Category Archives: Central Banks

How Is Bitcoin Different From The Dollar?

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As Bitcoin goes through another day of crazy price fluctuations and huge publicity, this time courtesy of the U.S. Senate, I recommend two readings for those interested in putting the Bitcoin phenomenon in historical context.

The first is this article by my colleague Stephen Kinsella. Stephen’s key point:

Bitcoin has no use value, only exchange value, and because it is has no worth in use other than what others are willing to pay for it, it is always in a bubble: these happen when prices of assets get dislodged from their fundamental value. So Bitcoin is the perfect bubble.

Now the obvious question that this raises is the following: Is Bitcoin so different from the dollar? A dollar bill also has no use other than what people are willing to pay for it. And if people decide they wish to trust the people who create Bitcoins more than their own government, then perhaps it could be an alternative medium of exchange.

Stephen partially gets at the answer as to why Bitcoin differs from the dollar. It is “a currency not backed by any state – meaning nobody has to take it as payment.” The fact that the U.S. government requires payment in dollars in itself creates a direct demand for dollars that cannot be replicated by Bitcoin.

History shows, however, that the state’s involvement in money goes deeper than merely requiring tax payments in its chosen currency and this history is useful for understanding the likely limits to “private monies” like Bitcoin.

My favorite article on this topic is Two Concepts of Money written in 1998 by legendary British economist Charles Goodhart. I strongly recommend that people interested in Bitcoin read it.

Goodhart argues that states have essentially always been in control of monetary systems. He emphasizes that governments have always viewed seigniorage as a useful form of revenue and are unlikely to allow this source of revenue to be replaced by a private source of money.

Right now, Bitcoins are effectively irrelevant when compared with the larger payments system, but those who anticipate it expanding to be widely used might ask how sure they are that private monies of this type would actually remain private. Once big enough to be termed a success, any such currency would attract more attention from governments than a cursory Senate hearing.

Goodhart also shows the theory that private money can emerge as a solution to the inefficiencies of barter has little historical backing. For example, while people often believe that precious metals were adopted over time by the private sector as a useful medium of exchange, in practice people could not be sure whether the metallic content of coins were equal to stated amounts.

Only when governments standardized and verified such coins – and provided security for mints – were coins widely used as a medium of exchange. Goodhart notes that much of the Roman empire went from a monetary economy back to barter after the empire’s decline. Bitcoin enthusiasts may believe that problems with security and verification are less likely to affect a digital currency. Time will tell us the extent to which that is true.

Advocates of Bitcoin enthuse about its commitment to limiting its supply of virtual coins. Goodhart’s paper discusses whether such commitments from private providers of money can actually be credible. He concludes such commitments probably run against the interest of those who control these currencies and so they should not be trusted. Blind trust in the people behind Bitcoin may turn out to be no more sensible than blind trust in the U.S. government, and quite possibly less so.

There’s no doubt that Bitcoin is an interesting invention, useful at a minimum for provoking good classroom discussions in Money and Banking courses about what exactly is the meaning of money. But people should be wary of investing large amounts of their savings in Bitcoins. History provides plenty of reasons to suspect that private money is unlikely to work. Maybe this time is different. Usually it’s not.

Ireland Exits Bailout With No Backstop: A Good News Story?

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After years of turmoil, Europe seems to finally have a good news story. Ireland will be the first of country to exit a “troika” program and yesterday its government announced that it would not even be seeking a “precautionary” credit line from Europe’s bailout fund, the ESM.  But is this quite the good news story that most people think it is? I’m not so sure. Indeed, I suspect yesterday’s announcement illustrates how political problems may undermine Mario Draghi’s plans to save the euro.

There is certainly some good economic news coming from Ireland. Targets laid down in the program for the budget deficit were met and while economic growth has been minimal and unemployment is high, employment is now growing again and a large stock of over €20 billion of cash has been built up via borrowings from financial markets and the troika. By the very low bar set by the recent economic performance of the euro area, Ireland is something of a success.

For these reasons, yesterday’s announcement that Ireland would not need a new bailout was not news. This has been known for some time. The news element here was the announcement that there would be no precautionary credit line. But is that actually good news?

Irish government politicians have been keen to claim that there is some good economic news in this announcement, that it “provides clarity” and “reduces uncertainty”.  In fact, the opposite is the case.

A precautionary credit line is something that doesn’t have to be used. Anything that can be done without a precautionary credit line can also be done with one.  However, without such a credit line, the Irish government run the risk of running out of funds and having to negotiate a new bailout or credit line under far less positive circumstances than currently prevail.  This adds to the uncertainties facing Ireland in the coming year, particularly given the possibility that Irish banks may need further recapitalisation next year.

Ireland’s finance minister, Michael Noonan, acknowledged yesterday that economic conditions may not be so benign next year. This should be seen as an argument for negotiating a credit line now but, strangely, Noonan used this observation as an argument for not seeking a credit line.  He seemed to be struggling to find anything better than weak talking points to explain the benefits of not having a credit line.

There is, of course, a narrow political benefit to the Irish government from this “clean” exit, because it allows them to triumph about the full restoration of “sovereignty.”  However, I don’t think they are so cynical as to have made this decision purely for that populist reason.  Instead, my assessment is that the precautionary credit line could not be arranged now because it was politically impossible and that the Irish government are merely putting a brave face on what is a bad outcome.

The political problem is that credit lines from ESM require the approval of all euro area member states and this was not going to be possible now. Germany still does not have a government as Angela Merkel’s CDU continue negotiations with the SPD to form a coalition. During these negotiations, the SPD has regularly insisted that they would not support an ESM credit line for Ireland unless the country followed a series of highly specific policy recommendations.

SPD requirements for approval of a credit line included raising the corporate tax rate and introducing a financial transaction tax. The SPD also ruled out any deal that involved used funds from the credit line to recapitalize banks.

This kind of micro-managing of other people’s economies was not what most people had expected ESM conditionality to look like. Given the existing raft of EU monitoring programs that exist (the six pack, the two pack, the macroeconomic imbalances) a sensible approach would be to require that a country seeking a credit line from ESM commit itself to meeting the recommendations on macroeconomic policy of the European Commission.

When Germany finally has a government and SPD politicians are firmly ensconced in ministerial Mercs, I suspect the desire to micro-manage Ireland’s affairs will recede. However, the damage may well be done. Having sold the Irish public on the idea that the credit line was something to be avoided, it seems unlikely that the government can change its mind next Spring.

This is the odd aspect of yesterday’s decision. Why not announce that Ireland was exiting the program without a precautionary credit line but that discussions about this issue were ongoing? One unattractive possibility is that Ireland’s leaders were asked by their German colleagues to make this announcement to remove it as an issue in the government formation negotiations.

Missed in yesterday’s discussion is that these developments have implications for the ECB’s Outright Monetary Transactions (OMT) program. This is the program announced by Mario Draghi after his “whatever it takes” speech last year.  Under this program, the ECB can purchase unlimited quantities of a country’s government bonds. However, the ECB decided that countries could only avail of OMT if they had an agreement with ESM for a bailout program or precautionary credit line.

Ask yourself this: If star pupil Ireland couldn’t negotiate a precautionary credit line based on reasonable conditionality, what chance is there that a credit line of this sort for Italy will be approved by all countries in the euro area? OMT may have been cast as the plan to save the euro but getting it up and running may not be so easy.

Mr Draghi, The Vicious Circle And The Stress Tests

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I was in Brussels on Monday and attended the European Parliament’s Economic and Monetary Affairs Committee for its latest meeting with Mario Draghi. The main topic of the meeting was the ECB’s new job as supervisor of the euro area’s banks. I came away from the meeting very concerned about two issues: The effect of banking problems on sovereign debt and the credibility of the upcoming stress tests.

Mario Draghi, President of the European Centra...

Mario Draghi, President of the European Central Bank. (Image credit: AFP/Getty Images via @daylife)

The Vicious Circle

The decision to allocate the ECB the task of single supervisor for banks stems from the June 2012 meeting of euro area leaders which declared “We affirm that it is imperative to break the vicious circle between banks and sovereigns.”  It was also agreed at that meeting that the euro area’s bailout fund, the European Stabilisation Mechanism (ESM) could be used to recapitalize banks that were in difficulty. For many at the time (including me) this statement was an important positive step.

Because Europe’s leaders would not agree to money being provided to banks in other countries without assurances that these investments had solved problems and could guarantee a return for taxpayers, it became politically imperative that there be a pan-euro-area supervisor of banks that could be relied on to provide an independent assessment.

The ECB has been chosen to do this supervisory job and its first task will be to undertake an assessment next year of the health of the approximately 130 banks that it is to directly supervise. Details on the upcoming assessment process are sketchy at this point other than that it will contain an asset quality review, a balance sheet assessment and stress tests run in conjunction with the European Banking Authority.

MEPs at Monday’s meeting repeatedly questioned Mister Draghi about what would happen if a bank failed the upcoming assessment and needed a large injection of capital. One potential answer was that the proposed new Single Resolution Mechanism, effectively a form of European FDIC, would provide the funds.  However, this mechanism won’t come in to place until 2015 and when it does it won’t have any money: As with the FDIC, it is to be funded over time via contributions to banks.  In the future, the Resolution Fund could borrow from the ESM but it is unclear if this could ever actually happen and highly unlikely that plans will change to see the Resolution Fund swing into action next year.

Instead, Mister Draghi repeatedly emphasized that “national backstops” were the key mechanism for dealing with banks that needed more funds (see reporting here and here.)  This shows how little progress has been made in breaking the vicious circle referred to in last year’s summit statement.

The euro area’s leaders have agreed to a grand plan under which at some point in the fairly distant future, the cost of dealing with bank failures won’t fall directly on the taxpayers unfortunate enough to reside in the same country as the bank. However, for now, Draghi’s comments ensure that national taxpayers remain first in the firing line when banks fail. In this sense, the current vicious circle that actually prompted the June 2012 summit has gone from something that it is “imperative” to remove to something that is effectively official European policy.

Credibility of Stress Tests

The continued reliance on “national backstops” seems likely to affect the credibility of the upcoming stress tests. ECB officials have repeatedly criticised the previous stress tests undertaken by the European Banking Authority for their lack of credibility. Implicit behind this criticism is the assumption that the ECB tests will be tougher, with more negative valuations for bank loans in arrears or other distressed assets.

Draghi’s statements about national backstops, however, undermine the credibility of the new exercise before it has even started. He insisted on Monday that it is realistic for national backstops to be used to sort out banking problems, even in countries like Spain or Greece. Given the perceived size of banking problems in these countries as well as existing levels of public debt, this is effectively an early signal that the new stress tests will not uncover many problems.

The balance sheet assessments will feature many outside advisors who will provide technical expertise in coming up with figures for capital shortfalls. This is a lucrative business and consultants who wish to be re-hired have an incentive to give the answer the client wants. Draghi waxed lyrically on Monday about how

One of the outcomes we expect from these tests is to dispel this fog that lies over bank balance sheets in the euro area

and expressed confidence that the condition of Europe’s banks was improving. This happy message will be taken on board by the outside consultants.

The hiring of Oliver Wyman as the ECB’s own consultant doesn’t do much to boost the credibility of the upcoming assessments. Leaving aside their infamous award to Anglo Irish Bank as the world’s best bank in 2006, this firm carried out stress tests on Spanish banks last year coming up with a €60 billion recapitalisation figure that few consider credible. (For comparison, the Irish state coughed up €64 billion for its banks — Ireland is a lot smaller than Spain and Spanish house prices are still falling.)

Of course, it’s also possible that the bank assessments will be realistically tough and, where public funds cannot be used, the ESM could be called on to provide money for recapitalization. However, the €60 billion currently earmarked for potential use by ESM is a small figure relative to the size of Europe’s bad bank assets and, even then, it seems unlikely that Germany, Finland and the Netherlands will budge from their position that ESM cannot be used to replace losses on “legacy assets.”

A final scenario consistent with the possibility of tough stress tests is that, where national governments don’t have the funds, there will be significant bail-in of bank creditors with bondholders and possibly depositors losing out. Given the chaotic implementation of the Cyprus bail-in and the lack of progress on resolution authority, I seriously doubt that the European institutions have the capacity to execute a simultaneous multi-country programme of bank bail-ins while maintaining financial stability.

That leaves the path of least resistance: Weak stress tests that see the vast majority of banks pass and the problems with bank assets continue to be largely ignored.  With so many new institutions in place, perhaps a gentle run-through was the best that could have been expected from this exercise in any case, with more serious tests reserved for down the road when the banks are in better condition and disagreements about resolution have been settled.

In the meantime, Europe’s weak banks are likely to continue in their zombie state, squeezing credit to firms and households and holding back the recovery that Europe so desperately needs.

Is the Fed Going to Go Bust?

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While the Federal Reserve’s quantitative easing program has not yet caused an increase in inflation, many are concerned that the money creation due to QE will provoke serious problems at some point.  So when leading economist Robert E. Hall of Stanford releases a paper (co-authored with Columbia‘s Ricardo Reis) focusing on the “risks to solvency” facing the Fed then many people are going to pay attention.  This is particularly so when the paper includes scenarios in which the Fed loses control of the price level and “the central bank would likely be dissolved and a new currency introduced.”

So is the Fed going to go bust and be dissolved? Will the dollar have to be replaced? Let’s start with a spoiler alert.  In the end, Hall and Reis conclude the possibility of a doomsday scenario for the Fed is “remote”.  Still, given the nature of controversies about the Fed, the extreme scenarios cited in the paper are likely to become part of public debate on the Fed’s future. In this post, I argue that even the “remote possibility” scenarios put forward by Hall and Reis rely on a range of counter-factual assumptions.

A Potential Problem?

Hall and Reis’s concerns can be summarised as follows.  Because the Fed now holds very large amounts of long-dated low-interest-rate bonds, future increases in interest rates may reduce the value of these assets. They describe a scenario in which the Fed reaches a point where its assets don’t generate sufficient income to cover its costs.

In particular, Hall and Reis are concerned about the Fed’s ability to pay interest on the reserve accounts that banks hold with it. Payments made to Fed ultimately arrive via deductions from various reserve accounts that institutions such as private banks or the Treasury hold with it while interest paid on reserves to banks takes the form of additions to the relevant bank reserve accounts.

Given this structure, if the interest payments made to the Fed don’t cover the interest payments it makes on reserves, then the total stock of reserves will increase. Hall and Reis express a concern that this process of additional money creation stemming from such an increase in the stock of reserves would result in higher inflation. (Exactly how this gets so bad that the currency ends up being dissolved is a little unclear to me.)

So it turns out that Hall and Reis are not actually concerned about the Fed going bust in the usual sense of being unable to meet its obligations. Rather they express a concern the Fed might only be able to meet its obligations by creating a quantity of money that generates high inflation.  Alternatively, they discuss a scenario in which the Fed keeps the interest rate on reserves low to restrict the growth in total reserves but this low interest rate results in a loss of control of the price level.

After crunching some numbers, Hall and Reis finally assure worried readers that their scenario in which the Fed loses control of inflation isn’t a likely event.  However, this still leaves some room for doubt that there may be some more extreme set of losses than those contemplated in the paper that could result in a doomsday scenario.

A Problem that Simply Isn’t a Problem

In fact, the doomsday scenario outlined by Hall and Reis simply doesn’t make any sense and it doesn’t require crunching of numbers to dismiss it.

The scenario revolves around the problems caused by payment of interest on reserves.  However, it’s worth noting that, far from being a time-honored tool for controlling interest rates, the Fed only began paying interest on reserves in 2008 and had little difficulty controlling interest rates prior to the introduction of this policy.

As explained in this paper, the principle argument for paying interest on reserves is that it acts as a floor on money market interest rates and so reduces day-to-day volatility.  However, when central banks pay interest on reserves or a deposit facility, this interest rate is rarely the one used to set the target for short-term private sector borrowing rates.

For example, the ECB has a deposit facility that pays interest to banks, an emergency marginal lending facility for overnight borrowing and a weekly refinancing operation in which it lends money to banks. It is the refinancing rate that usually dictates average money market interest rates with the deposit facility rate acting as a lower floor.  So, in general, there are few grounds for the idea that setting a low interest rate for remuneration of reserves (or indeed a zero rate) will lead to the Fed losing control of inflation.

Still, with banks currently flooded with reserves, one could argue that it might be difficult over the next few years to raise the federal funds rate without hiking the interest rate paid on reserves. So one could still ask whether concerns about income shortfalls could lead to the Fed having to abandon paying interest on reserves and the operational efficiency gains that come with it. This is extremely unlikely.

Firstly, the Fed holds large amounts of assets that are set against currency “liabilities” which in practice pay no interest.  So it could incur losses on the rest of its operations and still make a profit. Moreover, there is no operational need for the Fed’s stock of assets to exceed its stock of notional liabilities.

Secondly, the Fed holds long-term assets and short-term liabilities and yield curves generally slope upwards.  So, on average, the Fed is going to make profits even without the assets backing currency notes.  It could thus go through a period of making losses and simply offset these losses with later profits that are partly retained rather than handed over to the US Treasury.

Hall and Reis note in their paper that this latter option of smoothing out profits and losses by varying dividends to the Treasury may not be possible if the Treasury decided to prevent the Fed from accumulating too much profit income without handing it over to the rest of the US government.  Here I can only say that any future world in which the Treasury is allowed to bully the Fed into providing it with more income would indeed be one in which price stability is endangered but only because the Fed will have lost its independence, not because of QE-related losses on assets.

The US economy has many real problems for people to focus on. Economists can help by focusing on those problems rather than fairy stories about the Fed going bust and the dollar being abandoned.