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by George Selgin
University of Georgia
Economists, and central bankers especially, are inclined to treat financial innovations as something that makes managing the money stock more difficult, thus increasing the need for monetary discretion. Financial innovations, the argument goes, tend to lead to unpredictable changes in the "money multiplier" or in the demand for particular monetary aggregates or both. Consequently, the more innovations that occur, the less merit there is in monetarist arguments for binding the hands of monetary authorities, making them obey strict rules, and monetary base growth rules in particular. The emergence of new electronic means of payment, or "e-money," is only the latest private financial-market wrinkle to excite the anxieties of central bankers while giving them grounds for asserting their right to improvise.
But there is another way to think of financial innovations, which leads to quite opposite conclusions. Financial innovations are the private market's way of supplying new and improved alternatives to central-bank issued payments media. The more such innovations succeed, the less the public has to rely on central banks as direct sources of exchange media. And, the less the public has to rely on central banks, the more it can afford to deny such banks discretionary powers.
This seem to me to be particularly obvious in the case of e-money. For most of this century the Federal Reserve, like most other central banks, has had a monopoly of hand-to-hand currency. Regulations, including a prohibitive tax on state bank notes and bond-collateral requirements for National Bank notes, both dating back to the Civil War, have long prevented private financial firms from directly challenging the Fed's currency monopoly even when they might have been able to offer more attractive and efficient alternatives. The public has therefore had little choice but to allow the Fed the freedom to issue too much money, or bear the consequences of being stuck with too little.
The development of electronic money, and cash cards especially, means that the public need no longer be hostage to the Fed. E-money amounts to a technological end-around play, circumventing long-standing restrictions on private bank notes. In principle at least, cash and debit cards together could entirely take the place of Federal Reserve Notes. The money stock would then be fully privatized, with the Fed serving only as a source of bank reserves. Far from making a strict monetary base rule less workable, such a privatized money stock would make it more workable than ever, because the Fed would no longer have to have the power to adjust the amount of base money in response to changes in the public's demand for cash.
A little algebra helps clarify the argument. As any student of money and banking knows, up to now our monetary system has been one in which the money multiplier--the ratio of total public deposit and currency holdings to the monetary base (the outstanding amount of Federal Reserve Notes and bank reserve credits at the Fed)--depends on at least two variables. These are (1) the public's desired currency-to-deposit ratio (c) and (2) the bank's desired reserves-to-deposit ratio (r). The formula for the multiplier is m = (1 + c)/(r + c), where the total money stock, M, is equal to mB, and B stands for the monetary base. In this formula, B is the only thing that the Fed controls with any degree of precision. The great virtue of a monetary base rule is, therefore, that the Fed could not fail to abide by such a rule except through outright negligence or caprice. In contrast, with any other sort of rule (including a zero inflation rule), the Fed could always plead unforeseen circumstances if it failed to keep its promise.
A long-standing argument against a monetary base rule is that such a rule would not allow the central bank to adjust the base in response to unforeseeable changes in the currency ratio. Unpredicted changes in c would then lead to undesired changes in the money stock, nominal spending, and prices. The emergence of e-money strengthens the case for a strict monetary base rule by, in effect, setting the stage for removing the currency-ratio as a factor in the money-multiplier. The multiplier would then be simply 1/r--the reciprocal of the banking system reserve ratio. The challenge of monetary control would be simplified accordingly: With one less variable to worry about, the Fed would have one less reason to improvise.
That at least would be true if e-money could completely take the place of Federal Reserve Notes, making further issues of such notes unnecessary, and allowing the Fed to simply "sterilize" old notes turned in by banks for reserve credits, by automatically reducing its base-money growth target by (1 - r) times the value of returned notes. In fact, with perhaps $100 billion in Federal Reserve Notes still circulating within U.S. borders, we have a long way to go before we can afford to shut down the Bureau of Printing and Engraving. Poor people especially may need some encouragement to induce them to trade their greenbacks for cash cards. Perhaps the government might help things along by equiping needy applicants with free cards and card readers, financing the operation with funds diverted from the printing-presses. But don't expect either the Fed or the Treasury to jump at this idea: Both agencies stand to loose both revenue and power from any reform that lessens the demand for government paper money.
Of course even a thoroughgoing privatization of the money stock isn't enough to make a strict monetary base rule work perfectly: Undesired fluctuations in nominal incomes and prices could still occur as a result of unforeseen changes in the reserve ratio or the demand for money. But the monetarist case for a monetary rule has, after all, never been based on the claim that such a rule would be perfect. It is based on the claim that an imperfect rule would be better than any potentially ill-used, and therefore also imperfect, central bank discretionary powers. Monetarists ought to be grateful to e-money, for helping to bring a strict monetary base rule one step closer to perfection.
Prepared for the Cato Institute's 14th Annual Monetary Conference, May 23, 1996, Washington, D.C.