The Optimum Quality of Money, or Could Negative Nominal Rates Falsify the Quantity Theory of Money?

A short note on the monetary experiment-in-progress.

optimum_quantity_money_bookIn 1969, perhaps anticipating the era of irredeemable currency, Milton Friedman published “The Optimal Quantity of Money“, a collection of his essays from as early as 1952. [Its cover art, an image of US gold eagle coins, disguises a fool’s gold money system! More on this later…] If your recollection is that Professor Friedman advocated a steady 2% rate of inflation, you’ll be as surprised as I was to learn that the “Friedman Rule” for monetary policy, advocated by his central article, literally calls for a 0% nominal short-term interest rate coupled with mild deflation to yield a small positive real rate of interest. Daniel Sanches of the Philadelphia Fed recently wrote an excellent survey article on Friedman’s rule and its critics. The rule is clearly being dusted off as academic cover for the zero interest rate policy (ZIRP). I’ll see that bet and raise the stakes: the arrival of negative rates will validate the most piercing criticisms of Quantity Theory (QTM) and perhaps even expose it as a false conjecture.

In a 2014 “Grumpy Economist” blog post, John Cochrane hesitantly asked whether, given the onset of zero percent interest rates, central banks should proclaim Mission Accomplished vis a vis the Friedman rule. His hesitation is only over whether the trend is converging on 0%, or inexorably headed ever lower. If short term rates actually stabilize at or very near the 0% level, they would be landing, per Friedman, not on a zero bound but on the social marginal cost of printing irredeemable currency. This explanation is already waxing magical in its thinking. But if it’s so, and even adding in the spread that central bankers pay to bond speculators, we have many more halvings of the interest rate yet to go (a Zenoesque progression). In practice, impediments at the zero bound have materialized. But if Europe is any indication, these could turn out to be insubstantial faced with the brute force of monetary doctrine. Yet, if Friedman is right, current economic conditions are the sweet spot for irredeemable currency—Utopia here we come! If he’s not, could present circumstances form a falsifying experiment?

Is there a doctrine in the house?

Opponents of QTM, including Fredrick Hayek, question whether the Quantity of Money is a knowable aggregate value. Thomas Sargent and Neil Wallace honed this critique (in 1982) by calling out the “failure of ‘means of payment’ to be an analytical category that sharply distinguishes one class of assets from everything else.” Failing to be an analytical category is the respectable way to say a term is fuzzy thinking. One observation they made 35 years ago is particularly telling—even predictive.

Quantity theorists . . . propose . . . legal restrictions on private intermediation. The legal restrictions are meant to separate ‘money creation’ from ‘credit creation,’ that is, from the process of intermediation. Thus for example, Friedman (1960, p.21) hails the feature of the National Banking Act which taxed state bank notes out of existence and advocates 100 percent reserves against bank liabilities called demand deposits. Even Adam Smith, who, according to [Lloyd] Mints (1945, p. 9), had provided the ‘most elegant statement’ of the real bills doctrine, advocated restrictions: they should not be allowed to issue notes in small denominations and all notes should be payable on demand. (Sargent & Wallace 1982, p2 emphasis added)

The Fed’s many banking regulations and the ratcheting-up of the Basel accords regarding international banking are the most recent attempts to govern what can qualify as a demand-deposit of legal tender. Notice that Adam Smith’s restriction to large denomination notes (meant to keep the velocity of social circulating capital low relative to metal coins) cuts in the opposite direction of the modern War on Cash. At the zero bound, we’re seeing new modes of restriction, directed both at the intermediation (banks’ loan practices) and at the physical qualities of cash itself.

Quantity theory has long had a problem with the concept of cash equivalents. In Sargent & Wallace’s day, the challenge was money market funds (I fondly recall getting a 12% return in Vanguard’s Prime Reserve fund at that time!)

That any such ‘means of payment’ approach to defining money leads to difficulties can be illustrated by considering common-stock or money-market mutual funds. Everyone agrees that the function of such funds is to convert fund assets into other assets, shares in the funds, which are more easily held by lenders or savers. Under some circumstances, quantity theorists, who often favor laissez-faire in non-financial markets, endorse measures to restrict the scope of such intermediation. If fund liabilities become too convenient to hold, which is to say become too close to being ‘means of payment,’ then quantity theorists advocate intervention. (Sargent & Wallace 1982, p3 emphasis added)

In the War on Cash, cash equivalents are a Trojan Horse

In 2008, desperate to stanch the collapse of credit, the Treasury offered extraordinary deposit guarantees to money market funds as a subsidy for them to continue holding assets (such as securitized mortgage obligations) that were suddenly considered toxic. When the market threatened to fracture the monolithic edifice of cash equivalents into tiers of differing liquidity, the quantity theorists spent public resources to keep up the appearance of a distinct analytic category. Rumor has it that the Vanguard Prime Reserve fund, which by then paid only a 0.01% nominal return, was actually operating in the red for many weeks during 2009; a claim I have been unable to confirm.

In a sense, this Treasury program half-activated the Fed’s real bills doctrine thereby repudiating the passive role in which it had been invoked in 1929. Treasury’s assurances monetized assets that met a very liberal definition of ‘eligible paper’ without literally rediscounting them. As one move in a larger bailout effort, the after-action reviews have been mixed. But by preventing the worst case of ‘breaking the buck,’ full panic was averted and the appearance of cash equivalence was sustained.

Under Basel protocols, bail-ins will supposedly become the proper way to break the bucks of demand-depositors. It is hard to imagine this will have a calming effect in a panic. It’s only purpose is the orderly redistribution of losses. This is clearly impractical unless the possibility of on-demand redemption into cash has been ruled out. Like an invading army that sacrifices its escape route to emphasize its threat, Europe’s central bank (the ECB) is now eliminating €500 notes, and boarding the Trojan horse of pure deposit accounting. Such is the fervor for electronic fiat. Without a physical debt-extinguisher, and eventually without even a physical incarnation of the unit of account, the way beyond the zero interest bound may now lie open. What will that experiment reveal? Will the Greeks take the city or will the Trojan Horse trap its occupants?

Will the means of payment and store of value stay confined within the central bankers’ legal tenders? Or will people find substitute ways to exchange values so as to avoid losses being redistributed from disturbances in the financial sector? When the official money supply begins to violate peoples’ common sense expectations, increasing in value (deflation) even as their account balances dwindle away (due to negative nominal interest), do you think they will be content to stay within the boundaries drawn around the Quantity of Money that a central bank deems optimal? Friedman says yes. Indeed he says they’ll never be happier than when they’ve done so, as they’ll be holding just the right amount of cash equivalent to stay alive.

The Quality of Money

At this point, you surely know my answer to the above. The proposition that the asset with constant marginal utility can take on a multiplicity of forms is pretty doubtful. Strict cash equivalence is a convenient fiction, well worth trying to construct, but it is a fiction nonetheless. The attempts to mimic gold necessarily fall on a spectrum of fidelity to the original concept. This alternative view, which recognizes differences in degree of liquidity, should be familiar to anyone who has traded in any markets. The intellectual argument for gold standard money, augmented by a free banking system which works (for profit) to match liquidity to the customer’s needs, is more nuanced than the binary ‘our paper is money; your gold coin isn’t’ dictum from a central banker backed by legal tender laws.

In an election year, nuanced reason is drown out by the emotional appeals that assault us daily. Gold’s emotional appeal is muffled by a few weak excuses—the fear, uncertainty and doubts (FUD) sown by anti-capitalist propaganda. Beyond these, stretch the vast cultural memory of money so sound we still refer to the highest quality of any good as its Gold Standard. It is not by accident that Milton Friedman’s publisher and every popular article about bitcoin choose gold coins as illustrations. Only when a gold standard advocate deploys such artwork, is there no bait-and-switch in progress. When you talk about sound money, as an election issue, with other wage earners, or with your children, let them handle a coin or two—not as a boast or taunt, but as a fact of nature. Your arguments and advice will fade but the tangible, inimitable qualities of these valuable tokens will resonate on an emotional level to remind them of what is now, and ever shall be, money… political economists notwithstanding.

Greg Jaxon is an American software engineer and student of New Austrian economics. He devotes as little as 20 minutes a day to challenging reading on the subject because it virtually forecasts the financial news that has everyone else in a panic.

This article was originally published on GoldStandardInsitute (subscribe to their free newsletter).

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