Topic: Finance, Banking & Monetary Policy

Wrong Lessons from Canada’s Private Currency, Part 1

I’ve referred often in these pages to the virtues of Canada’s late-19th century currency system, with its heavy reliance upon circulating notes issued by several dozen commercial banks, most of which commanded extensive nationwide branch networks. I’ve also lamented the fact that so few monetary economists today, let alone members of the general public, seem aware of that arrangement, the superiority of which, both absolutely and compared to its U.S. counterpart, was once widely celebrated. For I’m certain that, if more people were aware of it, the scales might drop from their eyes, plainly revealing the gigantic blunder our nation (and most others) committed by entrusting the management of paper currency to a government-sponsored monopoly managed by bureaucrats.

So you might expect me to be jumping for joy after seeing this new Bank of Canada Staff Working Paper by Ben Fung, Scott Hendry, and Warren E. Weber, on “Canadian Bank Notes and Dominion Notes: Lessons for Digital Currencies.”  But no such luck: instead, after reading it, I’ve been in a blue funk.

How come? Because, instead of drawing badly-needed attention to the substantial merits of Canada’s private currency system, Messrs. Fung, Hendry, and Weber focus on its shortcomings, claiming that it suffered from serious flaws that only the government could fix. They then go on to argue that government intervention may also be needed to keep today’s private digital currencies from displaying similar flaws. In short, according to them, Canada’s experience, instead of casting doubt on the desirability of special government regulation of private currencies, supplies grist for regulators’ mill.

Is their perspective compelling? I don’t think so. As I plan to show, and as even a cautious reading of Fung et al.’s own assessment will suggest to persons familiar with other nations’ experiences, the imperfections of Canada’s private banknote currency were minor ones, especially in comparison to those of the concurrent U.S. arrangement. Nor is it even clear that they were genuine flaws, in the sense that implies market failure. The reforms that eventually eliminated the imperfections were, in any case, not imposed on Canada’s commercial bankers against their wishes, but instigated by those bankers themselves. Finally, the suggested analogy between Canada’s 19th-century banknotes and modern digital currencies, far from supplying solid grounds for supposing that unregulated digital currencies are likely to exhibit the same (real or presumed) shortcomings as their 19th-century Canadian counterparts, is so forced as to be utterly unconvincing. For all these reasons, those seeking to draw useful lessons from Canada’s private currency experience will be well-advised to look for them elsewhere.

Please Stop the Tyranny

While the newest federal agency, the Consumer Financial Protection Bureau (CFPB), has been controversial for many reasons, its most troubling feature may simply be its unconstitutional structure. Its sole director reports to no one but himself, and, under the terms of Dodd-Frank, can be removed by the president only for cause. And it receives its funding not through Congress, but through the Federal Reserve. Not even the Fed has the authority to challenge its spending, however. Instead, the law says the Fed “shall” give the CFPB the funds it requests, up to 12 percent of the Fed’s total operating expenses. As of 2015, that meant the CFPB could demand up to $443 million in one year.

Ending the Reign of the Administrative Law Judge

The system of checks and balances that the Constitution established is an essential safeguard against government overreach. Yet, the ever growing administrative state often undermines fundamental checks and balances. “Fourth branch” agencies frequently take on legislative, executive, and judicial roles simultaneously. And to make matters worse, administrative officials are much less accountable to the people than their counterparts in the traditional three branches.

One especially alarming example of the breakdown of essential separation of powers within the administrative state is the Securities and Exchange Commission’s use of administrative law judges (ALJs). ALJs adjudicate most of the SEC’s enforcement actions. They have the authority to impose significant civil penalties and can bar respondents from working in the securities industry.

Monetarism With Chinese Characteristics

Monetarism is often misunderstood, overlooked, forgotten, or even derided. Yet its basic logic, resting on the quantity theory of money, is evident and remains important in a world of pure fiat monies.

Most major central banks have abandoned monetary targeting in favor of setting interest rates to achieve long-run price stability and full employment. China is an exception. Since 1998, the People’s Bank of China (PBC) has used money growth targets to guide monetary policy aimed at maintaining stable nominal income growth and preventing excess inflation (see Figure 1).

Figure 1: PBC Monetary Framework[1]

That said, the PBC’s use of monetary targeting is embedded within China’s centrally planned and largely nationalized financial system. The PBC is subject to oversight by the State Council; the financial system is dominated by state-owned banks; capital markets are highly regulated; and interest rates and exchange rates are distorted. Just as the Chinese government refers to its unique mix of markets, statism, and communist ideology as “Socialism with Chinese Characteristics,” we can call the PBC’s monetary targeting “monetarism with Chinese characteristics.”

Why There Is No Fiscal Case for the Fed’s Large Balance Sheet

It is well known that the Federal Reserve System expanded its assets more than four-fold during and after the 2007-09 financial crisis by making massive purchases of mortgage-backed securities and Treasuries. The balance sheet has not returned to normal since. Total Fed assets stand today at $4.45 trillion, up from less than $1 trillion before the crisis. Whether, when, and how to normalize the size of the Fed’s balance sheet have been under discussion for years.

Economist-blogger David Andolfatto — not speaking for his employer the Federal Reserve Bank of St. Louis — now offers “a public finance argument” for “keeping the Fed’s balance sheet large.” Viewing the Fed as a financial intermediary, he observes that “The Fed transforms high-interest government debt into low-interest Fed liabilities (money),” and that this is a profitable business.

Curiously, Andolfatto omits to mention two important details: the Fed enjoys such a spread only because it is — for the first times in its history — (a) borrowing short and lending very long, also known as practicing “duration transformation” or “playing the yield curve,” and (b) heavily invested in mortgage-backed securities. The Fed is borrowing short by currently paying 0.75% (not 0.50% as Andolfatto reports) on zero-maturity bank reserves. It lends long by holding 10-year and longer Treasuries (paying 2.42% and up as of 17 Feb. 2017) and long-term mortgage-backed securities.

On Shrinking the Fed’s Balance Sheet

If you’re a regular Alt-M reader (and may the frost never afflict your spuds if you are), I needn’t tell you that I’m the last person to exalt the pre-2008 Federal Reserve System. Among other things, I blame that system for fueling the 2003-2006 boom, and for creating a credit famine afterwards. I also blame it for contributing to the dot.com boom of the 90s, for the rise of Too Big to Fail in the 80s, for the  inflation of the 70s, and for the disintermediation crisis of 1966, to look no further back than that.

Yet for all its flaws that old-time Fed set-up was a veritable monetary Shangri-La compared to the one now in place. For while the newfangled Federal Reserve System is no less capable of mischief than the old one was, it also has the Fed playing a far larger role than before in commandeering and allocating scarce credit.

The Road to Cordray’s Removal Just Got Longer

The plot thickens in the ongoing battle for the Consumer Financial Protection Bureau, the controversial agency created in the wake of the 2008 financial crisis.  Yesterday, a federal appeals court decided it would grant rehearing of last year’s case, PHH v. CFPB, which held the agency’s structure to be unconstitutional.  The decision issued last year not only ruled the agency’s structure to be unconstitutional, but also placed the director under the president’s authority, giving the president the power to fire the director at will.  Now that the court will rehear the case, its earlier decision is no longer binding, meaning the president can no longer rely on it if he wishes fire Director Richard Cordray.