Discussion of John Tamny’s: Who Needs the Fed?

John concludes that we do not need the Fed because the Fed has become irrelevant. He argues that the interest rate “set” by the Fed is not relevant for the rest of the economy and that the Fed’s influence on bank credit is unimportant because not much credit comes from banks anymore, and that in any event the Fed can’t really control money and credit. While I think that John and I agree on many of the basic propositions that he sets out in his book, I disagree with many of his specific statements and with all of the propositions in my opening two sentences above.  To be blunt, John reveals a shocking lack of understanding of how the Fed and monetary policy more broadly work. The book has three Parts: Credit; Banking; and The Fed. I will set out my agreement with John on some important broad principles and then quote only a few of the many statements I disagree with.

For starters, John, Dan [Dan Mitchel, the moderator of this debate between John Tamny and myself at FreedomFest] and I all agree that it is what government spends that determines the resources it has taken from us and thus limiting that spending to the essentials is more important than cutting taxes. Of course how the government takes our incomes to finance its activities is also important. Some taxes are worse than others. On the other hand, it is surely not true that anything the government spends reduces the economy’s output. Government provided public safety, national security, and contract enforcement increase private economic output.

We agree that bailing out banks is bad for the health and efficiency of the banking sector.

We agree that failure of private sector firms that can’t make a profit and the market’s reallocation of those resources to better uses is good for economic efficiency and growth and rarely happens in government.

We agree that the market should determine the supply of money whose value is fixed to something tangible. But many of John’s statements suggest that he does not understand what the Feds does and what it is mandated to do. I will have a lot to say about this shortly.

Credit

The first of the books three parts is about Credit. When I get past some unusual usage of the word Credit to what I think is John’s fundamental point, I agree with him that those borrowing to invest in the real economy can only acquire and invest real resources. They cannot build factories, buy equipment, hire and organize workers with money created by the Fed, though a sound currency and efficient payment system lowers to the cost of connecting savers and investors. At the end of the day, real investment requires the saving and provision of real resources. This is what economists call the “neutrality of money, the idea that in the long run a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption.” [Wikipedia] Unfortunately, throughout his book John fails to distinguish between real and nominal magnitudes.

John states this in several ways: “The Fed can’t create credit” [p. 4] However, it is not helpful when John defines credit as real resources when he means wealth or capital. Quoting him again: “Never forget that credit is the resources created in the actual economy.” [p. 26] And again: “Credit is just the name for real economic resources.” [p. 87] But near the end of his book he reverts to a more traditional definition of credit as a loan: “Credit is access to real economic resources.” [p. 178] There is a big difference between saying that credit “is real resources” and saying that it is “access to real resources.”

John talks a lot about what it takes for firms to attract funding of their activities. He provides many interesting examples of shifting credit risks in the economy and the credit market’s response in shifting resources away from higher risks to more promising uses, but these examples have nothing to do with monetary policy or the Fed. The Fed is not a credit institution. It does not allocate credit in the economy. The Fed is a monetary institution, whose job is to provide our currency and regulate its market value. John does not seem to understand the difference.

Banking

“It will never be a lack of money that fells Amazon [or any other company]. Only a lousy strategy will take it down.” [page 98] I sort of agree, but John then mistakenly applies this thinking to banks, which have a legal and business obligation to back all of their deposit and other liabilities with assets of equal or greater value, i.e. they must have positive capital. They must be solvent. John is mistaken to say that: “Because banks never simply run out of money, lack of investor patience is what causes them to file for bankruptcy.” [page 98] While banks can borrow when they are short of funds (credit in the usual sense of the word) as long as lenders and depositor think they are solvent, deposit and interbank funding runs can occur when depositors think the bank is not solvent. Solvency means having positive capital. Bank capital is difficult to assess because many of its assets are loans and it is not possible to know for sure how may of these loans will be repaid in the future. The real world, practical challenge with banks is to determine when they become insolvent as promptly as possible to prevent their continued borrowing and deposit taking as their capital hole grows so that most depositors and other creditors can be repaid when the bank is liquidated. A bank that continues to operate when insolvent is a ponzi scheme.

John correctly attack’s Murray Rothbard’s claim that fractional reserve banking is fraudulent. When banks lend out some or most of what we deposit with them—so called fractional reserve banking—they are doing exactly what they say they will. There is nothing fraudulent about it. It does make banks vulnerable to runs, however, which is why central banks are empowered to be lenders of last resort. John focuses his discussion on whether banks hold enough reserves (liquid deposits with the central bank and cash in their vaults) for unexpected deposit withdrawals and notes that any credit worthy bank can borrow what ever it need for this purpose from other banks. He says little about bank capital, however, which is the basis of whether a bank is credit worthy in the first place. If the market suspects that the bank has little or no capital, it will not lend to the bank.

John’s rejection of the broadly accepted proposition that banks multiple the money created by the central bank into a much larger quantity of bank deposits is completely wrong, as is his implicit rejection of the Chicago Plan of 100% reserve requirements by saying that “Banks can’t pay to stare at or warehouse dollars—they would quickly go out of business or be acquired—so logically they lend them.” [page 87]. Of course they can. If they are providing a valuable safekeeping and payment function, they can charge for it. Who remembers to old days when banks levied a service charge on demand deposits? Rather than focus exclusively on reserve requirements John should focus on the role of capital requirements for protecting depositor money. Positive capital means that the value of a bank’s assets exceeds its deposit and other liabilities.

John’s attempt to disprove the money multiplier fails to reflect or understand the intermediary nature of banks. They sit between the savers and the investors; between depositors and borrowers. He illustrates his claim with four friends at a table, one with a $100 who lends 90 to the next friend who lends ten percent of that to the next one and so on mimicking the standard text book explanation of the creation of money by banks. The correct game would have the friend with the $100 depositing it with the imaginary banker in the center of the table. The banker then lends $90 to the next friend by recording a deposit liability to the second friend of $90. The two friends between them now have $190 in deposits with the bank, which now lends $81 to the third friend by creating a $81 deposit for the third friend, etc. The example reflects a 10% reserve requirement. For some reason John doesn’t get this very real world phenomenon. The creation of deposit money by banks is only inflationary if their growth exceeds the growth of the public’s demand for them. It is forgivable if Joe six pack doesn’t understand the money multiplier by banks, but it is shocking for someone writing about the subject to failure so completely to understand it.

Banks are one of many financial intermediaries lending other peoples’ money, but they are the foundation of the payment system. Capital protects depositors’ money from the occasional non-performing loan made with those deposits. Historically virtually every country in the world bailed out insolvent banks rather than let depositors lose money. This created terrible moral hazard as John notes. Deposit insurance has improved the picture and the US has closed thousand of banks without serious disruption, but not the biggest ones viewed as too big to fail.

My recommendation is to separate the payment from the lending functions of banks, requiring 100 % reserves on demand and savings deposits, and requiring equity (capital) to finance bank lending and its other investments. Thus deposits and the payment system would be risk free and require very little further regulation.[1] The intermediated lending would be all equity financed, like a mutual fund investment, and require very little further regulation as well, as its investors would have total skin in the game and could take whatever amount of risk they wanted as they would reap the rewards or suffer the losses. Losses of loans and investments would no longer threaten bank deposits and the payment system. There would no longer be a need for the Lender of Last Resort function of the Fed or other central banks. This is the Chicago Plan put forth during the great depression by such notable economists as Irving Fisher, Frank H. Knight, Lloyd W. Mints, Henry Schultz, Henry C. Simons, Garfield V. Cox, Aaron Director, Paul H. Douglas, and Albert G. Hart.

The Fed

Most central banks these days have the legal mandate to regulate the supply of their currencies so as to keep its value stable— the so-called price stability mandate. The Fed has a problematic “dual mandate” of maximizing employment and stabilizing prices, which I will not discuss further here. There are several basic approaches to fulfilling this price stability mandate, ranging from fixing the price of the dollar to gold at one end of the spectrum to targeting inflation with market determined, i.e. freely floating, exchange rates at the other end. The policy debate is or should be about which of the rules for managing the money supply would be best for the U.S.

John says that “Friedman was the modern father of monetarism, a theory of money that says the central bank should closely regulate its supply.” [p 136] Friedman said no such thing.

Monetarism says that, like every other good, the value of money is determined by its supply and demand. The demand for money comes from the public and has been empirically related to their incomes. The supply is determined by the central bank in accordance with the policy rule it adopts. The gold standard was one such rule. A fixed monetary growth rate rule, once advocated by Friedman, is another. Inflation targeting, now in vogue, is yet another.

John makes a number of statements that suggest that he understands none of this. He says that: “Production is the source of money.” [p 136] We can make sense out of this strange statement if we change it to say that production is the source of the demand for money. Given that demand, monetarism says that the price or value of money (its purchasing power) will be determined by its supply and its supply will depend on the policy rule the central bank follows. If the Fed creates more money than the public wants to hold, people will spend the extra money. But as John and I agree, spending such money doesn’t create the goods people want to buy. Thus a money supply that exceeds its demand will drive up the prices of goods and services. That is the monetarist story of inflation.

John goes on to say that: “Friedman viewed inflation solely as a money-supply phenomenon. Inflation was a function of too much money, as opposed to a decline in the value of money.” [p 136] I can’t make sense of this strange statement. The statement that “inflation was a function of too much money” is a statement about the cause of inflation. The final clause of John’s statement says that: “inflation was a function of…a decline in the value of money.” But inflation is a decline in the value of money by definition. So what does John mean? His effort to explain why these are difference seems to concern the allocation of money around the country. He says: “money migrates to where production is.” Yes it goes to where it is demanded. John confuses the markets role in allocating credit around the country with the Fed’s role in controlling the aggregate supply of money. It is shocking that someone who writes regularly on this subject fails completely to understand its basics. I cannot find any evidence that John understands the basics of monetary theory of the supply and demand for money and its price, i.e., its value.

Another indicator of John’s confusion comes from the first Part of the book when he compares the Fed’s lowering the fed funds rate to Nixon fixing gasoline prices below the market price. Fixing the price of gas lower than the market price reduces its supply and increases its demand and produced long lines at gas stations in the hope of tanking up before the station runs out. But the Fed does not fix the fed funds rate; it sets a target for it. The difference is profound. The Federal funds rate is determined in the market by banks. When the Fed reduces its target for the Fed funds rate it increases its supply of liquidity to banks so that supply and demand force the interbank rate down. John repeats this fundamental misunderstanding throughout the book. In order to emphasize the importance of the distinction between fixing the Fed funds rate and targeting it, let me in Donald Trump fashion, repeat the point. The Fed does not fix the Fed funds rate. It enters the market as a buyer or seller of t-bills in order to increase or reduce the supply of bank reserves in order to stimulate the market to move the rate to the Fed’s target value.

John repeatedly describes the folly of the Fed trying to increase the money supply in Baltimore or Cincinnati to stimulate growth there, as markets will attract it away to healthier areas that demand it. He repeatedly discusses money as if it is credit. The Fed does almost no lending and then only to banks temporarily short of liquidity. When the Fed wants to lower the Fed funds rate in the market, it buys U.S. treasury bills from the market. The transactions (so called open market transactions) take place in New York but the sellers of these t-bills to the Fed are scattered all over the country and the newly created money is deposited in the sellers banks all around the country. John failures to reflect a basic understanding of how monetary policy works.

John’s misunderstanding of how the Fed operations is further illustrated in his following statements: “The Federal Reserve… proceeded to borrow reserves from the banking system so that it could buy trillions worth of U.S. Treasuries and mortgage back securities…. The Fed has credit to allocate only insofar as it extracts it from the real economy.” [p 149] This is completely wrong. The Fed supplied reserves to the banking system by buying Treasuries with money it created. Understanding this is absolutely fundamental to understanding what central banks do. John documents over and over again that he does not understand these basics.

John and I are both skeptical of the Fed’s ability to managing its monetary policy (the fed funds rate and/or the money supply) so as to smooth out business fluctuations while maintaining a stable value of the dollar. We both think that keeping short-term rates near zero for so long has been a mistake. In the long run, monetary policy determines the price level and its rate of inflation, not full employment and real income. John and I agree that the health of the economy, or its lack of it, is much more the result of stifling regulations, not monetary policy.

These suggest that the Fed would do better to adopt a different policy strategy or rule. John suggests that we can do away with banks and the Fed altogether, but says almost nothing about their replacements. I favor a supply of money determined by market demand whose value is fixed to a basket of goods. The Fed would supply currency under currency board rules whenever people wanted it and paid its official price and could redeem it at its official price, i.e. the market value of its valuation basket, if they had too much of it. In the case of the gold standard the only good in the valuation basket was gold, whose price is not as stable as would be a basket of goods. This proposal is discussed in my Real SDR Currency Board and other articles. Unfortunately you will not find John’s proposal for determining the money supply in his book.

John’s arguments that we do not need the Fed because it has no (or only negligible) affect on market interest rates and credit and because the Fed and banks cannot create money, are wrong. While interbank interest rates (the Fed funds rate) are a tiny fraction of all interest rates, market arbitrage insures that all interest rates are related to each other given the unique risks and characteristics of individual borrowers and classes of borrowers and of the appetites for risk of lenders. The Fed can and does “print money” expanding the currency held by the public and bank reserve deposits with the Fed (so called base money) and banks can and do multiply this base money into a much larger supply of money (currency and bank deposits) by lending it. While in the long run these activities of the Fed and banks only affect the value of money (inflation) with no affect on the real economy, they can and do have important real economy affects for good or ill in the short run. The question we need to answer is what monetary policy rules should the Fed adopt and follow in order to best fulfill its price stability and full employment mandate.

[1] “Changing direction on bank regulation” Cayman Financial Review, April 2015

Postscript

A few Booboos

“Housing is not investment…. Housing is consumption” [p 113]   Buying a house is an investment (it is a capital good). Living in or renting it is consumption.

“The Fed can’t create the credit that is economic resources” [p. 159] No but it can create money.

The Fed believes “that economic growth is the cause of inflation” [p. 159] Throughout John fails to distinguish real and nominal magnitudes (real exchange rate vs. nominal exchange rate; real interest rate vs. nominal interest rate; real income vs. Nominal income; real quantity of money vs. nominal quantity of money, etc.). Real economic growth with a constant money supply will cause deflation. Nominal economic growth when real income is constant is all inflation, etc.

“For those who still believe we need the Fed to keep a lid on the ‘money supply,’ what can’t be stressed enough is that our central bank cannot control that supply.” [p. 161] Not true.

References

Coats, Warren, 1982   “The SDR as a Means of Payment,” IMF Staff Papers, Vol. 29, No. 3 (September 1982) (reprinted in Spanish in Centro de Estudios Monetarios Latinoamericanos Boletin, Vol. XXIX, Numero 4, Julio–Agosto de 1983).

1983, “The SDR as a Means of Payment, Response to Colin, van den Boogaerde, and Kennen,” IMF Staff Papers, Vol. 30, No. 3 (September 1983).

2009, “Time for a New Global Currency?” New Global Studies: Vol. 3: Issue.1, Article 5. (2009).

2011, “Real SDR Currency Board”, Central Banking Journal XXII.2 (2011), also available at http://works.bepress.com/warren_coats/25

2014, “Implementing a Real SDR Currency Board”

_____. Dongsheng Di, and Yuxaun Zhao, 2016, Why the World needs a Reserve Asset with a Hard Anchor, http://works.bepress.com/warren_coats/34/

 

 

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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