Friday, July 8, 2016

Hyperinflation 2.0?

If you haven't heard, protests are breaking out in Zimbabwe and unpaid civil servants are going on strike. This sort of thing hasn't happened in many years.

It's possible to trace at least some of the motivation for these developments to monetary mischief. Over the last twenty years, no nation has suffered more problems with its money than Zimbabwe has. Everyone remembers the hyperinflation and subsequent dollarization in late 2008. The most recent episode has seen a nation-wide bank run break out as Zimbabweans queue at ATMs to withdraw U.S. dollars, the local currency.

Remember last year's Greek bank run? I'd argue that Zimbabwe's bank run is similar. If you recall, Greek depositors were worried that—in the event of a Greek exit from the Eurozone—their deposits would be redenominated from euros to a Greek version of the euro or even a new drachma. Better to cash out in good euros before getting stuck with something worse. Line-ups grew outside Greek banks until authorities had no choice but to shut the system down.

Like Greece, there is a decent chance that Zimbabwean bank deposits might be made payable in funny money, namely a Zimbabwean version of the U.S. dollar rather than the actual U.S. banknotes. This may explain why Zimbabweans have been desperately queuing up at bank machines—they want to cash out before the worst case scenario happens.

To understand what I mean by 'Zimbabwean version of the U.S. dollar', we need to take a quick tour of the Zimbabwean banking system. A nation's central bank usually runs the plumbing that connects local banks. These banks keep accounts at the central bank—in Zimbabwe's case the Reserve Bank of Zimbabwe (RBZ)—and use balances held in these accounts to clear and settle among each other. These accounts, along with central bank-issued banknotes, constitute a nation's supply of base money, the quantity of which determines its price level. When Zimbabweans spontaneously stopped using the local currency, the Zimbabwean dollar, in late 2008, RBZ accounts (and cash) became worthless. The RBZ-managed plumbing system had imploded.

Zimbabweans still needed to bank, however, so local banks soon began offering U.S. dollar accounts to clients. A new plumbing system was re-erected overseas; instead of maintaining clearing accounts at the now defunct Reserve Bank of Zimbabwe, local banks held U.S dollar accounts at banks in Europe and the U.S., otherwise known as nostro accounts. They used these offshore accounts to settle interbank Zimbabwe payments. [1]

To understand how this offshore plumbing system worked, say Joseph (who lives in the capital Harare) writes a cheque to Robert (who lives in Bulawayo). Joseph's local bank might settle the cheque thousands of miles away by having its New York bank wire funds to the nostro account of Robert's bank, which might be based in London. Circuitous, right?

As for cash, say Joseph wants to withdraw $100,000 in U.S. banknotes from his Zimbabwe bank account. His bank would request its New York bank to debit its nostro account by $100,000 and then ship the $100,000 in banknotes to Zimbabwe. Joseph now has a suitcase full of Ben Franklins.

This offshore plumbing system worked pretty well. However, it didn't take long for the RBZ to re-insinuate itself into the works by offering local banks U.S. dollar accounts. These accounts allowed the local banks to use the RBZ's re-christened real-time gross settlement system (RTGS) to settle interbank payments rather than using the offshore plumbing system. After having lost its printing press, the RBZ had got back into the monetary printing game. It had created a Zimbabwean version of the U.S. dollar.

My understanding is that as time passed the RBZ forced local banks to "repatriate" their clearing accounts from the overseas system and deposit them at the RBZ. In effect, local banks were told to wire U.S. funds from their foreign-based nostro accounts into an RBZ account held at a European/American bank. In turn, the local bank was credited with an equal quantity of U.S. dollar deposits on the RBZ's own books. Voila, local banks had gone from holding U.S. dollars in relatively safe foreign banks located in places like London to holding the domestic RBZ version of the dollar. I can't imagine that bank managers were terribly fond of this forced switch given the RBZ role in igniting the 21st century's first hyperinflation.

Let's see how this new system works. Now when Joseph wants $100,000 in cash, Joseph's bank—call it the Commonwealth Bank of Zimbabwe—has two choices. Use its foreign nostro account as before. Or it can ask the RBZ to debit the Commonwealth Bank RTGS account and provide the proper number of U.S. banknotes. The RBZ in turn sources the cash by requesting its foreign bank to debit the RBZ account—now plump with confiscated dollars—and send the cash to Zimbabwe by plane. The RBZ's overseas dollar accounts in effect "back" the dollar deposits that the RBZ has issued to local banks.

On paper this sort of system should work fine... as long as the RBZ doesn't abscond with the funds in the foreign bank accounts. Unfortunately, this may be exactly what happened. The RBZ had effectively gone from being bankrupt to having amassed large amounts of U.S. funds overseas. This proved tempting, and according to former finance minister Tendai Biti the regime began dipping into the RBZ's foreign stash to pay for expensive junkets and to finance public sector salaries. The upshot it that there may not be enough U.S. funds in the RBZ's foreign accounts to back its promises to local banks.

This means that now when Zimbabweans go to their banks to get U.S. cash, the banks—which before had no problems meeting these requests via their nostro accounts—are hamstrung. They have U.S. dollar accounts at the RBZ but the RBZ is unable to draw on its depleted overseas accounts to get the requested cash. The lineups that have developed are the public's attempt to squeeze out whatever spare dollars remain in the system, an attempt that is rendered much hard given the withdrawal limits that have been instituted to slow down the run.

Zimbabweans are already starting to see a divergence between the price of an electronic dollar and a paper dollar. Various media reports say the practice of "cash burning" has re-emerged for the first time since the hyperinflation of 2007-08. Anyone who needs to convert deposits into cash, frustrated by long lines at ATMs and withdrawal limits, can instead approach an informal dealer who offers to buy their deposits at a discount of 10-20% of their cash value (see here and here). Think of the 'cash burning' discount as the market value of an RBZ-backed bank deposit. If the regime has indeed wasted all the money in its nostro accounts, this discount will only widen.

The theory that the regime has absconded with the RBZ's overseas funds is consistent with a flurry of official proclamations over the last month or two. If the RBZ is indeed bankrupt, it would make sense for the ruling regime to adopt the same strategy that Greece did last year; implement capital controls to trap as many U.S. dollars in the banking system as possible, thus limiting the damage and buying time for the government to rebuild the balance sheets of both the RBZ and the local banks before reopening for business. This would probably require some sort of loan from China or elsewhere. Under this scenario, Zimbabwean deposit holders could very well have to take a large haircut.

As in Greece, the RBZ has started to ring-fence the system by instituting daily withdrawal limits (of around $100); enough to allow Zimbabweans to get by but not enough to hurt the banking system. To coax people into accepting electronic dollars rather than paper dollars, the central bank has suddenly decreed much lower fees on bank payments and transfers. The government has also invoked the Bank Use Promotion and Suppression of Money Laundering Act, which punishes citizens and business if they refuse to deposit their money in banks. More radically, it has imposed severe import restrictions on a broad variety of goods from furniture to beans to fertilizer, a policy that presumably prevents cash leaking over the border. Together, all these regulations seem designed to help stuff as many U.S. banknotes back into the RBZ as possible.

Alternatively, it's possible the Zimbabwe government cribs from the Argentina play book and sets up a corralito, or coral, followed by a redenomination of dollar accounts into the local unit. Unlike Argentina, which had pesos, Zimbabwe is fully dollarized and doesn't have its own paper currency in which to redenominate deposits. But so-called bond notes (which I wrote about last month), an issue of paper money set to debut this fall in denominations of $2, $5, $10 and $20, may be a step in the Argentinean direction. Rather than meeting conversion requests by providing U.S. dollars, the RBZ will be able to print off any quantity of bond notes it deems necessary. In this way U.S. dollar claims on Zimbabwean banks will cease to be payable in actual dollars but in the RBZ's peculiar brand of U.S. banknotes, probably worth far less than the real thing.

It seems perverse that Zimbabwe could see another hyperinflation while on the very dollar standard that was meant to immunize it from a hyperinflation scenario, but I'm starting to worry this could happen. Consider that Robert John Mangudya, the head of the RBZ, claims that retailers are beginning to put two different price tags on one product, a higher one for electronic payments and a lower one for cash. If the RBZ-issued electronic dollar continues to inflate then electronic dollar sticker price will rise but the U.S. paper dollar price will stay constant. This second set of prices would at least provide some modicum of price stability to the nation.

Not so fast. Mangudya warns that the central bank will prosecute any retailer that sets two prices. If retailers comply and set only one price for their wares, that effectively undervalues U.S. banknotes and overvalues RBZ-issued U.S. electronic dollars. Gresham's law will take hold as shoppers use only bad electronic dollars to pay for things while hoarding their good, and undervalued, paper dollars in their wallets. Unwilling to be the dupes and accumulate overvalued and unwanted electronic dollars, retailers will have no choice but to jack up their prices, essentially adopting the RBZ U.S. e-dollar as the standard unit of account, or unit in which they set prices. With U.S. dollars no longer being used as a medium of exchange and unit of account, price stability in Zimbabwe will cease to exist.

One hopes that rumors that the regime has absconded with the RBZ's funds are false and that the current bank run and potential inflation is just a temporary spate of animal spirits. But in my experience, most sustained bank runs are underpinned by something real.

[1] I get much of this information from here.

Tuesday, June 28, 2016

The Fedwire recession

I last wrote about Fedwire data two years ago. Since then, Fedwire has entered into a (nominal) recession. Is this something we need to worry about?

We should be interested in this data because Fedwire is the U.S.'s most important financial utility. Operated by the Federal Reserve, Fedwire processes payments between the nation's commercial banks using central banks money, or reserves, as the settlement medium. It accounts for a significant chunk of U.S. spending, or aggregate demand.

Below you'll see a chart of quarterly Fedwire transaction values using data back to 1992. It shows the total dollar volume sent over Fedwire each quarter:

You can see that the flow of spending conducted over Fedwire has been declining since the third quarter of 2014; a six quarter decline. How rare is it to see this degree of stagnation? To check, I've plotted Fedwire yearly data going back to 1987:

Assuming 2016 continues to trend lower (as it has in the first five months), then we are on the verge of seeing two consecutive years of declines in Fedwire transaction flows. The only other time we've seen this sort of pullback is from 2008-2010.

What makes the current Fedwire recession especially interesting is that the go-to measure of spending, nominal gross domestic product, continues to grow, at least tepidly. Fedwire provides a much broader measure of U.S. spending than nominal GDP, which confines itself to measuring spending on final goods and services. To get a feel for this difference, in 2015, U.S. NGDP amounted to $17.9 trillion. Fedwire transactions came out to $834 trillion, exceeding NGDP by a factor of 40x.

Why is Fedwire in a recession while NGDP isn't? Fedwire spending reflects a host of items that don't end up in NGDP. Any of the following could explain the discrepancy.

1. For starters, NGDP includes only spending on final products whereas Fedwire includes a host of intermediate spending. As an example, let's say that consumers spend $100 on bread over the year. Fedwire might include not only the $100 spent on bread, but also all the transactions involved in the course of producing that bread. If the miller wires the farmer $10 for the wheat to make flour, and the baker then pays the miller $50 for the flour, and the retailer wires $75 to the baker for the loaves, then Fedwire transactions sum to $10+$50+$75+$100=$235, far more than the $100 included in NGDP.

So if the U.S. economy's supply chain is undergoing big changes, look for this to get reflected in changes to Fedwire spending even as NGDP stays the same. When corporations become more vertically integrated, they will be do less payments over Fedwire while still providing the same amount of input to NGDP. If they turn to outsourcing, then Fedwire will see more value transacted while NGDP remains constant.

Could the current Fedwire recession be due to a shortening of the supply chain, or a decline in what Austrian economists would refer to 'roundaboutness?'

2. When it comes to spending on housing, NGDP includes only residential investment (spending on new homes) and 'housing services' such as rent and imputed rents. Fedwire, on the other hand, is a popular way for home buyers to settle housing purchases, not only for new homes but the much large category of already-constructed houses.

A housing bubble will get reflected in Fedwire data as ever more housing sales are pumped through Fedwire. NGDP won't get the same lift. Could the current Fedwire recession be due to a slackening in existing home sales?

3. Old houses aren't the only existing capital good that shows up in Fedwire but not NGDP. Firms may use Fedwire to pay for large ticket items like second hand airplanes, used Caterpillar construction equipment, commercial property, and farm equipment. None of this trade in second hand equipment gets reflected in NGDP.

4. Next up are financial assets. Payments for securities, especially government bonds, are often dispatched through Fedwire. NGDP, on the other hand, doesn't contain any financial assets. Mergers and acquisitions are often routed through Fedwire as well, but NGDP won't see a lick of that.

If financial markets and M&A are booming, expect Fedwire spending to grow faster than NGDP, and if they are stagnating, the reverse. Perhaps the Fedwire recession is due to a stagnation in capital markets activity?

5. Developments in payments efficiency may may affect the pattern of Fedwire payments. Banks will often net transactions among each other prior to using Fedwire for settlement. For example, say a client of Bank A pays a client of Bank B $100 while another client of Bank B pays a second client of Bank A $100. Rather than doing two Fedwire payments, $100 from A to B and from B to A, the two banks can just net out their debts and avoid using Fedwire. The same quantity of goods and services is being traded among individuals but the number of payments being conducted via Fedwire has been cut. If banks are becoming more efficient at netting, Fedwire transactions will decline while NGDP remains constant.

6. Cash payments, at least legitimate ones, are registered in NGDP but not in Fedwire. So as society uses less (more) cash and more (less) electronic payments, NGDP will stay constant while Fedwire payments will rise (fall).

My guess for why Fedwire has been weak relative to NGDP? Spending in markets not covered by NGDP—namely existing homes, equity, M&A, and bond markets—has been mute. Those who have criticized the Fed for abetting financial bubbles thanks to easy monetary policy should pay heed to this data. Sure, interest rates may be low compared to their historical levels, but it's not as if reems of transactions are being pushed through Fedwire, as we'd expect with bubbles.

Rather than easy monetary policy, it could very well be that the opposite is in effect. As David Beckworth has pointed out, the Fed has been embarking on campaign to tighten monetary policy since mid-2014. Interestingly, this move towards a tightening bias corresponds quite closely with the Fedwire recession that kicked off in the fourth quarter or 2014.

Wednesday, June 15, 2016

Another Fedcoin sighting

Early map of Fedwire. Source: FRBNY

The pace of Fedcoin sightings has been accelerating this year. If you're new to this blog, Fedcoin is a catch-all term I like to use for a central bank-issued cryptocurrency. Earlier this month the Federal Reserve itself hosted a conference called Finance in Flux: The Technological Transformation of the Financial Sector. The keynote presentation was given by Adam Ludwin, CEO of blockchain firm Chain Inc, who had some interesting things to say about a central bank digital currency.

A criticism I have of blockchain advocacy in general and Fedcoin in particular is that evangelists tend to understand little of the history or qualities of the institutions that they are trying to overthrow. The result is that they invariably end up mis-estimating the benefits of replacing existing systems with new ones.

For instance, Ludwin calls his presentation Why Central Banks Will Issue Digital Currency, a title that must have got Janet Yellen scratching her head since the Fed has been issuing digital currency, or reserves, for a long time now. A system called Fedwire, one of the most important utilities in the U.S., allows some 9,000 financial institutions to transfer these digital reserves among each other.

Ludwin goes on to provide more details on the sort of blockchain-style digital currency he is promoting:
...I find it more helpful to look back to bearer instruments, like banknotes, to appreciate what this new medium enables: a digital bearer instrument... With bearer instruments the payment is also the settlement. It is one step. This is a neat property of a bearer instrument...The goal of the blockchain industry is to collapse these steps into a single step, where payment is the settlement, just like with physical notes. 
Ok, Ludwin wants not just digital currency but instantly-settled digital currency. But Fedwire already achieves this. In a Fedwire payment between banks, the exchange of reserves constitutes settlement. Put differently, in the same way that a banknote or bitcoin payment involves a single step, a Fedwire payment also involves but one step. Say bank A wants to pay bank B $10,000 in reserves via Fedwire. The moment a bank hits the button to complete the payment, reserves change hands and the transaction is complete. An ensuing clearing process does not need to be initiated, nor does an underlying set of assets need to be mobilized to settle the payment. To top it off, trades cannot be undone. Fedwire payments are final. The moment reserves enter your account, you own them.

Fedwire is what is known as a real-time gross settlement system (RTGS); payments are made in real time and are irrevocable. Most of the world's central banks operate an RTGS. Ludwin's firm is leading the battlecry for central bank blockchains, but the main selling point—that Fedcoin collapses payments into a single step—brings nothing to the table that an RTGS like Fedwire doesn't already provide. So why bother?

Ludwin mentions security. Is he claiming that Fedwire is in any way insecure? Fedwire is a robust system that in 2015 processed 143 million transfers with a total value of $834 trillion. It has been operating without major mishap for decades. He also floats the idea that there will be "perfect clarity around where the asset is at any point in time." I'm sure that the Fed always knows the exact location of each reserve it has ever issued. He also brings up the question of speed. But as I pointed out above, Fedwire payments are instantaneous. In fact, Fedwire would probably be faster than Fedcoin.

As far as I can tell, the only difference between the two networks is that a proposed Fedcoin would be distributed while Fedwire is centralized. What this boils down to is that the Fedcoin network would be maintained by a large number of independent nodes whereas Fedwire is run out of a lone data centre in New Jersey (see my old post here for a map). If you take out a Fedcoin node the remaining nodes will continue to operate the payments network. Destroy Fedwire's New Jersey data centre (and its two back-up locations), however, and the system collapses. Redundancy is great, but is it enough to justify switching from Fedwire to Fedcoin? I'm not convinced.

What about operating costs? If Fedcoin and Fedwire have the same capabilities, but Fedcoin costs half as much  to operate, then an infrastructure switch could make a lot of sense. We know how much it costs for the Fed to process a Fedwire transaction because it publishes a set of fees that is designed to recoup its costs:

Source: Fedwire

A Fedwire transfer can cost as little as 15.5 cents (before incentives) for the Fed to process. So a $100,000 transfer might cost just 0.0002% in fees. That's not much. For comparison sake, the UK-equivalent RTGS—called CHAPS—costs just 16.5 pence per transfer. On a large transaction that's a pittance. Can Fedcoin beat theses costs while providing the same degree of speed and security? I'm not sure, but these are the sorts of questions that an advocate of Fedcoin needs to answer.

It's with small-value payments that Fedwire trips up. Between 1.55% to 7.9% of a $10 Fedwire payment will be eaten up by fees. That's not cheap. Payments of this size are the sort that a retail customer would typically originate, which means Fedwire is not a great retail payments network. If a proposed Fedcoin could bring down the cost of operating a small-value central bank payments than it might help banks serve retail clients. That's a worthwhile use case.

In addition to their RTGSs, central banks typically maintain a retail payments system. While the U.S.'s archaic system ACH is just awful (it takes several days to settle), more recent systems like the UK's Faster Payments Service (FPS) are decent. The drawback to FPS is that it isn't capable of collapsing a payment into a single step, say like Fedcoin or Fedwire. Instead of instantaneous settlement, FPS payments will typically be settled via CHAPS during one of three daily settlement cycles. Three times daily isn't bad, but it's not immediate. However, FPS fees are paltry, running around 3.51 pence per transaction. Even if Fedcoin achieves instantaneous settlement, would it be able to do so at a cost that is competitive with FPS? That's something Fedcoin advocates like Ludwin need to demonstrate before folks like Janet Yellen will make a move into small-value blockchain.

Finally, Ludwin suggests that central banks issue cryptocurrency not only to banks but also to non-bank financial companies, corporations, and individuals. He suggestion is a bit too casual for my taste and it probably made Janet Yellen wince. Central banks have a long tradition of steering wide of competition with banks. If the Fed (or any other central bank) were to begin providing digital money directly to the public, it would be breaking with this tradition; central bank digital tokens would effectively be competing head-to-head with private bank deposits. This would be one of the most momentous policy changes in Federal Reserve history and would have many far-reaching consequences.

Even if the Fed thinks the time is ripe to embark on such a historical path, Ludwin hasn't made the case for the blockchain. Why not just allow individuals to keep accounts at the Federal Reserve and make Fedwire payments via a Fedwire app?

Blockchain technology is cool and interesting and sexy. But I'm not convinced that the old fashioned centralized incumbents like Fedwire aren't up to snuff. I suppose time will tell.

PS: I won't be able to answer comments on this till the weekend.

Tuesday, June 7, 2016

Zimbabwe Shouldn't Be Printing Banknotes Again

A Zimbabwean washes U.S. dollars, from NPR Planet Money

Here's a surprising development.

Zimbabwe, a dollarized nation, is on the verge of issuing its own $2, $5, $10, and $20 banknotes. Here is is the central bank's press release. Let's back up a bit. Zimbabwe suffered one of the worst hyperinflations in history during the 2000s thanks to awful policies by the government. Citizens were so fed up that they spontaneously dropped the Zimbabwe dollar in late 2009, the U.S. dollar being recruited as media of exchange and unit of account and the South African rand serving a backup role as small change.

Since then the rand has been steadily moving to the background in Zimbabwe monetary affairs:

Currency utilization levels in Zimbabwe [source]

Another change is that last year Zimbabwe re-entered the world of monetary production by minting its own 1, 5, 10, 25, and 50 cent coins, otherwise known as bond coins. At the time I was in favor of bond coins because Zimbabwe was following the blueprint set by dollarized nations like Panama and Ecuador. These nations mint their own small change to complement Federal Reserve-printed dollar banknotes, and for good reason. Coins are heavy while not being particularly valuable, which means that shipping costs are prohibitive. As a result, local banks prefer to import paper dollars, the ensuing coin shortages that develop making it difficult for locals to engage in basic transactions.

While I was a fan of bond coins, I don't like the Reserve Bank of Zimbabwe's decision to print bond notes. It departs from the dollarization blueprint--neither Panama nor Ecuador (or any other dollarized nation that I know of) have chosen to get into the business of printing notes. Panama in particular is a highly successful dollarized nations, so if Zimbabwe wants to depart from the Panama model one would expect it to have a very good reason for doing so.

John Mangudya, head of the Reserve Bank of Zimbabwe, says that he wants to get back into the note-printing game thanks to a "shortage of U.S. dollars" that seems to be bedeviling the nation. Since March, line-ups have developed at ATMs all over the country as people try to withdraw U.S. dollar cash. This is true, the local press is full of articles on banking queues. Strict limits have been placed on the amount of cash that Zimbabweans can withdraw from their accounts.

I'm skeptical of Mangudya's dollar shortage story. There is a very simple process whereby a dollar shortage in a dollarized nation is remedied. Zimbabwean farmers, desperate to get their hands on U.S. dollars, will reduce their selling prices for tobacco and cotton, two important cash crops with flexible prices. Gold miners will do the same. The moment Zimbabwean crop and gold prices fall below the international price arbitrageurs will bring dollars into Zimbabwe to buy cheap these goods for shipment overseas. Since cash crystallizes a large amount of value in a small volume, handling costs are very low--unlike coins. Domestic commodity prices need only deviate by a small wedge from the international price before arbitrage is profitable and U.S. paper currency flows back into the country. Unless the government is interfering with this process, I can't see it taking more than a week or two for markets to rectify a dollar shortage.

Zimbabwean authorities are notorious for tampering with Zimbabwean industry--this may be short-circuiting the simple process I've just described. If so, why introduce bond notes to fix the problem when the underlying cause is silly government rules preventing cross-border markets from functioning?

On the other hand, if the government hasn't been preventing this process from playing out then Zimbabwe doesn't have a genuine dollar shortage. Lineups at ATMs may simply be the result of an insolvent banking system. Zimbabwe is currently battling a slowdown in growth as commodity prices fall. The U.S. dollar's  rise over the last year or two has reduced the nation's competitiveness. This slowdown may be taking a toll on banks. However, wads of newly-imported U.S. dollar bills or freshly-printed bond notes can't fix a sick banking system.

So Mangudya's reason for departing from the Panama model seems like a poor one to me, one made worse by the fact that the same nutcase who destroyed Zimbabwe's monetary infrastructure in the previous decade, Robert Mugabe, remains in power. Bond coins were one thing, but bond notes give Mugabe much more latitude to engage in monetary mischief.

How much mischief? Many Zimbabweans are worried that the introduction of bond notes will bring about a repeat of the hyperinflationary 2000s. I'm not as worried as them. The U.S. dollar not only circulates as Zimbabwe's medium of exchange but also serves as its unit of account. The fact that prices across the nation are expressed in terms of the dollar affords Zimbabweans a significant degree of protection from Mugabe.  If bond notes are to be introduced, they may very well circulate along with U.S. dollars as a medium of exchange but they will not take over the unit of account role. A nation's unit of account, like its language or its religion, is a set of rules and standards that, once adopted, is not easily changed. In the same way that society is locked-in to using the QWERTY keyboard, it gets yoked to using a certain language of prices.

This means that if the bond note turns out to be a sham and begins to inflate, Zimbabwean prices--expressed in U.S. dollars--will stay constant. Instead, the exchange rate between the U.S. dollar and bond notes will bear the burden of adjustment, bond notes falling to a discount to dollars. Because this leaves the price level unaffected, the process of adjusting to a bond note collapse would be far less burdensome to Zimbabweans than the hyperinflation of the 2000s. The move might even backfire and cause Mugabe significant embarrassment since a bond note discount could not be blamed on anything other than his own incompetence.

Even if the bond notes can never do as much damage as Zimbabwe dollars did in the previous decade, the fact remains that there is no rational for issuing them. Let the market work its magic as it does in Panama and solve any cash shortage problems. The decision to return to paper money is a particularly insensitive one given the fact that many citizens' livelihoods were destroyed by Mugabe's Zimbabwe dollar hyperinflation. Zimbabweans are right to be upset over the bond note; it's a shame that Mangudya, having so ably brought the bond coin idea to fruition, is now promoting a regressive idea.      

Thursday, June 2, 2016

What happens when a central bank splits in two?

Say the San Francisco Fed decided to secede from the Federal Reserve System or the Bank of Greece started to print its own euro notes without the consent of the Eurosystem. What happens to a nation's currency when the central bank is split into parts? There is a possibility we might be seeing such a situation developing in Libya with the emergence of two different Libyan dinars.

Libya's political scene is ridiculously complicated so I'll paint the picture in broad brush strokes. The Central Bank of Libya has several offices, the two relevant ones being the western one in Tripoli and the eastern one in Bayda. Prior to the Arab spring, each area was under the control of the Gaddafi government but both have since come under the control of competing regimes. Tripoli is run by the U.S.-backed Government of National Accord (GNA) while Bayda is under the control of the Tobruk-based House of Representatives.

As I understand it, over the last few years of strife the two offices have usually been able to work together despite being under different regimes.Yesterday, however, the Bayda branch announced that it would be putting new 20 and 50 dinar denomination notes into circulation. Both the Tripoli government and their U.S. backers quickly declared that the new issue was illegitimate. The U.S. Embassy's statement on Facebook said that "the United States concurs with the Presidency Council's view that such banknotes would be counterfeit and could undermine confidence in Libya's currency and the CBL's ability to manage monetary policy to enable economic recovery."

This brings up an interesting conundrum. Say the Bayda branch of the Central Bank of Libya starts to spend the new 'counterfeit' dinars and the U.S.-backed Tripoli branch refuses to recognize them. Will the public accept the new issue of Bayda dinars, and if so, at what rate will the notes trade relative to Tripoli's notes? Could Libya end up with two different dinar currencies?

Were the two note issues identical, it would be impossible for Libyans to discriminate between them. They'd happily accept the new notes and all dinars would continue to be fungible. But this doesn't seem to be the case. Unlike Libya's legacy note issue, which was printed by De La Rue in the U.K., the Bayda branch's new dinars are printed by Goznak in Russia. Apparently Goznak has used different watermarks and a horizontal serial number rather than a vertical one. Most importantly, the new notes bear the signature of the head of the Bayda office while the old notes have the Tripoli branch's chief on them.

If it does not recognize Bayda's 'counterfeit' notes as its liability, the Tripoli branch voids its responsibility to buy them back in order to maintain their value, effectively walling off its resources from the Bayda branch. These resources include any foreign reserves it might have, U.S. financial backing, and financial support from the local regime. And without any guarantee that those notes will have a positive value, the public—which can easily differentiate between the two bits of paper—may simply refuse to accept Bayda dinars at the outset when the Bayda branch tries to spend them into circulation. Long live the Tripoli dinar.

The Bayda branch might try to promote the introduction of Baydar dinars by pegging them at a 1:1 rate to existing Tripoli dinars. This is how the euro, for instance, was kickstarted. But that peg will be tested. Libyans will bring Bayda dinars to the Bayda branch to exchange for Tripoli dinars. If the branch runs out of Tripoli banknotes, it will have to buy more of them in the open market to maintain the peg, but with what? If it lacks the resources to buy them, the peg will be lost and Bayda dinars will fall to zero, or to a very large discount.

But the Bayda branch isn't without its own resources. First, it has the financial support of the local regime. Furthermore, according to this surreal article there is a vault in Bayda that contains 300,000 gold and silver sovereigns minted in honour of the late Colonel Gaddafi, worth nearly £125 million. The Bayda branch doesn't know the combination and Tripoli refuses to provide it. If the safecrackers that the Bayda branch has hired are able to get in, that amount will provide it with enough firepower to buy back Bayda dinars and help support the peg. In which case the two notes would circulate concurrently and be fungible.

If two dinars emerge, which central bank would control monetary policy? That depends on which brand of dinar Libyans choose to express prices and debts. As long as the existing Tripoli dinar is the medium of account—the physical object that people use as the definition of the dinar unit ل.د.—then any policy change adopted by Tripoli's central bankers will be transmitted to the entire Libyan price level, both the east and west. Usage of Tripoli dinars rather than Bayda dollars for pricing is likely to prevail for the same reason we all use QWERTY keyboards when better alternatives exist, force of habit is difficult to overcome. Even if Bayda dollars do emerge as a medium of account, as long as they are pegged to the Tripoli dollar, then Tripoli still gets to call the shots.

The situation isn't resolved yet—the Tripoli branch could very well accept Bayda dinars as its liability, thus defusing the situation. In any case, it will be interesting to follow. Incidentally, Libya's situation reminds me of one of the ideas put forth during the 2015 Greek crisis; a secession of the Bank of Greece from the Eurosystem so that Greeks could print their own type of euro. If Greece boils over again and the separation idea pops up, Libya may serve as a reference point.

Friday, May 27, 2016

From ancient electrum to modern currency baskets (with a quick detour through symmetallism)

Electrum coins [source]

First proposed by economist Alfred Marshall in the late 19th century as an alternative metallic standard to the gold, silver and bimetallic standards, symmetallism was widely debated at the time but never adopted. Marshall's idea amounted to fusing together fixed quantities of silver and gold in the same coin rather than striking separate gold and/or silver coins. Symmetallism is actually one of the world's oldest monetary standards. In the seventh century B.C., the kingdom of Lydia struck the first coins out of electrum, a naturally occurring mix of gold and silver. Electrum coins are captured in the above photo.

While symmetallism is an archaic concept, it has at least some relevance to today's world. Modern currencies that are pegged to the dollar (like the Hong Kong dollar) act very much like currencies on a gold standard, the dollar filling in for the role of gold. A shift from a dollar peg to one involving a basket of other currencies amounts to the adoption of a modern version of Marshall's symmetallic standard, the euro/yen/etc playing the role of electrum.

The most recent of these shifts has occurred with China, which late last year said it would be measuring the renminbi against a trade-weighted basket of 13 currencies rather than just the U.S. dollar. Thus many of the same issues that were at stake back at the turn of the 19th century when Marshall dreamt up the idea of symmetallism are relevant today.

So what exactly is symmetallism? In the late 1800s, the dominant monetary debate concerned the relative merits of the gold standard and its alternatives, the best known of which was a bimetallic standard. The western world, which was mostly on a gold standard back then, had experienced a steady deflation in prices since 1875. This "cross of gold" was damaging to debtors; they had to settle with a higher real quantity of currency. The reintroduction of silver as legal tender would mean that debts could be paid off with a lower real amount of resources. No wonder the debtor class was a strong proponent of bimetallism.

There was more to the debate than mere class interests. As long as prices and wages were rigid, insufficient supplies of gold in the face of strong gold demand might aggravate business cycle downturns. For this reason, leading economists of the day like Alfred Marshall, Leon Walras, and Irving Fisher mostly agreed that a bimetallic standard was superior to either a silver standard or a gold standard. (And a hundred or so years later, Milton Friedman would come to the same conclusion.)

The advantage of a bimetallic standard is that the price level is held hostage to not just one precious metal but two; silver and gold. This means that bimetallism is likely to be less fickle than a monometallic standard. As Irving Fisher said: "Bimetallism spreads the effect of any single fluctuation over the combined gold and silver markets."  Thus if the late 1800s standard had been moved from a gold basis to a bimetallic one, the stock of monetary material would have grown to include silver, thus 'venting' deflationary pressures.

Despite these benefits, everyone admitted that classical bimetallism had a major weakness; eventually it ran into Gresham's law. Under bimetallism, the mint advertised how many coins that it would fabricate out of pound of silver or gold, in effect setting a rate between the two metals. If the mint's rate differed too much from the market rate, no one would bring the undervalued metal (say silver) to the mint, preferring to hoard it or export it overseas where it was properly valued. The result would be small denomination silver coin shortages, which complicated trade. What had started out as a bimetallic standard thus degenerated into an unofficial gold standard (or a silver one) so that once again the nation's price level was held hostage to just one metal.

The genius of Alfred Marshall's symmetallic standard was that it salvaged the benefits of a bimetallic standard from Gresham's law. Instead of defining the pound as either a fixed quantity of gold or silver, the pound was to be defined as a fixed quantity of gold twinned with a fixed quantity of silver, or as electrum. Thus a £1 note or token coin would be exchangeable at the Bank of England not for, say, 113 grains of gold, but for 56 grains of gold together with twenty or so times as many grains of silver. The number of silver and gold grains in each pound would be fixed indefinitely when the standard was introduced.

Because symmetallism fuses gold and silver into super-commodity, the monetary authority no longer sets the price ratio between the two metals. Gresham's law, which afflicts any bimetallic system when one of the two metals is artificially undervalued, was no longer free to operate. At the same time, the quantity of metal recruited into monetary purposes was much larger and more diverse than under a monometallic standard, thus reducing the effect of fluctuations in the precious metals market on aggregate demand.

While symmetallism was an elegant solution, Alfred Marshall was lukewarm to his own idea, noting that "it is with great diffidence that I suggest an alternative bimetallic scheme." To achieve a stable price level, Marshall preferred a complete separation of the unit of account, the pound, from the media of exchange, notes and coins. This was called a tabular standard, a system earlier proposed by William Stanley Jevons. The idea went nowhere, however; the only nation I know that has implemented such a standard is Chile. As for Fisher, he proposed his own compensated dollar standard plan, which I described here.

The urgency to adopt a new standard diminished as gold discoveries in South Africa and the Yukon spurred production higher, thus reducing deflationary pressures. None of these exotic plans—Marshall's symmetallism, Jevons tabular standard, or Fisher's compensated dollar—would ever be adopted. Rather, the world kept on limping forward under various forms of the gold standard. This standard would be progressively modified through the years in order to conserve on the necessity for gold, first by removing gold coin from circulation and substituting convertibility into gold bars (a gold bullion standard) and then having one (or two) nations take on the task of maintaining gold convertibility while the remaining nations pegged to that nation's currency (a gold exchange standard).


Let's bring this back to the present. In the same way that conditions in the gold market caused deflation among gold standard countries in the late 1800s, the huge rise in the U.S. dollar over the last few years has tightened monetary conditions in all those nations that peg their currency to the dollar. To cope, many of these countries have devalued their currencies, a development that Lars Christensen has called an 'unraveling of the dollar bloc.'

A more lasting alternative to re-rating a U.S. dollar peg might be to create a fiat version of electrum; mix the U.S. dollar with other currencies like the euro and yen to create a currency basket and peg to this basket. China, which has been the most important member of the dollar bloc, has turned to the modern version of symmetallism by placing less emphasis on pegging to the U.S. dollar and more emphasis on measuring the yuan against a trade-weighted basket of currencies. This means that where before China had a strictly made-in-the U.S. monetary policy, its price level is now determined by more diverse forces. Better to put your eggs in two or three baskets than just one.

Bahrain, Oman, Qatar, Saudi Arabia and United Arab Emirates are also members of the dollar bloc. Kuwait, however, links its dinar to a basket of currencies, a policy it adopted in 2007 to cope with the inflationary fallout from the weakening U.S. dollar. In an FT article from April entitled Kuwaiti currency basket yield benefits, the point is made that Kuwait has enjoyed a more flexible monetary policy than its neighbours over the recent period of U.S. dollar strength. Look for the other GCC countries to mull over Kuwaiti-style electrum if the U.S. dollar, currently in holding pattern, starts to rise again.

Modern day electrum can get downright exotic. Jeffrey Frankel, for instance, has suggested including commodities among the basket of fiat currencies, specifically oil in the case of the GCC nations. Such a basket would allow oil producing countries to better weather commodity shocks than if they remained on their dollar pegs. If you want to pursue these ideas further, wander over to Lars Christensen's blog where Frankel's peg the export price plan is a regular subject of conversation.

Friday, May 20, 2016

Those new Japanese safety deposit boxes must all be empty

Remember all the hoopla about Japanese buying safety deposit boxes to hold cash in response to the Bank of Japan's decision to set negative rates? Here is the Wall Street Journal:
Look no further than Japan’s hardware stores for a worrying new sign that consumers are hoarding cash--the opposite of what the Bank of Japan had hoped when it recently introduced negative interest rates. Signs are emerging of higher demand for safes—a place where the interest rate on cash is always zero, no matter what the central bank does.
Well, three month's worth of data shows no evidence of unusual cash demand. As the chart below illustrates, the rate at which the Bank of Japan is printing the ¥10,000 note shows no discontinuity from its pre-negative rate rise. In fact, demand for the ¥10,000 is far below what it was in the 1990s, when interest rates were positive.

I should remind readers that the Bank of Japan, like any central bank, doesn't determine the quantity of banknotes in circulation; rather, the public draws those notes into circulation by converting deposits into notes. So this data is a pure indicator of Japanese cash demand.

The lack of interest in switching into yen notes should come as no surprise given the experience of other nations that have set negative interest rates. Data from Sweden, Denmark, and Switzerland has consistently shown that it takes more than just a slight dip into negative territory before the dreaded "lower bound," the point at which the public converts all their deposits into banknotes, is encountered.

For instance, despite the setting of a -0.5% repo rate by Sweden's Riksbank, Swedish cash in circulation continues to decline. I won't bother to provide a chart, you can go see the data here.

As for the Danes, the growth rate in Danish cash demand continues to hover near its long term average of 3.7%/year. This despite the fact that the Danmarks Nationalbank, the nation's central bank, is setting a deposit rate of -0.65%. I've charted it out below:

Definitely no lower bound in Denmark, at least not yet.

Finally, we have Switzerland where the Swiss National Bank has maintained a -0.75% rate since December 2014. Back in February, the WSJ and Zero Hedge were making a fuss out of the sudden jump in the demand for the 1000 franc note, in effect blaming the build up on the lower bound. I wrote a rebuttal at the time, Are Swiss fleeing deposits and hoarding cash, pointing out that the demand for Swiss francs is often driven by safe haven concerns. The observed increase in 1000s might therefore have very little to do with the SNB hitting the effective lower bound and everything to do with worries about falling equity prices, China, deteriorating credit quality, and more.

With many of these concerns subsiding in 2016, one might expect the safe haven demand for 1000 franc notes to be falling again. And that's exactly what we see in the chart below; the Swiss are accumulating notes at a decelerating pace, even though the SNB has not relaxed its negative deposit rate one iota.

What these charts all show is that the effective lower bound to central bank deposit rates has not yet been engaged, even after many months in negative territory. You can be sure that the global community of central bankers is watching this data too; it is telling them that, should the need arise, their respective interest rates can be pushed lower than the current low-water mark that has been set by the SNB and Danmarks Nationalbank at -0.75%, say to -0.85% or even -1.0%.

There are a few factors that might be dampening the demand for paper notes. Remember that the Swiss and the Japanese have installed cash escape inhibitors; mechanisms that reduce the incentive for banks to convert central bank deposits into cash. I've written about them here.

Secondly, the SNB and the BoJ, along with the Danes, have set up an array of interest rate tiers. While the marginal deposit earns a negative rate, the majority of the tiers are only lightly penalized or not penalized at all. This tiering represents a central bank subsidy to commercial banks; in turn, banks have passed this subsidy on to their retail depositor base in the form of higher-than-otherwise interest rates, the upshot being that very few banks have set negative deposit rates on retail customers. This has helped stifle any potential run on deposits.

Tiering and cash escape inhibitors have helped dissuade cash withdrawals by two members of the public, retail depositors and banks, but not the third; large non-bank institutions. That these latter institutions haven't bolted into cash shows that the natural costs of storing wads of paper are quite high, and that the effective lower bound quite deep.

Monday, May 16, 2016

Aggressive vs defensive debasement

COINING IN PARIS c. 1500 (From a French print c. 1755)

Not all debasements, or reductions of the precious metals content of coins, are equal. Among scholars of medieval coinage, there is an interesting distinction between aggressive, or bad debasement, and defensive, or good debasement.

Let's take defensive debasements first.

In medieval times, the minting of coins was usually the prerogative of the monarch. Any member of the public could bring their silver bullion or plate to the mint where the monarch's agents would strike a fixed amount of coins from that silver, returning the appropriate number of coins to the owner but taking a small commission for their pains.

A decline in the quality of coin was a fairly natural feature of medieval societies. As silver pennies passed from hand to hand, oil and sweat would remove small flecks of metal.  Compounding this deterioration were less honest methods of removing small bits from each coin, like clipping. Nicholas Mayhew, a numismatist, estimated that each year 0.2% of the coinage's silver content was lost; more colourfully, 'seven tons of silver vanished into thin air' during every decade in the fourteenth century. Less conservative estimates go as high as 1% per year.*

Using Mayhew's 0.2% rate of decline, if the king or queen's mints manufactured pennies that contained 2 grams of silver in 1400, these 1400-vintage pennies might contain just 1.81 grams by 1450, fifty years later.

This created a huge problem. Long before 1450 people would have lost their incentive to bring raw silver to the mint to be made into new coins. Let's say a merchant in 1450 owed 10 pence to his supplier. One option was for the merchant to bring enough silver to the mint to get ten new pennies and then pay off his debt. With the king maintaining his fifty year-old policy of turning two grams of silver into a new penny, that meant the merchant had to bring 20 grams to be minted.

But the merchant had a better alternative; buy ten pennies of the 1400-vintage that together contained just 18.1 grams of silver (1.81 x 21) and then pay off the supplier. The key here is that all pennies, whether they be 1400-vintage or 1450-vintage pennies, passed at face value as legal tender. Thus the merchant's creditor had to accept any penny to settle the debt, bad or good. The merchant's decision was therefore a simple one. Far cheaper to pay off the debt with ten 1400-vintage pennies, the equivalent of 18.1 grams of silver, than ten new pennies, which contained 20 grams.

Because the king's mint was effectively providing too few new pennies for a given quantity of silver, no one would ever bring silver to the mint. (If you work it out, you'll see this is in instance of Gresham's law.) And with no new coins, coin shortages emerged. The legacy coinage had to circulate ever faster to meet society's demand for a medium of exchange, and this would have only increased its rate of depreciation. And a faster decline in the quality of the coinage made them more susceptible to counterfeiters, which only reduced their legitimacy. An inflationary spiral emerged.

The way to simultaneously halt inflation and encourage the creation of new pennies was to introduce a defensive debasement. If, in 1451, the royal family announced a debasement of the coinage so that its mint now struck pennies that contained, say, 1.75 grams of silver rather than 2.0 grams, then people would start bringing silver to the mint again. After all, our merchant could take ten worn-out 1400-vintage pennies that contained 1.81 grams to the mint, have them recoined into ten new pennies with 1.75 grams of silver, pay his debt, and still have some silver left over. The entire generation of old worn out coins would be brought to the mint to be replaced with a new generation of harder-to-counterfeit and clip pennies.

In sum, to ensure a steady supply of new coins the king or queen had to debase the coinage ever few decades. Meir Kohn calls this a ratification of the natural deterioration in the silver content of coins; "defensive debasements did not cause the gradual inflation that took place so much as ratify it." This was sound monetary policy.

Aggressive debasements, one the other hand, were unsound monetary policy.

You may have noticed that by debasing the penny from 2.0 to 1.75 grams, the monarch would be drawing large amounts of silver and old pennies into his or her mint to be turned into new pennies. After all, why would anyone pay debts with pennies that contain 1.81 grams when they can bring them to the mint to be recoined into pennies that contain just 1.75 grams? Another way to think about it is this: if a horse is selling for a pound (where a pound was defined as 240 pennies), why pay for it with 240 pennies minted in 1400 containing a total of 434 grams when they can be first reminted into 240 new pennies that contain just 420 grams, these new pennies being just as acceptable in trade as the old ones? In other words, better to buy a horse for 420 grams of silver than 434.

Debasements were profitable for the monarch. As I mentioned earlier, the royal family levied a fee on all silver brought to his mint. This fee is referred to as seigniorage. In more modern terms, think of a mint as a pipeline where the owner takes a cut on throughput. So by debasing the coinage, the monarch would dramatically increase mint throughput and therefore boost seigniorage revenues.

When a monarch debased the coinage at a much faster rate than the natural rate of wear and tear, he or she wasn't just playing catch up, this was aggressive debasement. One of the most aggressive debasements of all, that of Henry VIII, involved ten debasements between 1542 and 1551, each in the region of 30-40%. These diminutions were so successful in driving silver to the royal mints that Henry had to erect six new mints just to meet demand, according to Kohn.

The motive for aggressive debasements was almost always the funding of wars. As John Munro points out, securing "additional incomes from taxes, aides, loans, or grants from town assemblies, ‘estates’, or other legislative assemblies was difficult and usually involved unwelcome concessions, and this was not necessarily forthcoming." The mints, however, were firmly under the control of the royal family and were therefore a trustworthy form of revenue.

In Henry VIII's case, his debasement revenues were used to fund wars in the 1540s against Scotland and France. But his debasements were bad monetary policy as they caused rampant inflation, specifically a 123% rise in the English consumer price index from 1541 to 1556.


By the way, it was in response to these aggressive debasements that one of the earliest economic tracts, Nicolas Oresme's de Moneta, was written. Oresme's essay, which dates to 1360, was a response to the aggressive monetary policies of Philip VI and John II. According to Robert Mundell, John II debased the coinage 86 times. Wrote Oresme:
I am of opinion that the main and final cause why the prince pretends to the power of altering the coinage is the profit or gain which he can get from it; it would otherwise be vain to make so many and so great changes.
All monetary policy debates since then, including the explosion of words on the econ blogosphere beginning after the 2008 crisis, are versions of the one that Oresme engaged in: what constitutes good debasement and what constitutes bad? While the content of the debate has changed, the structure is pretty much the same.

* I get this from John Munro.
Note: I have an old post from 2013 on defensive debasement. This post is different because it works out the aggressive side of the debasement equation.

Friday, May 6, 2016

What makes medieval money different from modern money?

What's the main difference between our modern monetary system and the system they had in the medieval ages? Most of you will probably answer something along the lines of: we used to be on a commodity standard—silver or gold—but we went off it long ago and are now on a fiat standard.

That's a safe answer. But the fiat/commodity distinction is not the biggest difference between then and now.

The biggest difference is that in the medieval age, base money did not have numbers on it. Specifically, if you look at an old coin you might see a number in the monarch's name (say Henry the VIII) or the date which it was minted, but there are no digits on either the coin's face or obverse side indicating how many pounds or shillings that coin is worth. Without denominations, members of a certain coin type could only be identified by their unique size, metal content, and design, with each type being known in common speech by its nickname, like testoon, penny, crown, guinea, or groat. Odd, right?

By contrast, today we put numbers directly on base money. Take the Harriett Tubman note, for example, which has "$20" printed on it or the Canadian loonie which has "1 dollar" etched on one side.

This seemingly small difference has huge consequences for the monetary system. I'll illustrate this further on in my post by having a modern central bank adopt medieval-style numberless money. The interesting thing is that, contrary to our prejudices about commodity-based money, the medieval system had the potential to be a highly flexible monetary system, far more capable of coping with shocks than our current one, and by implementing medieval money, a modern central banker would get a powerful tool to help in his or her efforts to keep inflation on target.

But first, here are a few more important details about the medieval monetary system. Back then, sticker prices and debts were not expressed in terms of coins (say groats or testoons) but were always advertised in the abstract unit of account, pounds (£), where a pound was divisible into 20 shillings (s) and each shilling into 12 pence (d).  Say that Joe wants to settle a debt with Æthelred for £2 10s (or 2.5 pounds). In our modern monetary system, it would be simple to do this deal. Hand over two coins with "1 pound" inscribed on it and ten coins with "one shilling" on them. Without numbers on coins, however, how would Joe and Æthelred have known how many coins would do the trick?

To solve this problem, Joe and Æthelred would have simply referred to royal proclamation that sets how many coins of each type comprised a pound and a shilling. Say Joe has a handful of groats and testoons. If the king or queen has proclaimed that the official rate is thirty testoons to the pound and eighty groats in a pound, then Joe can settle the £2 10s debt with 60 testoons and 40 groats or any another combination, say 75 testoons. If the monarch were to issue a new proclamation that changes this rating, say a pound now contains forty testoons, then Joe's debt to Æthelred must be settled with 100 testoons, not 75.

To sum up, in the medieval ages the method of determining the content of the unit of account was divorced from the physical objects that were in circulation. Rather than appearing on the coin, the proper ratings were printed up on a royal decree. By contrast, in our modern era monetary authorities have stopped the practice of remotely defining the unit of account in favor of striking it directly onto physical and digital objects.


Let's try to get a better feel for what it would be like as consumers if we didn't have numbers on our modern money. Let's convert today's standard into a medieval standard using U.S. currency as our example. Start by removing the words "one cent" from all one cent coins. Americans take to calling them Lincolns, since Abraham Lincoln is on the obverse side. Next, let's strip all mentions of "one dollar" and "$1" off the dollar bill, which now goes by the moniker "a Washington." Finally, blank out any incident of "100" and "one hundred" from the one hundred dollar bill. Say that people now call it the Franklin. (For simplicity, assume the $10s, $20s etc don't exist.)

Say we go shopping for groceries and get a bill for $302.15. Without numbers on our bills and coins, how are we to know how many Lincolns, Washingtons, and Franklins we should pay?

We would start off by launching our Federal Reserve app to check how many Lincolns, Washingtons, and Franklins the Fed has decided to put in the dollar unit of account that day. Now it could be that the Fed is rating the dollar as 100 Lincolns, 1 Washington, and 0.01 Franklins, which would correspond to the ratios we are so familiar with. In which case, the grocery bill can be discharged with three Franklins, two Washingtons, and fifteen Lincolns. Easy.

But there is no reason that the Fed couldn't be setting a different definition of the dollar unit of account that day. Say that the Fed has re-rated the dollar so that it is now worth 140 Lincolns, 1.4 Washingtons, and 0.014 Franklins. It would be as if an old dollar bill now had $0.714 printed on it instead of $1 (where 1/$1.4=$0.714). In effect, this increases the value of the dollar unit of account in terms of physical cash or, put differently, reduces the purchasing power of the Washington/Lincoln/Franklin. The $302.15 grocery bill must now be discharged with four Franklins and twenty-three Washingtons, where the Franklins cover the first $285.71 and the Washingtons cover the remaining $16.43.

So that's pretty interesting, no? In a modern version of the medieval monetary system, not only do we need to keep track of the coins and notes in our wallet, we also need to follow the Fed's ratings, say with an app. It's cumbersome system but it seems to have worked.


As for the central banker's perspective, let me repeat my earlier point: if the Fed (or any other central bank) were to adopt a medieval system, it would have far more flexibility in hitting its inflation targets than it currently does. Right now, an inflation targeting central bank like the Fed can only target the CPI by modifying the nature or supply of the physical and electronic tokens in circulation, say by altering the quantity of these tokens, changing their interest rate, or shifting their peg (to gold or some other currency). With denominations effectively etched onto coins and printed onto notes, the ability to directly manipulate the unit of account by adjusting the number of bills and coins per dollar has been taken away from it.

By blanking out the numbers and defining the coin/bill content of the dollar remotely, the Fed gets an extra degree of freedom. If it wants to create inflation, it simply posts an alert on its app that the dollar will now contain fewer Lincolns, Washingtons, and Franklins than before. In response, stores will quickly increase their sticker prices so that they receive the same real quantity of payment media as before. Voila, the CPI rises. To create deflation, the Fed does the opposite and puts more notes and coins into each dollar. Just as it currently schedules periodic interest rate announcements, the central bank might issue these edicts every few weeks or so.

In some sense, central banks already engage in alterations of the bill/coin content of the dollar when they redenominate currency. But redenominations are rare, usually occurring during hyperinflations when a central bank cancels all existing currency and issues new bills and coins with a few zeros lopped off. They aren't a regular tool of monetary policy because a continuous series of small redenominations would involve constant recoinages and printing of new notes, an expensive way of doing monetary policy.

By removing numbers from bills/coins so that only blanks circulate and then defining the value of those blanks remotely, redenominations become a cheap tool of monetary policy, much as they were in the medieval days. The Fed wouldn't have to call in all bills and coins and print/mint new ones, it would simply announce a re-rating on its app.


In any case, I hope you can see now that the medieval monetary system was far more complex than we commonly assume it to be. Because we are so used to having number on our bills and coins, we'd be quite lost if we were transported back to the 1500s. As for the monetary authorities, they had an extra set of powers that today's central bankers don't have, the ability to directly define the unit of account. Hypothetically, these powers could have been used to target stable prices or nominal income. In reality, monarchs had different motives, including the funding of wars, so they used the tool for that purpose. But that's another story.

[1] The Spufford Currency Exchange
[2] Meir Kohn: Medieval and Early Modern Coinage and its Problems
[3] John Munro: The Technology and Economics of Coinage Debasements in Medieval and Early Modern Europe