This is a rewrite and update of my e-gold blog post of 12/10/2007, "Set It and Forget It - Harnessing Collective Wisdom to Achieve Monetary Stability".
Vera Smith, in her landmark 1936 essay "The Rationale of Central Banking", concluded:
"How to discover a banking system which will not be the cause of catastrophic disturbances, which is least likely itself to introduce oscillations and most likely to make the correct adjustment... is the most acute unsettled economic problem of our day".
Fast forward to September 2011, to the remarks of William C. Dudley, President, Federal Reserve Bank of New York, at the 2011 Bretton Woods Committee International Meeting:
“Policymakers and market participants must acknowledge that the financial system is inherently unstable – that is it prone to booms and busts, and that these episodes can destabilize the real economy.”
The practice of banking—borrowing short and lending long—is indeed inherently risky business. It does not however follow that a financial ecosystem populated by institutions continuously exposed and vulnerable to folly and circumstance is doomed to periodic excesses and the risks of subsequent collapse they engender.
The root of systemic financial instability is monetary – institutionalized fallacies and contradictions that inevitably lead in ratcheting fashion to a cascade of unsustainable debt. This Gordian knot has a solution.
In this post I will contrast two qualitatively different institutional arrangements for systematic metering of a money supply: a conventional government central bank (using the Fed as example) vs the Better Money paradigm. My assertion is two-fold:
- Government central banks, in their formulation and implementation of monetary policies, amplify "oscillations" over successive boom and bust cycles – typically via a bias toward stimulus that causes salutary adjustments to be deferred1. Better Money, in contrast, is an automatically self-adjusting system that will ultimately attenuate fluctuations in public and institutional liquidity preferences.
- The advantage of the rules-based model of Better Money—as opposed to the "constrained discretion" model of central banks—largely derives from harnessing the benefits of collective wisdom in a timely and efficacious manner.
Framework for comparison
Let's begin by comparing the:
- Goals each system is designed to achieve,
- Processes by which information is channeled and assimilated into protocols that lead to monetary policy implementations, and,
- Levers by which adjustments are effected.
Goals
The Federal Reserve Act of 1913 provided "for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes." Over time and subsequent legislative initiatives—the Employment Act of 1946, the Federal Reserve Reform Act of 1977, the Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins)—the imperatives to which the Fed is subject have evolved into what is commonly "referred to as the dual mandate... to promote the coequal objectives of maximum employment and price stability.” While it is accurate to state that the Fed enjoys plenty of discretionary wiggle room in formulating and implementing its monetary policies, these mandates and other exigencies constrain the options available to the Federal Open Market Committee (FOMC).
Better Money is also designed with goals2 in mind but pursues these goals via the elimination of discretion in favor of systematically enforced rules memorialized in explicit contracts.
The idea of a "rules-based" system, however, is not, in and of itself, sufficient. Not all rules are well conceived. Perhaps you have been to a Christmas party where whoever is running the "dirty Santa" gift exchange has not thought it through properly. A faulty rule set can cause the process to degenerate into one where every turn ends up requiring ad hoc adjudication, typically by the very authority figure whose shoot-from-the-hip lack of coherent reasoning led to the mess in the first place. Or suppose there are (what appear to be) serviceable rules but these idealized rules are implemented in a system that is doomed from the git-go. I'll explore this a later post where I examine shibboleths such as the gold standard or the Taylor Rule.
Defining goals and devising systematic means of pursuing them is foundational to organization and implementation of a monetary system. Recall President Dudley's depiction of the financial system as "inherently unstable". The implication is that, lacking the well-considered ministrations of a cadre of government experts, the financial system would either fly apart or implode.
I disagree. I contend that economic activity, locally and globally, exhibits the characteristics of a nonlinear dynamical system as observed in the constructs of chaos theory3. Properly speaking, the "chaos" of chaos theory is strictly a property of mathematical models but the patterns generated by chaos theory bear striking resemblance to observable real world phenomena. The aspects that intrigue me relate to the sensitivity to "initial conditions" that determine the subsequent stability or instability of the complex system that derives from them. Certain initial conditions foster emergence of a system of sustained or "deterministic chaos"4. In such a system, "strange attractors" may emerge such that constituent parts remain in (complex unpredictable) orbits rather than flying apart in what I termed "calamitous trajectories"5 back in 1997 when I first invoked this metaphor. This does not mean that any particular state of that system can be predicted but the system itself persists – intact and contained within boundaries.
With discretionary monetary policies, it's as if the principal initial condition is that there are no initial conditions. No parameter is fixed; the planners make it up as they go along. Outcomes (imperfectly measured and with prolonged latency) influence inputs and the risk arises of positive feedback loops resulting in amplification rather than attenuation.
An example that I believe illustrates this difference in mindset is "price stability". I regard direct efforts to achieve this outcome as pursuit of a near-fraudulent fantasy. (Same thing with "full employment" for that matter.) Such goals open a Pandora's box of incessant trickiness devised to game statistical measurement and justify whatever analytical models (e.g. DSGE models) and policy measures are currently fashionable.
Contrast this with the obligation to back AUG with a 100% reserve (Fine Content) of Good Delivery gold bullion held in trust in Allocated Storage, reinforced by systematic governance and transparency measures to thwart error, coercion or malfeasance. There is no language there regarding prices or any other particular economic outcome. Instead there is a fixed initial condition that economic actors can treat as a given in their own economic calculations. It is from this and other initial conditions reliably implemented in Better Money, in combination with innumerable individual adjustments of economic actors predicated on them, that a beneficial strange attractor phenomenon might emerge.
Processing information: The "Knowledge Problem"
The collapse of the Soviet Union was widely seen as validating the economic superiority of free markets—Adam Smith's "invisible hand"—over government central planning. Analysts pinpoint the core difference between the two models as one of distributed knowledge versus centralized knowledge. No individual or committee could possibly gather, interpret and act on the vast quantity of data that ultimately reflects the actions and intentions of the people who comprise and lead households and firms with the timeliness and nuance of the individuals themselves. The idea is that a multitude of economic participants acting in their own self-interest benefit an economy more than any group seeking to determine and act in the collective interest.
Government central banks marshal and analyze data for the precise purpose of divining the actions and intentions of a diverse cohort of economic actors in order to determine and implement a discretionary monetary policy.
Harnessing collective wisdom
There is an alternative to this regime of experts - the wisdom of crowds.
One perspective for viewing a multitude of economic actors sees animal spirits, herd behavior, madness of crowds – benighted masses incapable of learning from mistakes or acting in their own (especially their collective) true best interests. Joe Sixpack is disinclined and ill-equipped to act responsibly with regard to such arcane matters as money and banking. Such "public goods" are best managed by experts.
An alternative perspective examines circumstances in which collective wisdom generates solutions or predictions with uncanny insight or accuracy. James Surowiecki's 2004 book "The Wisdom of Crowds" explores multiple examples of problems where "collective intelligence" produces better outcomes than a small cadre of experts. The most interesting paradigms are dynamical systems leading to emergent phenomenon, systems in which so many factors, and the feedback influences of their interactions, exist as to quickly overwhelm the computational capacity of the most advanced information systems.
No historic precedent
Historically, it was a moot point whether or not broad populations had a capacity that could theoretically be harnessed to modulate monetary systems. The critical factor that could act as the fulcrum for a systematic solution was lacking. That situation changes, however, due to a novel element integral to the Better Money System. This new possibility affects the nature of the levers that meter the money supply (and credit) and who wields them.
The availability of Better Money makes it possible for people to not bother with banks.
Why do people use banks, that is, why do they loan their money to banks? (That's what a deposit is – a loan to the bank.)
Elementary texts list reasons that compare money in the bank to physical cash. Physical security is cited as a factor, as is the fact that cash pays no interest (as if banks do!). But this is nonsense; people hold money in banks in order to access systems for remote payments. Their employers may expect them to have bank accounts for direct deposit. Credit card and other bills are paid by ACH draft or sending a check.
But the remote payments aspects of Better Money are faster, cheaper and safer.
So in a world where Better Money exists, for the first time ever it makes sense for a prospective depositor to consider - "is this (or any) bank offering me an attractive enough bid, interest-wise, for me to loan it my money?"
This is where levers come into play.
Levers for metering money supply and credit
Both central bank-based systems and Better Money have two sets of levers:
- Processes by which the aggregate quantity of Base Money, may increase or decrease6.
- Mechanisms that influence Broad Money supply (M1-2) by affecting the terms by which Base Money is made available to the banking/financial system.
For central banks, traditional levers for implementation of monetary policy were all about reserves, the component of the monetary base that banks and other financial intermediaries would leverage via their provision of credit. The Monetary Authority would seek to influence the behavior of financial institutions by interventions to make Base Money, functioning as reserves, more abundant/cheaper, or more scarce/costly.
The logic was based on the fact that reserves were scarce. Prior to the financial crisis of 2008, implementation of Fed monetary policies was largely a matter of fiddling with the supply and cost of reserves along with the required reserve ratios imposed on banks. The principal lever (lever 2 above) consisted of targeting the interest rate at which banks could borrow reserves in the overnight (mostly interbank) market - the Fed Funds rate. This, combined with the occasional nudge to required reserve ratios, would influence the money multiplier effect - the ratio of Broad Money relative to Base Money - whereby banks would supply credit to the real economy.
Metering the actual Base Money supply (lever 1) was more of a subordinate technical process involving Open Market Operations, as discussed in my post "The role of Currency Exchange in Better Money, part 4 - Primary Dealers" .
Since 2008, all of this has changed7. The concept of "money multiplier effect" and even the term "Fed Funds" are not much more than quaint anachronisms. What has not changed, however, is that the FOMC continues to wield levers by which it seeks to implement its discretionary monetary policies.
Let's examine an alternative scenario. What if, instead of a central authority controlling the availability and cost of reserves, people did it themselves, directly? Shouldn't people have the option to withhold reserves from the financial system if they feel they are not being offered adequate compensation?
Well, the fact is that heretofore the public has never had any practical means of influencing financial institutions on a routine day to day basis by providing or withholding reserves. There is a bidding process whereby banks compete with each other for the deposits of the public but the choice is limited to which bank or financial intermediary to lend to rather than whether to lend money to the financial system at all. Historically, the only form of Base Money that the general public could directly possess or use was physical tokens - paper cash and coins. Only in extreme circumstances, after financial conditions had entered a crisis, might the public seek to withdraw money from the financial system—thereby withholding reserves—in such quantity as to influence credit conditions. In all other, more routine, circumstances, pulling one's money from the banking system served only to deny the withdrawer access to remote payment systems. Life without access to remote payment systems may not be as dire as Hobbes’s “nasty, brutish and short” state of nature but is inefficient, costly, time consuming and demeaning. Advanced society with its exquisite specialization of labor cannot function without remote payment systems.
The Better Money System enables end users direct access to efficient remote payments capabilities that entail book entry transfer of Base Money. While extremely efficient RTGS platforms enabling transfers of Base Money by book entry have existed for decades, Better Money is the first such system capable of safely extending direct access privileges to the general public.
Here's how the lever situation changes with Better Money.
As discussed in the 2nd installment in my series on Currency exchange, the amount of (AUG) Base Money in circulation (lever 1) is a direct function of aggregate demand for AUG. Every participant in the Better Money system has his/her own little lever. Each participant is free to formulate and exercise his/her preferences regarding how much AUG to hold (in Base Money form). An overall increase or decrease in demand for AUG causes a corresponding increase or decrease in the quantity in circulation.
But Better Money also affords automatic metering of Broad Money supply (lever 2).
AUG Broad Money supply
This effect will become most apparent after emergence – after financial institutions have undertaken to create an AUG-denominated and payable Broad Money supply. In that circumstance, every participating economic actor, 24/7/365, has the option to reduce or eliminate his exposure to the financial system. They will no longer be obliged to loan their money to banks. They will have the option of holding Base Money, without exposure to any financial intermediary, while continuing to enjoy efficient remote payments capabilities.
Each individual choice to hold Base instead of Broad Money would incrementally throttle back availability (and inch up the cost) of reserves. Innumerable little levers, effective with zero latency (i.e. without lags/delays) make it possible for the invisible hand to maximize the public welfare without the distortions inevitably introduced by an interposed bureaucracy.
Conventional money supply
Better Money can potentially influence interest rates even in the absence of embrace by banks and emergence of a significant like-denominated Broad Money supply. It is a matter of marginal effects and tipping points.
Picture an individual who is concerned by what she perceives as easy credit run amok. Every month she receives solicitations from various credit card companies offering teaser rates for debt consolidation or simply for debt-financed consumption. Offers abound for home equity lines of credit. At some point she starts to receive offers of pre-approved credit addressed to her dog. She is concerned something may be awry with the current credit cycle, that (just maybe) the credit mongering process has reached an unsustainable frenzy.
So she decides it may be prudent to pull back a bit, reducing her exposure to a financial system she sees as being in bubble territory. Or perhaps she wants to exit the merry-go-round altogether. But how?
She can sell her stocks or mutual funds. But then what? Hold whatever wealth she has in bank deposits?
She has observed decade after decade that a so-called "hundred year storm" blows in every time an asset bubbles bursts such that the only thing preventing banking system collapse is ever more aggressive government response in the form of monetary and fiscal intervention. Perhaps she goes so far as to cash out, literally, and hide paper cash under the mattress. But is she now safe?
These successive crises seem to escalate in ratcheting fashion. What if this is the big one that leads to a cascading loss of public confidence so essential as the basis of the value accorded to government money? Might it make sense to instead acquire a stash of gold coins? But what if she actually needs to buy something at some point, say a pizza or some groceries? Even the smallest gold coin embodies way too much value for a modest retail expenditure; whatever she receives in change can't and won't be gold.
In any scenario where a person wishes to scale back exposure to risks that may affect banks or government issued money, the existence of Better Money affords an option never before available – decreased exposure without sacrificing access to efficient remote payments capabilities.
Expand these considerations—sensitivity to risk and reluctance to finance a bank without adequate compensation—to a population. Surely you would find an exquisitely granular spectrum of thresholds. At one extreme would be people who, given the option of using and holding Better Money, might never again darken the door of a bank and who would be loathe to hold any more conventional money than they have to. Others, in contrast might hang on to conventional money and bank deposits to the potentially bitter end. And there would be every gradation in between. Availability of the option to withhold value from the existing financial system might cause the emergence of Better Money to influence interest rates even without/before AUG denominated bank deposits become a consideration.
Footnotes
1 - For purposes of this post I am stating this premise—that the bias of central banks in the direction of monetary ease/stimulus tends to postpone adverse consequences of malinvestment—as if it were self-evident and without offering arguments to defend it. My intent is to take up this claim in later posts more focused on the current monetary landscape.
2 - I will elaborate the goals of Better Money in a later post. For now, the "Money is broke and does need fixin" section of my "Better Money starts here" post provides a glimpse.
3 - This paragraph draws repeatedly from the elegant introduction to Chaos Theory by Robert Bishop in the Stanford Encyclopedia of Philosophy. I make no claim that Prof. Bishop (or Stanford University) would approve my analogy between the Better Money system and the mathematical models of deterministic chaos.
4 - Metastable chaos would probably be more accurate; and, as an economic/financial system outcome, it would be perfectly fine provided it were of decades or centuries duration. Stars are metastable, but, depending on their mass relative to the Chandrashekar limit, they last a long time before they either go the fly-apart (supernova/neutron star/black hole) route or collapse into dwarfs.
5 - In a rant on the original e-gold website back in November 1996 I tried to express the analogy of a strange attractor. James Grant picked up on this and quoted that section at length in the January 31, 1997 issue of Grant's Interest Rate Observer (no free online reference for non-subscribers exists although individual archived issues are available for $115).
"Noah was surely regarded as a pathetic crank until it started to rain," writes Dr. Jackson, anticipating the observation, on his extraordinary Gold & Silver Reserve Web site (wonderful prose in the service of what amounts to a monetary-political-tract-cum-business-proposition: http://www.e-gold.com). "Paradigm shifts occur, and their timing cannot be accurately anticipated. They can develop quickly, catastrophically, feeding on themselves, allowing no opportunity to improve one's position once underway. Many a paper currency has spun out of control in a calamitous trajectory. There has never been an instance of gold or silver being discarded as worthless [only as, in the speculative argot, "dead money"—ed.]. G&SR is striving to build an enduring institution in (what we predict to be) the metaphysical vicinity of a future strange attractor. Our vision of the new millennium is civil society in dynamic equilibrium, an approximation of justice deriving stability from the fundamental gravitational forces of individual liberty and the rule of law.
"We submit these postulates to the ultimate reality tests," Dr. Jackson goes on, "the market, and the future..."
6 - More broadly, in my upcoming post "Bankers' Banks" we will consider the balance sheet of the issuer whose direct liabilities constitute the monetary base. In addition to examining how the overall size may be increased or decreased, the composition of the underlying asset portfolio merits attention.
7 - Everything has changed since 2008 as bank reserves have increased from < $2 billion to way over $2 trillion - more than a 1000-fold increase.. "Non-standard policy alternatives" has become an important addition to Fed jargon as the list of current and expired policy tools continues to grow. I plan to examine this topic in a future post about "bankers' banks".
In the meanwhile, the notion of the Fed Funds rate itself is probably careening toward the junk heap, soon to be replaced by the overnight bank funding rate (OBFR).
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