The vicious circle impeding the entry of a new currency

Cryptocurrency prices have been soaring and tanking and soaring again.  Here is a chart of the Bitcoin/£ exchange rate:

The following thought experiment shows how a new currency with a fixed supply protocol may find it hard to break through and gain wide usage.  One of the conditions for widespread use as a money is that it’s value is not too unstable.

You can imagine a period of relative stability, or at least predictable growth, when users think ‘this new currency could be the next medium of exchange’.  Demand rises in anticipation.  Given the existing cryptocurrency protocols, with supply unresponsive to demand, this implies a rise in the price.  Users observe the price volatility and become sceptical about its future as a medium of exchange, since its price is volatile, and demand falls.  The price of the currency falls again, confirming the sceptics’ view of its prospects as a widely used money.  After a while in which only the hard-core optimists want to hold it, and with corresponding price stability, opinion turns again, and the cycle repeats itself.

Of course words like ‘volatile’, ‘rise’, ‘falls’ are relative to the alternatives.  So this is a comment about how it may be hard to displace a currency which is managed so that the price absorbs fluctuations in demand.

A basket case currency, with even less desirable price dynamics, would be easier to displace.

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Larry Summers on the passing need for central bank independence

Larry Summers wrote this piece recently, marking the 20 year celebrations of independence for the UK’s Bank of England, explaining why he thought the case for central bank independence was now weaker than in the past.  I am going to push back on his arguments, one by one.

Larry writes:

“..after a splurge of indiscipline following the breakdown of Bretton Woods, politics seem to have internalized anti-inflation norms so insulation from politics is less important. It is noteworthy that in the US, Europe and Japan political criticism of central banks comes much more from the hawkish side than the dovish side.”

In the UK, the fracturing of the cross party consensus on monetary policy seems more symmetric.  Recall the Corbyn-McDonnell leadership campaign which pushed Richard Murphy’s idea of ‘People’s Quantitative Easing’;  and McDonnell’s previous hostility to the Bank of England, which he viewed as an agent of the establishment.  And note the new controversy, with protagonists on the left and the right, over whether monetary policy should target inequality.

Moreover, central bank independence is not just about insulating monetary policy from ill-advised inflationary politics;  it is to protect it from equally misguided hawkishness.  Without that protection, central banks might not have been able to keep interest rates low for so long or experiment with money-creating quantitative easing.

Larry again:

“Second, the problem of this era in most countries is too little inflation not too much. The United States, Europe and Japan have all fallen short of their inflation targets for close to 10 years now. And judging by the index bond yields, inflation will average well below target for the next 10 to 20 years.”

Two replies.  i) Repeating my point above, throwing monetary policy to the wolves of politics again might well condemn inflation to be too low for much longer than otherwise, if by weakening central bank independence price stability hawks got more control.  ii)  Summers’ argument could be read as ‘the horse is asleep;  no danger of it bolting, so leave the stable door open.’  If central bank independence does no harm [see below] it should be kept in place to prevent the inflationary horse from bolting again, if it were to wake up.

Prof Summers:

“much of the best contemporary thinking about the liquidity trap emphasizes the credibility issue with respect to central banks being willing to accept inflation after the economy recovers. Structural insulation of central banks likely reduces this credibility.”

This is not an argument against independence per se, but against allowing central banks to define their own monetary policy goals.  Provide goals are set by the finance ministry, and central banks are held accountable if they generate insufficient inflation, there should be no problem.

Summers:

“new institutional arrangements in which it is normal to pay interest on reserves reduce the concern that a non-independent central bank can be forced to enable excessive deficits through monetization. Money in the current environment is essentially equivalent to floating rate government debt so money finance involves much smaller savings than was once the case.”

True enough.  But there is no reason why monetary policy might not revert to the old method, without paying IOR.  The main [but not only] reason for moving to IOR was to allow central banks to put a floor to the policy rate above zero, at the same time as engaging in massive asset purchase programs.  Since this thinking, several central banks have shown that one can cut rates actually below zero without devastating banks and other intermediaries.  And at some point policy will normalise, shrinking balance sheets back to ‘normal’ and removing the need to encourage the market to hold excess reserves.

Summers writes about how central bank independence complicates coordination with the fiscal authorities:

“Fiscal monetary cooperation is a much more significant issue when an economy is in the liquidity trap, near the liquidity trap, or facing the possibility of getting into the liquidity trap at some point in the future. When monetary policy cannot sterilize impacts of fiscal policy on demand, there surely should be coordination of fiscal and monetary policy.”

This is true.  However, fiscal policy has not been universally ideal during the liquidity trap, either in the US or the UK, were in both cases one can make a very good case that it was too tight.   One could instead make a decent argument for allowing limited and coordinated delegation of fiscal policy to technocrats.  For instance, I suggested before that if a zero bound episode either threatened or was being experienced, central banks be instructed to quantify the missing stimulus that the zero bound implied, referring back to the Treasury the job of how to design a stimulus program to replace that stimulus [if it chose to take the advice] and the Office for Budget Responsibility the job of adjudicating on whether the stimulus plan did the job intended and was consistent with long term sustainability.

Summers again:

“Debt management policy where QE operates by shortening the maturity structure of the debt that a country’s creditors have to hold. The impact of QE is essentially the equivalent of changes in the maturity structure of a country’s debt accomplished through altered patterns of issuance or buybacks. It makes very little sense for debt maturity policies for one country to be set separately in two places.”

True.  But coordination could be achieved here either by delegating debt management back to the central bank [as was the case in the UK before 1997];  or by providing for codified control over the maturity mix during the lifetime of a central bank asset purchase program.

Agreeing a central bank communication strategy

In conversation at MMF yesterday, a few of us were discussing what it would take to tip the MPC or similar into deliberating on, voting on, and publishing interest rate plans?  With their frequent yield-curve-talking, MPC are heading towards this point [a point which their FPC colleagues already seem to have reached] but they are not there yet.  A thought experiment is to imagine the appointment of a hypothetical advocate of publishing said plans.

Let’s call this person Pupa, short for for PUblished Plan Advocate.  The existing majority view is of course that the status quo is fine.  In other words:

-that plans should not be published

-and it is sufficient to vote on current interest rates only, and to arrive at that vote by studying inflation forecasts conditioned on the assumption that interest rates follow the path estimated to be expected by markets over a 10 day average.

-and to desist from making reference to optimal policy or policy rule analysis in deciding on the vote, certainly in public, and perhaps even in private too.

-and to desist from making the forecasts replicable by supplying working version of the model codes, databases, and forecast judgements.

Pupa arrives in post.  One thought experiment is that she implements her own communication strategy, consistent with how she thinks the MPC as a whole should do it.  How do the rest of the rest of the MPC respond?

Some aspects of the implementation simply steamroller the other MPC members:  once the model, strategy analysis, and forecast judgements are disclosed, they are out there, against the wishes of the others.  Others make life very difficult.  With an interest rate plan out in the open, others will face direct questions about what their plans are relative to the one that is out there.  The yield curve against which others used to base their hints will, depending on where Pupa sits in the collective about the state of the economy may well be tainted by Pupa’s views.  If Pupa’s vote and plan are connected to policy rules and loss functions, others will be asked pointedly how they are arriving at their votes, and what they think of those rules and loss functions.[‘Q:  do you look at these rules too?  A:  Not telling you.  Q:  do your votes result from a plan?  A:  Not telling…..’]

To execute her own strategy, she has to commission monetary strategy analysis to allow her to arrive at her interest rate plan.  She has sole control over two MPC unit economists’ time, and access to all model codes and data, so, in principle, could eventually develop the capability to do this.  She could commission the central staff to do the analysis for her, but there are many calls on that time.  Would the other MPC members use their block vote to stop her devoting staff resources to these tasks?

One option would be for Pupa to execute the analysis behind interest rate planning [leave aside resourcing difficulties] but simply to submit and disclose just the current vote.  But as a known advocate for model/forecast/loss-function/interest rate plan transparency, would such a position be sustainable?

Imagine the first Q and A after a speech:  ‘you have explained how you think voting is incoherent in the absence of a plan, and that this plan and how you arrived at it should be disclosed.  Yet you seem to have simply voted on current rates like the others.  How do you justify that?  Are you not doing your job properly?  A:  I did the analysis and voted on current rates only, in the knowledge of what my plan was.  Q:  what was it?  A:  I’m not telling you.  Q:  will we find out in the minutes?  A:  No.  Q:  Why not?  A:  Er, because we decided to have that discussion outside the minuted meeting, so that it would not be minuted, and I could justify not telling you…..’

The question raised by thinking through this hypothetical is to what extent MPC members are team players, and to what extent they are individuals.  In order to function, all members have to agree to certain ways of doing things.  For example, they have to agree to attend a meeting if one is called.  Since resources are finite, they are likely to have to agree on compromises about what avenues are pursued and what are not.  Does the team-playing role extend to Pupa agreeing to forgo declaring interest rate plans?  Is such abstinence even tenable were Pupa to be appointed?  If this were in question, would that make it less likely that Pupa were appointed in the first place?  Should it make it less likely?

One way out of this issue – how MPC members should arrive at and enforce a collective communication strategy – would be for the Treasury to impose a communication strategy on the Bank.  It is arguable whether this would constitute a trespassing on operational independence.  It is a trespassing that has already taken place to some extent, with HMT commissioning the Bank to review the practice of forward guidance in 2013 around the time of Carney’s arrival.  And one that could be justified by pointing out that notwithstanding the literature about the possible downside of too much communication, more transparency helps the process of holding the institution to account.  HMT in so instructing might point out that any satisfactory vote must result from a plan;  so one is simply arguing that those plans should be disclosed at some point if only to assess whether the appointees were doing their jobs well or not.

Do monetary policy committees present an insuperable barrier to Odyssian forward guidance?

One kind of forward guidance – consciously eschewed by central banks during the crisis – was dubbed ‘Odyssian’.

The idea was that, deprived of being able to move the short interest rate by the zero bound, central banks would attempt to lower the long rate by promising to keep the short rate in the future lower than would normally be thought consistent with the inflation target.

The name derives from the Greek tale of the warrior instructing that his hands be tied to the mast of his ship as it sails within earshot of the song of the sirens, so that he could later resist their otherwise fatal attraction.

The corollary was a commitment to overshooting the target later.  The benefit of doing this was that provided a stimulus by lowering the real rate [nominal rate minus expected inflation], boosting demand, raising inflation now.  An overshoot later would be more than compensated for by a smaller undershoot now.

An objection commonly made is that the committee structure of MPC decisions precludes such a commitment, because current committee members have no means of binding their successors.

Two points.

The first was suggested by Richard Barwell at today’s MMF conference on monetary and financial policy.  He suggested – I may have garbled this – that the Chancellor could simply stipulate that once an Odyssian commitment was made, subsequent MPC recruits could not change the terms of that commitment.  The commitment would not be unconditional anyway, and would be data contingent to some extent, but their job would be to feed in the data into that commitment strategy, and not to re-evaluate.

Second, note that although committee members do turn over, expected turnover over a 5 year period, say, would be much less than 100%, with external MPC members serving typically renewable 3 year terms, and internals serving usually renewed 5 year terms.  A sufficiently large majority now might not be able to regulate the distribution of future rates so that it entirely conformed to one consistent with a follow through on the commitment, but it could tame that distribution of future rates quite a bit in that direction.  It would be wrong, therefore, to assert that Committees in themselves make Odyssian forward guidance impossible.  They would merely dilute it.

Has central bank independence had its day?

Charles Goodhart, speaking at the Bank of England’s recent conference celebrating 20 years of central bank independence, was reported to have said ‘it was nice while it lasted’.  Andrew Benito of Goldman Sachs, speaking on a panel at a Money Macro Finance conference on monetary policy, made a similar point.

Is this right?  Is central bank independence really over?  Some of the daftest Brexiteers, like Ruth Lea and Diane James, think so.

As these tweets reveal, they imagine that the Bank of England taints its forecasts to make them overly negative in service of the Government’s supposed desire to have the softest possible Brexit.

But this is not what Charles and Andrew had in mind. What they are thinking about is the capacity for the Bank to act – in good faith –  independently of the government, in pursuit of its inflation objectives, given that at the zero bound policies are needed that are fiscal, or require the support of the fiscal authority.

Going back to 1997 when ‘independence’ was granted, Ed Balls and Gordon Brown opted to assign what we term ‘instrument independence’ to the Bank:  operational control over the instruments of monetary policy.  Labour reserved for itself the task of assigning the goals of monetary policy.

Other central banks have elements of ‘goal independence too’.  For example, the Fed, given an unquantified inflation objective in its dual mandate, opted to quantify the objective itself – in the UK, the Chancellor does this every year.  The ECB ‘interprets’ [translates, sets itself the practical objective that follows from] the mandate enshrined in the EU Treaties.

New Labour’s solution was elegant, because it harvested some of the benefits of ‘independence’ – reducing suspicions that interest rate setting would be used for political ends – while avoiding some of its costs – that central banks would pursue aims that were not consistent with the populations they were supposed to serve.

The Bank of England has not lost any of its ‘instrument independence’.  On the face of it, it can do whatever it wants, provided it can be defended.  I say ‘provided’ since in extremis the Chancellor can seize control of monetary policy under the provisions of the Bank of England Act.  In fact, the Bank has gained a degree of independence over the operation of other instruments like asset purchases.

What has changed is our assessment about whether interest rate control was not just necessary, but sufficient to achieve the mandate handed to the central bank by the government.  In 1997 it seemed inconceivable that the UK could experience a financial crisis such as was occurring in Japan, driving interest rates there to the zero bound.  We were to learn differently in 2007.

So independence is as intact as before.  But the likely performance of the Bank in achieving its objectives – say the minimisation of deviations from the inflation target and of unemployment from its natural rate – absent cooperation of the government we now realise is less than we did before.  If we are prepared to say that the likelihood of that cooperation being forthcoming is no less than it was in 1997, we might say simply that the expected performance of the inflation target regime has declined on account of realising that the economy will hit the zero bound more often than we first thought.  Note that the true probabilites of things have not changed.  It’s just that our estimates of them in the light of lived experience have changed.

Stepping back a little further, we can appreciate that these statements are conditional on the existing legislation remaining in place;  and the government support for the 2 per cent target, and other somewhat discretionary aspects of the regime [like the letters delimiting what assets the Bank can buy and in what quantities] enduring.  We can then ask whether the likelihood that these features of the regime endure has changed relative to 1997.  This is another way of posing the question ‘has independence had its day?’.

My reflection on this is to think that the chance of revoking aspects of the institution has risen.

On the right, the hard Brexit faction of the Tory party have revealed that in pursuit of their European policy they are prepared to weaken any institution – including the Bank  – that offers analysis that is inconvenient.

Theresa May herself mentioned the concerns of another constituency – hard to apportion to the right or the left – that in my view incorrectly seeks to lay the blame at the Bank’s door for aggravating inequality with its post crisis monetary policy response.

And on the left Corbyn and McDonnell themselves – and some prominent supporters like Paul Mason – have advocated subordinating monetary policy to fiscal policy by compelling the Bank to finance directed public expenditure, badging this as ‘People’s QE’.

If one adds to this the general sense that the chance of policy choices following from rational and evidence based assessments by governments has diminished [what else is one to conclude from Brexit?], it is easy to draw the conclusion that monetary policy regime change is more likely than before.

So, returning to the question:  has central bank independence had its day?  Yes and no.  We need to dig a little deeper into the meaning of the term, and its implications for monetary policy outcomes to make progress.

 

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.

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.