Free Banking and the Friedman Rule

Imagine that there are two types of people in the world — recognizable and unrecognizable. Recognizable people can develop reputations, which can have either positive or negative effects. If a recognizable person develops a reputation for being trustworthy, then he or she will likely be able to issue debt to finance the purchase of goods and services. If the person is not trustworthy, but is easily recognized, then he or she will not be able to issue debt. All else equal, people who are recognizable will have an incentive to be trustworthy so that they can issue IOUs to pay for stuff. People who are not recognizable don’t have the same incentives. Since nobody can recognize them, they will never be able to issue IOUs.

Let’s think about this in the context of general equilibrium theory (without a Walrasian auctioneer and without any exogenously specified thing called “money”). In the absence of some auctioneer to price and distribute goods and in the absence of money, people must meet with every other person in the market to determine whether trade is possible. Recognizable people will be able to issue IOUs in order to trade as long as they are trustworthy and there is a mechanism to punish them if they do not repay their debts (e.g., exclude them to a world of autarky if they don’t repay their debts). But how can the non-recognizable people trade? Well, they could sell their goods to recognizable people in exchange for an IOU, but then all they have is an IOU. And what exactly does the IOU provide?

Assuming that each recognizable person can produce some good, the IOU would represent a promise to produce some quantity of the good in the future. A non-recognizable person could then present the IOU for this good at some future date or the person could turn around and use this IOU to purchase some other good. The seller in this circumstance would be willing to accept a third party IOU if (a) they want the good that IOU promises, or (b) they think they can pass on the IOU to someone else. Whether or not condition (b) is satisfied depends on the good the IOU-issuer is promising. Ultimately, what happens in this scenario is that certain goods will be found to satisfy condition (b) and those IOUs will start to circulate as a medium of exchange.

What this example resembles is a sort of free banking regime. People with good reputations are able to issue IOUs that can end up circulating like bank notes — these are banks. Eventually an IOU can be redeemed by whoever is holding it for some fixed quantity of a good that the IOU-issuer promised.

This implies that there is a key feature of free banking regimes. In actual free banking regimes, bank notes could be redeemed for one particular good, gold. The value of one bank note, consistent with our example, was defined as a particular quantity of gold. This implies that the price of gold in terms of bank notes is necessarily fixed. However, the relative price of gold to an index of all other prices is not fixed. In a growing economy, under these conditions, prices would decline on average with increases in productivity. As a result, the promise to pay a fixed amount of gold at a future date would actually entail a positive rate of return.

Thus, under a free banking regime, if (1) productivity is growing, (2) the decline in prices due to rising productivity completely offset the real interest rate, then a free banking regime naturally reproduces the Friedman rule.

Some Myths About Interest on Reserves

There are two myths that I see repeated about interest on reserves that I would like to address:

1. “Of course the banking system is holding more reserves. They have no choice. The quantity of reserves is set by the Federal Reserve.”

That last sentence is correct. However, the relevant question is why banks are holding these reserves as excess reserves rather than as required reserves.

The typical way that we teach students about open market operations is as follows. Suppose that each component of the bank’s balance sheet is consistent with profit-maximization given a binding reserve requirement. The central bank conducts open market operations by buying bonds from the bank and crediting the reserve account of the bank. The bank now finds itself holding excess reserves. If the central bank is not paying interest on reserves, this is costly for the bank since it is now holding more reserves than it would prefer. As a result, the bank would lend out these excess reserves. What follows is the process of multiple deposit creation. When this process concludes, the quantity of reserves in the system will not have changed, but since the reserve requirement is binding, no bank will be holding excess reserves. Each bank is holding the required amount of reserves.

To say that banks are holding excess reserves because they have no other choice is therefore incorrect. While it is true that banks must hold the quantity of reserves determined by the Federal Reserve, their decision-making will determine whether they hold these reserves as excess reserves or required reserves. If banks are holding excess reserves, this implies that there is no operative mechanism of deposit creation. We might want to ask ourselves why this is the case.

On this point, Dutkowsky and VanHoose have written an excellent paper that looks at the profit-maximizing behavior of banks. Their model provides for the possibility of three different equilibria: (1) an interior solution in which banks hold excess reserves and participated in the wholesale loan market, (2) an equilibrium in which banks participate in the wholesale loan (fed funds) market, but do not hold excess reserves, and (3) an equilibrium in which banks hold excess reserves, but do not participate in the wholesale loan (fed funds) market.

What they show is the equilibria that we end up in depends critically on the relationship between the interest rate on excess reserves and the fed funds rate. In particular, they show that the interior solution equilibrium is operable under very narrow restrictions on the relationship between rates. In other words, we tend to either be in an equilibrium in which there are no excess reserves OR in an equilibrium in which there is no wholesale lending. While it is slightly more complicated than this, a general rule-of-thumb from my reading of the paper is that if the interest rate on reserves is higher than the fed funds rate, then this results in an equilibrium in which banks hold excess reserves and do not participate in the wholesale loan market.

The interest rate on reserves has been higher than the fed funds rate since 2009. Dutkowsky and VanHoose show a corresponding precipitous decline in interbank lending that has taken place in the period since.

Why is this important?

Typically banks are not willing to hold excess reserves because doing so is costly. In fact, if the required reserves constraint is binding, then banks will never want to hold excess reserves because they do not even want to hold the required amount. However, if banks are willing to hold excess reserves, then this process of multiple deposit creation will not be operable — or at least not to the extent that it would be traditionally.

This leads me to the second myth about interest on reserves.

2. “Interest on reserves gives the central bank flexibility to provide liquidity without sacrificing its ability to conduct monetary policy.”

The idea behind this statement is that when the central bank pays interest on reserves, banks are willing to hold more reserves which helps to better facilitate payments and provide liquidity to the banking system. At the same time, or so the argument goes, the interest rate on reserves becomes the relevant policy interest rate. As a result, by paying interest on reserves, the central bank can increase the amount of reserves in the system, streamline the payment process, provide liquidity, and still conduct monetary policy as it normally does.

This argument, however, presumes that the monetary policy works solely through the short term interest rate. However, monetarists like Friedman and Schwartz and Brunner and Meltzer, argued that monetary policy worked through open market operations by adjusting the relative supply of assets. This change in the composition of assets required changes in relative prices since assets are not all perfect substitutes. The process of relative price adjustment continues until everyone is satisfied with their new portfolio. For example, consider Friedman and Schwartz’s description of the monetary transmission mechanism in their paper “Money and Business Cycles”:

Let us now suppose that an unexpected rise to a new level occurs in the rate of change in the money stock, and it remains there indefinitely…To be definite, therefore, let us suppose it comes from an increased rate of open market purchases by a central bank.

Although the initial sellers of the securities purchased by the central bank were willing sellers, this does not mean that they want to hold the proceeds in money indefinitely. The bank offered them a good price, so they sold; they added to their money balances as a temporary step in rearranging their portfolios. If the seller was a commercial bank, it now has larger reserves than it has regarded before as sufficient and will seek to expand its investments and its loans at a greater rate than before. If the seller was not a commercial bank, he is not likely even temporarily to want to hold the proceeds in currency but will deposit them in a commercial bank, thereby, in our fractional reserve system, adding to the bank’s reserves relative to its deposits. In either case, therefore, in our system, commercial banks become more liquid. In the second case, in addition, the nonbank sellers has a higher ratio of money in his portfolio that he has had hitherto.

Both the nonbank seller and commercial banks will therefore seek to readjust their portfolios, the only difference being that the commercial banks will in the process create more money, thereby transmitting the increase in high-powered money to the total money stock…

They go on to explain that this portfolio reallocation will result in changes in relative prices and ultimately economic activity until equilibrium is restored.

Similarly, Ben Bernanke has described the monetary transmission mechanism as follows:

I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public.

Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

The logic of the portfolio balance channel implies that the degree of accommodation delivered by the Federal Reserve’s securities purchase program is determined primarily by the quantity and mix of securities the central bank holds or is anticipated to hold at a point in time (the “stock view”), rather than by the current pace of new purchases (the “flow view”). In support of the stock view, the cessation of the Federal Reserve’s purchases of agency securities at the end of the first quarter of this year seems to have had only negligible effects on longer-term rates and spreads.

Implicit in these discussion is that there isn’t one particular asset price that matters for transmitted monetary policy. Rather, what matters are the relative quantities of the assets and the relative price adjustment necessary to get to an equilibrium in which everyone is satisfied with their portfolio.

If Bernanke and the monetarists are correct, then the change in the Federal Reserve’s operating procedures should give one pause about the ability of monetary policy to continue unaffected in a world of interest on reserves. Dutkowsky and VanHoose’s model suggests that open market operations should largely be irrelevant because we are currently in an equilibrium in which the interest rate on reserves is higher than the fed funds rate. As a result, banks are likely to hold excess reserves rather than engage in portfolio reallocation. Thus, one must rely on “the” short term nominal interest rate, in this case the interest rate on reserves, to influence economic activity. Whether or not this mechanism is sufficient depends on the sensitivity of macroeconomic variables to the short term interest rate. The empirical evidence suggests that the responsiveness of things like investment to interest rates is actually quite weak. As a result, there is some reason for concern about the ability of monetary policy to work as it normally does.

The Bullionist Controversy

My paper entitled, “The Bullionist Controversy: Theory and New Evidence” has been accepted at the Journal of Money, Credit, and Banking. Here is the abstract:

The Bullionist Controversy in the United Kingdom is one of the first debates about the determination of the price level and the exchange rate under a paper money standard. Despite the importance of the debate in the development of monetary theory, there remains little empirical evidence that uses modern, multivariate time series techniques. The evidence that does exist provides support for the Anti-Bullionist position. The purpose of this paper is to review the debate and develop a dynamic general equilibrium model that is capable of capturing key features of the 19th-century British financial system. The model is estimated using Bayesian procedures to test the competing hypotheses. The paper provides support for the Bullionist position.

On Why It is Important to Distinguish Between Consumption and Expenditures When Testing the Permanent Income Hypothesis

A central idea in modern macroeconomics is the permanent income hypothesis. The basic idea is as follows. Suppose that you could dichotomize your income into a permanent component and a temporary component. The permanent income hypothesis suggests that you would base your consumption decisions on the permanent component.

Why would people behave this way?

Well, individuals want to smooth the marginal utility of their consumption over time. To understand this, consider the following example. Suppose that you varied your consumption proportionately with your current income and that your income fluctuated significantly from year to year. This would imply that your consumption would be high in years when your income was high and low in years when your income was low. However, if consumption is subject to diminishing marginal utility, this would mean that the marginal utility of consumption in high income years is less than the marginal utility of consumption in low income years. So wouldn’t it be nice to take some consumption from your high income years (when the marginal utility is low) and transfer it to the low income years (when the marginal utility is high)? Yes, because your lifetime utility would be higher. Fortunately, you can do this by adjusting your savings behavior in response to temporary fluctuations in your income over time (note that this includes borrowing behavior, which is just negative savings).

So this sounds reasonable, but it is important to think about why the permanent income hypothesis might not hold.

Given our discussion, one obvious reason pops up. What if some fraction of consumers are subject to credit constraints (i.e. either limits or lack of access to borrowing). Individuals who face borrowing constraints might find themselves unable to borrow following a reduction in their income. If this is true, individuals might not always be able to smooth the marginal utility of their consumption over time.

Some have posited other, “behavioral” reasons why the permanent income hypothesis might not hold. For example, maybe people are myopic and don’t plan adequately for the future.

So how do we know if the permanent income hypothesis is a good guide in thinking about consumption decisions? Well, we have to go to the data.

Now suppose that you wanted to test the implications of the permanent income hypothesis. There are a number of ways you might do this. You might test the cross-sectional predictions of the model outlined by Milton Friedman. You might try to estimate consumption Euler equations with aggregate data. Or you might find identify periods of time in which people experience a significant decline in income and see what happens to their consumption behavior.

The evidence testing Friedman’s predictions with cross-sectional data seem to support the permanent income hypothesis. Estimates of the consumption Euler equation do not. (However, as John Seater points out, this is likely due to problems with aggregation and not the theory itself since aggregation imposes pretty strong implicit assumptions about households.) Finally, the work focusing on periods of significant declines in income seems to show a corresponding significant decline in consumption. It is this last bit of evidence that I want to discuss in more detail.

If you notice that consumption declines significantly after a person becomes unemployed or after they retire, this would seem to provide evidence against the permanent income hypothesis. The unemployed worker should be spending out of his savings or borrowing until he finds a new job. The retired person should have planned better for the future.

The problem with this assessment is that whether or not the permanent income hypothesis holds depends on consumption behavior. In reality, most of our data on consumption is typically consumption expenditures. It is important to understand the difference.

To understand why it is important to distinguish between consumption and expenditures, consider the following example. Suppose that I am interested in food consumption. How should I measure food consumption? I could measure food consumption by how much I spend on food. I could also measure food consumption by the number of calories I eat. This might not seem like an important difference, but it can be quite important.

Imagine that I can eat the same exact meal at home as I can at a restaurant. If I eat it at the restaurant, then my expenditures are equal to the market price of the meal. If I eat it at home, my expenditures are the cost of the ingredients. The latter should be less than the former. In addition, the degree to which the latter are less than the former will depend on how much time I spend shopping for the lowest prices of those ingredients. Nonetheless, despite the difference in expenditures, my food consumption is the same (by definition, it’s the same meal).

So why is this distinction important?

Think about people who become unemployed or people who retire. What they have in common is that they have more time than they had when they were working. The opportunity cost of their time has fallen. As a result, those who are unemployed and those who are retired are likely to spend more of their time cooking than they would if they were working. They are also likely to spend more time searching for better prices on the ingredients to make their meal than they would if they were working. The result is that the individual will spend more time on what economists call “home production” (and therefore home consumption) while reducing market expenditures.

This is important for the following reason. There is a difference between expenditures and consumption. Expenditures are simply the subset of consumption that occurs in a market setting.

So how significant is this distinction?

It turns out that this distinction is quite important. Mark Aguiar and Erik Hurst have a paper in the Journal of Political Economy that uses a cool data set that consists of food diaries of U.S. households. What the paper shows is that neither the quality nor quantity of food intake by retired households decline after retirement. In addition, they find that the food intake of unemployed workers does decline, but only as much as one would predict from the decline in permanent income typical of being displaced for some period of time from one’s job. In other words, if one considers the role of home production, then the evidence of a significant decline in expenditures following retirement or job displacement should not be interpreted as evidence against the permanent income hypothesis. Relying on expenditure data to measure consumption might cause one to incorrectly reject the permanent income hypothesis.

What does this mean for economists and their models?

First, as more and more micro-level data becomes available, it is important to consider whether one has the correct measure of the variable of interest before embarking on hypothesis testing. Second, this result seems to imply that if you are going to take a model to the data and you use standard measures of consumption expenditures, the model should include home production in the household decision. Otherwise, what the researcher is calling consumption and how consumption is calculated are not consistent.

Are Helicopter Drops a Fiscal Operation?

This is meant to be a quick note on what I think is a common misconception about helicopter drops. I am not advocating that the Federal Reserve or any other central bank undertake the actions I am going to describe nor do I care about whether it is legal for the Federal Reserve or any other central bank. All I am concerned with is helicopter drops on a theoretical level. With that being said, let me get to what I believe is a misconception.

First, some context. Typically, when the Federal Reserve wants to increase the money supply, they buy assets on the open market in exchange for bank reserves. These are called open market operations. One potential problem is that the Federal Reserve is typically purchasing short-term government debt. When short term nominal interest rates are near the zero lower bound, many believe that open market operations are impotent since the central bank is exchanging one asset that does not bear interest for another asset that does not bear interest. Banks are indifferent between the two. The exchange has no meaningful effect on economic activity.

Given this problem, some have advocated a “helicopter drop” of money. Typically, they don’t mean an actual helicopter flies overhead dropping currency from the sky. What they are referring to is something like the following. Suppose that the U.S. Treasury sends a check to everyone in the United States for $100 and issues bonds to pay for it. The Federal Reserve then buys all of these bonds and holds them to maturity. This is effectively a money-financed tax rebate. Thus, it resembles a helicopter drop because everyone gets $100, which was paid for by an expansion of the money supply. However, many people are quick to point out that this is actually a fiscal operation. The U.S. government is giving everyone a check and the Federal Reserve is simply monetizing the debt.

But are helicopter drops really a fiscal operation? Certainly if we think about helicopter drops as I have described them above, it is correct to note that such action requires monetary-fiscal cooperation. However, let’s consider an alternative scenario.

The Federal Reserve has a balance sheet just like any other bank. The Fed classifies things on their balance sheet into 3 categories:

1. Assets. Assets include loans to banks, securities held, foreign currency, gold certificates, SDRs, etc.
2. Liabilities. Liabilities include currency in circulation, bank reserves, repurchase agreements, etc.
3. Capital.

The balance sheet constraint is given as

Assets = Liabilities + Capital

Let’s consider how things change on the balance sheet. Suppose that the Fed took large losses on the Maiden Lane securities purchased during the financial crisis. What would happen? Well, the value of the Fed’s assets would decline. However, the liabilities owed by the Fed would not change. Thus, for the balance sheet to remain in balance, the value of the Fed’s capital would have to decline.

So imagine the following scenario. We all wake up one morning to discover that actual helicopters are lifting off from the rooftops of regional Federal Reserve banks. The helicopters fly through each region dropping currency from the sky. People walk out of their homes and businesses and see money raining down upon them. They quickly scoop up the money and shovel it into their pockets. It is a literal helicopter drop of money!

But how can this be? How could the central bank do such a thing?

If the central bank were to do such a thing, think about what would happen to its balance sheet. Currency in circulation increases thereby increasing Fed liabilities. However, asset values are still the same. So capital declines. (The latest Fed balance sheet suggests that the Fed has $10 billion in surplus capital. This would decline dollar-for-dollar with the increase in the supply of currency.)

What this implies is that a central bank could (in theory) conduct a helicopter drop by effectively reducing its net worth. In the future, the Federal Reserve could restore its capital by reinvesting its earnings into new assets. Thus, the helicopter drop is a form of direct transfer to the public that is paid for by the Fed’s future earnings.

[Now, some of you might be saying, “Ah ha! If the Fed is retaining earnings these are earnings that would have otherwise gone to the Treasury and so it is still a fiscal operation.” I would argue that (a) this is semantics, and (b) there is no reason to believe this is true. The Fed, for example, could simply have used those earnings to furnish new offices at the Board and all of the regional banks — in that case it would be a transfer of wealth from the staff to the general public.]

Money and Banking

You might be able to teach an entire course on the microeconomics of money and banking based on the following thought experiment.

Imagine the following scenario. I want to start a business, but I need to borrow $10,000 to get started. You offer to provide me with that $10,000. However, since you won’t get to consume using that $10,000 and you won’t get to invest that $10,000 in anything else you require that I pay you some interest. I give you a piece of paper that promises to pay you back, with interest, at some future date in time. Intrinsically, that piece of paper that I have given you is worthless. It is just a piece of paper. However, if that piece of paper represents a legally binding agreement, then we call that piece of paper a bond. You are willing to accept that piece of paper from me because you anticipate that I am going to do something productive with your money. In the event that I don’t, you will be entitled to the assets of my business. So, the value of the bond is the expected value of the bond over the duration of the loan plus the value of the option to seize my assets in the event that I cannot/do not pay you back. Now, of course, there is some chance that between now and when I have promised to pay you back you will want to spend money. As a result, a market emerges that allows you to sell this piece of paper to other people.

Now imagine the following alternative scenario. Suppose that you want to save, but you don’t want to deal with trying to figure out how to invest that savings. Fortunately, we have a mutual friend who likes to do this sort of thing. So you give your $10,000 to our friend and he promises to give you your money back plus some interest payment. I also make a visit to our mutual friend, but I ask him to borrow $10,000. He agrees to lend me $10,000, but I have to pay him back with interest (slightly higher than what he is offering you). Since our mutual friend knows that you might need cash for unexpected expenditures in the future, he promises to give you the right to show up and demand your $10,000 (or some fraction thereof) at any moment you want. Thus, to our mutual friend, the value of the loan is the expected value of the loan over the duration agreed upon plus the expected value of the option to seize my assets in the event that I cannot/do not pay him back. The value of the contract for you is the expected value of the loan that you have given our mutual friend plus the value of the option to get your $10,000 back whenever you want plus the value of the option to seize the assets of our mutual friend in the event that the value of his assets decline below what he owes you.

What is the difference between these two scenarios?

Some would say that in the latter scenario the problem is that our mutual friend is offering to give you dollars that he himself does not have to give. Thus, he is “creating dollars out of thin air.” In fact, if he doesn’t have actual dollars, he might give you a piece of paper that promises to give you those dollars in the future. If you are able to trade these pieces of paper in exchange for goods and services, it would appear as though our mutual friend has really created money out of thin air. But has he really? Or is he merely allowing you to transfer some fraction of what he owes you to another individual?

Why might people be willing to accept these pieces of paper printed by our mutual friend and use them in transactions?

Replace “$10,000” with “7.5 ounces of gold.” Do your answers to these questions change?

Reasoning from Interest Rates

A quick note…

We can think of long-term yields as consisting of two components, the average expected future short-term rate and the term premium. However, it is important to note that the average expected future short-term rate itself is a function of the rate of time preference, expectations of future growth, and expectations of inflation. Also, the term premium is a function of duration risk, a liquidity premium, and a safety premium.

So suppose that you see long-term yields change, what can you learn about the stance of monetary policy?