Thomas Klitgaard

English

Research Papers in Economics

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October 28, 1983
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Space Age Monetary Theory
In a recent article inthelournal ofEconomic
Literature, Robert Hall ofStanford Univer-
sity, discussed theworkofthose questioning
the theories ofmore conventional econo-
mists byapplyingthe principles ofmicro-
economicefficiency to monetary theory.
Labelled "free market" monetary theorists,
they claim thatthe financial and transac-
tions industries would function smoothly in
the absence ofgovernment intervention. To
counterclaimsthatregulation is anecessary
stabilizing influence on the economy, these
economists have had to suggest various
policy alternatives for a deregulated
environment when money as commonly
defined ceases to exist.
The recent moves toward financial deregu-
lation and the increasing sophistication
"ofthe financial system have led manyto
suspect that significant changes in theory
and policy might, at some point, be neces-
sary. This Letter will look briefly at the
various recommendations offree market
economists who project recent trends in
financial and technological innovation to
the extreme-to a point where the distinc-
tion between money and otherfinancial
assets is clearly meaningless_ In theirworld,
the Federal Reserve could not expectto
control thepricelevel bylimitingthegrowth
ofa group of assets called the money supply
becausedefiningsuch agroupingwould not
be possible. Some other method then must
be found to keep control overtheprice level.
Deregulation and technology
The free-market advocates contend that any
identifiable relationships between money
and prices will at some point disappear
because they are the result ofaparticular
regulatory structure. They cite, as examples,
required reserves behind bank deposits,
which have theeffect ofstabilizing the
supply and demand for money at the cost of
taking large amounts ofcapital outofthe
intermediation industry, and the restriction
ofprivatesubstitutes forcurrency(e.g., small
denomination bearer bonds, interest earn-
ing traveler'S checks), which help maintain
the conceptofmoney as the medium of
exchange at the cost of making currency
moreexpensive to use.
Some economists who do not share this
iconoclastic perspective have expressed
similarworries on the difficulties deregula-
tion and innovation have created fordefin-
ingand controllingthemoneysupply. Those
who believe in money's continued useful-
ness debatewhat is appropriateto include in
each monetary aggregate, and which ofthe
various definitionsofmoney is most useful
for policy purposes. The Federal Reserve is
itselfconcerned with the problems in inter-
preting the meaning ofchanges in the
moneysupply. In thepast year, itwarned the
public thatsurges in moneymaybe morethe
result ofthe changingfinancial structure
than ofa loosening ofpolicy.
Manyeconomists think that such problems
with money wiII be sorted outwhen the
financial system has adjusted to recent far-
reaching regulatory changes. They reason
that ifmost ofthe structural change has been
the result ofderegulation, then an end to
further significant legislative change should
restore stabilitytomoney's relationshipwith
prices. The growth rates of assets will regain
their meanings for monetary analysis as the
public finishes incorporatingthe recently
created financial assets into its portfolio_
Less optimistic economists claim that
changing technology will result in the con-
tinued evolution ofthe financial system
even in the absence offurther deregulation.
Newtechnology will increase the ease with
which any financial asset can be converted
into so-called "base money" or "high-
powered" money, which is madeupofbank
reserves and currency. This conversion is
critical for giving an asset its "moneyness,"()pif\I(),'j': \,',:PI'(-'-,':,eCi ~n l)t:" 11H,Y~;i,"tj('i ci() (l(1(
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i.e., acceptability as a means of payment.
Checks, for example, must in effect be con-
verted into reserves to clear between banks.
Cash managementservices, nowcommonly
offered by brokerage houses, mutual funds,
and money market funds, are using wire
transfers and automated clearing houses to
connect their customers to financial institu-
tions holding reserves. As such systems
improve the speed with which transactions
can be conducted and as they becomes less
costly, an increasing numberof assets will
take on the exchange characteristics of
money because they wiII easiIy be con-
verted into the medium needed for making
transfers. The financial system mightevolve
to a point where technology, rather than
complete deregulation, could destroy the
present concept ofmoney. For instance,
funds for any purchase could be electronic-
ally moved from an individual's bond
marketfund to a merchant's mutual fund
with the use ofadebitcard. The assets
would take the form ofreserves for only as
long as ittookto send the information of the
transfer between institutions.
Prices without money
Howwill the price level bedetermined ifthe
economy reaches a point where money
consists ofawide array offinancial assets,
all ofwhich can be used for spending pur-
poses? And what will this mean for control-
ling inflation when adjusting the money
supplywill make no moresense than manip-
ulating the holdings ofstocks or bonds?
Free market economists propose two solu-
tions. One group argues that the dollar may
be given meaning by tying itto acommodity
standard, that is, its value could be defined
in terms of the quantityof real goods. Sta-
bilizing the value ofmoney in terms of the
commodity standard then would ensure a
stable price level. Others believe that a
dollarofcurrency or reserves will have an
intrinsic value, orcan be given a real value
by linking itto production. For these
economists, the major policy tool for
2
stabilizing prices would consist ofcontrol-
ling the nominal quantityofsuch reserves
or currency.
Commoditystandards
A familiar version ofacommodity standard
is the use ofgold to define the value ofthe
dollar. The gold standard was successful at
keeping the inflation rate down, and even
produced some periods ofdeflation. But it
did not prevent the 40 percent cumulative
erosion ofthe dollar'spurchasingpowerthat
occurred from 1879 to 1914 (although it
probably contributed to stability by keeping
expectations ofinflation under control).
Gold's majordrawback today as acommod-
ity standard is its unstable demand. The
U.S., for example, would have experienced
excessive inflations and deflations ifithad
been on a gold standard the past few years
because gold's value fluctuated so sharply in
the interval.
There is, however, nothing sacred about
using gold as the commodity standard. The
dollar instead could be defined by astan-
dard composed ofa numberofcommon
goods, such as various raw materials and
agricultural products. Each dollarwould not
need to be backed by warehouses ofthese
goods, just as the gold standard did not
require the gold in Fort Knox. Rather, the
dollarwould be defined as a unitofaccount
whose value is determined by the real value
ofthe commoditybundle. The public would
then know what a dollarwas worth when
making a contract or completing atransac-
tion because itwould know the value ofthe
commodity bundle.
A groupofcommon commodities would be
an improvement on gold ifthe value ofthe
bundlechosen weremore stable in compar-
ison to the general price level. In addition,
the numberofgoods involved and their
importance in the production process would
minimizethe effect ofany shifts in demand,
caused by speculation on relative prices.
The ultimateextension ofthis idea would be
to include all goods in the standard. Theresult would be the same as ifthe govern-
ment indexed the entire economy against
inflation. A paycheck defined as so many
unitsofmoneywould always have the same
purchasing power in such a world.
These examplesare nothingmorethan ways
to define the problem ofinflation away by
creating a standard unitofaccount in which
all transactions can be denominated. Never-
theless, a commodity standard would not
guarantee zero inflation under all circum-
stances unless the government clearly had
no incentive to devalue the standard.
Reserves or currency
Some free market economists argue that
the government also could affect prices by
manipulating the supply ofreserves or cur-
rency. A parable used by Eugene Fama ofthe
UniversityofChicago may help explain this
concept. Suppose that in the distant future,
a country operating under a successful
commodity standard decides to try adif-
ferent approach. Because spaceships per-
form a valuable service, policymakers
decide that owners ofsuch vehicles will be
required to hold reserves as an additional
cost ofoperation (just as banks are required
now). The valueofspaceship travelcreates a
real demand for adollarofreserves. The
central bank can then maintain the desired
pricelevel in dollars by controlling the
supply ofreserves available to back space-
ship operations. The problem ofdetermin-
ing prices in this case is solved by regulating
something otherthan the transaction and
intermediation industries.
There are two extremes to which this logic
can be taken. Some economists have sug-
gested that both currency and reserves
perform special services that give them an
intrinsic value, so that government does not
have to impose regulations like reserve
requirements to give them value. Since cur-
rency has acomparativeadvantage for small
purchases, they claim itwill be in demand in
an unregulated world because of its conve-
nience. Similarly, reserves will have real
3
value because oftheirusefulness in thedaily
operation ofthe financial system, e.g., they
facilitate the actual movementoffunds
between institutions. These intrinsic advan-
tages mean that there will be a well-defined
demand for reserves and currency. Conse-
quently, the monetary authority can control
the price level by manipulatingthe supplyof
those assets.
But ifregulation were needed, then any
industry could be required to hold reserves.
Taken to the extreme under oneofthe more
unusual proposals, a reserve dollarwould
be issued for each dollarofvalue-added
calculated in the Gross National Product. In
order to produce a dollarofoutput in each
subsequent period, a firm would have to
have acorresponding reserve dollar. In-
creasing real output,orraising prices, would
require thepurchaseofareserve dollarfrom
another producer. Inflation would be con-
trolled because the nominal amount of
outputwould forever be the same by gov-
ernment decree. In this world, increasing
production would automatically be accom-
panied by a falling price level.
Conclusion
This Letter has looked at some suggestions
by economists who have concerned them-
selves with a very advanced financial system
in which the present worries about the use-
fulness of money for policy are fully real-
ized. Withoutthe present conceptofmoney,
some alternative must be created to control
the price level in their world. Their analysis,
while extreme, is valuable because it forces
conventional monetary economists to study
the problem ofcontrolling inflation from
a different perspective.
Thomas Klitgaard5S'110 .LSl:lI:l
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
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Selected Assets and liabilities
largeCommercial Banks
Amount
Outstanding
10/12/83
Change
from
10/5/83
Change from
year ago
Dollar Percent
loans'(gross, adjusted) and investments"' 162,219 408 1,231 0.8
loans(gross, adjusted) - total# 142,217 464 - 493 - 0.3
Commercial and industrial 43,060 53 - 2,722 - 5.9
Real estate 57,166 69 - 216 - 0.4
Loans to individuals 24,894 121 1,493 6.4
Securities loans 2,919 175 69 2.4
U.s. Treasury securities* 7,464 - 15 889 13.5
Other securities"' 12,537 - 41 - 1,627 - 11.5
Demand deposits - total# 44,054 - 42 2,986 7.3
Demanddeposits - adjusted 31,164 1,320 2,236 7.7
Savingsdeposits - tolalt 66,568 - 328 34,451 107.3
Time deposits - tota!# 67,367 855 - 34,526 - 33.9
Individuals, part. & corp. 61,850 111 5 - 29,837 - 32.5
(Large negotiable CD's) 17,024 151 - 22,085 - 56.5
Weekly Averages
of Daily Figures
Member Bank Reserve Position
Excess Reserves (+)/Deficiency(-)
Borrowings
Net'free reserves (+)/Net borrowed(-)
Weekended
10/12/83
75
24
51
Weekended
10/5/83
93
72
21
Comparable
year-ago period
66
12
53
" Excludes trading account seCUrities.
# Includes items not shown separately.
t Includes MoneyMarket Deposit Accounts, Super-NOW accounts, and NOW accounts.
Editorial commentsmay beaddressed to theeditor(GregoryTong) ortotheauthor...•Freecopiesof
this and other Federal Reserve publicationscan be obtained by callingor writi!1g the Public Infor~
mation Section, Federal Reserve Bank of San Frandsco, P.O. Box 7702, San Francisco 94120.
Phone(415) 974-2246.

Space age monetary theory

http://www.frbsf.org/publications/economics/letter/1983/el83-43.pdf

Space age monetary theory

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Research Papers in Economics