Are prices getting less sticky?

Sticky prices illustrated, from Eichenbaum, Jaimovich, and Rebelo (link)

What makes ride sharing firm Uber interesting is not just its use of new technology to mobilize unused car space, but the method it uses to price its services. Uber's surge pricing algorithm varies cab fares dynamically. To get from A to B, the car that you hired this morning for $10 could end up costing $100 this afternoon.

How unlike the traditional taxi fare it is displacing! In their 2004 paper on sticky prices, economists Bils and Klenow found that taxi fares tended to remain at the same level for 19.7 months before being adjusted. Getting from A to B pretty much costs you the same price day-in-day-out for almost two years.

In our internet age, are prices getting less sticky? 

At first glance no. Alberto Cavallo, who along with Roberto Rigobon created the Billion Prices Index (the bane of all inflationistas), has analyzed scraped data from the websites of retailers who continue to sell mostly through bricks & mortar stores, say like Walmart. Cavallo finds that U.S. online prices stay fixed for 42 days, about the same as offline prices.

On the other hand, Gorodnichenko, Sheremiro, and Talavera find that online prices exhibit more flexibility than offline prices. Unlike Cavallo, the authors analyze data from an online-only store, say like an Amazon (they aren't permitted to disclose which store). However, while Gorodnichenko et al find that online prices are less rigid than bricks & mortar prices, they still exhibit unusually long price spells, or periods of fixity. These spells tend to endure for about 7 to 20 weeks, two-thirds shorter than offline spells when the effect of discounts/sales has been removed. The result is counter-intuitive, say the authors, given that online stores have the technology to cheaply adjust prices as supply and demand change, yet for some reason choose not to.

Even though both papers were published in 2015, Cavallo and Gorodnichenko are using relatively stale data. The first dataset runs between October 2007 and August 2010 while the latter spans the period between May 2010 and February 2012. This delay is unfortunate as the online world is changing fast. Recent industry articles point to a large ramp-up in the use of dynamic pricing by retailers over the last few years. For instance, Profitero, a price intelligence provider, charts out a step-wise change in the pace of Amazon's price changes beginning in late 2012. According to competing price intelligence company 360pi, by 2014 some 18% of Amazon's prices were changing daily.

The same goes for an old dinosaur like Sears. While Sears' online prices rarely underwent changes in the earlier part of this decade, around 18% of its prices are now being adjusted each day, on par with Amazon. And now Sears is trying out digital signs in its bricks & mortar stores to ensure quicker offline price changes.

The moral economy

If we are indeed entering an Uber-style flex-price world, what underlying factors had to change for this to happen? It's not technology—we've always had the means to set rapidly changing prices, just look at financial markets. If anything had to bend in order for pricing patterns to change, it was the ethics of price setting.

To understand why, we need to explore one of the enduring questions in economics: why goods & services prices remain fixed in the face of continuously changing demand and supply conditions. When economist Alan Blinder polled businesses in the early 1990s to find out why they kept prices unchanged for long periods of time, the most common answer was the desire to avoid "antagonizing" customers or "causing them difficulties." Blinder's findings evoked Arthur Okun's earlier (1981) explanation for sticky prices whereby business owners maintain an implicit contract, or invisible handshake, with customers. If buyers view a price increase as being unfair, they might take revenge on the retailer by looking for alternatives. A retailer who promises to adjust prices rarely and only when costs justify it thereby avoids antagonizing customer sensibilities, and in return the customer provides a degree of loyalty.

The idea that prices are set within an overall moral framework predates Blinder and Okun. Nobel Prize winning economist John Hicks, for instance, once wrote that the notion that all prices are perfectly flexible was highly unrealistic and attributed rigidity to legislative control, monopolistic action "of the sleepy sort which does not strain after every gnat of profit, but prefers a quiet life," and "lingering notions of a ‘just price’."

Hicks' use of the word 'lingering' refers to the extended lineage of the concept of the just price. The belief that it is in some way sinful to sell a product for more than its fair price is a very old one, going back to early economic thinkers like Thomas Aquinas. In the age that Aquinas inhabited the economic roles that individual were permitted to play and the prices they could set were determined by tradition and custom. Historian E.P Thompson once referred to this as the "moral economy." For example, medieval English farmers could not sell their corn directly from their fields but had to bring it in bulk to the local "pitching market." Speculation, or the practice of "withholding" in the anticipation of better prices, was prohibited. Once at market, no sales of corn could be made before stated times. When the bell rang, the poor had the first chance to buy, and only after could larger dealers make purchases. These various market structures were designed to ensure a just price and fair profits.

Even as these structures were slowly unwound, writes Thompson, the English populace clung to the old morality, the physical incarnation of this being food riots which swept the countryside during the 18th century. These riots weren't random attempts to pilfer. Rather, they were relatively sophisticated affairs whereby rioters would organize to set the price of a good, in effect forcing the offending retailer to sell their wares at the level deemed just rather than at its much higher market-determined rate.

In the same way that 17th century rioters self-regulated markets by threatening to set the price for corn or bread, modern shoppers who encounter an unjust price threaten to cross the aisles towards the competition. Eager to avoid being punished by their customers' wrath, retailers implicitly promise to keep their prices fixed for long periods of time.

I find it interesting that even when we start from scratch, the notion of a just price quickly emerges. In his account of a temporary P.O.W. camp economy in which cigarettes circulated as money, R.A. Radford notes that:

There was a strong feeling that everything had its "just price" in cigarettes. While the assessment of the just price, which incidentally varied between camps, was impossible of explanation, this price was nevertheless pretty closely known. It can best be defined as the price usually fetched by an article in good times when cigarettes were plentiful. The "just price" changed slowly; it was unaffected by short-term variations in supply, and while opinion might be resigned to departures from the "just price," a strong feeling of resentment persisted. A more satisfactory definition of the "just price" is impossible. Everyone knew what it was, though no one could explain why it should be so.

Behavioral economists also find evidence of a just price mentality. Using telephone surveys, Kahneman, Knetsch, and Thaler were able to isolate community standards of price fairness. Generally, consumers feel they are entitled to their reference price, or past price. They also believe firms are entitled to their reference profit and deem it fair for a firm to raise prices to protect that profit, say because the firm's costs have increased. A firm that takes advantage of an increase in demand by raising its price and makes more than its reference profit is, however, breaking the rules of the game and acting unfairly.

----

So let's bring this back to Uber surge pricing and Amazon/Sears dynamic pricing.

I see two angles here. After centuries of a just price morality, perhaps we are inching towards an alternative framework. Maybe we've finally overcome our revulsion to an 'unfair price' that varies according to fluctuations in demand. Instead of the 19.7 month price spells of yore, we're now willing to endure 19.7 minute price spells. Morality changes, after all; slavery and death penalties used to be common, abortion was prohibited. If so, Uber and Amazon's pricing policy are emblematic of this underlying morality switch.

Or maybe we haven't switched at all and are still operating under the old rules of the moral economy. If so, the new pricing technologies adopted by Amazon and Uber are destined to be met by a titanic wave of consumer revulsion. This may be already happening; Uber's surge pricing policy has attracted plenty of negative press (here and here). Morality is a powerful force; unless they want to be dashed to pieces, the offenders will have to relent and make their prices more sticky.

Angolan macutes: Imaginary money

Economists are sometimes guilty of misrepresenting real-world liquid objects as living examples of the abstract variables populating their favorite monetary model. A good example of this is the incorrect reliance on Yap stones to illustrate the idea of fiat money by economists as varying as Keynes, Milton Friedman and James Tobin. Whereas fiat money is intrinsically useless, inconvertible, and unbacked, Yap stones certainly aren't, the anthropological evidence revealing that the stones had cultural and religious significance apart from their monetary value.

Similar in concept is the story of the macute, a unit of account used in Angola hundreds of years ago. Much like the exotic Yap stone, the existence of the macute (or macoute) came to the attention of Western thinkers as trade and conquest revealed ever large parts of the globe. Montesquieu was one of the first to describe the macute, noting:

The negroes on the coast of Africa have a sign of value without money. It is a sign merely ideal, founded on the degree of esteem which they fix in their minds for all merchandise, in proportion to the need they have of it. A certain commodity or merchandise is worth three macoutes; another, six macoutes; another, ten macoutes; that is, as if they said simply three, six, and ten. The price is formed by a comparison of all merchandise with each other. They have therefore no particular money; but each kind of' merchandise is money to the other. - Montesquieu, Esprit des Lois, 1748

Montesquieu's macute was later picked up by Sir James Steuart, an 18th century economist ranked just a notch or two below Adam Smith:

That money, therefore, which constantly preserves an equal value, which poises itself, as it were, in a just equilibrium between the fluctuating proportion of the value of things, is the only permanent and equal scale, by which value can be measured.

Of this kind of money, and of the possibility of establishing it, we have two examples: the first, among one of the most knowing; the second, among the most ignorant nations of the world. The Bank of Amsterdam presents us with the one, the coast of Angola with the other.

The second example is found among the savages upon the African coast of Angola, where there is no real money known. The inhabitants there reckon by macoutes; and in some places this denomination is subdivided into decimals, called pieces. One macoute is equal to ten pieces. This is just a scale of equal parts for estimating the trucks they make. If a sheep, e. g. be worth 10, an ox may be worth 40, and a handful of gold dust 1000. - An Inquiry into the Principles of Political Oeconomy, 1767

To Steuart and Montesquieu, the macute was an example of "ideal" money of account. The term money-of-account refers to the economy's pricing sign, or unit-of-account. It could be pounds (£), yen (¥), or dollars ($). Some real good typically defines this unit. For instance, the $ is the unit used to record prices in the US. The real good that defines the $ is base money issued by the Federal Reserve. In medieval times, prices were recorded in terms of £/s/d, with silver pennies being the defining real item (the "link coin"). To put this in the lingo of the econ blogosphere, the real good that defines the unit of account is the medium of account, a term popularized by Scott Sumner.

James Steuart's ideal money of account was a unit that, somewhat unusually, had no underlying real good defining it. It was a purely abstract accounting unit. There were prices in Steuart's economy, but no medium of account. Presumably Angolans were to keep the macute scale in mind, much like they might have a good sense for how long a foot was, or how much liquid a litre might contain. But at least with litres or feet there was a standard to which one might refer back to, say a metre stick or a measuring cup. Since the macute had no physical representation, goes the theory, it could only ever exist in people's heads.

Steuart and many others in his day believed in the necessity of an invariable scale of value. What was important to Steuart was the relative prices of real goods, not the price of some superfluous intervening good who's only job was to provide a measuring stick. If the money-of-account was a gold coin, for instance, then the "smallest particle of either metal added to, or taken away from any coin" would cause the entire price level to rise, destroying the ability of coins to measure the value of things. This would create macroeconomic difficulties:

any thing which troubles or perplexes the ascertaining these changes of proportion by the means of a general, determinate and invariable scale, must be hurtful to trade, and a clog upon alienation. This trouble and perplexity is the infallible consequence of every vice in the policy of money or of coin.

Fixing the money of account to a coin rather than allowing it to have an independent and abstract value caused distributional unfairness, since the relative interests of debtors and creditors were now at the disposal of anyone who could reduce the quality of coin,

not only of workmen in the mint, of Jews who deal in money, of clippers and washers of coin, but they are also entirely at the mercy of Princes, who have the right of coinage, and who have frequently also the right of raising or debasing the standard of the coin, according as they find it most for their present and temporary interest.

To those like Steuart, the advantage to society of an imaginary accounting unit like the macute was that, unlike physical coin, no prince or money clipper could ever debase it. It existed safely in the collective imagination where it could not be damaged, and therefore trade would no longer be held hostage to a fluctuating price level.

This idea spread. Around the time of Steuart, A.R.J. Turgot would also write of the macute as a purely imaginary unit:

The Mandingo negroes, who carry on a trade for gold dust with the Arabian merchants, bring all their commodities to a fictitious scale, which both parties call macutes, so that they tell the merchants they will give so many macutes in gold. They value thus in macutes the merchandize they receive; and bargain with the merchants upon that valuation. - Reflections, 1766

Macutes-as-ideal-unit would go on to be upheld a century later by John Stuart Mill:

This advantage of having a common language in which values may be expressed, is, even by itself, so important, that some such mode of expressing and computing them would probably be used even if a pound or a shilling did not express any real thing, but a mere unit of calculation. It is said that there are African tribes in which this somewhat artificial contrivance actually prevails. They calculate the value of things in a sort of money of account, called macutes. They say one thing is worth ten macutes, another fifteen, another twenty. There is no real thing called a macute: it is a conventional unit, for the more convenient comparison of things with one another. - Principles of Political Economy, 1848

As lovely as the idea of an imaginary macute was, it simply wasn't true. The macute was not so abstract as Montesquieu, Steuart, Turgot, and Mill would have liked it to be. William Stanley Jevons, for instance, scolded Montesquieu for misunderstanding the nature of money of account, since macutes served as "the name for a definite, though probably a variable, number of cowry shells, the number being at one time 2000." Lord Lauderdale accused Steuart of ignorance, noting that macutes were "pieces of net-work, used by the people of Angola for a covering." Like Lauderdale, John Ramsay McCulloch also found macutes to be bits of valuable cloth. Other writers declared that slaves were the missing medium-of-account used to describe the macute.

With the benefit of modern ethnographic accounts, we know that McCulloch and Lauderdale were right—macutes were neither imaginary, nor slaves, nor cowries, but cloth. In Power, Cloth and Currency on the Loango Coast, Phyllis Martin describes a coastal economy in which domestically produced cloth currency circulated. These libongo (pl. mbongo) were fourteen inch square pieces of cloth about the size of a hankerchief (see photo below). Mbongo had multiple uses. Not only could it be used in local markets to buy food and other consumption goods, but it could be made into clothes, wall hangings, bags, and floor coverings, and used for ceremonial purposes.

Kongo or Angola cloth, 17th century, raffia pile (source)

Martin also describes a traditional unit of account called a makuta (macute), defined as ten mbongo wrapped together in a strip. European trade brought foreign substitute cloth, and with that a decline in the purchasing power of the makuta, or inflation, resulted. As a result, copper coins came into increased use, although Martin finds that mbongo remained in circulation well into the eighteenth century. By the 1700s, around the time that Montesquieu was writing, the nature of the makuta unit of account had changed:

At Loango Bay traders used an abstract numerical unit of account based on a makuta, one mukuta being equal to 10. The unit may have developed from the older association of the mukuta with ten mbongo. Thus a slave-trader at Loango in 1701 wrote, "we bought men slaves from 3,600-4,000, and women, boys and girls in proportion." The goods to be exchanged were also valued in the numerical unit of account for example, a piece of "blue baft" or cotton cloth from India counted as 1,000, a piece of painted calico was 600, a small keg of powder was 300, and a gun was 300.40 

- Martin, Power, Cloth and Currency on the Loango Coast, 1986

What we have here is an example of "ghost money", not ideal money. An ideal money, having been divorced from any traded good, would have no commodity definition whatsoever. The mukuta (macoute) as described by Martin, however, was defined as a historically fixed, or "ghost" quantity, of mbongo. Though no longer prized as a highly liquid medium of exchange—copper coinage would have filled this place—mbongo were still desired for their non-monetary qualities. Thus any alteration in the real value of mbongo would continue to have an effect on all prices. It may have been this historically fixed "ghost" nature of macutes and their relative rarity in actual trade that confused Montesquieu into describing them as an ideal accounting unit.

In sum, macutes were not the ideal unit of Steuart and Montesquieu's imagination. Does that mean that ideal units of account can't exist? I'm hard pressed to come up with a logical explanation for how they might work. And I surely don't have any historical examples, the macute having been confined to the dustbin. I vote we toss the idea out, along with fiat money. Beware economists toting imaginary accounting units, abstract numeraires, and ideal money of account.

---

P.S. Indexed units of account like the Chilean Unidad do Fomento, which I wrote about here, are not imaginary units. Instead, I think they should be thought of as ghost monies.

The zero-lower bound as a modern version of Gresham's law

Sir Thomas Gresham, c. 1554 by Anthonis Mor

The zero-lower bound may seem like a new problem, but I'm going to argue that it's only the most recent incarnation of one of the most ancient conundrums facing monetary economists: Gresham's law. A number of radical plans to evade the zero-lower bound have emerged, including Miles Kimball's electronic money plan. When viewed with an eye to history, however, plans like Miles's are really not so radical. Rather, they are only the most recent in a long line of patches that have been devised by monetary tinkerers to spare the monetary system from Gresham-like monetary problems.

Here's an old example of the problem. At the urging of Isaac Newton and John Locke, British authorities in 1696 embarked on an ambitious project to repair the nation's miserable silver coinage. This three-year effort consumed an incredible amount of time and energy. Something unexpected happened after the recoinage was complete. Almost immediately, all of the shiny new silver coins were melted down and sent overseas, leaving only large denomination gold coins in circulation.

What explains this incredible waste of time and effort? Because it offered to freely coin both silver and gold at fixed rates, the Royal Mint effectively established an exchange ratio between gold and silver. English merchants in turn accepted gold and silver coins at face value, or the mint's official rate, and debts were payable in either medium at the given rate. Unfortunately, the ratio the Mint had chosen overvalued gold relative to the world price and undervalued silver. Rather than spend their newly minted silver coins to buy £x worth of goods or to settle £y of debt, the English public realized that it was more cost-effective to use overvalued gold coins to purchase £x or settle £y. Then, if they melted down their full bodied silver coins and sent them across the Channel, the silver therein would purchase a higher quantity of real goods, say  £x+1 goods, or settle more debts than at home, say £y+1 debts.

Newton and Locke had run into Gresham's law. When the monetary authority defines the unit-of-account (£, $, ¥) in terms of two different mediums, the market will always choose to transact using the overvalued medium while hording and melting down the undervalued medium. "Bad" money drives out the "good". (For a better explanation, few people know more about Gresham's law than George Selgin.)

The abrupt switches between metals that characterized bimetallism weren't the only manifestation of Gresham's law. Constant shortages of silver change in the medieval period were another sign of the law in operation. Over time, a realm's silver coinage would naturally wear out as it was passed from hand to hand. Clippers would shave off the edges of coins, and counterfeiters would introduce competing tokens that contained a fraction of the silver. Any new coins subsequently minted at the official standard would be horded and sent elsewhere. After all, why would an owner of a "good" full-bodied silver coin spend it on, say, a chicken at the local market when a "bad" debased silver coin would be sufficient to consummate the transaction? The result was a dearth of new full bodied coins, leaving only a fixed amount of deteriorating silver coins to serve as exchange media.

This sort of Gresham-induced silver coin shortage, a common phenomenon in the medieval period, was the very problem that Newton and Locke initially set out to fix with their 1696 recoinage. Out of the Gresham pan into the Gresham fire, so to say, since Newton and Locke's fix only led to a different, and just as debilitating, encounter with Gresham's law — the flight of all silver out of Britain.

Over the centuries, a number of technical fixes have been devised to fight silver coin shortages. By milling the edges of coins, clipping would be more obvious to the eye, thereby deterring the practice. High quality engravings, according to Selgin (pdf), rendered counterfeiting much more difficult. Selgin also points out that the adoption of restraining collars in the minting process created rounder and more uniform coins. Adding alloys to silver and gold strengthened coins and allowed them to circulate longer without being worn down. These innovations helped to prevent, or at least delay, a distinction between good and bad money from arising. As long as degradation of the existing coinage could be forestalled by technologies that promoted uniformity and durability, any new coins made to the official standard would be no better than the old coins. New coins could now circulate along with the old, reducing the incidence of coin shortages. Gresham's law had been cheated.*

Let's bring this back to modern money. As I wrote earlier, Gresham's Law is free to operate the moment that the unit of account is defined with reference to two different mediums rather than just one. In the case of bimetallism, the pound was defined as a certain amount of silver and gold, whereas in a pure silver system the unit was defined in terms of old debased silver coins and new full bodied silver coins. In our modern economy, £, $, ¥ are defined in terms two different mediums—central bank deposits and central bank notes. 

Normally this dual-definition of modern units doesn't cause any problems. However, when economic shocks hit a central bank may be required to reduce interest rates to a negative level in order to execute monetary policy. Say it attempts to do so by setting a -5% interest rate on central bank deposits. The problem is that bank notes will continue to yield 0% since the technical wherewithal to create a negative rate on cash has not yet been developed. This disparity in returns allows a distinction between good and bad money to suddenly emerge. Just as full-bodied silver coins were prized relative to debased silver coins, the public will have a preference for 0% yielding cash over -5% yielding deposits. It's Gresham's Law all over again, with a twist...

...when rates fall to -5% it isn't the bad money that chases out the good, but the mirror image. Everyone will convert bad deposits into good cash, or, as Miles describes it, we get massive paper storage. All deposits having been converted into cash, the central bank loses its ability to reduce interest rates below 0% — it has hit the zero lower bound.

In this case, the reason that the good drives out the bad rather than the opposite is because a modern central bank promises to costlessly convert all notes into deposits and vice versa at a 1:1 rate. If bad -5% deposits can be turned into good 0% notes, who wouldn't jump on the opportunity?

To make our analogy to previous standards more accurate, consider that this sort of "reverse-Gresham effect" would also have arisen in the medieval period if the mint had promised to directly convert debased silver coinage into good coins at a 1:1 rate.** As it was, mints typically converted metal into coin, not coin into coin. If mints, like central banks, had offered direct conversion of bad money into good, everyone would have jumped at the opportunity to get more silver from the mint with less silver. Good coin would have rapidly chased bad coin out of circulation as the latter medium was brought to the mint. In offering citizens such a terrific arbitrage opportunity, the mint could very quickly go bankrupt.

Here's a medieval-era example of the "reverse Gresham-effect". When it called in the existing circulating silver coinage to be reminted in 1696, Parliament decided to accept these debased coins at their old face value rather than at their actual, and much diminished, weight. In the same way that everyone would quickly convert bad -5% deposits into good 0% cash given the chance, everyone jumped at this opportunity to turn bad coin into good. John Locke criticized this policy, noting that upon the announcement, clippers would begin to reduce the existing coinage even more rapidly. After all, every coin, no matter how debased, would ultimately be redeemed with a full bodied coin. Why not clip an old coin a bit more before bringing it in for conversion? Even worse, since the recoinage was to take two years, profiteers could repeatedly bring in bad coin for full bodied coin, clip their new good coins down into bad ones, and return them to the mint for more good coin. Locke pointed out that this would come at great expense to the mint, and ultimately the tax-paying public. [For a good example of Locke's role in the 1696 recoinage, read Morrison's A Monetary Revolution]

Just as the reverse-Gresham effect would cripple a mint, allowing free conversion of -5% deposits into 0% notes would be financial suicide for a bank. As I've suggested here, any private note-issuing bank that found it necessary to reduce rates below zero would quickly try to innovate ways to save themselves from massive paper conversion. Less driven by the profit motive, central banks have been slow to innovate ways to get below zero. Rather, they have avoided the reverse-Gresham problem by simply keeping rates high enough that the distinction between good and bad money does not emerge.

In order to allow a central bank to set negative rates without igniting a reverse-Gresham rush into cash, Kimball has proposed the replacement of the permanent 1:1 conversion rate between cash and deposits with a variable conversion rate. Now when it reduces rates to -5%, a central bank would simultaneously commit itself to buying back cash (ie. redeeming it) in the future at an ever worsening rate to deposits. As long as the loss imposed on cash amounts to around 5% a year, depositors will not convert their deposits to cash en masse when deposit rates hit -5%. This is because cash will have been rendered equally "bad" as deposits, thereby removing the good/bad distinction that gives rise to the Gresham effect. The zero lower bound will have been removed.

To summarize, Kimball's variable conversion rate between cash and deposits is a technical fix to an age-old problem. Gresham's law (and the reverse-Gresham law) kick in when the unit of account is defined by two different mediums, one of which becomes the "good" medium and the other the "bad". When this happens, people will all choose to use only one of the two mediums, a choice that is likely to cause significant macroeconomic problems. In the medieval days, it led to shortages of small change. Nowadays it prevents interest rates from going below 0.

In this respect, Miles's technical fix is no different from the other famous fixes that have been adopted over the centuries to reduce the good vs bad distinction, including milled coin edges, high quality engravings, alloys, mint devaluations, and recoinages. Milled edges may have been new-fangled when they were first introduced five centuries ago, but these days we hardly bat an eye at them. While Miles's suspension of par conversion may seem odd to the modern observer, one hundred years from now we'll wonder how we got by without it. In the meantime, the longer we put off fixing our modern incarnation of the Gresham problem, the more likely that future recessions will  be deeper and longer than we are used to — all because we refuse to innovate ways to get below zero.

---

*Debasing the mint price, or the amount of silver put into new coins (other wise known as a devaluation, explained in this post), was another way to ensure that old and new silver coins contained the same amount of silver. A devaluation rendered all new coin equally "bad" as the old coin, ensuring that Gresham's law was no longer free to operate. In addition to devaluations, constant recoinages re-standardized the nation's circulating medium. Much like a devaluation, a recoinage removed the distinction between good and bad coins, at least for a time, thereby nullifying the Gresham effect and putting a pause to coin shortages.

** In a bimetallic setting, the process would have worked like this. Say that the mint promised to redeem gold with silver coins and vice versa at the posted fixed rate. When this rate diverges from the market, buyers needn't send the overvalued coin overseas to secure a market price. They only had to bring all their overvalued coins (the bad ones) to the mint to exchange for undervalued ones (the good ones), until at last no bad coins remained. Thus the good drives out the bad. In the meantime, the mint would probably have gone out of business.

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.

Transporting the macroblogosphere back to 1809: Usury Laws and the 5% upper bound

The zero-lower bound is the well-known 0% floor that a note-issuing bank hits whenever it attempts to reduce the interest rate it offers on deposits into negative territory. Should the bank drop rates below zero, every single negative yielding deposit issued by the bank will be converted into 0% yielding notes. When this happens, the bank will have lost any ability it once had to vary its lending rate.

The ZLB is an artificial construct. It arises from the way the banking system structures the liabilities that it issues, namely cash and deposits. We can modify this structure to either remove the ZLB or find alternative ways to get around it. Much of the discussion over the econblogosphere over the last few years has been oriented around various ways to get below zero.

There is another artificial bound, this one to the upside—let's call it the 5% upper bound, or FUB. The FUB is an archaic bound. Up until 1854, the Usury Laws prevented the Bank of England from increasing rates above 5%. This constraint meant that for almost two centuries, the Bank of England's discount rate was bounded within a narrow channel that had as its upper limit the 5% mark as stipulated by the Usury Laws and a lower limit of 0% due to the existence of 0% yielding banknotes (see chart above).

Imagine that we had a time machine and transported the econblogosphere, still hot over the ZLB debate, back to 1809. What sorts of discussions would we be having if we had risen up against the FUB? Given that the conventional route of increasing rates was constrained by the usury prohibitions, what sort of unconventional monetary policies would bloggers be providing to the Directors of the Bank of England to deal with inflationary booms? Would this advice be symmetrical to the policies they have been advocating for escaping the ZLB?

1809 is a significant date because the convertibility of the pound into gold had been suspended for over a decade. Although convertibility would be resumed in 1821, England would be on a 'fiat' standard very similar to our own for another decade. In the years since suspension, the pound had gradually depreciated against gold and other European currencies. A healthy debate began to flourish over whether the Bank of England was responsible for the pound's depreciation (ie. inflation) or if external events such as crop failures were to blame. It was in that context that banker/economist Henry Thornton published his famous Enquiry into the Nature and Effects of the Paper Credit of Great Britain. Although Thornton was circumspect on the precise causes of the deprecation of the pound, he drew attention to the difficulties that the Usury Laws caused in controlling the volume of credit. Here is Thornton:

In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances. This is to be judged of by considering two points: the amount, first, of interest to be paid on the sum borrowed and, secondly, of the mercantile or other gain to be obtained by the employment of the borrowed capital...

The borrowers, in consequence of that artificial state of things which is produced by the law against usury, obtain their loans too cheap. That which they obtain too cheap they demand in too great quantity.

Thornton pointed out that if there was a large deficit between the price at which a businessman could borrow from the Bank of England and the mercantile rate of profit—the rate at which the same businessman could invest the borrowed money—then the demand for and granting of credit would become excessive. While nudging the discount rate higher would normally be sufficient to reduce this excess, the laws against usury might prevent these increases from taking place.

If we were to drop Nick Rowe into the 1809 economic debate, he would complement Thornton quite well by making good use of the same pole-on-a-palm analogy he has so aptly used to explain the ZLB. Running an inflation targeting central bank is sort of like balancing a long pole upright in the palm of one's hand, says Nick. The bottom of the pole is the interest rate and the top is the inflation rate. As the pole starts to lean (ie. the price level begins to change), the holder needs to quickly move their palm far enough in the same direction (ie. interest rates must be changed) so as to stop the pole from falling over. A wall to the either the north or south impedes the holder's palm from moving sufficiently far and will cause the pole to tumble over.

Applying this analogy to monetary policy, the Directors of the Bank of England might be required to stop excess inflation by moving rates north of 5%. With the Usury Laws in place, the Director's efforts would be impeded. Nick's illustration is Thornton all over again.

Scott Sumner, Lars Christensen, David Beckworth, and other monetarist-types have been strong advocates of quantitative easing as a way to get below the ZLB. Whisk them back to 1809 and would they advocate getting above the FUB by quantity dis-easing, or QD — mass repurchases of Bank of England notes through the liquidation of the Bank of England portfolio of assets?

Assuming that the threat of QD is able to increase the expected purchasing power of the pound (just as the threat of QE is supposed to reduce the same), then the Directors could initiate a QD program to improve the real return on pound notes and deposits. As soon as the real return on notes and deposits exceeds real returns on capital, the inflationary boom will come to a halt. Conveniently for the Directors, the nominal 5% rate will have remained in place — only real rates will have increased — thereby allowing the Directors to abide by the Usury Laws.

What about New Keynesians like Paul Krugman? Promising to hold off on future interest rate increases after a recovery has begun is the sort of advice New Keynesians have given to the Fed as a way to bridge the ZLB. This is called providing forward guidance. As Krugman says, a central bank needs to "credibly promise to be irresponsible".

Parachute Krugman into 1809 and he would be counseling the Directors to do the opposite: hold off on reducing rates from 5% after a contraction had already set in. In other words, the Directors need to "credibly promise to be hard-asses." As long as this promise is taken seriously by the market, the promise of future monetary tightening translates into lower inflation in the present, and the real interest rate rises. This should reign in the inflationary boom. Much like Sumner and Christensen, Krugman's advice would allow the Director's to hold steady at the 5% nominal rate dictated by the Usury Laws, letting real rates do the job of reeling in prices and slowing down the economy.

What about Miles Kimball? Transport Miles back to 1809 and he'll probably be the most aggressive in the outright removal of the Usury Laws. Just as he is currently campaigning for the ability of central banks to set negative rates on deposits, I'm sure he'd by picketing outside of Parliament for the right of the Director's to bypass the Usury Laws and set 6-7% nominal rates.

Incidentally, what did the Directors of the Bank of England actually do? According to Jacob Viner, there is evidence that

bankers found means of evading the restrictions of the usury laws. In 1818, the Committee on the usury laws stated in its Report that there had been “of late years ... [a] constant excess of the market rate of interest above the rate limited by law.” Thornton notes that borrowers from private banks had to maintain running cash with them, and borrowers in the money market had to pay a commission in addition to formal interest, and that by these means the effective market rate was often raised above the 5 per cent level. Another writer relates that long credits were customary in London and a greater discount was granted for prompt payment than the legal interest for the time would amount to.

More convincing evidence that the 5 per cent rate was not of itself always an effective barrier to indefinite expansion of loans by the banks is to be found in the fact that the directors of the Bank of England, although they professed that they discounted freely at the rate of 5 per cent all bills falling within the admissible categories for discount, in reply to questioning admitted that they had customary maxima of accommodation for each individual customer and occasionally applied other limitations to the amount discounted.

In Paper Credit we find Henry Thornton verifying Viner's claim, noting the "determination, adopted some time since by the bank directors, to limit the total weekly amount of loans furnished by them to the merchants."

So the Director's preferred route for getting out from under the thumb of the Usury Laws was to maintain the 5% discount rate, but ration the quantity of loans issued at these rates, thereby limiting the quantity of credit in circulation. While this policy might not have been sufficient to prevent an inflationary boom, it may have prevented a hyperinflation from breaking out.

Before I sign off, I want to reverse something I said at the outset. I wrote that the 5% upper bound was archaic, but that's not entirely true. Sure, high interest rates are no longer illegal. But high nominal interest rates have never been politically palatable. Central bankers are not independent of politics, and therefore probably still operate with something akin to a 5% upper bound. Let's call it an "upper-ish" bound, or the point at which a central banker starts to get dirty looks from those who have the power to reappoint him. Central bankers may need to resort to unconventional techniques to free themselves of the upperish-bound. The Fed's motivations for adopting quantity targets in 1979, for instance, may have been such a technique. An overt jacking-up of interest rates to 15-20% would have been political suicide, goes the theory, so the FOMC chose to engage in a bunch of hand-waving about hitting money supply targets, thereby distracting would-be critics with a new set of monetary verbiage. This left Paul Volcker free to implement what would be at its peak a tremendously onerous 22%+ fed funds rate.

We're of course not anywhere near the upper bound these days, at least not in the developed world, but it's still an interesting puzzle to work through in order to help understand the current situation. Our investigation also offers a history lesson. In choosing to remove it over century ago, the FUB was revealed to be neither a law of nature nor a design of God. The FUB was a choice. Hopefully we'll eventually realize that the same applies to the ZLB.

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!

---

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.

Adam Smith's very own Lehman Crisis

It's interesting to see how after a credit crisis, economists start to take money and banking a bit more seriously. Adam Smith, who experienced his very own credit crisis -- the collapse of the Douglas Heron and Co, or the Ayr Bank, on June 22, 1772 -- is no exception. His views on money and banking became much more nuanced after that event.

Ayr Bank had been founded in 1769 in the Scottish town of Ayr. It expanded to Edinburgh and Dumfries, and in only a few short years it had succeeded in wrestling a significant chunk of Scottish banking business from incumbents the Bank of Scotland and the Royal Bank of Scotland. By 1772, according to Checkland, the Ayr Bank supplied 25% of Scotland's bank notes and deposits. In early June 1772 one of Ayr's largest customers, Alexander Fordyce, skipped London for Paris to avoid debt payments. A run on the Ayr Bank began that precipitated the bank's failure by the end of the month.

Upon observing the bank run, David Hume writes from Edinburgh, Scotland to his friend Smith on June 27, 1772:

We are here in a very melancholy Situation: Continual Bankruptcies, universal Loss of Credit, and endless Suspicions. There are but two standing Houses in this Place, Mansfield’s and the Couttses: For I comprehend not Cummin, whose dealings were always very narrow. Mansfield has pay’d away 40.000 pounds in a few days; but it is apprehended, that neither he nor any of them can hold out till the End of next Week, if no Alteration happen. The Case is little better in London. It is thought, that Sir George Colebroke must soon stop; and even the Bank of England is not entirely free from Suspicion. Those of Newcastle, Norwich and Bristol are said to be stopp’d: The Thistle Bank has been reported to be in the same Condition: The Carron Company is reeling, which is one of the greatest Calamities of the whole; as they gave Employment to near 10.000 People. Do these Events any–wise affect your Theory? Or will it occasion the Revisal of any Chapters?

Of all the Sufferers I am the most concern’d for the Adams, particularly John. But their Undertakings were so vast that nothing coud support them: They must dismiss 3000 Workmen, who, comprehending the Materials, must have expended above 100.000 a Year. They have great Funds; but if these must be dispos’d of, in a hurry and to disadvantage, I am afraid the Remainder will amount to little or nothing.

Hume asks if these events affect Smith's theory, the Wealth of Nations having not yet been published. In a letter to William Pulteney dated September 1772, a few months after the bank crisis, Smith notes that the events had indeed delayed the finishing of his book, which otherwise would have been completed that winter. When it was eventually published in 1776, Book II, Chapter II of the Wealth of Nations would include a long description of the Ayr crisis (though Smith never mentions the bank by name, most probably to protect those involved, see below).

Personal issues arising from bank failure also delayed publication of the Wealth of Nations. In the letter to Pulteney, Smith disavows any financial involvement in the crisis but notes that:

Tho I have had no concern myself in the Public calamities, some of the friends for whom I interest myself the most have been deeply concerned in them; and my attention has been a good deal occupied about the most proper method of extricating them.

According to Antoin Murphy and John Rae [biographer of Smith], the friends to whom Smith refers to probably included Smith's patron, the Duke of Buccleuch. The Duke was one of Ayr Bank's largest shareholders, and the source of Smith's £300 a year pension. Murphy intimates that as adviser to the Duke, Smith would have been privy to much of the gritty details of the bank's demise, as well as advising Buccleuch in the ongoing legal proceedings against the shareholders and directors of the bank. No doubt Smith had plenty to reflect on, including the fact that he might lose his pension.

There is also an odd letter from Hume to Smith, dated October 1772, in which Hume refers to Ayr banknotes in Smith's possession:

I ask’d the Question you proposd; and was told by Sir William Forbes, that tho’ they did not commonly take the Air Notes, yet he woud upon your Account: You may therefore send them over by the first Opportunity.

Not only did the collapse of Ayr put Smith's benefactor in financial trouble, but it seems that Smith himself was in possession of a few Ayr banknotes. Could it be that Smith himself was burned by the Air collapse, only to be helped out by William Forbes, an Edinburgh banker who had survived the crisis and generously agreed to take the notes off of Smith's hands? Or was Smith simply using his connections to help out a London-based friend who was stuck with Ayr Bank notes?

In any case, Smith's views on banking were inevitably modified by a crisis. According to Murphy, Smith became more conservative monetary theorist relative to his pre-1772 stance. Here is a quote from Smith's earlier Lectures on Jurisprudence, about six years before the crisis, in which he pooh-poohs the danger of banking crisis.

The ruin of a bank would not be so dangerous as is commonly imagined. Suppose all the money in Scotland was issued by one bank and that it became bankrupt, a very few individuals would be ruined by it, but not many, because the quantity of cash or paper that people have in their hands bears no proportion to their wealth. Neither would the wealth of the whole country be much hurt by it, because the 100 part of the riches of a country does not consist in money. (1766)

In The Wealth of Nations, Smith's benign view of banks was modified. No doubt influenced by his first hand experience of the Ayr collapse, Smith realized that the ruin of banks could have far greater consequences than he had earlier assumed. He went on to describe a set of guidelines that banks might use to avoid bankruptcy. Bankers, Smith wrote, should always verify that the bills of exchange upon which they issued credit (bills were a common collateral security accepted by banks) had arisen as the result of solid transactions between "real creditors" and "real debtors". Fictitious bills of exchange -- bills whose provenance was obscure and were usually issued by those whom Smith called "projectors", or speculators, and accepted (or co-signed) by collaborating projectors -- were to be treated with skepticism. The blogosphere's very own David Glasner describes this set of rules in this paper.

Like Smith, modern day economists are busily reappraising pre-2008 modes of thought, much of which abstracted from money and banking altogether. They have much to reflect on too. If Smith were alive today, he'd no doubt wonder why banks had lent on such unverifiable collateral, most of which in his eyes would appear to be entirely fictitious.

---

1: Much of this blog post is indebted to Antoin Murphy's chapter on Adam Smith in The Genesis of Macroeconomics.
2. For a full account of the demise of the Ayr Bank, here is the 1778 inquiry into the affair , or The Precipitation and Fall of Mess. Douglas, Heron and Co, Late Bankers in Air With the Causes of their Distress and Ruin Investigated and Considered. They sure loved long names back then.

Orphaned currency, the odd case of Somali shillings

A few weeks ago, David Beckworth egged me on to write about Somalian currency. I can't resist—it's a fascinating subject. The material I'm drawing on comes from Luther & White (2011), Luther (2012), Symes (2005), and Mubarak (2003)

Orphaned banknotes

When Somalia collapsed into civil war in January 1991, the doors of the Central Bank of Somalia were blown apart, its safes were blasted, and all cash and valuables were looted.* But something odd happened—Somali shilling banknotes continued to circulate among Somalians. To this day orphaned paper shillings are used in small transactions, despite the absence of any sort of central monetary authority.

The strange case of circulating Somali shillings forces us to ask some fundamental questions about money. If the Federal Reserve and all other branches of the US government were to be suddenly swallowed up into the sea, would Fed banknotes, like Somali shillings, continue to be used? What forces conspire to keep coloured squares of paper in circulation when their original issuer has long since expired?

According to Luther & White (2011), the shillings' continued circulation within the context of a collapsed state casts doubt on the universality of the chartal theory of money. According to chartal theory, the requirement that people pay taxes with government-issued bits of paper is what drives the positive value of these bits. Since a world with no state is a world with no taxes, the continued use of shillings means that something other than tax acceptance must be driving their positive value. [As an aside, I'd note that the ongoing circulation of bitcoin also contradicts the taxes-only theory of chartal money. After all, bitcoin isn't used to pay taxes, it's used to avoid taxes].

Luther & White give what seems to me to be a very Misesian explanation for the shilling's continued positive value: the "inertia of historical acceptance". According to Ludwig von Mises's regression theorem, outlined in Theory of Money and Credit (1912), people's expectations about the value of bits of paper may "regress" into the past. An intrinsically useless bit of paper is valued today because it had a positive value yesterday, and it had a positive value yesterday because it did the day before, all the way back to day 1 when that useless bit of paper was anchored to some commodity.

This process is described as a coordination game in Luther & White. Though the central bank had collapsed in January 1991, a Somalian trader might choose to still accept shillings the day after the collapse because he had accepted them the day before and he knew that others had accepted them too. In a self conscious manner, the trader would also know that other traders knew that he had accepted them. Expectations about expectations about expectations, a Keynesian beauty contest of sorts, was sufficient to drive the use of shillings beyond the day of the central bank's demise.

Counterfeit notes and contingent redemption

Let's add some more texture to our example. Not only did old shillings continue to circulate, but several new issues of counterfeit notes joined them. These counterfeit 1000 and 500 shilling banknotes were created by warlords and businessmen subsequent to the country's collapse. Although the counterfeit notes had the same design as the pre-1991 legacy notes, small differences allowed for differentiation. According to Luther (2012), of the five known forged issues, four have the date 1996 printed on them, long after the central bank ceased to exist. The counterfeits dated 1996 are signed by central bank governor Ali Abdi Amalow who, having been appointed in 1990, had never held office long enough to have his signature affixed to genuine Somali notes. Even without these imperfections, fake banknotes would have been instantly recognizable to anyone—they would have been crisp and clean relative to the limp and dirty legacy issue.

Despite being easily differentiable, Somalians willingly accepted counterfeit 1000 and 500 shilling notes. Not only did they accept them, they considered them to be fungible with real 1000s and 500s. In other words, the market refused to place a discount on the fakes.

Mubarak (2003) offers a few reasons for the acceptance of counterfeits. Any reticence the public may have had concerning the legitimacy of counterfeit note was overcome by A) coercion on the part of issuing warlord; B) a financial inducement to accept new notes including an initial 5% discount to the price of legacy notes, and C) the claim that new notes were liabilities of the Central Bank of Somalia. According to Mubarak the latter instilled a "general public belief that the forged... banknotes must eventually be upheld and honoured when effective national government comes to power."

This last detail is interesting because it might explain not only why counterfeits were accepted, but also why legacy Somali banknotes continued to circulate after the Somali state collapsed. Upon the eventual reconstitution of the Somalian state, a new central bank would most likely be created. This newly recapitalized Central Bank of Somalia would hold a stock of assets funded, say, by the IMF.  The central bank might take upon itself the original central bank's note liability No longer orphans, old banknotes could now be convertible into deposits held at the new central bank and, insofar as the central bank targeted inflation via open market operations, these deposits would in turn be convertible into genuine backing assets.

Thus the promise of redemption by a not-yet existing central bank may have been enough to give present shillings, both genuine and counterfeit, a positive value.

This means that any changes in the purchasing power of shillings might be due not only  to variations in the quantity of outstanding Somali media-of-exchange. Reassessments of the probability of a central bank both being created and honouring the previous note issue would also affect their purchasing power. For instance, should the Transitional Federal Government, a government in-waiting of sorts, succeed in consolidating its position in Somalia by winning a key battle, the odds of redeemability would increase, as would the value of shillings.

Historically orphaned currencies

This tension between fiat-paper-as-redeemabale-financial-asset and fiat-paper-as-medium-of-exchange is an old one. It was at the centre of one of the greatest monetary debates of the 19th and early 20th century, a dustup that involved luminaries like Irving Fisher, Knut Wicksell, Laurence Laughlin, Benjamin Anderson, Ralph Hawtrey, and Ludwig von Mises. The discussion centered on the irredeemability of US Greenbacks.**

Greenbacks, which had been issued in 1861 to pay for the Union Government's expenses, were initially 100% redeemable in specie. The redemption clause was suspended later that year and subsequent issues of greenbacks didn't even claim to be convertible into gold. Greenbacks quickly fell to a large discount relative to the metal. By August 1864 the discount had hit its widest point as the paper traded at 38 cents on the gold dollar.***

As with Somali shillings, economists were curious about these seemingly-orphaned liabilities. Why were greenbacks still accepted? What governed their value? Wicksell, Mises, and Hawtrey held that if there is a demand for the medium-of-exchange as such, this demand would be sufficient to give value to whatever instrument was established by custom as the medium-of-exchange. Thus the continued acceptance of greenbacks at positive values was mostly due their already-favorable marketability.

Countering this panel of illustrious economists was J. Laurence Laughlin. Though Laughlin doesn't attract the same brand recognition as do these other long-dead economists, in his day he was considered to be America's leading monetary economist. In his book The Principles of Money (1903), Laughlin outlined the view that greenbacks should be treated like non-dividend paying common stock. Just as a stock might have some positive value now due to potential dividends several years down the road, the continued positive valuation of greenbacks was due entirely to the possibility of their future redemption.

To illustrate his point, Laughlin drew attention to the market's reaction upon the success of the Union Goverment in the Battles of Gettysberg and Vicksburg. After these battles the greenback's discount to gold dramatically narrowed, presumably because these victories were perceived by the market as increasing the probability of future redemption of greenbacks in specie. Laughlin also mentions the passage of the Redemption Act of 1875, in which the government declared its intention to redeem all greenbacks come January 1, 1879. Though still trading at a discount to gold, greenbacks began to steadily appreciate towards par as this date approached, just like a t-bill approaching maturity. Thus Laughlin's redemption theory held up nicely to the evidence.

While Wicksell described Laughlin's theory as "perverse and fantastic," it was hard for Mises, Hawtrey, or Wicksell to deny that the expectation of future redemption didn't have at least some effect on greenback's value. In his book the Value of Money (1917), Benjamin Anderson struck a middle ground between all parties. Anderson held that Laughlin was right to treat greenbacks like any other asset whose value was dependent on eventual redeemability. But Anderson also thought that Mises and the rest were correct to put an emphasis on greenback's unique monetary function. Anderson combined these views by illustrating how greenback's "money-use" would be captured by the market as an extra bit of ascribed value on top of redemption value, or a liquidity premium.

Just to make things more complicated: New Somali Shillings

Back to the Somali shilling. The last feature of the Somalian monetary economy that I find interesting is the presence of yet another media of exchange — the "New Somali Shilling".**** Just prior to the January 1991 collapse, Somalia had been experiencing accelerating inflation. The Somali government drew up plans to replace existing shillings with the New Somali shillings. Each New Shilling was to be worth 100 old shillings, and notes were to be printed in 20 and 50 shilling denominations

 According to Symes (2006), the first shipment of New Shillings arrived in Somalia several months after the collapse of the state. Ali Mahdi Muhammed, a factional leader in Mogadishu, seized several billion of these official New Shillings and spent them into the economy in November 1991. While New Shillings did gain acceptance, their use was limited to a small area in North Mogadishu—the area controlled by Ali Mahdi Muhammed. Nor were they fungible with the legacy notes. 500 worth of New Shillings, for instance, was not worth 500 worth of old shillings. Nor did New Shillings circulate at the pre-1991 intended value of 100 old shillings to one New Shilling. At the time of Mubarak's article, a New shilling was worth only a third of an old shilling.

This challenges Luther & White's theory that Somalians accepted shillings because of their previous experience with them. Why did Somalians accept New Shillings at all if they were not accustomed to doing so? Why not refuse and continue to trade in legacy shillings? Legacy shillings circulated in Mogadishu at the time, so traders would have presumably had a choice. Why take a bet on an untested currency?

New Shillings also challenge the Laughlin-esque theory that redemption underpins the positive value of fiat paper. If Somalians universally valued shillings because of their future redeemability, why would they not place a higher value on New Shillings relative to old? After all, according to its stated plan, the Central Bank of Somalia was willing to convert 100 old shillings into 1 New Shilling. If it was believed that a newly chartered central bank would take on the liability of Somalia's counterfeit notes, wouldn't that same central bank uphold a commitment to value New Shillings at a far higher rate than old ones? Why then do New Shillings trade a third the price of old shillings rather than at a multiple of 100?

As much as I dislike to leave more questions than answers, that's about all I can do for the time being. One major data point is yet to come. What actually happens to legacy and counterfeit notes when a new central bank begins to operate? The Central Bank of Somalia's website says this:

Towards fully assuming its functional and institutional responsibilities, the Bank has completed the reconstruction of its Headquarters in Mogadishu while the branch in Baidoa has been established and is already functioning with personnel in place.

Perhaps we don't have long to wait.
_____________________________________________________

*Abduraham in Luther (2012)
**Debate also surrounded the irredeemability of Austrian gulder banknotes. The Revolution of May 1848 resulted in the withdrawal of the convertibility of Austrian gulden banknotes into silver. The discount on gulder notes relative to silver averaged around 15% for the first 10 years and then dipped to an average of 28% from 1859 to 1865. Laughlin pointed out that by the 1860s speculation began to grow that Austria would switch from the silver standard to a gold standard. If the banknotes, still irredeemable, were to be honoured, it became increasingly evident that redemption would be in gold, not silver. At the same time, large silver discoveries were driving down the value of silver relative to gold. As a result of these forces, the market value of notes rose back to par with silver. As the market became progressively more confident that the notes would be redeemed, and redemption would be in much more valuable gold, gulder notes eventually exceeded their stated silver value. Laughlin's theory seemed to be borne out by the facts--the value of orphaned notes was dictated by their future potential redeemability.
*** From A History of the Greenbacks (1903), by Wesley Clair Mitchell
**** Mubarak refers to this instrument as the Na' Shilling.