Juan Ramón Rallo has thoughtfully replied (in English) to my earlier Alt‑M post that discussed two versions of the real-bills doctrine and what I took to be his defense of a prudent-banking version of the doctrine. Here I offer a few comments on his reply.

1. One topic under discussion is the common banking practice of borrowing short and lending long (aka maturity transformation). The practice is remunerative to the bank when short-term interest rates are lower than long rates, but it exposes the bank to risks that I previously discussed.

   In his latest piece Rallo suggests a categorical condemnation of the practice: “The banks that transform the maturities of their assets and liabilities are causing a discoordination between savers and investors. They are promising savers to redeem their liabilities much sooner than the moment when their assets will be paid by investors, i.e., they are promising savers the availability of some future goods before they are provided by the investors’ projects they are financing.” In my view, by contrast, whether there is a “discoordination” does not depend so much on the promises or contract terms, or what we may call the de jure maturities, as on the de facto maturities.

   As Rallo recognizes, holders of short-term liabilities have the option to roll them over. This is especially obvious for demand deposits that remain in the bank for longer than one instant. A one-year certificate of deposit that is renewed at an unchanged interest rate can be considered de facto a two-year (or longer, if renewed again) deposit. This means that a profit-seeking bank faces the challenge of estimating the distribution of actual times-to-withdrawal-or-repricing of its liabilities, which are longer than the de jure maturities.

Ben Bernanke’s memoir is now out and is unapologetically pro-Fed. It is titled The Courage to Act. Here is the cover quote:

The main point of Bernanke’s book is that absent the Fed’s interventions over the past seven years the U.S. economy would have undergone another Great Depression. Thanks to him and his colleagues at the Fed the world is a much better place.

There has already been some push back on this Bernanke triumphalism. George Selgin, for example, notes that the recovery under Bernanke’s watch was anemic. Inflation consistently undershot the Fed’s target and the real recovery was weak. We may not have experienced another Great Depression, but we sure did get a long slump. Ryan Avent makes a similar point by observing that Bernanke had a chance in late 2011 to do something bold by endorsing a NGDP target, an action that could have jolted the economy from its doldrums. But alas, Bernanke failed to muster up the courage to have what Christina Romer called his “Volker Moment”.

Expect more push back along these lines from a book with such a bold title. One strand of criticism that many observers miss, but I hope will be considered in future reviews of Bernanke’s book is the role the Fed played in allowing the crisis to emerge in the first place. Could the Fed have done more to prevent the recession from becoming as severe as it did? Maybe a recession was inevitable, but was a Great Recession inevitable? These are the questions first raised by Scott Sumner and echoed by others including me. Our answer is no, the Great Recession was not inevitable. It was the result of the Fed failing to act aggressively enough in 2008.

This understanding draws upon the fact that the housing recession had been going on for about two years before a wider slowdown in economic activity occurred. As seen in the two figures below, sectors of the economy tied to housing began contracting in April 2006 while elsewhere employment growth and nominal income continued to grow. This all changed in the second half of 2008.

So what went wrong in the second half of 2008? Why did a seemingly ordinary recession get turned into a Great Recession? We believe the Fed became so focused on shoring up the financial system and worrying about rising inflation, that it lost sight of stabilizing aggregate demand. Based on theses concerns, especially the latter, the FOMC decided to do abstain from any policy rate changes during the August and September 2008 FOMC meetings. But by doing nothing at these meetings the FOMC was doing something: it was signaling the Fed would not respond to the weakening economic outlook. The FOMC, in other words, signaled it would allow a passive tightening of monetary policy in the second half of 2008.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in money velocity. The decline in the money supply and velocity are the result of firms and households responding to a bleaker economic outlook. The Fed could have responded to and offset such expectation-driven developments by properly adjusting the expected path of monetary policy.

The figures below document this monumental failure by the FOMC. The first one shows the 5‑year ‘breakeven’ or expected inflation rate. This is the difference between the 5‑year nominal treasury yield and the 5‑year TIPs yield and is suppose to reflect treasury market’s forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and half months leading up to the September FOMC meeting. This forward looking measure was screaming trouble ahead, but the FOMC ignored it.

One way to interpret this figure is that the Treasury market was expecting weaker aggregate demand growth in the future and consequently lower inflation. Even if part of this decline was driven by a heightened liquidity premium the implication is the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers’ monthly nominal GDP data indicates this is the case:

The Fed could have cut its policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just the change in the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signaling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten.

Recall that Gary Gorton provides evidence that many of the CDOs and MBS were not subprime, but when the market panicked a liquidity crisis became a solvency crisis. This is especially true in late 2008. Had the Fed responded to the falling market sentiment in the second half of 2008 the financial panic in late 2008 may have been far less severe and the resulting bankruptcies fewer. Again, the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed.

So had Fed had the courage to act in 2008 the economy would be in a very different place today. Future reviewers of Bernanke’s book should keep that in mind.

P.S. For a more thorough development of this view see the book by Robert Hetzel of the Richmond Fed.

[Cross-posted from Alt‑M.org]

Volatility is a well-recognized impediment to the success of Bitcoin as a currency. An example of the argument for volatility-based caution about Bitcoin, chosen at random, appears in Professor David Yermack’s December 2013 NBER working paper, “Is Bitcoin a Real Currency? An Economic Appraisal.” Wide swings in the price of bitcoins vis á vis other things will obviously tend to suppress its utility as a store of value or unit of account. Nobody wants to deal with recalculating prices denominated in Bitcoin day over day or hour over hour.

But I’ve long felt the volatility knock on Bitcoin to be slightly unfair. My favorite response line has been to say that judging Bitcoin based on its current volatility is like declaring a 10-year-old unfit to play in the NBA because he’s too short.

As a new asset class (or very different member of the “cash or cash equivalent” asset class), Bitcoin has yet to find its place in the world. The uses to which it is put will ultimately translate into a dollar price based on a recognized, relatively steady level of demand. Right now, speculation about where demand for Bitcoin will end up takes place in thinly traded markets. Just those two ingredients — uncertain future use and thin markets — are recipe enough for plentiful volatility.

But there’s every reason to believe that the market for Bitcoin will deepen and grow in sophistication, tempering its volatility. The capacity of the Bitcoin protocol to transfer and store value in exciting new ways will produce transaction demand — supplanting speculative demand, which today dominates because of anticipated price appreciation. Transaction or “use” demand will also increase because of Bitcoin’s capacity to administer countless economic and social functions beyond value transfer, including messaging, proof of authorship, land and title registry, and identity/​naming. This will drive volatility down, I believe, both because it will shift bitcoins out of speculation and because it will give the markets more concrete information about what use demand is and will be.

Based on an estimate from two years ago or so — eons in Bitcoin time — I spent much of 2014 saying that Bitcoin volatility was dropping at a rate of about two or three percent per year. This suggested that it would have dollar-price stability similar to that of the Euro in ten to fifteen years. That’s not bad for an all-new currency (or whatever Bitcoin is). It’s looking, though, like that time estimate was wrong.

Eli Dourado at the Mercatus Center recently updated his site for tracking Bitcoin volatility to include some other currencies and assets. The update opens new and interesting windows. In particular, it reveals that earlier this year, the Euro and Bitcoin had nearly the same 30-day volatility against the dollar. On June 8th, Bitcoin had volatility of 1.13% and the Euro’s was 1.00%.

That doesn’t suggest at all that Bitcoin’s volatility problem is solved. When the two volatilities air-kissed, Bitcoin’s was near a historic low and the Euro’s was at a high. Bitcoin’s volatility has risen again since, with jumpy Bitcoin prices attributable to the summer’s machinations in Greece and Bitcoin’s “blocksize” debate. But the overall trend shows a marked and relatively rapid drop in volatility relative to my earlier prediction of ten- to fifteen-year parity.

Using Dourado’s data, it’s easy to make a graph that, while far less attractive, shows the strong downward slope to Bitcoin’s volatility. That trend won’t continue, and it will still be some while before Bitcoin has the kind of low volatility that makes it a reasonable store of value or unit of account for people whose alternatives are the dollar, the Euro, and other major currencies. But many people around the world are not in that category. They may adopt Bitcoin to protect themselves from local currencies with even greater swings, or consistent loss of value. This will improve the volatility picture for the rest of us.

I see many virtuous dynamics around Bitcoin volatility in the offing. These may be relevant, or they may be evidence of my need for education. Eli takes pains to point out on his site that the Bitcoin and Euro volatility numbers are incompatible because markets for fiat currency are closed on weekends and holidays. The data “are presented for entertainment purposes only,” he says. I agree with the sentiment, and offer this post in the same spirit.

[Cross-posted from Alt‑M.org]

The FOMC decided last week against raising interest rates given its concerns about the global economy and financial conditions. While these concerns are reasonable, the FOMC’s decision highlights a growing problem that has increasingly plagued the Fed since the crisis erupted: its incredibly ad-hoc approach to monetary policy.

Just a few months ago the FOMC was signaling it would almost certainly raise interest rates, but now it has changed its mind. This change would not be so bad if it were predictable, but it was not so. No one expects the Fed to perfectly forecast the economy, but we should expect the Fed to make clear how it would respond to differing states of the economy. This simply has not happened. From the QE programs to forward guidance to lifting interest rates from zero, Fed policy has been made up on the fly. This unpredictable behavior has meant that no one, including Fed officials, knows for sure what will happen from one FOMC meeting to the next.

As a result, markets have become more and more obsessed with every word coming from the mouths of Fed officials. Post-FOMC press conferences like the one last Thursday became must-watch TV for anyone concerned about investments. Ironically, then, the Fed’s attempt to calm markets through these ad-hoc measures has only made them more fragile.

It would be far better for the Fed to focus on a narrow mandate in a rule-like manner that makes conditional forecasts possible. For example, if the Fed were to target a stable growth path for total dollar spending and adjust policy as needed to hit it there would be far less of the Fed’s current guessing game. The FOMC’s decision last week highlights how sorely this change is needed.

[Cross-posted from Alt‑M.org]

For all the ink spilled on TARP — the bailout package authorizing the Treasury to purchase or insure up to $700 billion of “troubled assets” during the financial crisis — that program is dwarfed by another market intervention that occurred around the same time. In fact, the Government Accountability Office estimates that the Federal Reserve lent more than $16 trillion to financial firms between December 2007 and July 2010 — a figure that comes close to matching the entire, annual gross domestic product of the United States.

On Wednesday, Cato’s Center for Monetary and Financial Alternatives hosted a two-part discussion of the Federal Reserve’s emergency lending power, and the legislative efforts underway to reform it. The first panel saw the Washington Post’s Ylan Mui interview Phillip Swagel, a former Treasury official turned University of Maryland professor, Marcus Stanley, the policy director at Americans for Financial Reform, and Mark Calabria, Cato’s own director of financial regulation studies. United States Senators Elizabeth Warren (D‑MA) and Richard Vitter (R‑LA) joined us for the second panel, during which they outlined their proposed “Bailout Prevention Act of 2015,” as well as their broader, bipartisan quest to end “too big to fail.”

As the participants in our first panel explained, the Fed’s emergency lending is governed by Section 13(3) of the Federal Reserve Act. At the time of the financial crisis, this gave the Fed broad authority to lend to “any individual, partnership or corporation” in “unusual and exigent circumstances” so long as “other banking institutions” were not prepared to pony up the cash. The Dodd-Frank Act of 2010 tried to temper this unbridled discretion, introducing a sensible requirement that the Fed only lend to solvent institutions as part of a broad-based program of market support. Alas, the devil proved to be in the detail — or, rather, the lack thereof.

The legislative intent in Dodd-Frank was clear enough: the Fed should intervene when a lack of market liquidity imperils otherwise viable firms, but it shouldn’t be in the business of bailing out specific, failing institutions. And yet, as several of our panelists explained, the Fed’s subsequent rulemaking took a far looser view: as far as the central bank is concerned, a program is “broad-based” as long as more than one firm receives support, and a firm is insolvent only if it has already entered bankruptcy proceedings. In other words: the Fed can continue to do more-or-less as it pleases.

Why is this a problem? Enter Senators Warren and Vitter. As they both pointed out, the goal of their proposed legislation is not simply to tie the Fed’s hands in a crisis. Rather, their overriding concern is that the very existence of these broad powers to bail out financial institutions encourages risk, leverage, and cavalier management in the banking industry, while simultaneously undermining any incentive lenders and investors have to supervise the financial firms into which they put their money. As Warren explained,

If you advertise to the market that the Fed is here, and no need for any large financial institution ever to have to go to the bankruptcy court house or declare itself insolvent, but instead there will be trillions of dollars available to back up these giant institutions, I think that changes fundamentally the behavior of the big banks themselves, the behavior of those who lend them money, the behavior of those who invest in them. And I’ve got to say, in all three cases: “not for the better,” because it encourages riskier behavior knowing that there is an option available.

Warren and Vitter went on to point out that this whole dynamic distorts the market over time, tilting the playing field in favor of the biggest banks — for whom implicit government guarantees mean a lower cost of capital — and eroding the competitiveness of smaller financial institutions, who know they are not too big to fail. This leads, in Warren and Vitter’s view, to greater market concentration and more systemic risk — the very things that financial regulation seeks to avoid.

Accordingly, the senators’ proposed “Bailout Prevention Act” would significantly tighten the rules surrounding the Fed’s 13(3) emergency lending, as amended by Dodd-Frank. First, it would define “broad-based” to mean that at least five firms must participate in any emergency lending program. Second, it would require that those participating firms certify that the value of their assets exceeds their liabilities. Third, it would insist that any emergency lending be offered at a penalty rate five percentage points above that on Treasury Bills. As Mark Calabria put it, “part of this should be making the Fed actually a lender of last resort, rather than a rescuer of first resort.” It certainly seems like a good start — even if some of us would prefer that there was no lender of last resort at all.

The full discussion, which also touches on the best way to approach financial regulation going forward, is available below.

[Cross-posted from Alt‑M.org]

The “real-bills doctrine” was roundly rejected by postwar monetary theorists of both the Chicagoan and the Austrian perspectives (Lloyd Mints 1945, Ludwig von Mises 1949). But George Selgin (1989) was right to warn us that “it would be a mistake to think of the real-bills doctrine as a ‘dead horse’” because “dead horses of economic theory have a habit of suddenly springing back to life again.”

In recent years no less prominent an economist than Thomas Sargent (2011) has declared that in the debate over alternative monetary regimes, “The real bills doctrine is alive and well today.” Most recently the leading young Spanish economist Juan Ramón Rallo of the OMMA business school and the Juan de Mariana Institute in Madrid has defended propositions that he identifies with the real-bills doctrine. Rallo draws on the writings of Antal Fekete, who has been advancing what he calls “Adam Smith’s real bills doctrine” for more than 20 years. I had the pleasure of an on-stage dialogue with Professor Rallo in Madrid this summer, where we discussed aspects of the doctrine. Fortunately, what Rallo actually defends is mostly free of the shortcomings of the usual versions of the real-bills doctrine.

To begin, let’s identify what is a real bill. To use a common example, a miller sells $1000 worth of flour to a baker and presents a bill for $1000 with payment due in 90 days. The baker endorses the bill, pledging to pay $1000 in 90 days. He plans to pay out of income to be made by producing and selling bread from the flour. The miller need not wait 90 days to get paid but can immediately sell the endorsed bill to a bank (one that considers the baker a good credit risk) at its present discounted value, say $980. The bill is “real” in being “backed” by tangible goods in process. Thus real bills are short-term commercial IOUs that finance goods through stages of production. High-quality real bills are low in default risk and liquid (have a thick secondary market with small bid-ask spreads).

It is crucial to distinguish between two different doctrines that refer to real bills.

(1) The first real-bills doctrine is a norm for money issuing. It says that a banking system will automatically issue the right (equilibrium) quantity of monetary liabilities (banknotes and checkable deposits), and will not over-issue no matter what quantity it issues, if it always issues in exchange for real bills offered to it, and never in exchange for other assets (government bonds, ordinary loans). In some versions it doesn’t matter whether the system is dominated by a central bank or whether it is on a gold standard. Thus the British anti-Bullionists claimed that the Bank of England could not have over-issued while off gold 1797–1819 because the Bank only discounted real bills, a claim endorsed by John Fullarton of the Banking School in the 1840s. The Federal Reserve proclaimed a similar doctrine in the 1920s. A monetary policy guide is clearly what Sargent (2011) has in mind when he contrasts the real-bills doctrine to the quantity theory of money. (As David Laidler (1984) showed, however, what Sargent and Wallace (1982) enunciated wasn’t the traditional money-issuing real-bills doctrine. Neither is the position that Sargent (2011) defends.)

The errors of the monetary policy doctrine are well known. (a) It wrongly takes the nominal quantity demanded of a particular type of credit as a reliable guide to the nominal quantity of money the public wants to hold. Not only are these quantities different but, as Henry Thornton noted back in 1802, a central bank can increase the quantity of credit demanded simply by supplying more money, which lowers its discount rate and raises the price level. (b) It wrongly takes the quality of bank assets acquired as a reliable governor of the quantity of monetary liabilities issued. (c) It makes redeemability of bank liabilities (in gold or otherwise) an inessential “fifth wheel” in the process that determines the quantity of money.

The money-issuing norm is what critics of fractional-reserve banking have in mind when they assert (Hülsmann 1996, p. 20) that modern free banking theorists “are nothing but modern advocates of the real-bills doctrine” or (Baeriswyl 2014, p. 13) that our theory “repeats basically the same error as the real bills doctrine.” Such criticism is completely off the mark, because modern free banking theorists (among which I count myself) have consistently rejected the real-bills money-issuing norm. In particular, Selgin (1989) and White (1995, ch. 5) emphasize its errors and show how it differs from our theory of the self-regulating properties of a free banking system.

In a nutshell, our account of the self-regulation of the quantity of bank-issued money (banknotes and checkable deposits, redeemable on demand) in a competitive free banking system centers on the premise that profit-seeking banks must carefully attend to their reserve positions. Running out of reserves and defaulting is costly. A bank that issues an excessive volume of demandable liabilities will soon experience adverse clearings (will lose reserves to other banks). To lower the risk of payment default it will be compelled to reverse its expansion to stop the outflow and rebuild its reserves. Conversely, a bank that issues less than its clientele wants to hold will gain reserves and find it profitable to expand. These responses to adverse or positive clearings will return the quantity of bank-issued money at an individual bank, and economy-wide (where flows of reserves out of and into the system play an important role), to the quantity demanded. This account does not refer to the type of earning assets that any bank holds, whether real bills or otherwise, as central to the self-regulation of the money stock. Thus it does not share any of the errors of the real-bills money-issuing norm.

While not offering a quantitative guide, selling and buying real bills did offer a convenient means for a bank to contract and expand the volume of its demandable liabilities in response to changes in demand (Glasner 1992), as indicated by changes in its reserves. Attention to reserve surpluses and deficits, not any property of the bills themselves (short duration, low default risk, liquidity) automatically guided a bank (and the banking system) to contract and expand appropriately. The maturation of bills of exchange did not as such compel a commercial bank or a central bank to contract (it did not “close a vent,” contrary to the Banking School’s “law of the reflux”). A bank unconcerned about its reserves could always purchase new bills to replace maturing bills.

Nor did a system-wide reduction in the quantity of bills offered to the entire banking system at a given lending rate – even a reduction associated with fewer goods in process – compel the banking system to decrease the overall quantity of monetary bank liabilities by an equivalent amount to maintain monetary equilibrium. A decrease in the demand for credit is not the same as a decrease in the quantity of bank liabilities that the public wants to hold. Though both are correlated with a decrease in output, the correlation is less than 100%, and the coefficient is not one (the demand to hold bank-issued money does not decline 1:1 with the volume of real bills discounted). Normally a system-wide decrease in the demand for credit in the bill market calls for an equilibrating decrease in the market discount rate.

Conversely an increase in the quantity of bills offered at a given lending rate, associated with more goods in process, does not signal that the entire increased volume of bills can be prudently purchased at the previous discount rate. A rise in the rate is called for to ration the scarce supply of funds that the banks have with which to intermediate. Competition for now-scarcer funds implies a concomitant rise in the deposit rate, which will somewhat increase the quantity of deposits demanded, but again not generally 1:1 with the volume of bills discounted. By contrast the money-issuing norm version of the real-bills doctrine calls for accommodating all offers of real bills for discount, presumably at an unchanged interest rate, and is silent on the need for equilibrating changes in interest rates.

(2) The second real-bills doctrine – and the one that Rallo proposes – is a prudent banking norm. Its origins lie in remarks Adam Smith made in The Wealth of Nations. Smith recommended real bills as a safe commercial bank portfolio asset. (Actually both real-bills doctrines are in Smith, including an erroneous money-issuing norm. But Smith also offered a more correct analysis of money-stock self-regulation, noting correction via reserve losses when a bank or a banking system tries to issue more liabilities than the public wants to hold.) A prudent bank should avoid purchasing unreal bills, Treasury bonds, or mortgages.

The prudent-banking real bills doctrine, which is what I take Rallo to be defending, is basically innocuous with respect to monetary theory so long as it does not contend that a bank purchasing only real bills cannot over-issue its liabilities. It is irrelevant to understanding how redeemability and the adverse clearing process regulate the quantity of bank-issued money.

There is much to commend (in my view!) in Rallo’s writings when he rejects mandatory 100% reserves in banking and when he favors free banking over central banking. [All the quoted passages to follow are my Google-aided translations from the original Spanish.] He rightly observes (Rallo 2013a) that a 100% gold reserve requirement “will provoke such economic inefficiencies that it will inevitably be abandoned.” Thus “the real choice is between a free-market monetary and credit system” and an unfree system. He told an interviewer: “Of course society without monopolistic state organs can soundly self-regulate the value of money and credit,” adding that healthy credit “occurs naturally in a competitive market.”

Clearly Rallo does not want to impose any real-bills requirement by statute or regulation, and he does not view the real-bills doctrine as a set of instructions for central bank policy. Rather, he views (Rallo 2013) the doctrine as a prudent banking norm toward which competition will compel free banks to practice:

A bank without privileges in an environment of freedom is therefore to be prudently managed, which in my view would result in having covered its financing with cash or self-liquidating short-term credits and in counting on abundant capital to absorb losses in relation to the risk assumed in its assets. It is what is known as the Real Bills Doctrine.

Modern free banking theorists would agree that competition in an unprivileged banking system promotes prudent bank management (insolvency and its resolution weed out the imprudent), and everyone can agree that prudence includes adequate liquidity and adequate capital. But I have two concerns about the above statement.

First, contrary to the last sentence quoted and as already noted, a prudent banking norm is not the only or even the main idea known as the real-bills doctrine. Historians of economic thought commonly use the name to refer to the money-issuing norm described above. Free banking theory rejects the real-bills-centered view about the process that regulates the quantity of broad money. Again, Rallo is not defending a money-issuing norm here, but rather talking about prudent bank management.

Second, the concept of “self-liquidating” (autoliquidable in Spanish) credit, which Rallo invokes here and in other writings, is unhelpful to clear thinking. In some authors’ arguments it is part of the magical thinking underlying the notion that real-bills-only discounting will properly regulate the quantity of money.

What does “self-liquidating” mean? Every debt instrument of finite maturity is “self-liquidating” in the sense that it eventually comes due and the borrower ordinarily repays the principal. So that can’t be it. Rallo cannot mean by “self-liquidating” only that the debt will come due soon, because then it would be redundant in the above-quoted phrase “self-liquidating short-term credits.” Instead “self-liquidating” seems to signify an IOU that (like a real bill) finances a batch of goods in process through a stage of production, like the batch of flour in the example above, such that the sale of the goods ordinarily enables repayment of the IOU. (Sometimes “self-liquidating” bills are said to be those financing consumer goods, or goods in high demand.) But business loans of all kinds finance projects that are expected to generate revenues sufficient to repay the loans. Granted, real bills were typically lower-risk assets than ordinary business loans, but of course the repayment of a real bill did not carry zero risk. The bill might not be repaid if for whatever reason the goods were not produced in timely fashion (the flour was not baked into bread within 90 days) or the products did not sell at the expected price.

Rallo has a broader concern about imprudent banking: the danger of banks undertaking “harmful maturity mismatch” by making long-term loans with short-term deposits that might not be rolled over. Holding real bills (or other short-term assets) instead of longer-term loans reduces the mismatch. Maturity mismatch, aka maturity transformation or duration gap, is a practice that does carry risks as well as performing a valued service for which there is normally a reward. The reward for a bank with a positive duration gap (assets longer than liabilities) is that it borrows at a lower rate and lends at a higher rate than with a zero gap in a market where (as usual) long rates are higher than short rates. The risk is capital loss when rates rise. If the bank has to pay unexpectedly higher deposit interest rates to roll over its deposits, before it can roll over its loans, then it suffers a loss in net worth. The US savings banks hugely suffered such losses in the 1980s.

Rallo seems to be of two minds on the extent to which a free banking system would exhibit excessive maturity mismatch. On the one hand he writes (Rallo 2009): “While I can agree with Selgin that a system of free banking would curb credit expansion and tend to remain liquid, I deny that any banking system (free or not) can be kept liquid by borrowing short and investing long. And we should not overlook, however superior free banking is in comparison to central banking monopoly, the risks and trends that exist in the former to artificially inflate credit.” On the other hand, and more accurately I think, Rallo (2012) recognizes that a free banking system will limit undue risk-taking by making imprudent bankers bear the consequences of their own actions:

Fortunately, in a market where the currency and banking develop in freedom and without government privileges, banks have little room for these dangerous operations, because as soon as their creditors stop refinancing them, they fall into receivership. Unfortunately, in our ultra-interventionist and ultra-privileged market, a state institution called the central bank has the monopoly of issuing paper money, allowing it to provide cheap refinancing to private banks that have large maturity mismatches … and perversely to prolong the duration and devastation of economic cycles.”

Note that the US savings banks, which suffered from huge duration gaps when interest rates rose sharply in the early 1980s, were not operating under laissez-faire. They had been specifically compelled by law to keep almost all of their asset portfolios in fixed-rate home mortgages.

To summarize: the characteristic of being backed by goods in process does not endow a bank-owned IOU with any special qualities not equally present in, or make it any more prudent to hold than a differently-backed IOU with equivalent default risk, liquidity, and maturity. An emphasis on real bills as the mark of prudent banking is therefore misplaced, as opposed to an emphasis on the management of default risk, liquidity, and capital risk from duration gap. These properties – not “self-liquidation” or any property of automatically regulating money-issue – explain why prudent banks in a historically competitive system, like Scotland’s held real bills in their asset portfolios.

[Cross-posted at Alt‑M.org]

If I haven’t been posting much lately, it’s because I’m working on a paper about the 1908-12 National Monetary Commission, and have been up to my neck in research concerning it. As that commission supplies a precedent for the Centennial Monetary Commission plan that’s presently wending its way through Congress, I thought it would be a good idea to take a closer look at it so as to better understand its merits and shortcomings, with the aim of suggesting how the new Commission might replicate the first while avoiding the last.

That the original Monetary Commission was hardly free of shortcomings seems evident enough today, for it was largely thanks to that commission’s efforts that we ended up with the Federal Reserve System, the failures of which have prompted requests for a new commission. But there were also those who recognized the Fed’s shortcomings even before the Federal Reserve Act became law at the end of 1913. One of them was Elihu Root, a brilliant Republican Senator for New York.

Root offered his blistering criticisms of the Fed in a speech delivered just day’s before the Federal Reserve Act’s passage. He especially took aim at the bill’s provision — included as a sop to William Jennings Bryan and other influential populists within the Democratic party — making Federal Reserve notes obligations of both the Federal Reserve banks themselves and of the United States government. That provision, Root observed, encouraged other banks and the public to treat Federal Reserve notes as the equivalent of greenbacks, and hence as legal tender in fact if not (yet) in name.

There would, consequently, be no tendency for those notes to be routinely returned to their sources, or to the U.S. Treasury, for redemption in either actual greenbacks or gold. It followed that, despite the language of its preamble, the Federal Reserve Act did not actually provide for an “elastic” currency, and therefore did not achieve what had long been almost universally regarded as the very sine-qua-none of currency reform. As Root put it:

What is an elastic currency? We all agree that it is a currency which expands when more money is needed and contracts when less money is needed. It is important not merely that the currency shall expand when money is needed, but that it shall contract when money is not needed, for to an industrial commercial country a redundant currency is the source of manifold evils… .

The Federal Reserve, however,

does not provide an elastic currency. It provides an expansive currency, not an elastic one. It provides a currency which may be increased, always increased, but not a currency for which the bill contains any provision compelling reduction.

Although Root recognized that gold reserve requirements placed an upper limit on the Federal Reserve Banks’ total note issues, his point was that, notwithstanding the nominal convertibility of Federal Reserve notes, there were no forces at work in the proposed system to prevent it from always issuing up to this maximum, whether economic conditions warranted so much expansion or not.*

Root understood, in short, that instead of resembling ordinary banknotes, or the “emergency” currency issued under the Aldrich-Vreeland Act or, prior to that, by private clearinghouse associations, Federal Reserve Notes were what we now refer to as “high-powered” money. Since banks’ deposit credits with the Fed might be converted into such notes at any time, those liabilities amounted to high-powered money as well.

What was wrong with that? The problem was that a supplier of high-powered money can supply more of it, and have it remain outstanding, even when doing so doesn’t serve to accommodate a prior increase in the demand for real money balances. If the high-powered money isn’t needed for that purpose, it will instead give rise to an excessive quantity of money of all sorts. In short, the new law could mean more frequent bouts of excessively easy money, and, consequently, more booms and busts.

Both the presence of gold reserve requirements and the tendency for gold to leave the country in response to rising prices placed long-run limits on monetary expansion. But those constraints would only serve to limit the duration of booms, without preventing them.

With the exhaustless [sic] reservoir of the Government of the United States furnishing easy money, the sales increase, the spirit of optimism pervades the community.

Bankers are not free from it. They are human. The members of the Federal reserve board will not be free from it. They are human. Regional bankers will not be free from it. They are human. All the world moves along upon a growing tide of optimism. Everyone is making money. Everyone is growing rich. It goes up and up, the margin between cost and sales continually growing smaller and smaller as a result of the operation of inevitable laws, until finally some one whose judgement was bad, some one whose capacity for business was small, breaks; and as he falls he hits the next brick in the row, and then another, and then another, and down comes the whole structure.

Need I state that events would more than amply vindicate Root’s dire predictions? Root himself lived to witness two major boom-bust cycles, including the worst bust of all. Had he lived a few months longer, he would also have witnessed the United States’ third-worst depression — that of 1937–8.

The whole idea of currency reform was, Root went on to say, to have a currency that wouldn’t lend itself to this sort of thing. That meant, to be sure, having a currency the supply of which would expand when the demand for currency rose. But it also meant having a currency the supply of which was bound to shrink when the demand for it subsided.

Nor would Root allow himself to be consoled by a colleague’s observation that the Federal Reserve Board had the ability to reduce the quantity of money any time it chose to. “I am not now speaking,” he said, “about what the reserve board may do. I am speaking about what we do; about how we perform our duty”:

Always up to this time the American Congress has attempted to perform its own duty in regard to the vital matter of currency. Always the American Congress, when it did not want inflation, has undertaken so to frame its legislation that its injunctions and requirements would prevent inflation. Now it is proposed that we shall make it possible that…a body of appointed officers…will perform the duties that we ought to perform.

The wiser, and proven, alternative, Root argued, “is to provide for a currency that will come down by the operation of natural forces as well as go up.” Like many others before him, Root offered the Canadian system as an example of what he had in mind.**

Finally, for all you opponents of Big Government, Root declared the Federal Reserve Act to be part of what he considered a deplorable tendency, to wit: the tendency “to substitute the support of a paternal government for that individual self-dependence which settled, which built, which developed, which made our country.”

Not bad, Senator. Not bad at all.

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*In a system of competing banks-of-issue, in contrast, there is no need for any statutory reserve requirement. Instead, banks are compelled to hold reserves against their outstanding notes for the purpose of settling interbank note clearings, with the optimum reserve ratio varying along with the public’s demand for real money balances.

**Alas — in an apparent nod to Senator Aldrich and to the findings of the Aldrich-led National Monetary Commission — Root instanced as well the currency systems of England, France, and Germany, although those arrangements had much more in common with the pending Federal Reserve system than they had with Canada’s decentralized alternative.

[Cross-posted from Alt‑M.org]