner, the quantity of bank liabilities; it will cause them to vary in quantity in accordance with the "needs of business"; and it will mean that the bank's assets will be of such a nature that they can be turned into cash on a short notice and thus place the bank in the position to meet unlooked-for calls for cash. - A History of Banking Theory

Mints's RBD states that so long as only real-bills (short term liquid debt instruments created by merchants to finance inventory) are discounted by the banking system, an excess amount of notes can never be issued. When businesses require cash, they'll simply discount bills at a bank, and when that cash is no longer required, they'll pay back their borrowing. Even in a world *without* note convertibility into specie (a "fiat standard")  the real bills stipulation alone is sufficient to keep the price level anchored.

Mints rightly declared that this version of the RBD was "completely wrong". After all, a central bank not constrained by convertibility might discount only real bills, yet by discounting at an unreal price, it would alter the purchasing power of the notes it issues and create either runaway inflation or deflation). The price level was indeterminate in Mints's RBD-world.

Mints singled out Adam Smith for being "the first thoroughgoing exponent of the real-bills doctrine". For the next forty years, Smith's reputation as a monetary theorist would be tarnished. [2]

2. Adam Smith's version

Though tarred and vilified, poor Adam Smith never actually conformed to the real bills doctrine as described by Mints. This has been pointed out by David Laidler in his 1981 paper Adam Smith as a Monetary Economist, one of the first efforts to rehabilitate Smith's reputation as a monetary theorist.

Smith lived in an era in which paper money was fully convertible into a fixed amount of gold. Mints's description of the RBD, on the other hand, applies to a fiat world. For Smith, the gold convertibility clause was sufficient to ensure that the economy needn't endure an excess amount of notes. After all, should banks as a whole issue more than was desired, the public would return the notes en masse for specie. This is the so-called reflux process.

That being said, Smith did mention real bills several times in the Wealth of Nations. He famously advises banks that they should only discount "real bills of exchange drawn by a real creditor upon a real debtor." (I go into some detail in my last post on the personal and historical reasons that may have motivated Smith to advocate this position).

Why limit discounts to real bills? When the banking system issues excess paper currency, gold convertibility ensures that this excess will soon reflux back to issuer. A bank that holds long term loans and bonds issued by speculators will be insufficiently prepared to meet the demands of reflux since liquidating such debts might take time. A bank that holds short term bills issued by credit-worthy merchants will be better equipped to meet redemption demands, and less likely to meet the same demise as that experienced by the Ayr Bank, a bank run that Smith personally witnessed.

Thus Smith's admonishment to only discount real bills wasn't a mechanism for anchoring the economy's price level—gold convertibility served this purpose. Smith's real bills stipulation was just good advice for individual banks: stay liquid and don't take on too much credit and term risk. This distinction has been aptly described by David Glasner in his paper the Real Bills Doctrine in the Light of the Law of Reflux, and for his part Laidler notes that "as advice to an individual bank, it's probably pretty sound, as a principle of
monetary policy under commodity convertibility it is relatively harmless..." [link]

3. The Bank Directors' version

Why did Mint's cast Adam Smith as his first thorough-going exponent of the RBD?

In 1797, some seven years after Smith had died, Britain went off the gold standard. (See this post for details). The pound soon began to trade at a discount to its pre-1797 gold value. In other words, the pound was capable of purchasing less gold. The Directors of the Bank of England found themselves accused of creating inflation, notably by the members of the 1810 Bullion Committee. One of the apologizers for the Directors, Charles Bosanquet, a pamphleteer, wrote a famous rebuttal in 1810 that insisted that by limiting discounts to "solid paper for real transactions," the Bank could not have contributed to a deprecation of the pound. According to Bosanquet, several factors outside of the Bank's control had caused the deprecation.

To help buttress his point, Bosanquet invoked the name of Adam Smith. Wrote Bosanquet: "The axiom, or rule of conduct, on which the Committee has been pleased to heap contempt and ridicule, respecting which they have declared that the doctrine is fallacious, and leads to dangerous results, was promulgated by, and is founded on, the authority of Dr. Adam Smith."

Bosanquet's appropriation of Smith's name was inappropriate since Smith implicitly assumed gold convertibility. But the damage had been done. From then on, economic historians like Mints would automatically associate Smith's name with the arguments of the Directors.

The Directors' RBD is very much a manifestation of Lloyd Mints's RBD, which we already know was a poor guide for monetary policy. Years later, Walter Bagehot would write that when the Directors were examined by the Bullion Committee in 1810, "they gave answers that have become almost classical by their nonsense". If anyone deserved to be castigated as the first thoroughgoing exponents of Mints's real bills doctrine, it was the Directors and not Smith.

4. Antal Fekete's version

If you've spent some time wading through the online monetary economics community, you'll have run into Antal Fekete's real bills doctrine. This is an attempt to apply a warmed over version of Adam Smith's RBD mixed in with some Austrian free market economics.

The use of bills of exchange began to diminish in the late 1800s and today they are a relatively unimportant financial instrument, having been replaced in bank portfolios by commercial paper, bonds, mortgages, and other types of debt. Fekete tries to draw a number of broad based conclusions from this trend. The crowding out of real bills by non-real bills (longer term finance bills and government issued treasury bills), for instance, is seen by Fekete as the reason for the Great Depression and the creation of the modern Welfare state:

When real bills were replaced by non-self-liquidating finance bills, payment of wages has become haphazard. Employment was made touch-and go, hiring, ‘hand-to-mouth’. This threatened with unemployment on a massive scale, unless governments were willing to assume responsibility for paying wages. [Link]

Conversely, rehabilitating the real-bills system would end chronic unemployment and reduce the size of government. I only have a passing knowledge of Fekete's thinking — it really doesn't do much for me —so hopefully someone in the comments section can pick up the slack.

5. Mike Sproul's version

Of the modern reincarnations of the RBD, I'm far more familiar with Mike Sproul's version.

Mike's version is an application of modern finance to monetary economics. The price of a financial asset is determined by the discounted value of the expected flows of cash thrown off by underlying capital. Alcoa's stock price, for instance, will equal the sum of discounted earnings that Alcoa's machinery and employees are expected to generate. Transferring this idea to the monetary landscape, Mike says that value of modern central bank liabilities should be determined by the earnings power of the assets held by that central bank.

Like the other versions of the RBD, Mike's version shares a preoccupation with the asset side of a bank's balance sheet. But that ends their similarity. For instance, Mike doesn't have a fetish for actual real bills. I doubt he'd agree with the Directors that so long as they only discounted short-term mercantile bills of exchange, they'd never cause a decline in the value of the pound.

That's why I prefer to call Mike's RBD the backing theory. It's a very different beast from the RBDs of Mints, Smith, Fekete, and the Bank Directors, and to share the same name only adds to the confusion.

So there you have it. If you're going to have an argument over the RBD, make sure you know which one you're arguing about!

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1. Fischer Black received this letter from Milton Friedman on August 6, 1971: "With respect to your so-called passive monetary policy, here you are simply falling into a fallacy that has persisted for hundreds of years. I recommend to you Lloyd Mints' book on The History of Banking Theories for an analysis of the real bills doctrine which is the ancient form of the fallacy you express. Do let me urge you to reconsider your analysis and not let yourself get misled by a slick argument, even if it is your own. " Ouch. Play nicely, Milt. I get this via Perry Mehrling's book on Fischer Black.
2. Here's a video of Lloyd Mints in 1988 upon his 100th birthday.