I recently had a thoughtful comment on LinkedIn in reply to Replacing the Fed with a computer from someone on the far-opposite spectrum on monetary policy thinking as me. To see the whole discussion click here. Now, I don’t think a fix-amount-of-currency monetary policy could work because of human psychology, but I love thought experiments. Therefore, I wanted to consider whether it could work somehow. Below are the five criteria the comment outlines:
In my opinion the best currency guarantees neutrality and is immune to manipulation by a central entity. In that sense I think Bitcoin is less of a pseudo-currency than the USD or the EUR, because:
1-It guarantees a stable money supply regardless of what certain GDP statistics and Price Indexes might say, that invariably induce central banks to a) print more money or b) print even more money at the expense of the purchasing power of the majority of the population.
2-It guarantees that interest rates correspond to the real risk of borrowing money to a certain entity, instead of being something cooked up by a central bank that decides the level of ‘steroids’ the Economy needs to continue its induced artificial growth.
3-It guarantees that everyone respects a 100% reserve requirement, i.e., you have to be willing to save a certain amount of money to be able to borrow that same amount of money.
4-It guarantees that whether we are in an inflation or deflation scenario, there’s always a global interest rate bid-ask.
5- And finally, it can destroy the Keynesian myth that deflation = lower wages => lower purchasing power, as well as the myth that deflation/inflation is an egalitarian measure that hits the 1%, the 10% and the 89% the same way.
I think what the comment is recommending is something like what Bitcoin will become (provided that mining rewards are actually capped at 21 million bitcoins in the future). All the five points above relate to having a fixed supply of money at some point in the future. This policy would be very deflationary. As world population and economic output grow, fewer bitcoins would chase more goods and services. The value of a single bitcoin would grow just by holding it.
Oddly enough, there may be a world where this actually works, and it’s a world some European countries are flirting with now. Negative interest rates. Apparently even in a world with cash, interest rates can go negative (see Scott Sumner’s blog post). But with a crypto currency, you could feasibly make interest rates as negative as you like.
First off, let’s examine the possible target of a monetary policy for a currency, private or public:
- Nominal GDP growth: This would insure that nominal incomes rise by 5% per year. In a credit economy like ours where we buy houses with 30-year mortgages, this is an ideal policy because we can match our credit spending with our future income expectations.
- Money stock growth: Milton Friedman famously said we could replace the Fed with a computer that just made sure the money stock grew. The one ratio he leaves out of this policy is velocity. In Friedman’s world, a fixed amount of cash would expand based on reserve ratios and deposit ratios. But income could crash based on a fall in velocity.
- Commodity price: The gold standard guaranteed a certain amount of gold for every dollar (or pound or franc or mark). But the amount of monetary gold can (and did) fluctuate depending on demand. Those fluctuations just took a longer time to play out than under our current fiat currencies. So greater demand for hard currency in the later 1800’s which resulted in the free silver movement was only solved by major discoveries and improvements in technology.
- Fixed amount of currency: This is like what the comment above proposes, and what Bitcoin may become.
What would interest rates look like under the above regimes? Here’s where the commenter goes off the rails. Our credit economy rests on ever-growing amounts of currency and nominal income. We take out big mortgages because we expect our incomes to grow over time. Thus we will tolerate 5% interest rates on our loans because those loans will shrink as time goes on. But the less expansionary our money stock gets, the lower interest rates will be.
The author is correct in pointing out that more expansionary regimes reward debtors at the expense of savers. Because the biggest debtor is usually the sovereign, there’s a conflict of interest. But the sovereign also provides the legal framework under which we use credit. It’s hard to see a private currency like Bitcoin displacing the US dollar short of a massive inflationary crisis. Despite what the doomsayers say, lots of inflation is not just around the corner. In fact central banks have been too tight with money, which is what caused the 2008 collapse in nominal GDP growth. Also, there’s good reason private currencies in the past never succeeded. Without the backing of sovereign law, it’s hard to get the benefits.
However, let’s imagine for a moment that such a crisis did occur, and it led to the widespread adoption of a currency fixed in its amount. For sake of ease, let’s say it’s value is what the dollar is valued today (we’ll call it a fixed dollar). And let’s also pretend that we’re starting from scratch in terms of credit. Because the crisis was massive inflation, that would probably be the case anyway.
So with no mortgages, no bonds, no loans, my salary might be $50,000 fixed dollars per year. But if the real economy grows at 3% per year simply because of population growth (and my productivity stays the same), next year my $50,000 buys $51,500 worth of real goods compared to last year (my nominal salary stays $50k).
If I’m in a low-skilled job and my productivity never increases, my company is still giving me a 3% raise every year just by virtue of real economic growth. In 20 years I’ll be able to buy almost $88,000 of goods just by maintaining my salary even if I do the same exact job with the same exact skills.
Clearly companies wouldn’t accept this. Instead of seeing raises, my wages would be cut. So in 20 years my salary would be $28,000. I’d be no worse off because prices would be the same amount lower. Therefore I should be happy, right?
What happens to the interest rate I’m willing to accept for a 20-year mortgage? Either I can plan for an extremely low mortgage or I’d need a negative rate to keep pace with my falling wage. With a crypto currency that didn’t allow you to hold physical money (or stash them somewhere outside the interest rate regime), you could have varying degrees of negative rates depending on risk (the less risky, the more negative). I could then tolerate falling wages so long as my credit obligations shrank alongside my wages.
The other way for our fixed dollar system to work would be to have no credit. Instead of mortgages, we’d rent until we could buy a house outright. The commenter’s point 3 seems to make an argument for this. But credit is very useful. We use it to smooth out life cycle consumption. When we’re young we take out debt to buy a house (and force ourselves to put ever-increasing equity into our house). We expect our incomes to grow to a point where we can more than afford the house. Then we retire and remove some of that equity to live.
Companies work the same way. Whether by shares or bonds or commercial loans, good business opportunities demand up-front money now with the promise of increased future money repaid. A fixed dollar regime would change those calculations. If you invested in a company, you would be happy with a less-negative payback than the negative rate on your bank savings. The whole system becomes a bizarro world where up is down, black is white, etc.
Mathematically and logically, a system with fixed currency and varying negativity in interest rates could work. But it works against the psychology of money we’ve been living with for a very long time. Mainly, we all believe that incomes rise and interest rates are positive. It’s very difficult to get your head around a flipped world where most rates of return are negative. A currency that works against human psychology may offer improvements in transaction efficiency, but will never replace sovereign money.