Tag Archives: Sumner

Here’s How Cryptocurrencies Could Replace the US Dollar

Ever since Bitcoin started to capture the public imagination, I have downplayed the idea that it could ever represent a serious challenge to the US dollar. I disagree with the goldbugs who believe that simply fixing the supply of money is the best monetary policy, that inflation is theft, etc. Rather, I have argued that Bitcoin is a good medium of exchange despite being a bad unit of account and a risky store of value. These three functions of money tend to go together for reasons that Ludwig von Mises outlined over a century ago in The Theory of Money and Credit. But more recent research from the 1980s and 90s has explored the possibility of the separation of these three functions. A contemporary example of separation is that Treasurys are used to settle transactions in the shadow banking system, even though the transactions are denominated in dollars—the medium of exchange is different than the unit of account. Bitcoin could be just another example of the continuing separation of the functions of money as technology progresses.

I still think that this is correct—we are observing modest separation of the functions of money. Bitcoin doesn’t need to be a unit of account in order to be useful. On it’s own, Bitcoin makes a terrible unit of account.


This is speculative, but there is a scenario in which Bitcoin could create a real challenge for state-backed currencies. This scenario is not impossible.

As I wrote last week at The Umlaut, Bitcoin is not just money, it is a decentralized platform for generalized, programmable contracting, a transport layer for finance. It can be used to create all kinds of financial contracts, including, with the help of a trusted computer called an oracle, contracts contingent upon events in the real world. Suppose that an oracle existed that reliably provided information about the USD/BTC exchange rate. It would become possible to create a long-term contract, executed through Bitcoin, denominated in dollars. If the cost of querying the oracle were negligible (as we might expect it to be), then the cost of this trade would be the forgone interest on the funds used to meet the “margin requirements” built into the contract.

Now assume a second oracle that reports nominal GDP. By combining the two oracles, it becomes possible to write a contract, executed over Bitcoin, that is denominated in shares of NGDP. In fact, we could simply standardize this transaction and create a new currency unit, built on top of Bitcoin, that is equal to a trillionth of NGDP. We could call it a Sumner. Instead of getting a mortgage for $300,000 for a house, you could promise to pay 19,000 Sumners. That way, if the economy went south, you would owe less in real terms, and repayment would not become harder. If the economy boomed, you would owe more in real terms, and repayment would not become easier. Similarly, workers who had wage contracts denominated in Sumners would experience a real pay cut when the economy shrank, decreasing their employers’ incentive to fire them, and an automatic raise as the economy grew again. Sumners would have built-in monetary policy.

So by combining information from two oracles into a simple, standardized, tradable futures contract executed over Bitcoin, we create a cryptocurrency overlay that is superior to dollars, at least according to the market monetarists (see Scott Sumner’s 1989 paper and his recent Mercatus paper). As I said above, this is speculative; as far as I can tell, there are no oracles or Bitcoin-executed futures contracts yet. And there are at least two further (possibly surmountable) problems.

First, it remains to be seen what the long-term cost of hedging will be. The margin requirements built into a Sumner depend on how volatile Bitcoin is with respect to NGDP. It’s possible that over the long run, the volatility of Bitcoin will settle down a fair bit, even if it is never as stable as the dollar. If Bitcoin is some day only 3-5 times more volatile than the dollar, that should be enough to support the creation of Sumners. For now, Bitcoin’s price swings are still incredibly wide.

Second, there remains the puzzle of why we don’t see NGDP futures in the dollar economy. As far as I can tell, there are no regulatory barriers to creating them and using them to denominate transactions. Yet in spite of their supposed superiority to dollars, no one uses NGDP futures to trade, and indeed, there aren’t even NGDP futures markets. If it’s a question of there not being enough permissionless innovation in the financial system, then maybe market monetarists should embrace cryptocurrencies as a way to try out their ideas.

Replies to My Critics

Last week, I argued that the short run is short—that there is good reason to believe that we’re now past the point where monetary stimulus can do much to help the economy. Again, I am broadly friendly to market monetarism and not especially hawkish on inflation. I am not so much against QE3 as skeptical that it will work. I think that the broad facts and a lot of mainstream macro theory back me up.

My post garnered a fair bit of criticism around the blogosphere. Let me make one quick empirical point to get everyone on the same page, and then I will try to respond to my critics point by point.

The empirical point is summed up in the graph below. NGDP grew around 5 percent per year until around 2008, and then it fell, and then it grew at around 5 percent—or slightly less—per year again beginning in mid 2009. These facts are well known, but I bring them up here because they do constrain the kind of stories we can tell about the economy. Any story you tell has to contain a one-time shock that ended years ago, and it has to be consistent with NGDP that has grown at about the same rate over the last 3 years as it did before the shock arrived.

OK, now with that out of the way, let’s take the criticisms one by one.

Bryan Caplan and ADP unemployment

Bryan cites Akerlof, Dickens, and Perry on long-run unemployment as a reason why QE3 might boost employment in spite of the fact that we are out of what we would conventionally call the short run. The ADP model assumes heterogeneous firms and workers with money illusion. At any given time, some firms need to cut real wages, and since nominal cuts hurt morale, higher inflation helps those particular firms cut wages instead of jobs. Consequently, in a low-inflation environment, monetary stimulus can help lubricate the employment market.

This argument is a good one as far as it goes. Unfortunately, I don’t think it goes very far given the stylized facts. As I noted above, NGDP is growing at a rate of 4-5 percent per year, not that different from before the crash. So any long-run ADP-style unemployment should be about the same now as it was before the crash unless there was a structural change in the economy. You can’t have it both ways—if we’re in a low-inflation environment for ADP purposes now, then we were in a low-inflation environment for ADP purposes before the crash as well.

Furthermore, assuming QE3 is a temporary policy, then if unemployment is long-term ADP unemployment, the effect of QE3 on unemployment will be temporary. I would regard a temporary dip in unemployment as a result of QE3 as good but underwhelming, given the claims of many market monetarists. There may of course be interactions between short-run unemployment and ADP unemployment, and for that reason, the dip in unemployment may not literally be temporary, but I would be surprised if QE3 could fix the economy through this channel.

Bryan makes an interesting linkage between my views on the ZMP hypothesis and ADP unemployment. If there is a decreasing secular trend of low-skill labor productivity, then ADP unemployment will become more serious over time. I think this is a good point, and it pushes me at the margin to favor a higher long-run NGDP target than I otherwise would. I was previously inclined to believe that the exact value of the target doesn’t matter once you get to levels of around 3 percent, but now I see more merit in a higher target.

Insider-outsider models

Bryan and some of the commenters at MR say that it is a mistake to focus on the wage demands of the unemployed. Rather, it is the wage demands of the employed that are especially sticky. The failure of insider wages to adjust downward to long-run levels means that there’s no ability to hire outsiders at below long-run levels, either because companies can’t afford to do it or because they are afraid of hurting insider morale.

The problem is that even if this story is true, we are probably, again, out of the short run. NGDP is almost 10 percent higher now than it was at the pre-crash peak. The number of people employed, even with population growth, is still below the pre-crash peak. Even assuming that insider nominal wages are totally inflexible, nominal output per worker has grown fast enough that insider real wages have probably adjusted. Furthermore, in five years, a non-trivial fraction of insiders retire or change jobs.

More generally, I’ve never been a fan of insider-outsider models, at least not for the United States in recent times. Maybe it makes sense as a model of Europe or Detroit in the union heyday. But today in the US, “labor” is less homogeneous than ever, private sector unions have declined, and fewer workers have an expectation of lifetime employment. Yet the past three recoveries have been increasingly jobless! How can you square the fact that at a time when the insider-outsider distinction is weaker than ever, labor hoarding has basically ended and labor market adjustment has become more difficult? I do it by assuming that the insider-outsider mechanism does not play that big of a role.

But again, even if the insider-outsider story was true at the beginning of the recession, there is little reason to believe that it is still true.

Ryan Avent and corporate profits

At the Economist, Ryan Avent focuses on my point that corporate profits are at record highs.

Firms could be enjoying high profits simply because revenues have stabilised while costs are low, perhaps because low expectations for future nominal spending growth have discouraged investment.

First, note that in the series I cited, corporate profits are adjusted for inventory valuation and capital consumption. The purpose of these adjustments is to make the series less responsive to exactly the kind of behavior Ryan posits. If firms decide not to invest in production and simply sell out of inventory instead, that can increase profits, but it doesn’t increase profits adjusted for inventory valuation. Likewise, a firm can temporarily increase profits by making inefficient use of existing equipment, which could lead to faster depreciation. Are these adjustments perfect? No. But they do offset some of Ryan’s concerns. Corporate profits are high even when you subtract some of the temporary gains firms get from not investing. The unadjusted series is here, by the way; I avoided it because I anticipated Ryan’s argument.

Second, whatever firms’ expectations were, as I’ve said repeatedly, nominal spending growth has not been especially low in the last three years. A better story, if you are trying to resist structural theories, might be that firms are wary of investing due to fears of shocks from Europe or Asia, which monetary easing now does little to help. It would be great if the Fed would commit now to keeping NGDP growing at 4-5 percent when those shocks do hit, but in the meantime, I am not expecting a lot out of QE3.

Ryan also makes a couple of other points, but none of them cut to the heart of my critique of QE3 optimism. He gestures to the New Keynesian literature, but of course even the New Keynesians don’t argue that the short run lasts forever. And Mankiw, who is one of the authors Ryan cites, is a well-known proponent of the unit root hypothesis. I do not read Mankiw as expecting a return to trend, no matter what monetary policy is, although I of course do not speak for him and am happy to be corrected. Ryan also quotes Weitzman on how increasing returns creates unemployment, which is true, but tautologous: if there were no increasing returns, anyone who was unemployed could start his own firm and be just as productive as when he was employed.

Bill Woolsey

Bill Woolsey cordially welcomes me, despite my heterodoxy, to the market monetarist club. I am glad to make the cut.

I think that I failed to make myself clear in my original post. Bill says, “Dourado’s version of how shifts in nominal GDP impact real output and employment is based upon an assumption of market clearing.” This is not what I intended to convey. I think that part of the effect of nominal shocks propagates through market-clearing monetary misperceptions (Lucas islands), and the rest through non-market-clearing nominal rigidities, or as I wrote in the original post, “because some wages, prices, and contracts don’t adjust instantaneously.” I am not as New Classical as Bill seems to think. I like some elements of the New Classical school, but in the end I think the correct theory of macro for now is pluralism.

In the long run, I do think that markets mostly clear. And I think that Bill must agree, for he writes at the end of his post:

On the other hand, most of us do believe that firms eventually cut prices and wages in the face of persistent surpluses of output and labor. Most of us remain puzzled by the slow adjustment.

This is my point. If our problems were purely cyclical, “eventually” would have happened already, so our problems must not be purely cyclical. Time to start looking at structural explanations.

Scott Sumner and cutting-edge research

I was pleased to get a reply from the high priest of market monetarism himself, Scott Sumner.

I addressed the plausibility of sticky wages here, and in numerous other posts in reply to Tyler Cowen and George Selgin. I’d also point out that there is lots of cutting-edge research that tells us that the “common sense” approach to the wage stickiness hypothesis is not reliable. By common sense I mean; “Come on, wouldn’t the unemployed have cut their wage demands by now.” Yes, they would have, but that doesn’t solve the problem.  This is partly (but not exclusively) for reasons discussed in this recent Ryan Avent post.

Well ok, I followed the first link, which gives the usual argument and then ends with the line, “Until we get a more plausible theory of unemployment, I’m sticking with stickiness.” This is honest, and it certainly is a common view, but I don’t think it’s a good idea to rely so heavily on a theory just because we don’t understand competing theories well yet. Macro of the gaps, I call it.

We have a long way to go in macro, so I’m glad that Scott brings up the issue of cutting-edge research. If he has particular examples of recent work that undermines the common sense approach, he should write about them at greater length. I assume that when he says “cutting-edge” he is not referring to the papers cited in Ryan’s post, since those are both from the 1980s.

Speaking of cutting edge research, let me point everyone to a paper, “Countercyclical Restructuring and Jobless Recoveries,” by David Berger, a new PhD from Yale, and now a professor at Northwestern. Berger creates a model in which firms grow fat during expansions and respond during recessions by laying off their least productive workers. His model creates jobless recoveries and matches the new stylized facts (they have changed since the 1980s) about business cycles pretty well.

One thing that I like about the Berger paper is that it shows why some nominal shocks, if not addressed immediately, are not easily reversible by monetary authorities. Once a firm has fired its least productive workers, it is not going back. If the monetary authority wants to prevent a recession, at least post-1984, it needs to act before firms lay off their workers. This perspective actually bolsters the case for NGDP targeting, because it means that the Fed should have an apparatus in place now so that the economy will be automatically stabilized when the next shock hits. Here is Tyler on Berger.

My question for Scott, since he’s so interested in cutting-edge research, is: “What do you think about Berger’s paper?” I assume that Scott is familiar with the changes in business cycles that Berger documents. Does he not think that Berger’s model accounts for some significant fraction of our current unemployment better than simply sticky wages forever?

The bottom line

None of my critics seem to be willing to make any sort of broadly falsifiable claim about how long the short run lasts. (I should say that Bryan is not arguing that we are necessarily in the short run in the bulk of his post). There is a lot of assuming trend stationarity, talk about output gaps, and pointing to literature I am well aware of—in short, a lot of question begging.

I would like to see a greater emphasis in the blogosphere on understanding stylized facts about recessions, a greater willingness to explore micro phenomena (even if we are not using fully microfounded models), and more macro-ecumenicism. No one school of macro has it all figured out, and that includes market monetarism. There is enough ambiguity in our current situation that reasonable people can disagree about what is going on. But I don’t think that reasonable people can be totally certain that all we need is more nominal stimulus.

The Short Run is Short

I’m a fan of Scott Sumner, NGDP level targeting, and many of the ideas of market monetarism in general. However, unlike many of those who support these ideas, I am pessimistic that QE3 will fix the economy, and I worry that too much celebration by market monetarists over the structure of easing will only serve to undermine what remains good in market monetarism if and when the economy fails to recover quickly. In particular, I think that many commentators fail to appreciate the mainstream macroeconomic distinction between short run and long run analysis, and that many economists overestimate how long the short run lasts.

The case for stimulus is based in monetary non-neutrality. If we double the money supply, the real productive capacity of the economy does not increase—real productive capacity has nothing to do with monetary factors. However, because people are tricked, and because some wages, prices, and contracts don’t adjust instantaneously, output may go up briefly. Business owners see an increase in nominal demand for their products and mistakenly assume that it is an increase in real demand. They see this as a profit opportunity, so they expand production. As prices, wages, and contracts adjust to the new money supply and their assumption is revealed to be false, they cut back on production to where they were before.

If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

Obviously, there is no signal that is fired to let everyone know that the short run is over, so reasonable people can disagree about how long the short run lasts. But I think there is good reason to think that the short run is over—it is short, after all.

My first bit of evidence is corporate profits. They are at an all time high, around two-and-a-half times higher in nominal terms than they were during the late 1990s, our last real boom.

If you think that unemployment is high because demand is low and therefore business isn’t profitable, you are empirically mistaken. Business is very profitable, but it has learned to get by without as much labor.

A second data point is the duration of unemployment. Around 40 percent of the unemployed have been unemployed for six months or longer. And the mean duration of unemployment is even longer, around 40 weeks, which means that the distribution has a high-duration tail.

Now, do you mean to tell me that four years into the recession, for people who have been unemployed for six months, a year, or even longer, that their wage demands are sticky? This seems implausible.

A third argument I’ve heard a lot of is that mortgage obligations have remained high—sticky contracts—while income has gone down. Garett Jones endorses this as a theory of monetary non-neutrality, and I agree. In fact, I beat him to it. But just because debt can make money non-neutral in the short run does not mean that we are still in the short run.

In fact, there is good evidence that here too we are out of the short run. Household debt service payments as a percent of disposable personal income is lower than it has been at any point in the last 15 years.

Yes, this graph includes mortgage payments.

So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment, but even if unemployment is cyclical, it doesn’t mean that monetary adjustment has failed to occur—real sector recalculation may just take longer than monetary recalculation.

Again, I favor NGDP targeting, but it is most effective when it is done simultaneously with the nominal shock. Evan Soltas points to the case of Israel, and indeed, the Israelis did it right. But it seems like wishful thinking to assume that four to five years after a nominal shock, you can fix the economy with monetary stimulus.

I would be delighted to be wrong. And I wouldn’t be surprised to see a slight decrease in unemployment as the result of QE3. But I would be surprised if we experience a plummeting of unemployment in the next two years down to what we previously thought of as “normal” levels of around 5 percent. Yes, it is good that the Fed is now using the expectations channel, but it did it four to five years too late, and there’s little theory or evidence its failure can be easily reversed.

UPDATE: I reply to my critics here.

What’s Right and Wrong With Austrian Macro?

“There’s something wrong with everything. In macro; not, you know, in life.” That may not be a verbatim quotation, but I remember Tyler explaining this in PhD macro I, and it has stuck with me. You don’t really understand a school of macroeconomic thought until you can dispassionately evaluate both its strengths and weaknesses. If your answer is that it has no strengths, then you don’t understand it; lots of very smart people developed the theory for a reason. If your answer is that it has no weaknesses, then you don’t understand it; lots of very smart people disbelieve the theory for a reason.

I’m writing this post on Austrian macro because the Austrian school seems to be both en vogue with and poorly understood by Tea Party types. For that matter, it is poorly understood by critics of the Tea Party. I’ll be the first to admit that I am not the most qualified person in the world to write this post. I am not an Austrian or a macroeconomist. Lots of people, including some GMU first-years who are taking the macro prelim this weekend, could do a better job than I will do. Maybe they can comment and refine the post that way. Let’s get started:

What’s right with Austrian macro?

The starting point for modern macroeconomics is what is known as dynamic stochastic general equilibrium (DSGE) models. These models vary depending on the point that the theorist is trying to make, but in the broadest class of them, there is in fact very little economics even going on. Say we start with Long and Plosser’s classic RBC model. How many goods are there in Long and Plosser? One (plus leisure). How many people are there in Long and Plosser? One! How much trade is there in Long and Plosser? Zero. Now, if what you mean by economics is intertemporal optimization in the face of random shocks, then Long and Plosser is an economic model. But as Hayek argues, “This, however, is emphatically not the economic problem which society faces.” DSGE models are poorly suited to evaluating changes in an economy with arbitrarily diverse agents with arbitrarily diverse preferences and arbitrarily diverse information sets. This critique of DSGE-style macro is part of the core of Austrian theory.

Furthermore, in the Austrian view, capital is heterogeneous and multi-specific. If you invest in a pet store, and then decide you want to convert it to a massage parlor, that is costly and time-consuming. This opens the door to malinvestment. In many RBC and New Keynesian models, capital is homogeneous, meaning that it is costless to switch from one investment into another. Kydland and Prescott explicitly assume time-to-build, but this is not the only friction in real-world investment.

According to the Austrians, production functions for the multi-specific capital are discovered over time. In virtually all RBC and New Keynesian models, production functions, the way of transforming the single type of capital into the good or (rarely) goods are specified in advance and do not change. Austrians emphasize competition as a discovery procedure. Entrepreneurs are constantly trying to find new ways to turn existing capital stocks into goods that consumers may want. This discovery procedure is obviously sensitive to policy shocks.

What is wrong with Austrian macro?

The biggest problem with the Austrian school is a legacy of the fact that much (not all!) of the theory was developed before the rational expectations revolution. Even if you think rational expectations is bogus, the fact is that many Austrian models do not explicitly state what is driving expectations. If the monetary authority inflates, everyone is tricked. This is clearly problematic. A better Austrian theory in my opinion would evolve along the lines of the Lucas islands model. I have written before that I think our current situation is one of severe model uncertainty. Some people think money is tight and others think money is loose. If that is the case, then even if people have, say, Bayesian expectations, many of them will be tricked, resulting in monetary distortions.

The other major weakness in Austrian business cycle theory is that it focuses way too much on one particular distortion, monetary policy. Now, the Austrians have an answer to this; they argue that money is one half of every single transaction in the economy, so if money is distorted, then that is a big problem. I don’t think this is true. First, monetary distortions will cause primarily intertemporal distortions. This may be problematic, but as I wrote above, one of the biggest strengths of the Austrian model is that it takes seriously the heterogeneity of goods, capital, and preferences. Focusing primarily on intertemporal investment gives away that huge gain. Austrians should be more open to examining other distortions, such as the subsidization of fixed-value financial claims (FDIC insurance, favoring debt versus equity) and industrial policy. I think Arnold Kling is onto something with his emphasis on Patterns of Sustainable Specialization and Trade.

What is misunderstood about Austrian macro?

The Austrian mantle has been claimed by the Tea Party, but very few Tea Partiers are familiar with modern Austrian scholarship. Michelle Bachmann famously takes Mises with her to the beach, but there is a great deal of Austrian theory that is post-Mises. In particular, most of the modern Austrians I have talked to are not goldbugs. They understand that the most important characteristic of money is not its store-of-value property. In general they favor rules versus discretion in monetary policy, but those rules are ones that non-Austrians can easily get behind. For instance, George Selgin writes, “Scott Sumner’s general views on macroeconomics are so much in harmony with my own that, in commenting on the present essay, I’m hard pressed to steer clear of the Scylla of fulsomeness without being drawn into a Charybdis of pettifoggery.” Furthermore, to the extent that Austrians like gold as currency, they like it because they believe it would “win” in a free-market competition against fiat currency, not because gold is special per se. A simple test would be to get rid of capital gains taxes on gold and other assets and see what wins.

Modern Austrians view policies like NGDP targeting as coming straight out of Hayek, who wrote about the importance of preventing a “secondary deflation.” Consequently, the mainstream accusation that Austrians favor no policy in the face of a financial crisis is misguided. The correct policy, according to many Austrians, is to adopt the most non-distortionary monetary policy there is, which is to keep nominal spending at the expected level. Letting spending collapse is itself a distortionary policy.

The Tea Party is populist, but it seems to be populist for the sake of populism. Austrian theory, on the other hand, is anti-elitist because it believes that neither elites nor anyone else can successfully “manage” the economy. There is consequently a certain populist interpretation of Austrianism; but the theory is not so much about giving the masses what they want as about letting a decentralized process take place. This is the main reason I am skeptical about the political adoption of Austrianism. It is being used as a rhetorical tool in a cultural dispute, not as a way of understanding the nature of the economic problems we face.

Keep the Debt Ceiling

“Manufactured crisis” is the term going around to describe the near-failure of Congress to raise the debt ceiling. Mitch McConnell says that we can expect more of them in the future. It’s not surprising that big-government types want to get rid of the debt ceiling altogether, but even some of the cool people are getting in on the action. “Get rid of the debt ceiling, for God’s sake,” says Scott Sumner. “Now more than ever the debt ceiling has to be permanently removed,” says Adam Ozimek. I’m not for manufactured crises, but this seems like a severe overreaction that would have really bad long-run consequences.

The argument for getting rid of the debt ceiling goes like this: Congress has already approved federal spending. Increases in the debt ceiling merely authorize the executive branch to spend what the legislative branch has ordered it to spend, so it is redundant. Furthermore, Congress has now discovered that the debt ceiling can be used as a source of gridlock (or “hostage-taking” or “terrorism,” depending on how shrill you want to get). Most governments don’t have debt ceilings; they work just fine. So the debt ceiling creates an opportunity for political opportunism and pointlessly increases our risk of a big crisis.

This argument strikes me as shockingly naïve. First of all, to get rid of the debt ceiling would be to vastly expand the power of the executive branch. The US Constitution lists borrowing as an Article I power. “The Congress shall have Power…To borrow Money on the credit of the United States.” Giving the executive branch the power to borrow on the credit of the US whatever it interprets to be necessary could have terrible consequences. For instance, current Constitutional jurisprudence seems to give Congress the authority to declare war, but no mechanism by which to undeclare war. Wars end when the executive branch says they end. However, at present Congress can at least de-fund a war. If the debt ceiling were eliminated, once war had been declared, the executive branch could prosecute it basically forever, even if Congress disapproved. The president could borrow whatever money was necessary to do all the spending that Congress ordered, plus the money for the war. And when you factor in that the Obama administration seems to have blatantly ignored the War Powers Resolution in its action in Libya, this should be cause for serious alarm among anyone with even a modicum of sense. The left especially, which complained incessantly about expansions of executive power during the Bush administration, if it has any principles left should oppose giving the executive branch any freer rein.

Furthermore, it’s simply not true that every Congress approves of all federal spending. Congress passes a discretionary budget every year, but much of federal spending is “mandatory,” meaning it is not subject to the ordinary how-a-bill-becomes-a-law process. On entitlements, for instance, some past Congress approved a given path of spending, but the current Congress can only change that path if they can override a presidential veto (or induce a non-veto). Assuming no veto-overrides, to cut discretionary spending, you need both houses of Congress. To cut entitlement spending, you need both houses plus the President. So the structure of the spending power is in fact different with discretionary versus “mandatory” spending. Faced with an executive branch that opposes cuts to entitlement spending, Congress will never be able to cut spending if they cannot force a cut through the debt ceiling. If all federal spending were discretionary, then there would be some merit to the claim that the debt ceiling is redundant; since some spending cuts are subject to a presidential veto, the debt ceiling provides an important non-redundant tool to force those cuts.

More generally, I would remind people that decreasing the holdout problem with respect to spending increases the holdout problem with respect to cutting spending. If you agree that the US needs to drastically cut entitlements over the medium term (i.e., if you are paying attention), you should want to decrease the holdout problem for spending cuts, not for spending increases.

So what about the severe crisis that will result if the US bumps up against the debt ceiling, gets downgraded, or delays payments? I agree that this will be a manufactured crisis, but those who favor spending more seem to deserve as much, if not more, of the blame as those who oppose borrowing more. But it seems the biggest blame should be laid at the feet of those who make our economy so fragile with respect to a single security. The best way to avoid a crisis in the future is to take steps now to make financial institutions more robust. First, eliminate rules that will trigger huge sell-offs of T-bills if when the US loses its AAA credit rating. Eliminate the favorable tax treatment of debt and improve the tax treatment of equity (I facetiously call this “Islamic banking lite”). Allow checkable brokerage accounts. Increase the average maturity of US debt to give the government some leeway with respect to seigniorage in the event the crisis occurs.

And of course, the ultimate solution to the debt ceiling issue is to spend less. Even if you oppose cutting spending during a recession, it’s hard to justify a debt ceiling that is as high as the US’s. If the output gap of a recession is 8 percent of GDP for 4 years, even if there is no monetary stimulus, that justifies a debt ceiling that is 32 percent of GDP, not 100 percent or more. In reality, there can be more monetary stimulus and fiscal stimulus is pretty ineffective, so even 32 percent of GDP seems like excessive borrowing across the business cycle.

My bottom line is that the US is a big, diverse economy. As it has gotten more diverse, interests have come into greater conflict. The result will be either gridlock in Congress, consolidation of executive branch power, or devolution of power to local authorities (at which scale there is less conflict) and the market. We should take this last path, and the quickest and least painful way to get there is to keep the debt ceiling and make smart reforms to spending and the financial system. Eliminating the debt ceiling will ensure that power continues to be consolidated and that spending will be harder to cut.

The Economics of Cryptocurrency

Is there a word for serendipitous Wikipedia browsing? Yesterday I started out seeking information on punk music and I ended up discovering Bitcoin, an open source peer-to-peer digital currency. Bitcoin uses strong cryptography and decentralized computing to produce scarcity in the money supply, which grows at a predefined rate that is clearly visible in the source code. Tamper with that growth rate and your software becomes incompatible with the rest of the cloud, and your Bitcoin holdings become valueless. Double-spending is impossible unless at least half the computing power of the cloud is in on the attack against the currency. You can read all the technical details here.

The total supply of Bitcoins is scheduled to grow geometrically and will asymptotically approach 21 million. This means that if the currency becomes successful and its velocity does not accelerate proportionally to its use, we should expect long-run deflation in Bitcoin-denominated prices. Bitcoins are technically divisible to 8 decimal places to accommodate this. Notably, if I am reading the data correctly, Bitcoins have appreciated by a factor of 300 against the dollar in the last year. One Bitcoin is worth around 88 cents as of this writing.

I have a number of questions. Perhaps my readers know some of the answers, or perhaps some enterprising young monetary economist will address some of these in an academic paper (calling Will Luther).

  1. Currencies are based on trust, and trust in money is accomplished through scarcity. Bitcoin is cryptographically guaranteed to be scarce since its supply will never exceed 21 million. But there is reason to believe that a perfectly fixed supply is not optimal. If people suffer from money illusion, it is better if prices increase gradually over time. If money has real effects, then it is best if the money supply is countercyclical. These two facts are at least part of why Sumner advocates a fixed NGDP trajectory. Is it possible to create a cryptocurrency that targets NGDP instead of the money supply?
  2. If there are competing currencies would we still want any one currency to target NGDP? MV ≡ PT, but notably T only represents transactions denominated in a particular currency. In general, what is the optimal path of the various money supplies when there is more than one currency in use in a given economy? When there are competing currencies, is there less money illusion? Does money continue to have real effects?
  3. What are the monetary implications of the fact that governments will probably have difficulty regulating banking in cryptocurrency? Does cryptocurrency provide a test of the legal restrictions theory developed by Fischer Black, Neil Wallace, and others?
  4. What if prices come to be denominated in Bitcoin (with its fixed supply), but different media of exchange and settlement are used? How does that change any of the above?
  5. In a number of the above scenarios, there may not be much deflation in Bitcoin-denominated prices (since the money supply is not defined, say, under the absence of legal restrictions on financial intermediation). Putting these scenarios aside, if deflation were consistent, then Bitcoins would yield a positive return due to appreciation. Would we see more money hoarding during recessions? Would the world finally see a real liquidity trap? With monetary policy out of the picture, would fiscal policy become necessary? Is crypto-anarchy self-defeating because it requires big government interventions?
  6. Decentralization of the currency means that it cannot be debased, but it also means that it cannot be confiscated at an institutional level. What are the political effects of this change?

I suppose I should add that I am not exposed to Bitcoin and am long USD. And by the way, thinking about Bitcoin reminded me of David Friedman’s Future Imperfect, which you may want to read if you enjoyed this post.

Update 4/4/11 — Bitcoin is the subject of today’s EconTalk.

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.