Observations from the 29th Annual Cato Monetary Conference

Thanks to my work, I was able to spend most of Wednesday attending the Cato Institute’s 29th Annual Monetary Conference. The speakers were a pretty diverse group ranging from Rep. Ron Paul to Richmond Fed President Jeff Lacker to Professor Allan Meltzer.

The attendees came from even further afield. There were representatives from establishment organizations including the Bank of Korea and the IMF, but there was also a convicted “domestic terrorist.” I sat next to the former general manager of the Wu-Tang Clan. He now makes a living as an adviser to investors interested in sub-Saharn Africa, although he claimed that his real passion is monetary policy. Who can blame him?

The conference was divided into four panel presentations, two speeches, and a lunchtime conversation. I did not stay until the end but I was there for most of it. Additionally, I got a packet of all the papers that were presented during the panels. Some of the topics that were discussed: the role of a central bank, historical and international monetary arrangements, and ways to reform the existing system.

Rep. Paul was the first to speak. His talk had several themes but the most relevant for the conference was his pledge to introduce “currency competition” and end the Federal Reserve’s monopoly on producing legal tender. This idea was picked up by several other speakers. On the surface, this has a great deal of intellectual appeal. After all, what freedom-loving American wants to give monopoly power to an unaccountable, secretive elite? Would it not be far better if everyone had more choices?

As I see it, the main problem is that the government is always going to enforce a monopoly on the currency unless the government itself loses legitimacy. This is because the government gets to pick which currency it accepts for taxes and gets to pick which currency it uses to pay beneficiaries and employees. There is no way a credible alternative currency can emerge unless the existing system completely collapses.

The proof of this was inadvertantly provided by several of the other presenters. Much was made of the fact that countries including Zimbabwe, Ecuador, and El Salvador all use dollars even though they cannot print them. In effect, it is like a modern-day gold standard. This demonstrates that some nations are willing to abandon their monetary sovereignty and the discretionary powers associated with fiat money.

So what? These are all tiny countries with primitive financial systems. Most of them adopted the dollar because their native currency had been completely debased and the political authorities had lost their legitimacy. While this could happen in the United States, it is extremely unlikely. Moreover, creating a new private currency is never the first choice when the existing unit of account is destroyed. Usually, the political authority regains its legitimacy by establishing a new public currency. This is how almost all hyperinflationary episodes have ended, including most of the famous examples (Weimar, Hungary, and Turkey).

Sometimes, when the government is particularly weak, the people in a country adopt another country’s national currency as its own. This is what occurred in Ecuador and Zimbabwe. The recent hyperinflation in North Korea is a mixed case because some areas of the country started adopting dollars, yen, and South Korean won while others have switchd to the new North Korean won. Again, however, these are primitive financial systems in third-world authoritarian countries. It is difficult to imagine the United States in such a situation. Moreover, if the U.S. did get itself into this kind of trouble, I doubt that the transition to a new currency regime would be particularly pleasant.

The conclusion I come to is that currency competition will never work. Having a currency that anyone can use for transactions is a public good. This is why governments have always determined the unit of account. During the 19th century, depository institutions had their own distinctive banknotes. Some people think that this was an example of competitive privately-managed currencies. It was not. The U.S. was on a gold standard. The government established a legal definition of the dollar as a given amount of gold. The banknotes were credits to pay gold on demand.

Moreover, users of these banknotes faced counterparty risk that in turn created exchange-rate risk vis-a-vis other banknotes. This seems like a lot of hassle relative to the current system, even if it worked much better than one might imagine from my description.

Some presenters seemed to have recognized this and advocated a return to a fixed gold standard. Professor Larry White said that transitions of this sort are similar to the transition between the upper and lower portions of the Niagara River, although he still thought it was worthwhile. He gave an impassioned defense of fractional-reserve banking and tried to argue that there was enough gold in Ft. Knox to back a modern gold standard at current market prices, which is ridiculous. There is about $50 trillion or so of debt in the United States, not including derivatives. There is about $400 billion worth of gold in Ft. Knox at current market prices. White’s plan would involve leveraging the money stock by a factor of 125. This would never work, especially not given the current macro environment, which requires a reduction in the ratio of debt to money.

Judy Shelton argued that the government could begin to institute a quasi-gold standard by issuing zero-coupon Treasury bonds that have an option to be redeemed for a given quantity of gold or a fixed amount of dollars. If the spot price of an ounce of gold is higher at the time of maturity than the amount of dollars promised in the bond, an investor would choose to redeem the bond in gold. If it were lower, he would prefer the paper.

I do not know why anyone would buy these bonds rather than just buy physical gold, which is not particularly difficult to do. Moreover, I do not know why the Treasury would ever issue such a bond because it would almost certainly raise the Treasury’s real cost of borrowing. Even if the bonds paid no interest, the Treasury would still be putting itself in the position of borrowing in a currency it cannot print, which creates default risk. I am incredulous that anyone thinks the government would choose to do this unless it were forced to do so after some severe inflationary crisis.

Several presenters seemed to have arrived at the conference from another planet. They sincerely believed that the central bank ought to care only about changes in the Consumer Price Index and that the biggest problem facing America today was the fact that prices were rising at a 3.5% annual rate. One presenter thought that the dual mandate enabled Fed doves to use the current rate of unemployment as “an excuse” for further monetary ease. Those were her words. She never bothered to tell us the “true” motive for wanting loose policy.

It is reasonable to debate whether the Fed is capable of affecting the economy the way it wants to. I believe that the transmission mechanism of Fed policy is incredibly complex and constantly evolving, which is why it remains so poorly understood. It is almost certainly the case that further Fed easing—absent fiscal stimulus—will not be able to accomplish much except subsidize certain agents in the financial sector.

It is also reasonable to argue about the distributional tradeoffs of policy choices. Perhaps the tightening suggested by the price stability mandate will create better outcomes in the medium term than the easing that the doves want to use to address unemployment. That was certainly the case in the 1960s and the 1970s. But it is absurd and inhumane to think that the joblessness of tens of millions of Americans ought to be irrelevant to the development of economic policy.

During the second panel discussion (by far the most interesting one), Richmond Fed President Jeff Lacker and Professor George Selgin had an interesting debate about how a central bank ought to conduct its operations. Lacker believed that the Fed ought to fulfill its objectives solely by buying and selling Treasury securities to manage the supply of base money, as opposed to how the Fed behaved during the crisis.

Since 2008, the Fed has provided trillions of dollars in liquidity to a wide array of institutions while accepting collateral that included equity in bankrupt companies. The Fed also bought about $1 trillion worth of MBS in order to stabilize mortgage spreads. This was what Lacker was particularly opposed to. He thought that the policy amounted to favoritism on behalf of a particular group of Americans at the expense of another. His preferred policy was “Treasurys only.”

Selgin agreed that the Fed’s operations tended to favor some over others but he was more concerned with the cartel known as the Primary Dealers. Why, he asked, were 21 privileged firms (22 before MF Global blew up) given the unique opportunity to deal directly with the Fed? After all, plenty of regular Americans own Treasury securities, either directly, through their retirement accounts, or their pension plans. Why can’t we sell them to the Fed in open-market operations? Why couldn’t we borrow at low rates from the Term Auction Facility or the Primary Dealer Credit Facility?

The most interesting part of Selgin’s presentation, however, was his claim that Walter Bagehot did not actually support the existence of a lender of last resort. Rather, he viewed the institution as a second-best alternative. Bagehot’s famous solution to this problem was to have the lender of last resort demand high-quality collateral and charge punitively high interest rates. This rule always ends up getting ignored during crises.

The Federal Reserve was created to be the America’s lender of last resort in 1913 following the hairy experience of the Panic of 1907. It was supposed to fill in for the role played by J.P. Morgan by lending to illiquid (but supposedly solvent) banks during a crisis in order to stem panic. Only later did it get additional mandates to ensure price stability and full employment.

Bagehot (and his modern disciples) had three good reasons to be skeptical of lenders of last resort.

First, the markets know that any institution able to access the discount window is going to be safer than any that cannot, so capital will flow to those under the government’s protection. This lowers these banks’ borrowing costs and boosts their return on equity—an implicit subsidy.

Second, during a crisis, it is nearly impossible to differentiate between a bank that is “merely” illiquid and one that is insolvent. This is because all insolvent banks eventually become illiquid and all illiquid banks blow up unless they are promptly bailed out. Moreover, illiqudity is usually caused by fear of insolvency. So how can one tell which is which?

In a crisis, the bias of policymakers is always to assume that all troubled institutions are illiquid but solvent, irrespective of the truth. The result is that even the genuinely insolvent ones can access the discount window and borrow below market interest rates. This can sustain them for a very long time, especially if they are large enough to constitute a “systemically important financial institution.” Banks that survive like this are known as zombies.

Finally, there is something deeply unfair about the fact that large corporations can take out enormous loans at rates far below anything you or I could get solely because the government decides they are “too big to fail.” Why not have equality? If the banks can borrow in the Fed Funds market at 0.1% and deposit the money as excess reserves at the Fed at 0.25%, why not everyone else? If someone gets stuck with an unforeseen medical expense or loses his job, why can’t he access the discount window? There is nothing fair, much less capitalist, about a government institution that provides special privileges to the few while denying them to the masses. It is even more galling when banks use the profits they “earn” from this privilege to pay obscenely large bonuses to their employees.

The last paper I will discuss was presented by Roger Garrison. He made some of the most sensible points of the entire day. He focused on the distinction between the interest rates that would occur in the market in the absence of a central bank and the prevailing rates of interest that are the result of central bank manipulation as well as market forces. Differences between these two sets of interest rates can cause excessive investment and bubbles or can cause deflationary depressions from insufficient investment.

This presents a serious problem for central bankers. They cannot help but affect the entire shape and level of the yield curve but they would rather not distort real economic activity if they can help it. Yet their very existence distorts market pricing from what it would have been. Moreover, the prices that the market would have set are inherently unknowable in the absence of a fully free market.

Central bankers try to compensate for this by carefully studying the condition of the economy and the financial system. Then they develop forecasts for what they believe will happen under various scenarios and various policies. Finally, they choose the one that best fits their desired goal, whether it is a fixed exchange rate to another currency, some mix between price stability and full employment, or something else entirely.

As you might imagine, this is fiendishly difficult to do correctly on a consistent basis. There are simply too many opportunities to make mistakes. What if the assessment of current conditions is incorrect? This happens all the time, sometimes simply due to data collection problems. What if the forecast is wrong? Hardly unreasonable, considering that it is difficult to predict the future. What if the central bankers incorrectly estimate the impact of their policy decisions on the financial markets and the economy? As noted above, the transmission mechanism is constantly changing, which makes this question nearly impossible to answer reliably. Garrison’s point was that we should not be surprised that the U.S. has experienced just as much if not more macroeconomic instability since the establishment of the Federal Reserve as it did before.

All in all, the conference presented a lot of views outside the mainstream monetary policy discourse. There were certainly plenty of bad ideas, but the creativity and dissatisfaction with the status quo was more than welcome.

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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