Dear WSJ Editors:
Your letter-writer Robert Eisenbeis (“Treasury and the Fed’s Cash Flow, Jan. 19) is missing the forest for the trees. He is correct that the act by which the Fed rebates its interest earnings on Treasury bonds back to the Treasury does not itself generate revenue for the government, any more than a husband transfering funds to his wife is a source of household revenue. But he is completely wrong to assert that “Your editorial ‘The Fed Cash Machine’ (Jan. 12) is wrong in implying that the Fed has been a ‘huge money-maker for the Treasury.’” The Fed certainly has been a huge money-maker for the federal government. The huge money-making comes earlier, before the rebate, when the Fed purchases additional Treasury debt for itself in the open market. The Fed pays by increasing its own monetary liabilities, making a profit for the government by converting Treasury debt into lower-yielding Fed debt (bank reserves or zero-yielding currency). As Eisenbeis himself notes, the Treasury debt "has effectively been retired" by this act. Expansion in the Fed's liabilities is an undeniable source of government revenue. To deny this would be like denying that a husband is contributing to household revenue when he pays his wife’s bills by running a counterfeiting operation in the garage.
Larry White is Professor of Economics at George Mason University. He specializes in the theory and history of banking and money, and is best known for his work on free banking. He received his A.B. from Harvard University and his M. A. and Ph.D. from the University of California, Los Angeles. He previously taught at New York University, the University of Georgia, and the University of Missouri - St. Louis.
Professor White is the author of The Clash of Economic Ideas (Cambridge, forthcoming); The Theory of Monetary Institutions (Basil Blackwell, 1999); Free Banking in Britain (2nd ed., Institute of Economic Affairs, 1995; 1st ed. Cambridge, 1984), and Competition and Currency (NYU, 1989). He is the editor of F. A. Hayek, The Pure Theory of Capital (Chicago, 2007); The History of Gold and Silver (3 vols., Pickering and Chatto, 2000); Free Banking (3 vols., Edward Elgar, 1993); The Crisis in American Banking (NYU, 1993); William Leggett, Democratick Editorials (Liberty Press, 1984); and other volumes. His articles on monetary theory and banking history have appeared in the American Economic Review, the Journal of Economic Literature, the Journal of Money, Credit, and Banking, and other leading professional journals.
In 2008 White received the Distinguished Scholar Award of the Association for Private Enterprise Education. He has been Visiting Professor at Queen's University of Belfast, Visiting Fellow at the Australian National University, Visiting Research Fellow and lecturer at the American Institute for Economic Research, visiting lecturer at the Swiss National Bank, and a visiting scholar at the Federal Reserve Bank of Atlanta. He co-edits a book series for Routledge, Foundations of the Market Economy. He is a co-editor of Econ Journal Watch, and hosts bi-monthly podcasts for EJW Audio. He is a member of the board of associate editors of the Review of Austrian Economics and a member of the editorial board of the Cato Journal. He is a contributing editor to the Foundation for Economic Education's magazine The Freeman and lectures at the Foundation's annual seminar in Advanced Austrian Economics. He is an adjunct scholar of the Cato Institute and a member of the Academic Advisory Council of the Institute of Economic Affairs.
Dear WSJ Editors:
I visited Quito and Guayaquil in Ecuador last month to speak at conferences celebrating the fifteenth anniversary of official dollarization. The conference in Quito was sponsored by the Universidad de San Francisco de Quito, headed by Dr. Santiago Gangotena; in Guayaquil by the think tank IEEP which is headed by Dora de Ampuero. Although dollarization is popular and successful, the government appears to be working to undermine it. Here are some highlights from the remarks I prepared.
Dollarization and Free Choice in Currency
The dollarization of Ecuador was not chosen by policy-makers. It was chosen by the people. It grew from free choices people made between dollars and sucres. The people preferred a relatively sound money to a clearly unsound money. By their actions to dollarize themselves, they dislodged the rapidly depreciating sucre and spontaneously established a de facto US dollar standard. (Many commentators refer to this decentralized process of voluntary currency switching “unofficial dollarization.” I prefer to call it popular dollarization, or dolarización popular.) Finally, in January 2000, Ecuador’s government stopped fighting their choice. Until that point the state tried to use legal penalties or subsidies to slow currency switching. Today the state threatens an attempt to reverse the people’s choice through legal compulsion. Such policy actions violate the widely accepted principle that the individual is sovereign over his or her own household property.
Everyone knows that free and open competitive markets better serve consumers (and producers) than state-granted monopolies. For example, it is clearly better for consumers to have several mobile phone companies competing for their business than to be subject to monopoly pricing from a single state-licensed monopoly. To make economic policy with the individual’s welfare in mind requires policy-makers to respect the principle of individual sovereignty in markets.
Many economists have thought, however, that currency is an exception to the rule. They don’t understand how there can be a competitive choice among currencies. Theory tells them that “network effects” ensure that a single monetary standard (silver, gold, US dollar, sucre, Mexican peso, euro, et cetera) prevails in any economy. The usual policy conclusion from this line of argument is that, since the market will only have a single provider in any case, the state should run the monetary system in the public interest.
Such economists are only looking at the blackboard and not at what is happening outside the window. (Evidently they have never lived where multiple currencies have been widely used.) Transactional network effects do exist, not only at the national level but at the global level: other things equal, you prefer to use the money that more of your trading partners use. Ecuadorans chose the US dollar over (say) the Swiss franc precisely because of such network effects. But current network size is not the only characteristic that matters to consumers and businesspeople when choosing among currencies for use in transacting, saving, or posting prices. The costs of holding and using a currency also matter. When people are free to choose, they will abandon an established currency, no matter how locally dominant, that is being so rapidly issued that its purchasing power is rapidly disappearing. If the established monetary standard could never be dislodged by free choice, then Ecuador would still be using the sucre.
Economists or policymakers who argue against a country’s dollarization, even when its people clearly demonstrate a preference for the dollar, either fail to think about dollarization as a market phenomenon that grows from individual choices, or they don’t believe that individuals deserve respect. Instead they think about the monetary system only as a tool to be engineered and manipulated by expert policy analysts (presumably themselves). They conduct themselves not as citizen advocates, but as technical advisors to the state.
Ecuador’s success with dollarization
Although some local critics of dollarization in 1999 predicted that the transition from the sucre to the dollar would cause a deep recession with high unemployment, the opposite happened. Due to high inflation, the people had of course already dollarized themselves by the end of 1999. Making dollarization official in January 2000 helped to complete the transition from the disorder of a collapsing currency to the calm of a relatively stable currency. The economy did not fall further into recession but responded with growth. After a steep drop in real output in 1999 (-4.74%), output growth returned to the positive range in 2000 (1.09%), then resumed a healthy pace in 2001 and 2002 (4.02% and 4.10%). Growth under dollarization has continued to be much healthier than under the sucre regime. From 2000 to 2013, Ecuador’s real GDP grew 75% in total, a compound annual rate of 4.4%. During the previous 13 years, 1987 to 2000, total real growth was only 36%, an annual rate of only 2.4%.
Today, the Ecuadoran economy is doing quite well on several standard macroeconomic indicators. The American economist Steve Hanke provides one way to rank its performance in his article in the magazine Globe Asia in May 2014. There he defines and applies a “misery index” in which a country’s current misery index = inflation rate + lending interest rate + unemployment rate (all bad things), minus per capita GDP growth over the previous year (a good thing). Venezuela has the worst score, the #1 highest measured macroeconomic misery not only in South America, but in the world. Ecuador’s score is the best in South America. Is dollarization responsible? Yes. The only two countries with better scores in Latin America are El Salvador and Panama, the only other dollarized countries.
Dollarization has also brought improvement to Ecuador’s banking system, according to two analysts at the Federal Reserve Bank of Atlanta. Mynam Quispe-Agnoli and Elena Whisler, in a 2006 article, noted correctly that dollarization, by ruling out an official lender of last resort able to create dollar bank reserves with the push of a button, eliminates an important source of moral hazard. In this way dollarization has the potential to reduce risky bank behavior, and thus so “make banks runs less likely because consumers and businesses may have greater confidence in the domestic banking system.” Lacking the expectation that “the monetary authority would come to the rescue of troubled banks” whether solvent or insolvent, banks in a dollarized system “have to manage their own solvency and liquidity risks better, taking the respective precautionary measures.”
We have long seen this benefit realized in the stability of banks in offshore centers like the Cayman Islands, the Bahamas, Jersey and Guernsey, and Panama, which have no official lenders of last resort – and no crises. The Atlanta Fed analysts saw it being realized in Ecuador as well. Ecuadoran banks now hold higher reserves and a greater share of liquid assets overall, and hold safer asset portfolios than in the 1990s. Just as importantly, because it has eliminated large swings in the inflation rate and in the expected inflation rate, dollarization “fosters an environment beneficial to financial intermediation.” In particular, it encourages the public to hold greater bank deposits (the ratio of deposits to GDP in Ecuador, which was just below 20 percent in 2000, is today just above 30 percent) and thereby provides a greater volume of funds to investors. On the lending side, loan quality has improved because banks no longer face loan default risks due to exchange rate swings that render borrowing firms unable to repay. Meanwhile, as compared to a system with partial dollarization, banks themselves have become less prone to large devaluation losses, because dollarization eliminates the devaluation risk that used to arise from currency mismatches on bank balance sheets.
While 15 years is only a fraction of a century, it is not too much to hope that Ecuador’s banking system is following in the path of Panama’s. With more than a century of dollarization, Panama has the deepest financial markets and most efficient banks in Latin America.
To summarize, official dollarization in Ecuador has (1) lowered inflation, (2) fostered financial deepening and thereby real growth, and (3) lowered transaction costs for importing, exporting, and making remittances. What it has not done, of course, is to limit the growth of government spending while government revenue has grown, although it has eliminated the ability to cover deficits by printing money.
While we celebrate Ecuador’s fifteen years of success with dollarization, and think about extending it, we must take note of two dark clouds on the horizon.
First, Ecuador still has a central bank. Although the BCE is presently precluded from issuing paper currency, it continues to be assigned by public law “the responsibility of implementing the monetary, credit, foreign exchange and financial policies formulated by the Executive.” Why? We should have no doubt that the Executive would dearly love to once again have a monetary policy to conduct. We should expect the BCE’s own funcionarios to seek to enlarge the scope of the bank’s discretionary powers, if only in the sincere hope that they could do more good. But we know that the direction of greater discretion in monetary policy leads back toward the conditions of 1999. With dollarization, a central bank is completely unnecessary.
Second, I have been learning with concern – as I am sure you have – about the plans of the national government of Ecuador to issue its own digital mobile-phone currency. The idea is for the Banco Central to issue dollar-denominated electronic credits that customers of the government-owned mobile phone network CNT can use to make payments by phone. As the Associated Press reported August 2014: “Such mobile payments schemes are already popular in African nations including Kenya and Tanzania, where they are privately run. The new currency was approved, and stateless crypto-currencies such as Bitcoin simultaneously banned, by Ecuador’s National Assembly last month. The official in charge of the new currency, Fausto Valencia, said the software is already used in Paraguay by cellphone companies.”
There is no reason to believe that a national government can run a mobile payment system more efficiently than private firms like Vodafone (which originated and runs the successful M-Pesa system in Kenya) and Tigo (which runs the Giros Tigo system in Paraguay). Why not let the private mobile phone companies also compete to provide mobile payments in Ecuador, issuing their own dollar-denominated account credits? Instead they are banned unless they use the government’s credits. Such a ban is costly to ordinary consumers. Evidence from around the world shows that payment by mobile account credits is the type of service that firms in a competitive market can produce, will produce when there is a normal rate of return to be earned, and produce at lower cost than state-owned enterprises.
The government insists that its new system will be “voluntary.” But when the state gives itself a monopoly on a service, blocking individuals from the voluntary choice to use another provider, the option to “take it or leave it” is not fully voluntary. If the government sincerely wishes to help the poor and unbanked, it should let private providers enter the competition, which will drive down the fees that the poor and unbanked will have to pay.
It is very curious that a law supposedly seeking to provide the poor with low-cost access to payment systems would ban Bitcoin. (The only other country in South America to ban Bitcoin appears to be Bolivia.) In countries that receive income from remittances, Bitcoin has the potential to noticeably increase national income by lowering the cost of remittance. What the family in the home country receives is much closer to the amount that the worker abroad has paid to send when the worker uses Bitcoin rather than Western Union or another old-fashioned high-priced system. Researchers at the Pew Center in the United States estimate that remittances account for about 3% of Ecuador’s GDP. In 2012 the average Ecuadoran working in the United States sent home $2607 dollars. So this is not a trivial matter. Bitcoin remittances could contribute many dollars to the pockets of Ecuador’s poor.
A report from the news service Payment Week says of the government’s mobile payment project: “The currency will serve as… a way for the country to regain some control over its economic system. The production of the new currency would completely depend upon demand.” But these two sentences can’t both be true. The new system can’t both allow the government to “regain some control” over the economy and also make the volume of credits “completely depend on demand,” which implies that the government is passive and exercises no control.
Given that is doesn’t make economic sense, why does the government want to issue mobile payment credits as a monopolist? It seems likely that the project is meant as a fiscal measure. One million dollars held by the public in the form of government-issued credits is a million-dollar interest-free loan from the public to the government. According to Payment Week, “The government has said it won’t use the [new] currency to fund public spending,” but this is hard to fathom. If the project makes a profit, where else would the profit go?
If the government can make a profit at mobile payments, even though they have no expertise or comparative advantage in the area, surely Movistar or Claro can operate more efficiently and make larger profits, even while charging lower fees. Why not let the private sector operate in this area? Why not let the public choose which firm has the most reliable and trustworthy service? If the government desires to subsidize the use of the service by the poor, it has the option of issuing them vouchers. It need not provide the service itself, and certainly not as a monopolist.
Personally, I would find dollar-denominated account credits that are claims on Movistar or Claro more credible than claims on the government of Ecuador. After all, unlike the government, neither company defaulted on its bonds in the past 12 years. Claims on private companies are legally enforceable. The company cannot suspend payment or devalue its IOUs without taken to court and forced to pay or dissolve. Competition for business compels payment firms them to worry about reputation, and so compels them to manage the business so that their readiness, ability and willingness to pay is not in doubt. A government agency, by contrast, cannot be sued for breach of contract, and has no concern about maintaining a good reputation when it has no competitors. If CNT or the BCE decides to devalue mobile credits against the US dollar, holders have no remedy in court. People who are thinking about holding the credits need to consider the default risk. The “backing” requirements in the law are completely toothless against a government that chooses to default.
In sum, there is no plausibly efficient or honorable reason for the Ecuadoran government to go into the business of providing an exclusive medium for mobile payments. Consequently it is hard to make any sense of the project other than as fiscal maneuver that paves the way toward official de-dollarization. I gather that President Correa does not like the way that dollarization limits his government’s power to manage the economy. He has compared the limitation to “boxing with one arm.” But as I have already emphasized, retiring the government from boxing against the economy by means of money-printing is precisely dollarization’s great virtue.
Paul Krugman has noticed the sound money movement. In yesterday's NYT blog post he writes:
In other words, libertarianism is a crusade against problems we don’t have, or at least not to the extent the libertarians want to imagine. Nowhere is this better illustrated than in the case of monetary policy, where many libertarians are determined to stop the Fed from irresponsible money-printing — which is not, in fact, something it’s doing.
This is a very artful choice of verb tense. Notice what he doesn't say: that irresponsible money-printing is "not, in fact, something it has done."
I'm reminded of Bill Clinton's famous response when asked whether his lawyer had spoken a falsehood when he said that "there is" no sexual relationship of any kind between the President and Monica Lewinsky: "it depends on what the meaning of the word "is" is." It would be another matter, Clinton allowed, if the lawyer had said "is and never has been." Similarly, the problem of the Fed engaging in irresponsible money-printing has not disappeared even if, by Krugman's (unspecified) criteria, this month's monetary policy is okay. Because irresponsible money-printing is a recurrent problem that we do have, it makes perfect sense to be determined to stop it even if (for the sake of argument) it were the case that it isn't happening this month.
Gandhi is supposed to have said: "First they ignore you. Then they laugh at you. Then they fight you." Krugman seems to be somewhere between the 2nd the 3rd steps.
Ex-Fed chair Ben Bernanke is currently a resident fellow at the Hutchins Center on Fiscal & Monetary Policy at the Brookings Institution. The Center’s director, David Wessel, appeared on NPR’s Morning Edition yesterday to express views on inflation and deflation that are essentially indistinguishable from Bernanke’s.
In particular, like Bernanke, Wessel spoke as though inflation below 2% per annum, and a fortiori deflation, is always bad.
Asked to explain why it should be bad to have less of a bad thing like inflation, Wessel first responded: “I mean it sounds appealing, prices going down, people paying less at the store. But when inflation is low that means wages are going up very slowly too. That's of course not very popular.“ This sort of answer would earn an undergraduate a poor grade from any instructor who emphasizes the distinction between real and nominal variables. Workers should not applaud rising nominal wages per se; what matters for them is their real wages. When inflation is low, so too are nominal wage increases ordinarily. But that says nothing about the path of real wages, which in the long run are not determined by monetary policy.
Wessel continued: "There are a couple of problems with too little inflation. It can be a symptom of a lousy economy, one in which demand for goods and services and workers is anemic."
A key word here is symptom. A condition that can be a symptom of a problem is not the problem itself, and can also appear under healthy conditions. Wessel failed to note that low inflation need not be a symptom of a lousy economy, because he spoke only of variation in the aggregate demand for goods and services. Low inflation (or even deflation) can instead be the benign result of abundant growth in the real supply of goods and services. Under the gold standard, as Atkeson and Kehoe (2004) have reported, periods of lousy economy (recession) were not more common during deflation periods, nor vice-versa.
If the Fed were today targeting the path of nominal income, because the growth rate of nominal income is the sum of the inflation rate and the real income growth rate, low inflation would be a sign of a healthy economy with high real economic growth. Thus Wessel would have provided a more accurate analysis if he had spoken of problems with growth in nominal aggregate demand being weaker than anticipated, not inflation being below its target. (In terms of dynamic AD-SRAS analysis, unexpectedly low growth in AD moves the economy below the natural rate of output.)
Wessel’s second concern is harder to interpret favorably. Low inflation, he said, "can make it hard for the Fed to spur borrowing because it's hard for them to get the interest rate below the inflation rate." Two responses: (a) The Fed should not be trying to “spur borrowing.” Fed efforts to spur borrowing helped to fuel the housing bubble. (b) The Fed is not in fact currently finding it hard to get the interest rate below the inflation rate. The interest rate on 1-year T-bills has been below the CPE inflation rate for more than four years, since 2009’s dip into deflation (in that case due to weak demand for goods following the financial crisis).
Wessel went on the cite the problem of rising real debt burdens in deflation. That can indeed be a problem in an unanticipated deflation (Wessel never distinguished anticipated from unanticipated), but again, only to the extent that the deflation is driven by unexpectedly weak aggregate demand growth and not by robust aggregate supply growth. In the latter case, borrowers have more real income with which to repay.
In his answer to the interviewer’s last question, Wessel declared: “So it used to be that economists believed that a central bank can always create inflation by printing more money. But lately it's been -seems harder to do that than the textbooks had told us.” But what is the evidence that expanding the stock of money does not still generate inflation the way the old textbooks tell us? Surely not the experience of the Fed undershooting its target of 2.0% growth in the PCE by 0.4%, which only implies that the broad money growth rate was 0.4% lower than the rate that would have hit the target. Fortunately or unfortunately, it remains the case that the Fed can always raise the PCE inflation rate by engineering a higher rate of broad money growth, just as the textbooks explain.
By the way, today’s announced number for the May CPI raises year-over-year CPI inflation to 2.1%. The increase of 0.4% over April’s CPI, compounded twelve-fold, implies an annual rate of 4.9%. At this rate the “problem” of an undershooting PCE-deflator inflation rate will be “solved” before long.
(HT to David Boaz)
In a blog post yesterday, entitled “Friedman and the Austrians” , Paul Krugman quotes Milton Friedman’s charge that in the “London School (really Austrian) view,” i.e. the view held by F. A. Hayek and Lionel Robbins,
the depression was an inevitable result of the prior boom, that it was deepened by the attempts to prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by “easy money” policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate weak and unsound firms.
Krugman then remarks:
I have, incidentally, seen attempts to claim that nobody believed this, or at any rate that Hayek never believed this, and that characterizing Hayek as a liquidationist is some kind of liberal libel. This is really a case of who are you gonna believe, me or your lying eyes.
One of the "attemps" Krugman may be referring to is my June 2008 article in the Journal of Money, Credit, and Banking, “Did Hayek and Robbins Deepen the Great Depression?” (Ungated pre-publication version here). Or he may be referring to subsequent discussion of the question on Brad DeLong’s blog -- if you follow this link, please scroll down to see my comments on DeLong’s post.
In either case Krugman’s remarks call for a reply.
In the 2008 article I point out that Hayek enunciated a monetary policy norm of stabilizing nominal income (aka nominal aggregate demand, or MV in the equation of exchange) in the face of a declining money multiplier or declining velocity of money. Under a gold standard, a high price level driven unsustainably high (by the boom-creating inflationary policies that Friedman references) needs to return to the sustainable level, but there is no virtue in “secondary” deflation going beyond that point. Thus, according to Hayek, the central bank should expand its liabilities H to offset an increased bank reserve ratio or public hoarding that reduces M/H or V. In yet other words, it is better to remedy an unsatisfied excess demand for money balances by supplying the called-for money balances than by putting a burden of downward price adjustment on the economy.
Overlooking Hayek’s stable-MV norm, Friedman and others have mischaracterized Hayek as prescribing only “to let the depression run its course.” Hayek did oppose cheap-money policies that distort the economy, and did counsel policy-makers not to obstruct the process of correcting the mistaken investments made during the boom. But quoting such statements doesn’t show that he said nothing else about depression policy.
It’s a question of who you gonna believe, a one-sided quoting of only some bits of Hayek by people unaware of the rest, or the full story of what Hayek wrote about depression policy?
I’m sorry that Krugman didn’t call me out by name. It prevents his readers from finding and reading the other side of the debate.
I might also mention that my article treats the question of what Hayek really said as a matter of getting the intellectual history right. I do not suggest that mischaracterization of Hayek’s position is limited to left-liberals. Indeed, as Krugman’s blog post does, my article prominently quotes Milton Friedman’s criticism of Hayek for supposed liquidationism. Friedman is no left-liberal. Thus I would never call it “some kind of liberal libel.”
I interviewed Prof. Hugh Rockoff of Rutgers University for the latest installment of the Econ Journal Watch Audio podcast. We chat about his research on episodes of lightly regulated banking, and his take on others' research. Along the way we discuss Milton Friedman's views on free banking, and the recent banking debacle in Cyprus.
Listen or download here.
I have a book review now up on reason.com of Bernard Lietaer and Jacqui Dunne's Rethinking Money: How New Currencies Turn Scarcity Into Prosperity. I wanted to like the book more, because I too like alternative currencies. Unfortunately Lietaer and Dunne make some very crankish arguments, suggesting that the phenomenon of a positive interest rate creates problems for the economy, and that a proliferation of free currencies will ameliorate those problems.
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