Bitcoin and the lender of last resort function

Dario Perkins of Lombard St Research got me thinking about whether Bitcoin – or some other digital cryptocurrency – would obviate the need for or possibility for a lender of last resort.  Without implicating him in any bad thinking here, what follows came out of our conversation.

Some [for example, see this by Axel Weber] see that the impossibility of a lender of last resort will prevent Bitcoin from becoming, or being allowed to become the medium of exchange/unit of account.

Others relish a future in which Bitcoin replaces fiat currency precisely because it eliminates the evil lender of last resort function operated by a corrupt, meddling and misguided state, a step towards a libertarian utopia.

To progress, here are two scenarios in which fiat currency is displaced by digital.

One scenario is that central banks pre-empt a crypto currency takeover by supplying their own digital currency.  They offer digital accounts at the central bank to individuals and firms.  Paper currency is withdrawn or withers.  As central bankers have recognised, this may well entirely disintermediate private banks.

However, there will still be the same job to do that exists in the fiat currency economy of intermediating between those who have funds to save, and are happy to postpone consumption until tomorrow, and those who have projects to finance and need funds today, but who cannot raise equity or issue bonds directly.

Banks will finance lending by issuing equity themselves, or selling non-retail-deposit bonds, and borrowing wholesale at short maturities from the same counterparties as they do now.   Just as now, those institutions will be undertaking maturity transformation, making money out of it, but taking risks in so doing for  themselves and the wider financial system.

Is there a motivation for LOLR in this economy?  Is it possible if there is?

There is a motivation for LOLR.  For starters, it’s entirely possible to envisage a run on a maturity transforming bank here.  And one that, because of interlocking exposures to those who are engaging in risky investment projects, could bring down all the banks.  [Let’s plausibly assume away the possibility that central banks can figure out how to eliminate systemic risk].  Although the payments system will not collapse – one of the fears in the face of a bank run in a fiat currency system – since payments in currency are transacted across the central bank balance sheet, there is still a risk of a systemic collapse in credit.

Is a LOLR possible?  Of course.  The central bank/government makes a loan of digital currency to the ailing bank or banks, financed by either creating new digital currency, or selling government debt.

In a second scenario, a private cryptocurrency like Bitcoin takes over as the unit of account and medium of exchange.

Is this economy, banks operate just like banks do now, intermediating between those who have BTC to lend, and those who need it.  Just like now, they take risks and transform maturity.  Just like now, there is a possibility of a bank run.  I might find it profitable to ‘deposit’ my BTC in a bank by temporarily signing it over to them on the distributed ledger.  And they will ‘lend’ the funds by signing over my BTC to an entrepreneur.  If I get spooked by rumours about my bank, I will call them, asking them to transfer back my BTC, and, if enough others do the same, they will refuse.  If banks have interlocking or common exposures, one bank failure will be the harbinger or the trigger for others, motivating lending in the last resort.

In this economy the central bank can’t create the medium of exchange.  [That’s why some people like it so much].  BTC is a private construct, and whose creation is governed by an agreed protocol.  But the central bank is not powerless.  For starters, unless the entire world is in the grip of a liquidity shortage [this was not true even in 2009] the consolidated central bank/govt can issue debt, obtain BTC from those who are not short of it, and lend it to a bank that is.  This is a lender of last resort function that is proscribed to some degree, but it is not so far removed from the actual LOLR in Western economies.  That function is usually not wielded independently of the Treasury;  and there is an expectation that the inflation target that pins down monetary policy is to be adhered to.  So LOLR operations are not monetary financing, and since they are fiscal operations, they happen with the consent of the fiscal authority.

LOLR under private Bitcoin carries a risk of deflation to the extent that the loan is large relative to the global market [or rather the sum total of such operations across the world is large].  In that case the central bank/govt debt issue will bid up the value of BTC relative to goods, which is what deflation means in this economy.  And that could make the credit crisis they are fighting worse.  [For example if I take out a loan that requires me to repay a defined quantity of BTC, yet my wages are regularly renegotiated, then a deflation will reduce my wages in BTC, raising the real value of my BTC loan, making me more likely to default, impairing my bank’s balance sheet, etc].

So, in sum, it’s possible to imagine digital currencies, private or public, coexisting with banks that fail, and may have to be loaned to by the public sector;  and ways in which that can happen effectively.  We can get rid of the lender of last resort function if we want, but proactively supplying digital currency, or allowing it to take over, won’t achieve it for us.   Nor should we avoid going digital because we think LOLR will be impossible.

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Where does the false balance policy come from in the broadcast media?

Ben Chu and Simon Wren Lewis have both opined on how the broadcast media let us down in their coverage of Patrick Minford’s memo as chair of ‘Economists for Free Trade’.  They make the point that an impression of false balance of  competing opinions was created by the juxtaposition of Minford’s ‘report’, and Minford himself, with an interlocutor from the opposing side.

This latest episode is a recurrence of a frequent problem on the topic of Brexit economics.

There are not many points to add to these incisive pieces by Ben and Simon.  But we might well ask why the false balance phenomenon happens so often.

A feature of the equal status policy is to recapitulate debates as battles of talking heads.  Let the viewers see the heads talk, the merits of the arguments should become apparent, and viewers can evaluate them for themselves.  Sometimes we get a head from each side.  At other times, the interviewer plays the role of the opposing side.

There are all kinds of problems with this;  the implicit signalling that the arguments are balanced by having one person from each side of the argument;  the apparent status of the argument as a live debate [‘look:  they are arguing?  Even the experts have not reached a settled view on this!’];  allowing the outcome to be determined by the fleet-footedness on the day of the chosen protagonists, or, if it’s the interviewer playing the part, by how well they are briefed.

But the format of talking heads slugging it out, however maddening, solves a problem.  The basic topic is boring for most viewers.  Editors have to entertain, otherwise their programs lose their followers and their raison d’etre.  And if they don’t entertain, and viewers and listeners fall away, they are not there to be educated.  The judgement is  – probably rightly – that it is much less boring to watch fisticuffs and experience the thrill of discovering who will win today, than it is to watch a lecture, even when such lectures are  punctuated by modern graphics of  arrows, scales, euro symbols, pictures of cargo ships and robots making cars.

The false equal status policy arises, perhaps, for two other reasons, which colour treatments of Brexit economics in textual outputs like the BBC website.

One, I conjecture, is a business model that means an inevitable shortage of the requisite technical knowledge to recognise an economic debate that is not a debate any more.  The BBC and similar have to sell clicks and eyeballs.  And this is not done most efficiently within a given budget by carrying teams capable of gold-plating material that trespasses on technical economics.

Another reason for the equal status may be that is that they interpret the formal and informal regulatory constraints on them to mean that if there is sufficient ‘balance’ in the political controversy concerning a topic, then, regardless of the technical merits of the political arguments, the matter has to be treated as a live debate with protagonists of apparently equal claim to the truth.

In a democracy, state media and media with state functions perhaps has to behave in that way. It’s the same calculation that would divvy up seats on Question Time in a way that was roughly proportional to seats in Parliament, or percentages scored in opinion polls.  If a sufficiently strong political group took the view that climate science was a hoax, despite overwhelming scientific opinion to the contrary, the same pressure for balance would be felt [and indeed, one could argue that the airtime given to Lord Lawson reflects this].

In which case the responsibility for the flat earth economics’ coverage lies with the political faction that does not accept the overwhelming economic consensus.  For whatever reason, whether through lack of exposure to this consensus, or because they judge other non-economic factors surrounding Brexit sufficiently important to their constituents that the economics has to be disregarded and even undermined, members of this faction treat the economics as a live debate, and expect, rightly, that live debates are treated as such in media regulated by the state.

It might well be contended that the formal and informal regulations governing the BBC and similar are sufficiently vague that an editorial policy that would have ruled against the false balance model in the case of Brexit economics was possible.  In which case, the outcome we got must be seen as a result of a balancing act by the broadcasters, choosing a point within the set of allowable policies that weighs some unknown vision for what it is they want to do against competing pressures of commerce and the power exerted by the political faction that it is not prepared to give up on pro-Hard-Brexit economics.

If things are how I see it, we are stuck with the coverage we have got, and there does not seem to me to be an easy way to fix it.  Unfounded views amongst political factions survive because constituents are not persuaded to the contrary.  This faction exerts rightful control over airtime on state regulated media and its views are heard;  this reinforces the constituency for the unfounded view, and the cycle repeats.

 

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Brexit connundrum is not incompetence

David Allen Green’s latest blog – the latest in an FT series that has become compulsory reading – opines on a popular theory that the mess we are in has as its root cause the incompetence of Theresa May in particular, and of the government in general.

What he and others seem to set aside, often, is that the most important difficulty the UK faces is how to resolve the competing desires of the different Brexit factions.

Given the ill-defined nature of Leave in the Referendum, those in favour of it hailed from a very broad church, including:

1) ‘liberal leavers’ who wanted to leave the single market and create open borders and free trade with the rest of the world;

2) liberal leavers who wished to stay in the single market and retain symbolic control over sovereignty;

3) those who wanted to de-globalise, intervene more in industry, and close all borders, and ‘take back control’.  And perhaps other factions too.

It is not incompetence to have failed to reconcile these irreconcilable factions.  What has to happen to move forward is that some factions have to submit, or be forced to in favour of a winner.

An aggravating factor that prevents an easy compromise is the incentives facing the EU.  For them, Brexit is part of an existential crisis.  Existential because of a list of other threats:  the Mediterranean refugee crisis;  an unfriendly US;  an unfriendly and meddling Russia;  populist governments in Poland and Hungary;  a financially unstable Italy;  not entirely vanquished populist movements in Holland, Spain, Greece, Italy, France.

Presenting the UK with a neat offer curve trading off free movement and trade openness is not possible.  The curve is defined by cancel Brexit/join EEA at one end [which they can deliver] and loose Free Trade Agreement with no Free Movement at the other [which they are also ready to negotiate].  Each interior point on such a curve threatens an unravelling of the Treaties that bind EU members that they don’t want to risk.

So, the UK Brexit factions are faced arguing over whether a symbolic Brexit only or loose FTA is to win the day.  The feasible options are very far apart and so each side finds it hard to contemplate giving in.

It is fair enough to criticise Theresa May for instigating the A50 process, and wasting time afterwards by calling the general election.

But one can make a reasonable argument that GE17 was intended and expected to deliver a victory of the deglobalising faction over the others, resolving the deadlock.  One can also point to how negotiations between competing sides proceed in other cases, often with compromises or capitulations happening only at the last minute.  If a last-minute agreement [within the Conservative Party] is our fate, why not start the A50 clock and hasten us to that point?

Seen this way, the real questions of competence are twofold.  First, there is the concern whether the different factions correctly apprehend the set of feasible deals given the EU’s stance.  Second, we can worry about whether they correctly understand the economic and politial consequences of the choices open to them.

Some of the public statements by the participants suggest that their understanding of these things is not as it should be.  But, applying a theme of DAG’s blog – faux chaos – to this different topic, these unreal statement may themselves be a ploy in the battle between the Leave factions, or between the UK and the EU.

For example, Bulldog Britain or Secret Remainer speeches could both equally spark the following thought process in their adversaries: ‘They really believe this don’t they, despite evidence to the contrary?  So they are not going to back down.  And if we are to avoid the disaster of disunity in the negotiations, or have a chance of picking up the pieces at some point, perhaps we should back down now and let the other lot take a run at it.’

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The Office for Budget Responsibility’s Fiscal Risks Report

This is a new product.  It’s a tour de force, ranging from obscure line items on government finances, to some philosophising about the nature of uncertainty.

But it is not beyond criticism.  This post pulls together tweets I sent last night [Sat 11 July].

First, I was hoping to read something explaining how indefinitely low equilibrium real interest rates, and therefore central bank rates, would translate into greater fiscal risk for a given recession risk, on account of there being a greater call on fiscal stimulus – automatic, or discretionary, or both – at the zero bound.  This extra fiscal risk comes about on account of monetary policy being more constrained than it was during the past recessionary episodes that the OBR’sreport discussed.

Even if you thought that quantitative easing was a perfect substitute for interest rate policy – a position that would be rather extreme – this itself would translate extra risks in the balance sheet of the consolidated government/Bank of England, as assets were bought and sold in the busts and booms.

Second, it is curious that the risks relating to our current >8 year spell at the zero bound are not spelled out.  It may be that the UK economy cruises back to a resting point for interest rates at say 2%, permitting a slow further consolidation of fiscal policy.  Or it may not.  It may instead prove to be the case that we are trapped indefinitely at the zero bound for the need of a very large fiscal stimulus to achieve lift off.

The silence on this risk mirrors the need that the Bank of England itself feels not to comment directly on current fiscal policy.  The BoE’s silence is more understandable.  But despite the existence of 2 independent bodies commenting on or implementing macro policy, there seems to be a missing mandate or preparedness to point to the major macro-fiscal risk of the day.

There is some interesting text about the Treasury’s risk management structures.  We are told of the existence of a dedicated ‘Fiscal Risks Group’ which writes reports regularly to the ‘Executive Management Board’, from which advice emerges.  We are told of activities like ‘horizon scanning’.  Well, we are clearly in safe hands then!  An analogy is writing a report in 2007 that observes with approval that the Bank of England writes a ‘Financial Stability Report’ and expecting us to draw comfort from this.  Merely alerting us to the existence of committees and meetings and reports cannot be at all reassuring.  Such things may not amount to a hill of beans in the face of a choppy world economy and a struggling polity.  Writing about them so uncritically, the OBR’s report dilutes its normally severe and disapproving tone of independence.

A curious thing about the report is that it does not draw out that in many ways the whole point of government is to assume risk, not to avoid it.  Many government policies fill in for missing, or poorly or inequitably functioning markets for risk [unemployment insurance, health insurance, pensions].  Government is the means by which many of the risks we face are pooled.  Since it has the deepest pockets of all, the largest risks naturally lie with it.  Its power to borrow allows us to spread risks across cohorts through time.  A government balance sheet which was managed to continually avoid risk would be one that was wasted.  Of course, the capacity of the government to absorb risk is limited and so attention must be devoted to ensuring that scarce fiscal space is used for the most worthy causes.  But nevertheless it must be used.

Finally, the Report seems to abstract from risks emanating from government policy itself.  Recent UK history has been characterised by the repeated adoption, fudging and then dumping of fiscal rules. This itself has probably impaired the credibility of policy and the capacity of the government to bear risk.  And that this behaviour may be repeated is itself a source of risk to the trajectory of fiscal balances going forward.  The practice of the OBR – just like the BoE – of conditioning its analysis taking stated policy as a given precludes commenting on this problem, ultimately reducing the chance that the problem is ever fixed.

 

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More crypto monetary dystopia: political fall-out of a partial take-over

Writing a serialised monetary policy dystopia seems to be a good way to thin out your readership, but I am going to plough on regardless.

In the event of a partial take-over of a cryptocurrency, politics in the state may become strained.

The currency fissure creates a new cleavage of monetary and fiscal interests that did not exist before.

Most obviously, those who have adopted the cryptocurrency have an interest in using whatever power their state has to preserve or improve the protocols underpinning that currency, to nurture its integrity and ensure that it offers the most enlightened monetary and payments security policy possible.  This is less of a priority for the vestigial fiat currency users.

As discussed in the last post, the introduction of a new exchange rate into the economy warps ideal monetary and fiscal policy towards managing fluctuations in the nominal exchange rate between the vestigial fiat and the new cryptocurrency.

A channel for this to happen is the price stickiness in home units of account that typifies economies today.  Which means fluctuations in the nominal exchange rate translate to fluctuations in the real exchange rate.  Those fluctuations – caused by this price rigidity – are damaging.  But from the perspective of those who live only in the vestigial economy, policy could be improved upon, freed from the compromises enforced by a multi-currency area.

Moreover, for  similar set of reasons the new currency cleavage will induce a commonality of interests in fiscal flows amongst those on either side of the divide that did not exist before.

If the cleavage were to produce two economies that were in other respsects identical, these problems would not arise.  But such a cleavage is highly unlikely.  More likely, it would arise because cryptocurrencies worked well for some activities or some people and not others, or in some places and not others.

The unit of account and medium of exchange cleavage will give rise to a correlation in outcomes for employment and output and all the things we care about, even if there is no change in the fundamental disturbances hitting either economy.  And that will mean there are now times when there are fiscal transfers needing to go one way across the currency cleavage, and times when they go the other way.  In a situation where these flows reverse quickly, it might be relatively easy to sustain support for the fiscal union.  But as we see from the Eurozone and, in fact, the history of the US, differences in ‘business cycle’ conditions can persist for very long periods – decades.  During such time, voters in one region see their taxes [or their fiscal space] used for spending in the other economy, and may resent it, having short enough memories that they don’t recall times when things were in reverse, and short enough horizons not to care about a reversal in the future.

Aside from this stress, and supposing that the monetary policy in the cryptocurrency area is rubbish – as it seems to be in the protocols for those currencies currently operating that I know about – voters in the vestigial fiat area will grumble at the volatility in fiscal settings in their region caused by the need to compensate for the gold-standard like monetary inflexibility in the neighbouring crypto-economy.

It might not be too implausible to think that the new currency cleavage could cause functions of the old state – like risk sharing – to wither, and even, if the currency cleavage operated also as a geographical cleavage, for the state to split eventually.

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Central bank policy in the face of a crypto take-over

Continuing the dystopian theme – at least dystopian from the perspective of the fiat currency issuer – a partial take-over by a borderless cryptocurrency will pose interesting questions for central bank monetary policy.

For starters, it will introduce a motive to care about fluctuations in the real exchange rate – and thus fluctuations in the nominal exchange rate – between the vestigial zone covered by the old fiat currency and the new crypto-region.  This must surely mean worse macroeconomic performance overall for both regions.

Another way of interpreting this is that it will lead to pressure for the protocol governing the issuance of central bank currency to move closer to the – probably inferior – protocol governing the issuance of the cryptocurrency.

Past decades have seen much hope for, and occasional outbreaks of, enlightened cross-currency monetary policy coordination.  But just as there would be nobody for a centralised polity to negotiate with in the face of a partial anarchist takeover, so there would be no-one with whom to discuss modifying a decentralized, hard-coded and damaging cryptocurrency issue-protocol.

In this way, the reach of the apparently partially victorious cryptocurrency would have extended further than is at first apparent, much like in the case of the reach of the old Deutschemark in the former Eurozone, or of the dollar with the countries who adopt currency boards, fixed or managed exchange rates.

 

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Crypto-currencies and the vestigial states they plunder

That headline was a bit strong.

But a thought.  In a previous post on Alphaville I wrote about how the currency area that a private sector cryptocurrency created would be undesirable.  That was because it would likely straddle national borders, and therefore there would not exist institutions to funnel fiscal resources around it to perform the functions that we hope for in an optimal currency area, and have been tragically absent in currencies like the Eurozone.

Rather obviously, the vestigial states carved up by this hypothetical crypto currency would face new problems and constraints.

In a conventional currency area, where the state has a monopoly on supplying the currency, to some extent the central bank can stand behind its government, which may need to borrow large sums to tackle fiscal or financial crises.  I say ‘to some extent’ because the costs of high inflation, and the inefficiency of money-financing when inflation is expected, limit the ability of the money printers to stand behind fiscal policy.  [One reason why I think those who dismiss concerns that the UK could ever have faced a run on its own sovereign bonds as unfounded are wrong].

If part of the economy now functions using a cryptocurrency, this financer of last resort function does not work so well for the affected region.  [I say ‘region’, though the cryptocurrency takeover need not be of any contiguous geographical area].  Resources to be funnelled to that part of the economy have to be in Cryptos, which means either issuing bonds directly to the quasi ‘foreign’ Crypto economy, or milking the vestigial fiat currency holders, and then going to the market to buy Cryptos.

If the former, then the central bank does not stand behind those fiscal actions.  And if the latter, this highlights how the vestigial state constitutes a shrinking of the inflation-tax-base for the ‘standing behind’.

The central bank could try forcing those in the Crypto part of its economy to accept its own currency in any emergency operations – like paying local government civil servants, or suppliers – but it would face subjecting the economy to the same trauma as Tsipras contemplated would happen if Greece had exited the Euro and began issuing new Drachmas.

In view of this, we might expect the authorities not to be particularly relaxed about a significant invasion of private sector crypto-currrencies.  That is, unless they happen to be presiding in states which cannot discipline themselves to use the financer-of-last- resort function sparingly enough, and have the wisdom to forego it.

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