What the F*D?! Part 4

Published on 10/04/19 | Saurav Sen | 5,082 Words

The BuyGist:

  • This the 4th installment of The Buylyst Fed Papers.
  • We recap the Fed’s strengths and its flaws.
  • We recap how Money works on Faith.
  • We discuss whether cryptocurrencies are viable alternatives. 
  • We discuss whether the Modern Monetary Theory has a future.
  • We list our what the current Monetary System can learn from Cryptos and MMT.

Why this article?

This is the fourth installment in the ambitious Buylyst Fed Papers series. So far, we’ve covered:

  1. Why have a Fed at all?
  2. How the Fed has evolved.
  3. How the Fed works today.

This article is about alternatives to the Fed-based money system we have now. There are enough people in the US and around the world that don’t like the concept of centralized Monetary Policy driving the value of their money. The main objection is opacity. I think that is a legitimate complaint. Bear in mind, it was only in 2016 that the Fed came out in public confirming that their true north is a 2% inflation Target. Before that, they didn’t publicly announce mention the words “Inflation Targeting” until 2012! And until the 70s, Inflation and Price Stability wasn’t even a priority.

What the Fed does and how it does it is a mystery to most people. I have done my best (so far) to clear it up. But I’ve been a student if Economics and Investing for almost 20 years. Most people have other interests and other things to worry about. So, when a bunch of Economists and Bankers come out with jargon-filled language about Inflation Targeting, the Fed Funds Rate and the PCE Core Deflator, it’s natural to question this nominated group of people. After all, they influence our lives in significant ways – maybe a bit too much.

This article looks at the two most discussed alternatives to the Fed-based money system we have today.

  1. Cryptocurrencies.
  2. The Modern Monetary Theory.

Before we get into the competition, we’ll do a quick recap of what’s good about our current system and what’s not.

The Fed’s strengths and its flaws.

The Fed’s mandate as decreed by the US Congress is:

  1. Promote Maximum Employment.
  2. Promote Price Stability.

The Fed does this primarily by keeping a close eye on Inflation. And it does that by adjusting the Money Supply enough to make sure that it meets Money Demand.  I’ve discussed this in detail in WTF 3.

It’s a big misconception that the “Fed prints money”. Money is created within the private sector – within the banking system. The Fed’s job is to make sure the banking system has enough capital and incentives to lend to businesses and people who need capital to produce and consume. The main strength of the Fed is that it plays the role of a stabilizing force in our laissez-faire capitalistic system. And it does this based on more than 100 years of institutional knowledge. The way it works today with all that institutional knowledge – along with better quality data and computing power – is the best situation we’ve ever had. But there are still some gaping holes.

OK – so the Fed’s responsible for “promoting” and environment where there is maximum employment and price stability. Over the years, they’ve realized that if they focus on Price Stability, Maximum Employment should follow. Great. But this is not a science and that’s the main problem.

In WTF 3, I ended the worldview article with a list of what I find objectionable about the way the Fed works today. Here it is again:

  1. The 2% inflation target seems rather rigid and definitive. What if the economy consistently grows at a much higher rate in the future because of, say, technological progress? Can the Fed change this number? And if it does, does it affect the Fed’s credibility?
  2. The Fed’s structure seems too much like a “politburo”. The President nominates the Chairman for the Federal Reserve Board. Of course, the nomination must get approval of the Congress. And then there is an FOMC (and Open Market Committee) that’s also based on nominations. It all sounds a bit Stalinist.
  3. And precisely because of #2, the Fed can get political. As I write this, Fed Chairman Powell and President Trump are in a war of words. But if Mr. Powell bows down to the President’s wishes to lower rates and ignore Inflation, the Fed could lose its credibility. It hasn’t happened yet. But it can.
  4. There still seems to be inefficient layers between the real economy and the Fed’s attempts to keep prices and employment stable. Fed policies take months, even a year, to make an impact on price stability and employment. A lot can happen in a year. I get the impression that the world is moving too fast for its policies to make a big impact.
  5. As income inequality increases in the US, does it impact the effectiveness of a one-size-fits-all monetary policy? Does it need to be more decentralized?
  6. Ultimately, the Fed relies on imperfect data and imperfect economic models (there are no perfect economic models). This leaves huge room for mistakes.
  7. There is a shadow banking system that’s outside the purview of the Fed. Banks may not be the primary source of credit in a few years. It’s a possibility. What is the relevance of the Fed then?

If I had to summarize all the above into a more succinct list of the Fed’s flaws, it would be this:

  1. It’s run by nominated people, which makes it susceptible to political pressures.
  2. It relies on economic forecast models, which (as we’ve seen time and time again) can be misleading.
  3. It works in a system in which most of the money is created within the Commercial Banking System.

In short, the concept of Money rests on faith that the Fed knows what it’s doing. To many, that’s unsettling.

Money works on Faith.

The world has seen 2 kinds of currency in the past 100 or so years.

  1. Commodity-backed currencies.
  2. Fiat Currency

Until the Gold Standard existed (which I went over in WTF 2), most major currencies were commodity-backed. After World War II, the US Dollar was pegged to the supply of Gold, and every major currency in the world was pegged to the Dollar. It worked fine until it didn’t. The US Dollar, being the reserve currency of the world and the major economic power, was always in high demand. Money supply, however, was supposed to be pegged to the supply of Gold. It didn’t. As I pointed out in WTF 2, the supply of USD far outstripped the supply of Gold. And the system broke down when periodic sell-offs in the dollar resulted in Inflation, partly because cost of imports increased substantially. Richard Nixon, the US President at the time, reacted by essentially ending the Gold Standard era. He did it primarily to free up the Fed to implement an expansionary Monetary Policy right before an election. That’s how politics works. The result was even more Inflation. And with that came more Unemployment, which debunked the economic theory of the Phillips Curve (more on this WTF 2). But the US Dollar (and consequently most other major currencies) went off the Gold Standard. This was the beginning of the Fiat Money era.

Fiat Money runs on faith – faith that the Government will ensure stability in the currency. The only thing that makes the Dollar worthwhile today is the belief that because this currency is blessed by the US Government, it will be widely accepted, and its value will be stable. We don’t think of this every day, but our world runs on Trust. And that’s unnerving.

We think of money as a highly technical concept that’s been “sciencified” since the beginning of the Computer era. But, ultimately, money is a unit of account and a store of value. It’s a very philosophical concept. Money is how we assign value to the industriousness, willingness, and effort of people to solve problems for fellow people. Money is nice because it’s fungible. All types of effort – from farming to coding – are weighed using a common unit of account. It’s rather arbitrary. But in the US (and in most countries in the world), that arbitrary value of effort is calibrated by the “free market” – good old supply and demand of labor.

If you read the Fed’s mandate again, it has a rather non-scientific and philosophical tone to it. Here’s the mandate:

The objectives as mandated by the Congress in the Federal Reserve Act are promoting (1) maximum employment, which means all Americans that want to work are gainfully employed, and (2) stable prices for the goods and services we all purchase. In this way, the Fed’s monetary policy decisions truly affect the financial lives of all Americans—not just the spending decisions we make as consumers, but also the spending decisions of businesses—about what they produce, how many workers they employ, and what investments they make in their operations.

This line is interesting: “…are promoting (1) maximum employment, which means all Americans that want to work are gainfully employed, and..”

It’s a rather sociological stance, isn’t it? For all its technicality, jargon and fancy econometric models, the Fed’s objective is rather fluffy and nebulous. Now, the Fed has realized over the years that the way to “promote” an environment where “…all Americans that want to work are gainfully employed…” is via Price Stability. And Price Stability means Inflation Targeting. 

Whether the Fed is successful in carrying out its rather “social” mission is a matter of faith for most of us. Some of us, who are lifelong students of Economics (a sociological subject to begin with), are slightly better at visualizing the transmission of the Fed’s policy moves to the real economy. But we’re in the minority. For most people, the Fed is a “black box” that has failed in the past. And for them, other black-box systems may be just as bad; or just as good.

Cryptocurrencies are not viable alternatives.

I’m going to use Bitcoin as the poster boy for Cryptocurrencies because it was the original “crypto” and is still one of the most popular ones. I understand most of it – I think – from my 7 or 8 readings of the original paper by its elusive creator – Satoshi Nakamoto. I wrote about Bitcoin in 2018 in which I came at it from an economics point of view. That won’t change.

The original paper is a brilliant piece of work and is “elegant” as an academic may say. I’m not going to question the robustness of the code because I’m not a computer scientist. From an economics standpoint, Bitcoin wants to challenge the hegemony of Central Banks.

Nakamoto’s original Bitcoin paper has no mention of Price Stability or Maximum Employment. Right there, it’s “mandate” is different. So, what is it all about? There are thousands of “why Bitcoin will save the world” type of articles online but I’ll stick to what the original paper says. First it starts off with this motive:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”

Why does it want to do this? It goes on to say: 

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for nonreversible services.”

What I got out of all that was this: 

  1. It wants to take out middlemen like banks, Visa, Mastercard etc.
  2. It wants to reduce or eliminate transaction fees, especially for small transactions.
  3. It wants to make transactions time-stamped and irreversible. 

All good features. No one will argue with that. In fact, the last feature there – about the code time-stamping transactions and making those records irreversible is actually a useful technology. It’s called Blockchain. The immutability aspect of it clearly has applications beyond cryptocurrencies – into normal (fiat) currencies, legal agreements, journalism, elections etc. The effort to take out middlemen and eliminate transaction costs is also laudable. I will go ahead and (ironically) “trust” Nakamoto to believe that the code does all this with no hiccups. The reason is that the code is supposed to be open-sourced, and so I assume that many programmers have validated it. So far so good.

The setup described above essentially decentralizes “trust”. It’s almost like having social proof – powered by cryptography – that tells you that the person sending you bitcoins actually has them. 

Then we get into the meat of the matter: Mining. I went over this in “Bitcoin’s merits are inflated”, but the gist is that “money” is created by “miners”, who are presumably skilled programmers. The “master code” is designed to mine these coins (digital signatures) at a pace of about 1 coin every 10 minutes. As more coins get mined, the “proof of work” that’s needed to mine coins gets harder. And there is a limit to the final number of coins that will be in circulation. I believe the number is 21 million coins. They are at about 16 million or more right now. 

Nakamoto goes on to say:

“The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.”

This is where he starts losing me. Maybe I’m conditioned in my thinking of Economics. But this “Gold Standard” thinking is outdated. The biggest fear Gold-Standard aficionados have is Inflation. Nakamoto confirms this:

“Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.”

This is why there is a hard stop on the total number of coins in circulation. The concern is Inflation. But what about Deflation? I went over the Great Depression in WTF 2 where Deflation caused all sorts of problems. Mass Unemployment was a big setback. As I was thinking about this, I realized that Bitcoin was never really designed to be a functional currency for an economy. It’s designed to be a supplementary currency for a shadow economy that wants to avoid regulation and taxes. It’s a libertarian’s dream. No oversight. Decentralized money creation. No Inflation. But Deflation? They don’t really care because Bitcoin’s only mandate seems to be freedom from government. 

On a site called Bitcoin.org (which I assume has some legitimacy), I read this rebuttal to the Deflation issue. 

“The deflationary spiral theory says that if prices are expected to fall, people will move purchases into the future in order to benefit from the lower prices. That fall in demand will in turn cause merchants to lower their prices to try and stimulate demand, making the problem worse and leading to an economic depression.

Although this theory is a popular way to justify inflation amongst central bankers, it does not appear to always hold true and is considered controversial amongst economists. Consumer electronics is one example of a market where prices constantly fall but which is not in depression. Similarly, the value of bitcoins has risen over time and yet the size of the Bitcoin economy has also grown dramatically along with it. Because both the value of the currency and the size of its economy started at zero in 2009, Bitcoin is a counterexample to the theory showing that it must sometimes be wrong.

Notwithstanding this, Bitcoin is not designed to be a deflationary currency. It is more accurate to say Bitcoin is intended to inflate in its early years and become stable in its later years. The only time the quantity of bitcoins in circulation will drop is if people carelessly lose their wallets by failing to make backups. With a stable monetary base and a stable economy, the value of the currency should remain the same.”

They’re right in the first paragraph. That’s what happened in the Great Depression. The second paragraph starts with a somewhat snarky remark about inflation-loving Central Bankers. The example about Consumer Electronics is rubbish. The fact that $1,000 can buy a lot more in consumer electronics today than it could even 20 years ago is not Deflation. Yes, prices have fallen but that is the triumph of the capitalistic system, competition, and R&D that has proved Moore’s Law to be roughly accurate. It has nothing to do with the inflation or deflation of the US Dollar. The “End the Fed” crowd often cites the devaluation of the US Dollar as one of its favorite charts. 

So, inflation has been clocking in at around 3% a year for the last 100 years. Does that mean we can buy less now than we used to? That’s rubbish. Yes, one dollar can buy less of some products than it used to, like milk. But on average, people in the US can buy a lot more milk than they could back then. Why? It’s called economic growth. The pie grew for everyone; maybe not equally, but it did grow. Would you rather have $100 that buys you 100 loaves of bread or have $1,000 that buys you 500 loaves. It’s no good preserving the purchasing power of one unit of currency if you can’t grow the number of units for most people. Yes, inflation happened. But so did income growth. And quantity of money in the system increases with economic activity and economic growth. This is the sort of chart-crime that stinks of adolescent libertarianism. 

If we’re talking about the whole economy, there are two parts to it – the supply side and the demand side. There are businesses that hire people, and there are people that spend money to keep those businesses in, well, business. Deflation is basically a sign that there isn’t enough money supply to meet money demand. This is bad for the supply-side. There isn’t enough capital for them to do their business. Interest rates shoot up. Their cost of doing business goes up. Companies go out of business. People are laid off. And the cycle continues. If this happens economy-wide for a long time, it’s a problem.

The third paragraph confuses me. It says that Bitcoin is not designed to be a Deflationary currency. But it seems like it is. The supply of Bitcoins seems to be pre-determined and set to grow at a pre-determined rate. And it expects the demand for the currency to keep pace with the supply? How can it control the demand for money? If a business wants to set up shop, can it borrow in Bitcoins to do that? That’s a need for new Bitcoins being created. In our system today, money is created by Commercial Banks because they find lending opportunities to businesses and to people. The demand for money in the system is reflective of the producing and consuming capacity of the economy. The supply of money should reflect that activity. The Fed spends its time trying to make sure that money supply and money demand are roughly matched. In the Bitcoin world, it seems that there is no consideration for money demand. It seems un-tethered to real economic activity – like Gold.

Maybe I’m old-fashioned but I think any viable currency should be reflective of real economic activity. New Money should be created because people want to borrow and spend or borrow and invest. This is how most major currencies work today. Banks do the job of allocating our society’s pooled savings to economically viable ideas, which – usually – creates some equity out of that asset-liability match. That’s a sign of economic growth. If the supply of money is limited and fixed by an algorithm that has nothing to do with economic activity, is there room for economic growth?

As far as I can tell, there is no mechanism for either Price Stability or Maximum Employment in Bitcoins or other Cryptocurrencies. So, in that regard, I like our current system (however flawed) better. Bitcoin’s advantages are limited to: 

  1. Independence from Governments. 
  2. Security of Transactions.
  3. Anonymity. 

Until credit and equity markets – meaning the capacity to lend and/or invest – in the Bitcoin world are formed, it’s very hard for Bitcoin or other Cryptos to replace the current system. And if credit and equity markets have to be functional, money supply must match money demand for Price Stability. And if that facility doesn’t exist, and prices aren’t stable, then it’s hard to see Bitcoin growing beyond the politically motivated or tax-evading crowd.

Modern Monetary Theory is a pipe dream.

This is another attractive theory (like Bitcoin) that strikes a chord with a lot of people who focus on the flaws of the current Monetary system. This one is not libertarian in its approach, however. It’s on the opposite end of the spectrum.

The Modern Monetary Theory (MMT) posits that since money is printed by the government, it is impossible for the government to default on its debt, and so government debt is irrelevant. Sounds too good to be true? That’s because it probably is. My first question was: What about Inflation? MMT has an answer. It suggests that inflation can be tamed by taxation. When inflation exceeds a pre-specified limit, taxes will be increased to reduce aggregate demand in the economy. And so, prices will stabilize. This is a big assumption.

First, the method of taxation to influence aggregate spending or investment is something that looks good on paper but I’m not sure how well it works in real life. I doubt it’s a formulaic relationship that works like clockwork all the time. And if the margin of error is big enough that it doesn’t instill confidence in businesses and people that inflation will be tamed, the whole experiment doesn’t work.

Second, the trust in elected representatives to make big spending decisions for the economy by printing money is uncomfortable even for someone like me who’s on the Liberal side on most issues. The Fed works as a facilitator to the laissez-faire system in which banks and private individuals makes lending, investing and spending decisions. That’s a much more robust system than politicians deciding how to spend money.

The Financial Times has an excellent critique of the MMT, and in it the writer quotes a line from a Margaret Thatcher speech in 1983. I don’t agree with Thatcher on a bunch of social and moral stances but on this I couldn’t agree more:

“the state has no source of money other than money which people themselves earn” and “there is no such thing as public money”

Money is created by the Private Sector. That’s the principle on which the Fed operates. The Fed may “intervene” to smooth out persistent mismatches in money supply and money demand. But the process of money creation happens in the Private Sector.

In short, I’m skeptical of two central tenets of MMT:

  1. Tax rules will predictably control inflation.
  2. Elected representatives – politicians, not subject-matter experts – will be the best allocators of society’s resources.

I like our current system (however flawed) better.

But both Cryptos and MMT have something to offer.

While both Bitcoin and MMT have many unanswered questions to answer, they have each raised some important questions for our current system.

The idea of a cryptocurrency is not inherently bad. But it must be tethered to real economic activity and the demand for money by the private sector for it to serve as a currency rather than an asset. However, these central ideas of Bitcoin should be taken seriously by central banks:

  1. Low transaction costs
  2. Decentralization of decision-making

The idea of decentralization is particularly important for the European Central Bank to consider. Unlike the US, European countries each have their own Fiscal Policy and wildly different consumption patters across borders. The idea of a one-size-fits-all monetary policy looks rather fragile and ineffective to me in such a varied economy.

In countries where Monetary Policy is completely ineffective and ridden with corrupt politics – and there are many such countries – Bitcoin may be the better option. Sure, the supply of bitcoins is designed to have nothing to do with real economic activity in that country, but at least Bitcoin could be a store of value, like Gold.

And lastly, with regard to cryptocurrencies, there’s talk amongst central bankers that maybe a cryptocurrency can serve as the world’s reserve currency. Mark Carney, governor of the Bank of England, has floated the idea of a Libra (Facebook’s crypto) type of reserve currency that’s tethered to the major fiat currencies of the world as an idea for central banks to consider. The idea of a global reserve currency isn’t new. A long time ago Keynes suggested a similar idea at the Bretton Woods conference. His idea of a global reserve currency was called Bancor. I was digging around for details and ran into a cryptocurrency network that has borrowed the name. This idea of a global reserve cryptocurrency needs further research.

As for the MMT, I appreciate the idea that obsession over government budget deficits is probably misplaced and is usually a political stance linked to the idea of government tyranny. Government deficits – as Keynes had argued – can be a good thing, especially in times of economic slowdown. It can act as a “spender of last resort”, if you will. 2008 was a perfect example. The Fed went outside its purview to become a buyer of assets at a time when credit markets froze. It did this to avoid a deflationary spiral that could have threatened one of its two core mandates: Full Employment. In times of extreme stress, MMT-like thinking can work to avoid mass layoffs across the economy.

At a minimum, here’s what I hope comes out of these two alternatives to the Fed:

  1. The popularity of cryptos forces central banks to be more transparent.
  2. The popularity of MMT forces governments to rediscover its post-WWII role in building infrastructure, better public schools and finding ways to provide better healthcare.

But whatever happens, Price Stability and Maximum Employment are worthy goals to strive for.

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