Notes from an inter-planetary monetary anthropologist

My work as an inter-planetary monetary anthropologist has brought me to dozens of different planets to study their monetary systems. The monetary system of the most recent planet that I visited, the planet of Zed in the Xv2 galaxy, falls into the same classification as the systems on Vigil X and Earth (which I last visited in 1998 and, according to other anthropologists, hasn't changed much).

As on Earth, markets on Zed tend to lie towards the free end of the spectrum. Zedians can own property. And property rights are enforced. Zedians often put their savings in institutions much like banks and earn interest. Banks in turn lend to individuals and business.

However, one of the oddities of the planet of Zed is that its inhabitants universally adhere to an economic religion, Zodlism. One of the strictures of Zodlism is that all monetary instruments must yield at least 2% interest. Even a transactional account, say like Earth's checking accounts, must offer the account holder a minimum 2% per annum.

This requirement is based on the Zodlist stricture that anyone who is temporarily deprived of an object to the benefit of someone else deserves a minimum reward for their sacrifice. Banks that fail to meet the 2% requirement risk censure from the planetary religious organism, the Zodl Council, and ostracism by customers. (For a full account of Zodlist economic doctrine, see Smith & Elf33, pgs 450-512).

Interestingly, banknotes (which on Zed are issued by all sorts of different institutions and individuals, unlike Earth which confines that role to central banks) also pay 2% interest. Each note has a sensor in it that records how much interest the note has accrued. Any Zedian can access unpaid balances by uploading them to their account or claiming them at a trading post when making a purchase. Zed is a little further ahead than Earth in this respect, which still hasn't bothered digitizing its banknotes.

While I was visiting Zed, the planet's economy was facing an unprecedented economic slowdown. With optimism sapped, borrowing on Zed had been plummeting. Zedians were simply too afraid about the future to take out loans to fund business expansion or enlarge their underground shelters. In response to this decline in loan demand, bankers had been trying to make loans more attractive to the Zedian public by pushing lending rates ever closer towards 2%. 

Bankers have even been entertaining the revolutionary idea of lending at rates below 2%, say to 1.5%.

This would leave Zedian banks and note issuers in an odd position. If they only earn 1.5% from borrowers while paying depositors the obligated 2%, banks would be effectively paying out more than they receive in interest. But this is the opposite of what banks are supposed to do! They would soon go out of business. (Any Zedian could make a risk-free profit by taking out a bank loan at 1.5% and depositing those funds at the bank to earn 2%.)

Pressure is building on Zed's religious leaders to alter the 2% rule. Some moderate Zodlists have proposed that a ceremonial 2% rate continue to be paid to depositors and banknote owners, but a fee be levied to claw back a part of the interest. So that if someone is paid 2 Zed in interest, the bank or banknote issuer will take back about half that in fees, ie. 1 Zed. This would allow issuers to 'synthesize' an interest rate of 1% while still conforming to the letter of Zodlism. Once this change is implemented, banks would be able to safely lend at 1.5% or so.

These pragmatists argue that at 2% per annum, borrowing it just too expensive for most people. The planet requires an interest rate of 1.5% if lenders are to be successful in luring the public back into taking on loans. They further argue that when would-be borrowers are priced out of the market, the downturn is exacerbated and prolonged. But strict Zodlists refuse to budge. The idea of earning just 1% on banknotes appalls them. "It's unnatural!" they cry.

The debate certainly reminds me of my time on Earth. Historically, Earth's religions also set limits on interest rates. But whereas Zodlism dictates a minimum interest rate on deposits, Earth tended to set a maximum rate on loans. These rules were referred to as usury laws. Perhaps Zed could learn from its distant planet, since Earth (or at least parts of it) saw it fit to end usury laws long ago. I feel like this softening is likely to happen. In their survey of 450 planetary monetary systems, LeGuin & Xsszym find that law and religious practices tend to bend to planetary economic exigencies. 

Unfortunately, I never saw the resolution to Zed's 2% debate. My ship had arrived to take me to the next planet. Perhaps I can come back one day to see if Zedians have solved the problem.

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Addendum: In 2019 I returned for a quick return visit to Earth. Who would have guessed, but they are facing many of the same problems that Zed is experiencing!

Kocherlakota on cash

Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:

I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.

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P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.

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.