How to evaluate “central banking for all” proposals

The first question to ask regarding proposals to expand the role of the central bank in the monetary system is the payroll question: How is the payroll of a new small business that grows, for example, greenhouse crops that have an 8 week life cycle handled in this environment? For this example let’s assume the owner had enough capital to get the all the infrastructure of the business set up, but not enough to make a payroll of say $10,000 to keep the greenhouse in operation before any product can be sold.

Currently the opening of a small business account by a proprietor with a solid credit record will typically generate a solicitation to open an overdraft related to the account. Thus, it will in many cases be an easy matter for the small business to get the $10,000 loan to go into operation. Assuming the business is a success and produces regular revenues, it is also likely to be easy to get bank loans to fund slow expansion. (Note the business owner will most likely have to take personal liability for the loans.)

Thus, the first thing to ask about any of these policy proposals is: when a bank makes this sort of a loan how can it be funded?

In the most extreme proposals, the bank has to have raised funds in the form of equity or long-term debt before it can lend at all. This is such a dramatic change to our system that it’s hard to believe that the same level of credit that is available now to small business will be available in the new system.

Several proposals (including Ricks et al. – full disclosure: I have not read the paper) get around this problem by allowing banks to fund their lending by borrowing from the central bank. This immediately raises two questions:

(i) How is eligibility to borrow at the central bank determined? If it’s the same set of banks that are eligible to earn interest on reserves now, isn’t this just a transfer of the benefits of banking to a different locus. As long as the policy is not one of “central bank loans for all,” the proposal is clearly still one of two-tier access to the central bank.

(ii) What are the criteria for lending by the central bank? Notice that this necessarily involves much more “hands on” lending than we have in the current system, precisely because the central bank funds these loans itself. In the current system (or more precisely in the system pre-2008 when reserves were scarce), the central bank provides an appropriate (and adjustable) supply of reserves and allows the banks to lend to each other on the Federal Funds market. Thus, in this system the central bank outsources the actual lending decisions to the private sector, allowing market forces to play a role in lending decisions.

Overall, proposals in which the central bank will be lending directly to banks to fund their loans create a situation where monetary policy is being implemented by what used to be called “qualitative policy.” After all if the central bank simply offers unlimited, unsecured loans at a given interest rate to eligible borrowers, such a policy seems certain to be abused by somebody. So the central bank is either going to have to define eligible collateral, eligible (and demonstrable) uses of the funds, or some other explicit criteria for what type of loans are funded. This is a much more interventionist central bank policy than we are used to, and it is far from clear that central banks have the skills to do this well. (Indeed, Gabor & Ban (2015) argue that the ECB post-crisis set up a catastrophically bad collateral framework.)

Now if I understand the Ricks et al. proposal properly (which again I have not read), their solution to this criticism is to say, well, we don’t need to go immediately to full-bore central banking for all, we can simply offer central bank accounts as a public option and let the market decide.

This is what I think will happen in the hybrid system. Just as the growth of MMMFs in the 80s led to growth of financial commercial paper and repos to finance bank lending, so this public option will force the central bank to actively operate its lending window to finance bank loans. Now we have two competing systems, one is the old system of retail and wholesale banking funding, the other is the central bank lending policy.

The question then is: Do federal regulators have the skillset to get the rules right, so that destabilizing forces don’t build up in this system? I would analogize to the last time we set up a system of alternative funding for banks (the MMMF system) and expect regulators to set up something that is temporarily stable and capable of operating for a decade or two, before a fundamental regulatory flaw is exposed and it all comes apart in a terrifying crash. The last time we were lucky, as regulatory ingenuity and legal duct tape held the system together. In this new scenario, the central bank, instead of sitting somewhat above the fray will sit at the dead center of the crisis and may have a harder time garnering support to save the system.

And then, of course, all “let the market decide” arguments are a form of the “competition is good” fallacy. In my view, before claiming that “competition is good,” one must make a prior demonstration that the regulatory structure is such that competition will not lead to a race to the bottom. Given our current circumstances where, for example, the regulator created by the Dodd-Frank Act to deal with fraud and near-fraud is currently being hamstrung, there is abundant reason to believe that the regulatory structure of the financial system is inadequate. Thus, appeals to a public option as a form of healthy competition in the financial system as it is currently regulated are not convincing.

Advertisements

When can banks create their own capital?

A commenter directed me to an excellent article by Richard Werner comparing three different approaches to banking. The first two are commonly found in the economics literature, and the third is the credit creation theory of banking. Werner’s article provides a very good analysis of the three approaches, and weighs in heavily in favor of the credit creation theory.

Werner points out that when regulators use the wrong model, they inadvertently allow banks to do things that they should not be allowed to do. More precisely, Werner finds that when regulators try to impose capital constraints on banks without understanding how banks function, they leave open the possibility that the banks find a way to create capital “out of thin air,” which clearly is not the regulator’s intent.

In this post I want to point out that Werner does not give the best example of how banks can sometimes create their own capital. I offer two more examples of how banks created their own capital in the years leading up to the crisis.

1. The SIVs that blew up in 2007

You may remember Hank Paulson running around Europe in the early fall of 2007 trying to drum up support for something called the Master Liquidity Enhancement Conduit (MLEC) or more simply the Super-SIV. He was trying to address the problem that structured vehicles called SIVs were blowing up left, right, and center at the time.

These vehicles were essentially ways for banks to create capital.  Here’s how:

According to a Bear Stearns report at the time, 43% of the assets in the SIVs were bank debt, and commentators a the time make it clear that the kind of bank debt in the SIVs was a special kind of debt that was acceptable as capital for the purposes of bank capital requirements because of the strong rights given to the issuer to forgo making interest payments on the debt.

The liability side of a SIV was comprised of 4-6% equity and the rest senior liabilities, Medium Term Notes (MTNs) of a few years maturity and Commercial Paper (CP) that had to be refinanced every few months. Obviously SIVs had roll-over (or liquidity) risk, since their assets were much longer than their liabilities. The rating agencies addressed this roll-over risk by requiring the SIVs to have access to a liquidity facility provided by  a bank. More precisely the reason a SIV shadow bank was allowed to exist was because there was a highly rated traditional bank that had a contractual commitment to provide funds to the SIV on a same-day basis in the event that the liquidity risk was realized. Furthermore, triggers in the structured vehicle’s paperwork required it to go into wind down mode if, for example, the value of its assets fell below a certain threshold. All the SIVs breached their triggers in Fall 2007.

Those with an understanding of the credit creation theory of banking would recognize immediately that the “liquidity facility” provided by the traditional bank was a classic way for a bank to transform the SIV’s liabilities into monetary assets. That’s why money market funds and others seeking very liquid assets were willing to hold SIV CP and MTNs. In short, a basic understanding of an SIV asset and liability structure and of the banks’ relationship to it would have been a red flag to a regulator conversant with the credit creation theory that banks were literally creating their own capital.

2. The pre-2007 US Federal Home Loan Bank (FHLB) System

In the early naughties all of the FHLBs revised their capital plans. For someone with an understanding of the credit creation theory, these capital plans were clearly consistent with virtually unlimited finance of mortgages.

The FHLBs form a system with a single regulator and together offer a joint guarantee of all FHLB liabilities. The FHLB system is one of the “agencies” that can easily raise money at low cost on public debt markets. Each FHLB covers a specific region of the country and is cooperatively owned by its member banks. In 2007 every major bank in the US was a member of the FHLB system. As a result, FHLB debt was effectively guaranteed by the whole of the US banking system. Once again using the credit creation theory, we find that the bank guarantee converted FHLB liabilities into monetary assets.

The basic structure of the FHLBs support of the mortgage market was this (note that I will frequently use the past tense, because I haven’t looked up what the current capital structure is and believe that it has changed):

The FHLBs faced a 4% capital requirement on their loans. Using the Atlanta FHLB’s capital plan as an example, we find that whenever a member bank borrowed from the Atlanta FHL bank, it was required to increase its capital contribution by 4.5% of the loan. This guaranteed that the Atlanta FHL bank could never fall foul of its 4% capital requirement — and that there was a virtually unlimited supply of funds available to finance mortgages in the US.

The only constraint exercised by FHLBs on this system was that they would not lend for the full value of any mortgage. Agency MBS faced a 5% haircut, private label MBS faced a minimum 10% haircut, and individual mortgages faced higher haircuts.

In short, the FHLB system was designed to make it possible for the FHLBs to be lenders of last resort to mortgage lenders. As long as a member bank’s assets were mortgages that qualified for FHL bank loans, credit was available for a bank that was in trouble.

The system was designed in the 1930s — by people who understood the credit creation theory of banking — to deliberately exclude commercial banks which financed commercial activity and whose last-resort lender was the Federal Reserve. Only when the FIRRE Act in 1989 was passed subsequent to the Savings and Loan crisis were commercial banks permitted to become FHLB members.

From a credit creation theory perspective this major shift in US bank regulation ensured that the full credit creation capacity of the commercial banking system was united with the US mortgage lending system making it possible for the FHLBs to create their own capital and use it to provide virtually unlimited funds to finance mortgage lending in the US.

 

Access to Credit is the Key to a Win-Win Economy

Matt Klein directs our attention to an exchange between Jason Furman and Dani Rodrik that took place at the “Rethinking Macroeconomic Policy” Conference. Both argued that, while economists tend to focus on efficiency gains or “growing the pie”, most policy proposals have a small or tiny efficiency effect and a much much larger distributional effect. Matt Klein points out that in a world like this political competition for resources can get ugly fast.

I would like to propose that one of the reasons we are in this situation is that we have rolled back too much of a centuries-old legal structure that used to promote fairness — and therefore efficiency — in the financial sector.

Adam Tooze discusses 19th century macro in follow up to Klein’s post:

Right the way back to the birth of modern macroeconomics in the late 19th century, the promise of productivist national economic policy was that one could suspend debate about distribution in favor of “growing the pie”.

In Britain where this approach had its origins, access to bank credit was extremely widespread (at least for those with Y chromosomes). While the debt was typically short-term, it was also the case that typically even as one bill was paid off, another was originated. Such debt wasn’t just generally available, it was usually available at rates of 5% per annum or less. No collateral was required to access the system of bank credit, though newcomers to the system typically had to have 1 or 2 people vouch for them.

I’ve just completed a paper that argues that this kind of bank credit is essential to the efficiency of the economy. While it’s true that in the US discrimination has long prevented certain groups from having equal access to financial services — and that the consequences of this discrimination show up in current wealth statistics, it seems to me that one of the disparities that has become more exaggerated across classes over the past few decades is access to lines of credit.

The facts are a harder to establish than they should be, because as far as I can tell the collection of business lending data in the bank call reports has never carefully distinguished between loans secured by collateral other than real estate and loans that are unsecured. (Please let me know if I’m wrong and there is somewhere to find this data.) In the early years of the 20th century, the “commercial and industrial loans” category would I believe have comprised mostly unsecured loans. Today not only has the C&I category shrunk as a fraction of total bank loans, but given current bank practices it seems likely that the fraction of unsecured loans within the category has also shrunk.

This is just a long form way of stating that it appears that the availability of cheap unsecured credit to small and medium sized business has declined significantly from what it was back when early economists were arguing that we could focus on efficiency and not distribution. Today small business credit is far more collateral-dependent than it was in the past — with the exception of course of credit card debt. Charge cards, however, charge more than 19% per annum for a three-month loan which is about a 300% markup on what would have been charged to an unsecured business borrower in the 19th century. To the degree that it is collateralized credit that is easily available today, it will obviously favor the wealthy and aggravate distributional issues.

In my paper the banking system makes it possible for allocative efficiency to be achieved, because everybody has access to credit on the same terms. As I explained in an earlier post, in an economy with monetary frictions there is no good substitute for credit. For this reason it seems obvious that an economy with unequal access to short term bank credit will result in allocations that are bounded away from an efficient allocation. In short, in the models with monetary frictions that I’m used to working with equal access to credit is a prerequisite for efficiency.

If we want to return to a world where economics is win-win, we need a thorough restructuring of the financial sector, so that access to credit is much more equal than it is today.

Equity financed banking is inefficient

I see that Tyler Cowen and John Cochrane are having an exchange about banking. First, Cowen expresses a nuanced view of banking, then Cochrane takes the opportunity to promote his narrow (aka equity-financed) banking proposal, and Cowen questions how successful equity-financed is likely to be in practice.

With my latest paper, I have something different to contribute to the discussion: a model of how banking — and the leverage of banks — promotes efficiency. From a macro perspective the argument is really very simple: we all know from the intertemporal Euler equation that it is optimal for everyone to short a non-interest bearing safe asset. (The Friedman Rule is just an expression of this fact.) The point of my paper is that we should understand banking as the institutionalization of a naked short of the unit of account.

How is this efficiency-enhancing? A naked short position requires you to sell something that you do not have. It is a means of creating a temporary “phantom” supply of what is sold, until such time as the short position is closed out. The Euler equation tells us that a “phantom” supply that supports short positions is exactly what the economy needs to achieve intertemporal allocative efficiency.

Of course, the problem with a naked short position is that if a short squeeze (aka bank run) forces the closure of the positions too early, bankruptcy will be the result. The paper is a careful study of what is necessary to make this role of the banking system incentive feasible, and finds (alongside many other studies) that competitive banking is inherently unstable. Two means of stabilizing banking in the context of the model are (i) the natural monopoly approach: permit a non-competitive industry structure, but regulate what banks can charge; or (ii) the central bank approach: set a lower bound on the interest rate banks can charge.

So I don’t think that Cowen really captures what banks do when he presents “transforming otherwise somewhat illiquid activities into liquid deposits” as the primary liquidity function of banks. In my model banks promote allocative efficiency by creating “phantom” units of account. But I think Cowen does capture a lot of the regulatory complexity that is created by the liquidity function of banks.

Cochrane is the one, whom I really think is working from the wrong model. I’ll go through his points one by one.

1) We’re awash in government debt.

So what. Unless the government is going to start guaranteeing private sector naked short positions in government debt, it doesn’t matter how government debt we have, because it will do nothing to solve the monetary problem. We need banks because they do make possible for the private sector in aggregate to support a naked short position in the unit of account (that’s what bank deposits are) and this is necessary for intertemporal allocative efficiency.

2) Liquidity no longer requires run-prone assets. Floating value assets are now perfectly liquid

This view fundamentally misunderstands the settlement process in securities transactions. I responded to this view in a previous post and will simply quote it here:

Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it. (See Kaminska 2016 for liquidity problems related to collateralized central bank support.) In fact, arguably the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.

Just as RTGS systems can inadvertently create liquidity droughts, so the system Cochrane envisions is more likely to be beset by liquidity problems, than “awash in liquidity” (p. 200) – unless of course the Fed is willing to take on significant intraday credit exposure to everybody participating in the RTGS system. (Here is an example of a liquidity frictions model that tackles these questions, Mills and Nesmith JME 2008). Overall the most important lesson to draw from Cochrane’s proposal is that we desperately need better models of banking and money, so we can do a better job of evaluating what it is that banks do.

3) Leverage of the banking system need not be leverage in the banking system.

Because the purpose of banking is to promote economic efficiency by providing society with “phantom” units of account, we need leverage in the banking system. What Cochrane calls “banking” cannot play the role of banks as I model them.

4) Inadequate funds for investment

My model of banking does not provide funds for investment — as least as a first order effect. My model of banking only provides funds for transactions. On the other hand, as a second order effect by promoting allocative efficiency, it seems likely that banks make investing more profitable than in an environment without banks. So an extension of the model that shows that banking promotes investment should not be difficult.

In short, both Tyler Cowen and John Cochrane are in desperate need of a better model relating the macroeconomy to banking. It’s right here.

 

Bank deposits as short positions: the details

So I’ve finally posted the paper I’ve been working on — a New Monetarist model of bank money — on SSRN. Warning for non-economists: lots of Greek  in this one.

Here’s the title and introduction.

The Nature of Money in a Convertible Currency World

This paper studies the nature of money in an environment where the means of payment is convertible at a fixed rate into the numeraire consumption good. By focusing on this environment we eliminate the possibility that the means of payment changes value over time, and deliberately construct a situation where the price level is disabled as a means of equilibrating the supply of money with the demand for it. To our knowledge no one else has studied such an environment in a Lagos-Wright-type framework. Our goal in this paper is to demonstrate that in this environment the first-best can still be attained – if the means of payment is effectively a naked short of the unit of account.

A naked short has the effect of creating a “phantom” supply of the shorted object that disappears when the short is closed out. We demonstrate here that banks can create this “phantom” supply of the unit of account in the form of acceptances of private debt.[1] This type of bank liability is issued when the bank stamps a private commercial bill “accepted,” and the bank obligation is put into circulation when the borrower makes purchases. Then, when the borrower pays off the loan, the phantom supply of the unit of account along with the outstanding, but contingent, bank liability that was used to create it is closed out.

Why do we model the means of payment as a naked short of the unit of account? We argue, first, that this is the best way to understand the nature of the banking system in its developmental stages. Second, by modelling the means of payment in this way our model demonstrates the efficiency gains that can be created through the introduction of a banking system. Third, by carefully evaluating the incentive feasibility conditions for our bank money equilibria, we are able to relate the monetary system to banking stability. We find that the implementation of central bank monetary policy via interest rates can be explained by the need to stabilize the banking system. Finally, we also find support for the use of usury laws as a means by which policymakers choose amongst multiple equilibria to favor the interests of non-banks over those of banks.

The monetary system modelled in this paper is based on the 18th century British monetary system as described in Henry Thornton (1802) An enquiry into the nature and effects of the paper credit of Great Britain. Privately issued bills function as a means of payment because they are “accepted” as liabilities by the banks that underwrite the monetary system. While these bills were denominated in a gold-based unit of account,[2] as a practical matter there was no expectation that they would be settled in gold. Instead, they were used as a means of transferring bank liabilities from one tradesman to another. Thus, bills that are simultaneously private IOUs and bank liabilities are used to make payment. The non-bank debtor pays off her debt by depositing someone else’s bank-certified liability into her account. (The 18th century monetary system was the precursor of the checking account system and operates just like a system of overdraft accounts.) The bank’s liability on a deposited bill is extinguished when funds are credited to the depositor’s account.

In our model productivity is stochastic, and as a result the demand for money is stochastic. We show that the bank-based money described in our model can accommodate this stochastic money demand so that a first best is attained. Thus, our model can be viewed as a model of the “banking school” view where money is issued on an “as needed” basis at the demand of non-banks.

We argue that the convertible currency environment forces a reconsideration of the nature of money. Typically the monetary literature views money as “an object that does not enter utility or production functions, and is available in fixed supply” (Kocherlakota 1998). Shifts in the price of money equilibrate the economy in these environments. Historically, however, stabilization of the price of money by tying it to a fixed quantity of gold was a foundation of economic success in the early modern period (van Dillen; Bayoumi & Eichengreen 1995). Thus, we consider how money functions in an environment where its price is “anchored”. We show that a solution is for the means of payment to be a debt instrument that is denominated in the anchored unit of account and is certified by a bank. This solution is based on actual market practice in the early modern period.

This approach allows us to reinterpret general results such as Gu, Mattesini, and Wright (2014)’s finding that when credit is easy, money is useless, and when money is essential, credit is irrelevant. While their conclusion is correct given their definitions of money and credit, we argue that this standard definition of money is not the correct definition to apply to an environment with banks. We argue that the means of payment in an environment with banks is a naked short of the unit of account, which would be categorized in GMW’s lexicon as “credit”.

This paper employs the methods of new monetarism. Our model combines an environment based on Berentsen, Camera, and Waller (2007) with an approach to banking that is more closely related to Gu, Mattesini, Monnet, and Wright (2013) and Cavalcanti and Wallace (1999a,b). Our model of banking is distinguished from GMMW because non-bank borrowing is supported not by collateral, but by an incentive constraint alone, and from Cavalcanti and Wallace because our banks don’t issue bank notes, but instead certify privately issued IOUs. We find that for values of the discount rate that accord with empirical evidence, such a payments system can be operated with no risk of default simply by setting borrowing constraints.[3] We start by finding the full range of incentive feasible equilibria of the model, and then discuss how, when there are multiple equilibria, a policymaker may choose between these equilibria.

In this environment competitive banking is incentive feasible only when enforcement is exogenous. In the case of endogenous enforcement, competition in banking typically drives the returns to banking below what is incentive feasible and the only equilibrium will be autarky. This result is consistent with many other papers that have found that the welfare of non-banks is improved when there is a franchise value to banking (Martin and Schreft 2005, Monnet and Sanches 2015, Huang 2017. See also Demsetz et al. 1996).

Thus, the challenge for a policymaker is how to regulate competition in the banking sector so that banking is both incentive compatible – and therefore stable – and also meets the policymaker’s goals in terms of serving non-banks. One solution is to treat banking as a natural monopoly, allowing an anti-competitive structure while at the same time imposing a cap on the fees that can be charged by banks. This solution explains usury laws, which by capping interest rates at a level such as 5%, the rate in 18th century Britain, is able to generate both a robust franchise value for the banks that provide payments system credit and at the same time to ensure that a significant fraction of the gains created by the existence of an efficient means of payment accrue to non-banks. An alternate solution is to impose a competitive structure on the banking industry, but also to set a minimum interest rate as a floor below which competition cannot drive the price. We argue that this is the practice of modern central banks and thus that monetary policy should be viewed as playing an important role in preventing competition from destabilizing the banking sector.

Section I introduces the model of a convertible currency. Section II describes the equilibria of the model. Section III presents the equilibria using diagrams. Section IV discusses the means by which policymakers choose between the difference equilibria of the bank-based monetary system. Section V concludes.

[1] While it would be easy to reconfigure the means of payment to be deposits or bank notes, we believe the monetary function of bank liabilities in this paper is sufficiently different from the existing literature that it useful to present it using an unfamiliar instrument.

[2] For the purposes of keeping the exposition simple, assume that we model the monetary system prior to 1797 (when gold convertibility was suspended).

[3] Indeed, we argue elsewhere that the credit based on precisely such constraints constituted the “safe assets” of the monetary system through the developmental years of banking (Sissoko 2016). Treasury bills, the modern financial world’s safe assets, were introduced in 1877 and modeled on the private money market instruments of 19th century Britain (Roberts 1995: 155).

Bank deposits as short positions

A quick point about monetary theory and banking.

Monetary economics has a basic result: nobody wants to hold non-interest bearing fiat money over time unless the price level is falling, so that the value of money is increasing over time. Many, if not most, theoretic discussions of money are premised on the assumption that fiat money is an object and that therefore one can hold no money or positive quantities of money, but one can’t hold a short position in fiat money.

Maybe this is one of macroeconomics greatest errors. Perhaps the whole point of the banking system is to allow the economy as whole to hold a short position in fiat money. After all, from the perspective of a bank what is a bank deposit if not a naked short position in cash? And by lending to businesses and consumers banks allow the rest of us to be short cash, too. This makes sense, because the basic principles of intertemporal economic efficiency state that we should all be short cash.

In Defense of Banking II

Proposals for reform of the monetary system based either on public access to accounts with the central bank or on banking systems that are 100% backed by central bank reserves and government debt have proliferated since the financial crisis. A few have crossed my path in the past few days (e.g. here and here).

I have been making the point in a variety of posts on this blog that these proposals are based on the Monetarist misconception of the nature of money in the modern economy and likely to prove disastrous. While much of my time lately is being spent working up a formal “greek” presentation of these ideas, explaining them in layman’s terms is equally important. Thanks to comments from an attentive reader, here is a more transparent explanation. Let me start by quoting from an earlier post that draw a schematic outline of Goodhart’s “private money” model :

The simplest model of money is a game with three people, each of whom produces something another seeks to consume: person 2 produces for person 1, person 3 produces for person 2, person 1 produces for person 3. Trade takes place over the course of three sequential pairwise matches: (1,2), (2,3), (3,1). Thus, in each match there is never a double coincidence of wants, but always a single coincidence of wants. We abstract from price by assuming that our three market participants can coordinate on an equilibrium price vector (cf. the Walrasian auctioneer). Thus, all these agents need is liquidity.

Let the liquidity be supplied by bank credit lines that are sufficiently large and are both drawn down by our participants on an “as needed” basis, and repaid at the earliest possible moment. Assume that these credit lines – like credit card balances that are promptly repaid – bear no interest. Then we observe, first, that after three periods trade has taken place and every participant’s bank balance is zero; and, second, that if the game is repeated foerever, the aggregate money supply is zero at the end of every three periods.

In this model the money supply expands only to meet the needs the trade, and automatically contracts in every third round because the buyer holds bank liabilities sufficient to meet his demand.

Consider the alternative of using a fiat money “token” to solve the infinitely repeated version of the game. Observe that in order for the allocation to be efficient, if there is only one token to allocate, we must know ex ante who to give that token to. If we give it to person 3, no trade will take place in the first two rounds, and if we give it to person 2 no trade will take place in the first round. While this might seem a minor loss, consider the possibility that people who don’t consume in the first stage of their life may have their productivity impaired for the rest of time. This indicates that the use of fiat money may require particularized knowledge about the nature of the economy that is not necessary if we solve the problem using credit lines.

Why don’t we just allocate one token to everybody so that we can be sure that the right person isn’t cash constrained in early life? This creates another problem. Person 2 and person 3 will both have 2 units of cash whenever they are making their purchases, but in order to reach the equilibrium allocation we need them to choose to spend only one unit of this cash in each period. In short, this solution would require people to hold onto money for eternity without ever intending to spend it. That clearly doesn’t make sense.

This simple discussion explains that there is a fundamental problem with fiat money that ensures that an incentive compatible credit system is never worse and in many environments is strictly better than fiat money. This is one of the most robust results to come out of the formal study of economic environments with liquidity frictions (see e.g. Kocherlakota 1998).

In response to this I received the following question by email:

In your 3 person model, [why not allocate] a token to everybody? – I don’t understand how you reached the conclusion that “this solution would require people to hold onto money for eternity without ever intending to spend it”. If people have more units of cash than they need for consumption, the excess would be saved and potentially lent to others who need credit?

This question arises, because I failed in the excerpt from my post above to explain what the implications of “allocating a token to everybody” are when translated into a real world economy. In order for an efficient outcome to be achieved, you need to make sure that everybody has enough money at the start of the monetary system so that it is not possible that they will ever be cash-constrained at any point in time. In my simple model this just implies that everybody is given one token at the start of time. In the real world this means that every newborn child is endowed at birth with more than enough cash to pay the full cost of U.S. college tuition at an elite institution (for example).

Turning back to the context of the model, if the two people with excess currency save and lend it, we have the problem that the one person who consumes at the given date already has enough money to make her purchases. In short there is three times as much currency in the economy as is needed for purchases. What this implies is that we do not have an equilibrium because the market for debt can’t clear at the prices we have assumed in our model. In short, if we add lending to the model then the equilibrium price will have to rise — with the result that nobody is endowed with enough money to make the purchases they want to make. Whether or not an efficient allocation can be obtained by this means will depend on the details of how the lending process is modeled. (The alternative that I considered was that there was no system of lending, so they had to hold the token. Then when they had an opportunity to buy, choose to spend only one token, even though they were holding two tokens. This is the sense in which the token must be held “for eternity” without being spent.)

Tying this discussion back into the college tuition example. If, in fact, you tried to implement a policy where every child is endowed at birth with enough cash to pay elite U.S. college tuition, what we would expect to happen is that by the time these children were going to college the cost would have increased so that they no longer had enough to pay tuition. But then of course you have failed to implement the policy. In short, it is impossible to “allocate a token to everybody”, because as soon as you do, you affect prices in a way that ensures that the token’s value has fallen below the value that you intended to allocate. There’s no way to square this circle.

Connecting this up with bitcoin or deposit accounts at the central bank: the currently rich have a huge advantage in a transition to such a system, because they get to start out with more bitcoins or larger deposit accounts. By contrast in a credit-based monetary system everybody has the opportunity to borrow against their future income.

The problem with the credit-based monetary system that we have is that guaranteeing the fairness of the mechanisms by which credit is allocated is an extremely important aspect of the efficiency of the system. That is, in a credit-based monetary system fairness-based considerations are not in conflict with efficiency-based considerations, but instead essential in order to make efficiency an achievable goal.

Because of the failure to model our monetary system properly, we have failed to understand the importance of regulation that protects and supports the fair allocation of credit in the system and have failed to maintain the efficiency of the monetary system. In my view appropriate reforms will target the mechanisms by which credit is allocated, because there’s no question that in the current system it is allocated very unfairly.

The problem with proposals to eliminate the debt-based system is that as far as I can tell, doing so is likely to just make the unfairness worse by giving the currently rich a huge advantage that they would not have in a reformed and well-designed credit-based monetary system.