Eli Dourado

Miscellaneous thoughts on the Fed

Everyone is interested in monetary policy and the Fed all of a sudden, so, what the hell, I’ll chime in too.

Here is my ranking of monetary regimes:

  1. Depoliticization and denationalization of money. Free banking. The market selects a currency and banking is “regulated” in court under the common law of contract.
  2. The Fed is a Sumnerian robot. It runs a market in quasi-velocity futures and a computer uses the market price to decide whether to expand or contract the money supply.
  3. The status quo.
  4. Congress itself “coin[s] money and regulate[s] the value thereof.”

Most people who want to abolish the Fed think that we can go from number 3 to number 1, but more likely, if we End the Fed, we’ll go to number 4. For all the exaggerated claims about how the Fed is turning us into Zimbabwe, number 4 would go much further in that direction than number 3 has.

If anti-Fed steps are to be taken, they should be along the lines of Ron Paul’s Free Competition in Currency Act, which weakens the Fed by eliminating legal tender laws and eliminates capital gains for alternative currencies. The capital gains issue is important because money is half of every transaction, and even if the value of money is stable such that there are minimal capital gains and losses, the amount of record-keeping that is needed to use an alternative currency is prohibitive. The bill doesn’t go far enough, though; the optimal currency may be none of the things that are exempted from capital gains taxes under the bill, and really the only solution is to eliminate taxation of capital gains entirely. Can you imagine the political uproar from our friends on the left?

People complain that since the inception of the Fed, 95% of the purchasing power of the dollar has been inflated away, but this is looking at the wrong derivative. When inflation is consistent and expected, rates of return adjust to compensate for it. As long as you are not holding most of your assets in currency or non-interest-bearing dollar-denominated accounts, steady inflation doesn’t matter. Inflation is a tax on people who hold literal dollars, which is probably not you unless you are a crime lord or a foreign dictator.

QE2 brings us slightly closer to the number 2 monetary regime above, and I support it on those grounds and those grounds only. If we had had the Sumnerian infrastructure in place in early 2008, it would be telling us to expand the money supply now, and therefore expanding it now is what we should do. I regret that it is being done on a discretionary basis, but you give policy advice in the policy environment you’ve got.

By the way, QE1 was not really QE, as Alex Tabarrok explained in 2008. The Fed started paying interest on reserves, which has the effect of massively decreasing velocity. The Fed needed to increase M to offset the decrease in V. Why the Fed would take such velocity-decreasing action in the middle of a crisis, I do not know.

Tyler Cowen writes this morning that if you want a countercyclical money supply, you must have a central bank. Tyler, this is false! I had a discussion once with a different Tyler in which we traced the effects of using shares of the S&P 500 as currency. Since the stock market is cyclical, money would appreciate in booms and depreciate in busts, just as it would if you had a decent central bank. The big downside would be a long-term deflationary trend, but nevertheless as a proof-of-concept it shows quite clearly that a countercyclical money supply is possible under a commodity currency.

For those who are opposed to monetary central planning, the real story is not QE2, but the looming disaster in the Eurozone, which is quite obviously not an optimal currency area. If they can get past the current crisis somehow, they will just be inviting the next one if they do not do something radical like banning all languages other than English. I’m still hoping that if the Greek collapse comes, it comes when I am in Greece next month.

The bottom line is that whether the Fed has been a failure depends on what you think the alternative is. The Fed made some big mistakes in the 1930s and in 2008-2009, but at least (1) we’re not Europe and (2) Congress is not in charge. I think that if we give in to populism, we are likely to get something worse than the Fed, not better, though if the populists want to start getting serious about monetary theory, I would welcome that.