Four Principles for a Base Money Regime.

• Author: Luther, William J.
• Position: Report

Most of the money used throughout the world is created inside the banking system. In the United States, for example, the M2 money stock less the currency component is nearly $13.5 trillion. (1) The monetary base, in contrast, is only around $3.1 trillion. (2) The difference is even greater in other countries, where financial institutions are not encouraged to stockpile so many reserves and the currency circulates to a much lesser extent beyond the borders of the issuing country or currency area. (3) It might seem reasonable, then, to focus on bank-issued money and pay little attention to base money. But that would be a mistake.

The claims issued by banks, primarily demand deposit account balances, are redeemable for base money. As such, these claims derive their value from the underlying base money asset, perhaps with some discounting for bank-specific risks. A bank that issues too few claims leaves profits on the table. (4) Since creating and lending additional claims generates sufficient income to warrant the additional risk of illiquidity, such a bank would be well-served by decreasing its reserves to deposits ratio. A bank that issues too many claims, in contrast, takes on more risk of illiquidity than is warranted by the income those claims generate. Such a bank would be wellserved by increasing its reserves-to-deposits ratio, since it risks suffering reserve drain and losing market share to rival banks. Base money is high-powered money. It serves as the reserves of the banking system. An optimizing bank will only expand its loans and deposits as the supply of base money expands or demand for base money contracts; it will only contract its loans and deposits as the supply of base money contracts or demand for base money expands. (5) The contractual obligation to redeem its claims for base money constrains a bank. Hence, the base money regime is of the utmost importance. The growth of base money--and, in particular, reserves--determines the course of financial activity. Bank-issued money is the ship. Base money is the rudder.

In what follows, I offer four principles for a base money regime. In brief, I maintain that an ideal base money is (1) stable, (2) demand elastic, (3) global, and (4) incentive compatible. I argue that these principles are necessary for evaluating alternative base money regimes, like a government-issued fiat money, commodity money, or more recent cryptocurrencies. I conclude that, since most real-world monies fall short of the ideal on one margin or another, one must consider the tradeoffs when ranking the available alternatives.

Long-Run Stability

How should the supply of money be governed? I set aside, for now, consideration of the precise mechanism or the features of a desirable mechanism. Instead, I focus on the outcomes of a desirable mechanism. I also set aside the question of how the money supply should behave over relatively short periods of time For now, I focus exclusively on how the money supply should behave over the long run. To that end, I take the consensus view--that the absolute rate of money growth should be low--and consider the range of disagreement in the literature.

In the long run, inflation is a monetary phenomenon. Hence, asking how the money supply should be governed over the long run is akin to asking what the optimal rate of inflation is over the long run, where "optimal" means maximizing genuine productivity. (6)

There are essentially three views in the literature: (1) zero inflation, (2) slightly negative inflation, and (3) slightly positive inflation. The first view maintains that the productivity-maximizing, or optimal, rate of inflation is zero. Advocates of such a position, including Meltzer (1999), typically maintain that the general price level is a numeraire and, hence, any costs incurred to change the numeraire are unwarranted. Some also note drat, since nominal capital gains are subject to tax, inflation results in costly distortions in saving and investment (Feldstein 1999). Still others stress the salience of zero inflation, which might reduce uncertainty (and, hence, boost productivity) about price level drift (Gavin and Stockman 1988).

The second view maintains that inflation should be slightly negative. This view, credited to Friedman (1969), is typically justified on the grounds that individuals will hold insufficient cash balances when tire real rate of return on currency is lower than the real rate of return on bonds of similar risk and duration. If individuals do not hold enough cash, they will have to incur the costs of managing smaller cash balances. Moreover, some transactions (and, hence, the mutual gains from those transactions) will go unrealized. Paying interest on cash is technically possible (e.g., banknote lotteries), but very costly. Far better, proponents of the second view maintain, to generate a mild, expected deflation so that currency yields a positive real rate of return comparable to similar financial assets. Then, everyone will hold enough cash to make the desired transactions.

The third view maintains that some low, but positive rate of inflation is desirable. This view, as put forward by Akerlof, Dickens, and Perry (1996), is usually justified on the grounds of lubricating labor markets--that is, enabling employees to accept a lower real wage without enduring the psychic costs of seeing the amount on their paychecks decrease and enabling employers to offer lower real wages without reducing morale and, hence, labor productivity. Others more or less accept the first view but worry that conventional measures overestimate inflation (Bernanke and Mishkin 1997). (7) In other words, achieving zero percent actual inflation requires a slightly positive rate of measured inflation. (8) More recent studies yield a positive optimal rate of inflation on the grounds of avoiding the zero lower bound (Carreras et al. 2016) or compensating for financial frictions (Finocchiaro et al. 2018). (9)

Note that, in all three views, there is some cost to be minimized. In the first view (and the third view, when held on the grounds of mismeasurement), it is the cost of changing prices. In the second view, it is the costs of managing smaller cash balances and occasionally missing out on exchange opportunities. In the third view, it is transactions and/or psychic costs. A more general view would take all of these costs (and potentially others) into...