Transporting the macroblogosphere back to 1809: Usury Laws and the 5% upper bound

The zero-lower bound is the well-known 0% floor that a note-issuing bank hits whenever it attempts to reduce the interest rate it offers on deposits into negative territory. Should the bank drop rates below zero, every single negative yielding deposit issued by the bank will be converted into 0% yielding notes. When this happens, the bank will have lost any ability it once had to vary its lending rate.

The ZLB is an artificial construct. It arises from the way the banking system structures the liabilities that it issues, namely cash and deposits. We can modify this structure to either remove the ZLB or find alternative ways to get around it. Much of the discussion over the econblogosphere over the last few years has been oriented around various ways to get below zero.

There is another artificial bound, this one to the upside—let's call it the 5% upper bound, or FUB. The FUB is an archaic bound. Up until 1854, the Usury Laws prevented the Bank of England from increasing rates above 5%. This constraint meant that for almost two centuries, the Bank of England's discount rate was bounded within a narrow channel that had as its upper limit the 5% mark as stipulated by the Usury Laws and a lower limit of 0% due to the existence of 0% yielding banknotes (see chart above).

Imagine that we had a time machine and transported the econblogosphere, still hot over the ZLB debate, back to 1809. What sorts of discussions would we be having if we had risen up against the FUB? Given that the conventional route of increasing rates was constrained by the usury prohibitions, what sort of unconventional monetary policies would bloggers be providing to the Directors of the Bank of England to deal with inflationary booms? Would this advice be symmetrical to the policies they have been advocating for escaping the ZLB?

1809 is a significant date because the convertibility of the pound into gold had been suspended for over a decade. Although convertibility would be resumed in 1821, England would be on a 'fiat' standard very similar to our own for another decade. In the years since suspension, the pound had gradually depreciated against gold and other European currencies. A healthy debate began to flourish over whether the Bank of England was responsible for the pound's depreciation (ie. inflation) or if external events such as crop failures were to blame. It was in that context that banker/economist Henry Thornton published his famous Enquiry into the Nature and Effects of the Paper Credit of Great Britain. Although Thornton was circumspect on the precise causes of the deprecation of the pound, he drew attention to the difficulties that the Usury Laws caused in controlling the volume of credit. Here is Thornton:

In order to ascertain how far the desire of obtaining loans at the bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances. This is to be judged of by considering two points: the amount, first, of interest to be paid on the sum borrowed and, secondly, of the mercantile or other gain to be obtained by the employment of the borrowed capital...

The borrowers, in consequence of that artificial state of things which is produced by the law against usury, obtain their loans too cheap. That which they obtain too cheap they demand in too great quantity.

Thornton pointed out that if there was a large deficit between the price at which a businessman could borrow from the Bank of England and the mercantile rate of profit—the rate at which the same businessman could invest the borrowed money—then the demand for and granting of credit would become excessive. While nudging the discount rate higher would normally be sufficient to reduce this excess, the laws against usury might prevent these increases from taking place.

If we were to drop Nick Rowe into the 1809 economic debate, he would complement Thornton quite well by making good use of the same pole-on-a-palm analogy he has so aptly used to explain the ZLB. Running an inflation targeting central bank is sort of like balancing a long pole upright in the palm of one's hand, says Nick. The bottom of the pole is the interest rate and the top is the inflation rate. As the pole starts to lean (ie. the price level begins to change), the holder needs to quickly move their palm far enough in the same direction (ie. interest rates must be changed) so as to stop the pole from falling over. A wall to the either the north or south impedes the holder's palm from moving sufficiently far and will cause the pole to tumble over.

Applying this analogy to monetary policy, the Directors of the Bank of England might be required to stop excess inflation by moving rates north of 5%. With the Usury Laws in place, the Director's efforts would be impeded. Nick's illustration is Thornton all over again.

Scott Sumner, Lars Christensen, David Beckworth, and other monetarist-types have been strong advocates of quantitative easing as a way to get below the ZLB. Whisk them back to 1809 and would they advocate getting above the FUB by quantity dis-easing, or QD — mass repurchases of Bank of England notes through the liquidation of the Bank of England portfolio of assets?

Assuming that the threat of QD is able to increase the expected purchasing power of the pound (just as the threat of QE is supposed to reduce the same), then the Directors could initiate a QD program to improve the real return on pound notes and deposits. As soon as the real return on notes and deposits exceeds real returns on capital, the inflationary boom will come to a halt. Conveniently for the Directors, the nominal 5% rate will have remained in place — only real rates will have increased — thereby allowing the Directors to abide by the Usury Laws.

What about New Keynesians like Paul Krugman? Promising to hold off on future interest rate increases after a recovery has begun is the sort of advice New Keynesians have given to the Fed as a way to bridge the ZLB. This is called providing forward guidance. As Krugman says, a central bank needs to "credibly promise to be irresponsible".

Parachute Krugman into 1809 and he would be counseling the Directors to do the opposite: hold off on reducing rates from 5% after a contraction had already set in. In other words, the Directors need to "credibly promise to be hard-asses." As long as this promise is taken seriously by the market, the promise of future monetary tightening translates into lower inflation in the present, and the real interest rate rises. This should reign in the inflationary boom. Much like Sumner and Christensen, Krugman's advice would allow the Director's to hold steady at the 5% nominal rate dictated by the Usury Laws, letting real rates do the job of reeling in prices and slowing down the economy.

What about Miles Kimball? Transport Miles back to 1809 and he'll probably be the most aggressive in the outright removal of the Usury Laws. Just as he is currently campaigning for the ability of central banks to set negative rates on deposits, I'm sure he'd by picketing outside of Parliament for the right of the Director's to bypass the Usury Laws and set 6-7% nominal rates.

Incidentally, what did the Directors of the Bank of England actually do? According to Jacob Viner, there is evidence that

bankers found means of evading the restrictions of the usury laws. In 1818, the Committee on the usury laws stated in its Report that there had been “of late years ... [a] constant excess of the market rate of interest above the rate limited by law.” Thornton notes that borrowers from private banks had to maintain running cash with them, and borrowers in the money market had to pay a commission in addition to formal interest, and that by these means the effective market rate was often raised above the 5 per cent level. Another writer relates that long credits were customary in London and a greater discount was granted for prompt payment than the legal interest for the time would amount to.

More convincing evidence that the 5 per cent rate was not of itself always an effective barrier to indefinite expansion of loans by the banks is to be found in the fact that the directors of the Bank of England, although they professed that they discounted freely at the rate of 5 per cent all bills falling within the admissible categories for discount, in reply to questioning admitted that they had customary maxima of accommodation for each individual customer and occasionally applied other limitations to the amount discounted.

In Paper Credit we find Henry Thornton verifying Viner's claim, noting the "determination, adopted some time since by the bank directors, to limit the total weekly amount of loans furnished by them to the merchants."

So the Director's preferred route for getting out from under the thumb of the Usury Laws was to maintain the 5% discount rate, but ration the quantity of loans issued at these rates, thereby limiting the quantity of credit in circulation. While this policy might not have been sufficient to prevent an inflationary boom, it may have prevented a hyperinflation from breaking out.

Before I sign off, I want to reverse something I said at the outset. I wrote that the 5% upper bound was archaic, but that's not entirely true. Sure, high interest rates are no longer illegal. But high nominal interest rates have never been politically palatable. Central bankers are not independent of politics, and therefore probably still operate with something akin to a 5% upper bound. Let's call it an "upper-ish" bound, or the point at which a central banker starts to get dirty looks from those who have the power to reappoint him. Central bankers may need to resort to unconventional techniques to free themselves of the upperish-bound. The Fed's motivations for adopting quantity targets in 1979, for instance, may have been such a technique. An overt jacking-up of interest rates to 15-20% would have been political suicide, goes the theory, so the FOMC chose to engage in a bunch of hand-waving about hitting money supply targets, thereby distracting would-be critics with a new set of monetary verbiage. This left Paul Volcker free to implement what would be at its peak a tremendously onerous 22%+ fed funds rate.

We're of course not anywhere near the upper bound these days, at least not in the developed world, but it's still an interesting puzzle to work through in order to help understand the current situation. Our investigation also offers a history lesson. In choosing to remove it over century ago, the FUB was revealed to be neither a law of nature nor a design of God. The FUB was a choice. Hopefully we'll eventually realize that the same applies to the ZLB.

Real or unreal: Sorting out the various real bills doctrines

In the comments section of my post on Adam Smith and the Ayr Bank, frequent commenter John S. brought up the real bills doctrine. The phrase real bills doctrine gets thrown around a lot on the internet. To muddy the waters, there are several versions of the doctrine. In this post I hope to dehomogenize the various versions in order to add some clarity.

1. Lloyd Mints's version

We may as well start with Lloyd Mints's version, since he coined the phrase real bills doctrine back in 1945 on his way to denouncing the doctrine. Mints taught at the University of Chicago and mentored Milton Friedman. [1] Here is Mints:

The real-bills doctrine runs to the effect that restriction of bank earning assets to real bills of exchange will automatically limit, in the most desirable manner, the quantity of bank liabilities; it will cause them to vary in quantity in accordance with the "needs of business"; and it will mean that the bank's assets will be of such a nature that they can be turned into cash on a short notice and thus place the bank in the position to meet unlooked-for calls for cash. - A History of Banking Theory

Mints's RBD states that so long as only real-bills (short term liquid debt instruments created by merchants to finance inventory) are discounted by the banking system, an excess amount of notes can never be issued. When businesses require cash, they'll simply discount bills at a bank, and when that cash is no longer required, they'll pay back their borrowing. Even in a world *without* note convertibility into specie (a "fiat standard")  the real bills stipulation alone is sufficient to keep the price level anchored.

Mints rightly declared that this version of the RBD was "completely wrong". After all, a central bank not constrained by convertibility might discount only real bills, yet by discounting at an unreal price, it would alter the purchasing power of the notes it issues and create either runaway inflation or deflation). The price level was indeterminate in Mints's RBD-world.

Mints singled out Adam Smith for being "the first thoroughgoing exponent of the real-bills doctrine". For the next forty years, Smith's reputation as a monetary theorist would be tarnished. [2]

2. Adam Smith's version

Though tarred and vilified, poor Adam Smith never actually conformed to the real bills doctrine as described by Mints. This has been pointed out by David Laidler in his 1981 paper Adam Smith as a Monetary Economist, one of the first efforts to rehabilitate Smith's reputation as a monetary theorist.

Smith lived in an era in which paper money was fully convertible into a fixed amount of gold. Mints's description of the RBD, on the other hand, applies to a fiat world. For Smith, the gold convertibility clause was sufficient to ensure that the economy needn't endure an excess amount of notes. After all, should banks as a whole issue more than was desired, the public would return the notes en masse for specie. This is the so-called reflux process.

That being said, Smith did mention real bills several times in the Wealth of Nations. He famously advises banks that they should only discount "real bills of exchange drawn by a real creditor upon a real debtor." (I go into some detail in my last post on the personal and historical reasons that may have motivated Smith to advocate this position).

Why limit discounts to real bills? When the banking system issues excess paper currency, gold convertibility ensures that this excess will soon reflux back to issuer. A bank that holds long term loans and bonds issued by speculators will be insufficiently prepared to meet the demands of reflux since liquidating such debts might take time. A bank that holds short term bills issued by credit-worthy merchants will be better equipped to meet redemption demands, and less likely to meet the same demise as that experienced by the Ayr Bank, a bank run that Smith personally witnessed.

Thus Smith's admonishment to only discount real bills wasn't a mechanism for anchoring the economy's price level—gold convertibility served this purpose. Smith's real bills stipulation was just good advice for individual banks: stay liquid and don't take on too much credit and term risk. This distinction has been aptly described by David Glasner in his paper the Real Bills Doctrine in the Light of the Law of Reflux, and for his part Laidler notes that "as advice to an individual bank, it's probably pretty sound, as a principle of
monetary policy under commodity convertibility it is relatively harmless..." [link]

3. The Bank Directors' version

Why did Mint's cast Adam Smith as his first thorough-going exponent of the RBD?

In 1797, some seven years after Smith had died, Britain went off the gold standard. (See this post for details). The pound soon began to trade at a discount to its pre-1797 gold value. In other words, the pound was capable of purchasing less gold. The Directors of the Bank of England found themselves accused of creating inflation, notably by the members of the 1810 Bullion Committee. One of the apologizers for the Directors, Charles Bosanquet, a pamphleteer, wrote a famous rebuttal in 1810 that insisted that by limiting discounts to "solid paper for real transactions," the Bank could not have contributed to a deprecation of the pound. According to Bosanquet, several factors outside of the Bank's control had caused the deprecation.

To help buttress his point, Bosanquet invoked the name of Adam Smith. Wrote Bosanquet: "The axiom, or rule of conduct, on which the Committee has been pleased to heap contempt and ridicule, respecting which they have declared that the doctrine is fallacious, and leads to dangerous results, was promulgated by, and is founded on, the authority of Dr. Adam Smith."

Bosanquet's appropriation of Smith's name was inappropriate since Smith implicitly assumed gold convertibility. But the damage had been done. From then on, economic historians like Mints would automatically associate Smith's name with the arguments of the Directors.

The Directors' RBD is very much a manifestation of Lloyd Mints's RBD, which we already know was a poor guide for monetary policy. Years later, Walter Bagehot would write that when the Directors were examined by the Bullion Committee in 1810, "they gave answers that have become almost classical by their nonsense". If anyone deserved to be castigated as the first thoroughgoing exponents of Mints's real bills doctrine, it was the Directors and not Smith.

4. Antal Fekete's version

If you've spent some time wading through the online monetary economics community, you'll have run into Antal Fekete's real bills doctrine. This is an attempt to apply a warmed over version of Adam Smith's RBD mixed in with some Austrian free market economics.

The use of bills of exchange began to diminish in the late 1800s and today they are a relatively unimportant financial instrument, having been replaced in bank portfolios by commercial paper, bonds, mortgages, and other types of debt. Fekete tries to draw a number of broad based conclusions from this trend. The crowding out of real bills by non-real bills (longer term finance bills and government issued treasury bills), for instance, is seen by Fekete as the reason for the Great Depression and the creation of the modern Welfare state:

When real bills were replaced by non-self-liquidating finance bills, payment of wages has become haphazard. Employment was made touch-and go, hiring, ‘hand-to-mouth’. This threatened with unemployment on a massive scale, unless governments were willing to assume responsibility for paying wages. [Link]

Conversely, rehabilitating the real-bills system would end chronic unemployment and reduce the size of government. I only have a passing knowledge of Fekete's thinking — it really doesn't do much for me —so hopefully someone in the comments section can pick up the slack.

5. Mike Sproul's version

Of the modern reincarnations of the RBD, I'm far more familiar with Mike Sproul's version.

Mike's version is an application of modern finance to monetary economics. The price of a financial asset is determined by the discounted value of the expected flows of cash thrown off by underlying capital. Alcoa's stock price, for instance, will equal the sum of discounted earnings that Alcoa's machinery and employees are expected to generate. Transferring this idea to the monetary landscape, Mike says that value of modern central bank liabilities should be determined by the earnings power of the assets held by that central bank.

Like the other versions of the RBD, Mike's version shares a preoccupation with the asset side of a bank's balance sheet. But that ends their similarity. For instance, Mike doesn't have a fetish for actual real bills. I doubt he'd agree with the Directors that so long as they only discounted short-term mercantile bills of exchange, they'd never cause a decline in the value of the pound.

That's why I prefer to call Mike's RBD the backing theory. It's a very different beast from the RBDs of Mints, Smith, Fekete, and the Bank Directors, and to share the same name only adds to the confusion.

So there you have it. If you're going to have an argument over the RBD, make sure you know which one you're arguing about!

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1. Fischer Black received this letter from Milton Friedman on August 6, 1971: "With respect to your so-called passive monetary policy, here you are simply falling into a fallacy that has persisted for hundreds of years. I recommend to you Lloyd Mints' book on The History of Banking Theories for an analysis of the real bills doctrine which is the ancient form of the fallacy you express. Do let me urge you to reconsider your analysis and not let yourself get misled by a slick argument, even if it is your own. " Ouch. Play nicely, Milt. I get this via Perry Mehrling's book on Fischer Black.
2. Here's a video of Lloyd Mints in 1988 upon his 100th birthday.

From intimate to distant: the relationship between Her Majesty's Treasury and the Bank of England

James Gillray, a popular caricaturist, drew the above cartoon in 1797. In it, England's Prime Minister William Pitt the Younger is fishing through the pockets of the Old Lady on Threadneedle Street -- the Bank of England -- for gold. At the time, England was in the middle of fighting the Napoleonic wars and its bills were piling up.

According to its original 1694 charter, the Bank of England was prohibited from lending directly to the Treasury without the express authority of Parliament. Over the years, the Bank had adopted a compromise of sorts in which it provided the government with limited advances without Parliamentary approval, as long as those amounts did not exceed £50,000. In 1793 Pitt had this prohibition removed and in formalizing the Bank's lending policies, imposed no limit on the amounts that could be advanced by the Bank.

Thenceforth Pitt made large and continuous appeals to the Bank for loans. Without the traditional Parliamentary check, there was little the Bank could do except satisfy Pitt's demands. As Pitt liberally spent these borrowed funds in Europe, gold began to flow out of England in earnest, a pattern that was compounded by an internal gold drain set off when a small French force invaded Ireland in early February 1797, causing a crisis of confidence in banks. Pitt suspended convertibility of Bank of England notes into gold on February 26. England would not go back onto the gold standard until 1821, some twenty-four years after Pitt had taken it off.

Having removed both Parliament and the gold standard as checks, Pitt had effectively turned the Bank of England into the government's piggy bank. Thus the inspiration for Gillray's caricature of a groping William Pitt. To some extent, Gillray's worries were borne out as a steady inflation began after 1797. However, the Pound's inflation over that period came far short of the terrible assignat hyperinflation that had plagued France only a few years before. The fears so aptly captured in Gillray's caricature were never fully realized.[1]

Back to the future: Ways and Means advances

Pitt's robbing of the old Lady on Threadneedle street illustrates an episode in which the traditional English divide between Bank and State was removed. Both the Treasury and the Bank of England were effectively consolidated into one entity with the Treasury calling the shots.

The last decade or two illustrate the opposite -- the re-erection of walls between Bank and State. If you browse the asset side of the Bank of England's balance sheet, for instance, you'll notice an entry called Ways and Means advances to HM Treasury ("Her Majesty's Treasury"). Ways and means advances are direct loans to the government. They are generally short term, designed to provide the government with temporary financing to plug gaps between expected tax receipts.

Ways and means advances provide the government with an extra degree of freedom because they offer an alternative avenue for funding. Rather than relying on the bond market or the taxpayer for loans, the government can tap its central bank for money. Ways and means advances are very much like banking overdraft facilities. Unlike a regular loan, the borrower needn't provide a detailed account of what the overdraft will be spent on, nor do overdrafts require specific collateral. They are provided automatically and without fuss.

While overdrafts typically come with specified limits and must be paid back on schedule, they don't always turn out that way. William Pitt's machinations secured for himself what was effectively an unlimited overdraft facility to fund the war against Napoleon. A chunk of the British government's WWI expenses were funded by Bank of England Ways and Means advances and though supposedly of a short term nature, these advances took years to pay down. [2]

While any sovereign would welcome the opportunity to directly borrow from a central bank, from the perspective of the lending bank, overdrafts are risky. First, they are illiquid. Other central banking operations, say open market operations, bring a marketable asset onto the central bank's balance sheet, giving the bank the flexibility to rid itself of that asset whenever it sees fit. Secondly, overdrafts are uncollateralized. Should the borrower go bankrupt, the central bank lacks a counterbalancing asset to compensate itself for its loss.

While the Ways and Means overdraft amount to a piddling £370 million, or 0.1% of the Bank's portfolio of assets, in times past it was very large. See the chart below, cribbed from this Bank of England publication.

At various points in the late 1990s, The Bank's Ways and Means overdrafts amounted to as much as £20 billion. Given the fact that the Bank's note issue then stood at around £25 to £30 billion, Ways and Means advances provided as much as 80% of the backing for paper pounds! Insofar as the value of currency is set by the assets that back the issue, the purchasing power of the pound during the 1990s depended very much on the quality of these Ways and Means advances.

Why did Ways and Means advances contract?

In 1997, the government decided that it would cease using the Bank of England as its source for short term financing and instead would turn to money markets. The final changeover occurred in 2000, at which point the Ways and Means balance was fixed at £13.4 billion, and eventually paid down to £370 million in 2008. Thus ended the Treasury's ability to turn to the Bank of England for financing. As for the Bank, it had earned for itself a larger degree of flexibility -- a large and illiquid asset no longer existed on its balance sheet.

There seem to be a few reasons for ending Ways and Means advances. To begin with, the Treasury was already in the process of handing over its control of monetary policy to the Bank of England. Prior to 1998, the Treasury had been responsible for setting rates. Subsequent to 1998, the Bank of England's Monetary Policy Committee has set rates. The decision to freeze and eventually pay down Ways and Means advances went hand in hand with the Bank's increased independence in setting monetary policy.

Secondly, the third stage of European and Monetary Union (EMU) requires that all member nations cease to lend directly to their government. While the United Kingdom is a signatory to EMU, it never proceeded to the third stage, so it was not required to end Ways and Means advances. Nevertheless, given the possibility that it might proceed to the third stage at some future point in time, it probably made sense to plan ahead by ensuring that the government had already established a viable short term financing alternative to the Bank of England.

Dormant, but not dead

While Ways and Means advances are no longer used, the mechanism isn't dead. The interactive chart below illustrates the Bank of England's balance sheet since 2006. Let's remove all component assets except for ways and means advances, the purple series, and see what we get.

As the chart illustrates, after being paid down in early 2008, Ways and Means advances spiked briefly in late December 2008 to £20 billion only to fall back by April 2009 to £370 million. According to this Bank of England report, the explanation for this spike is that the Treasury briefly borrowed from the Bank to refinance loans that the Bank had earlier made to the Financial Services Compensation Scheme and to Bradford & Bingley.

Bradford & Bingley was a failing bank that was nationalized by the UK government in September 2008. The Bank of England had lent around £4 billion in emergency "Special Liquidity Scheme" funds to Bradford & Bingley as it coped with withdrawals. The SLS had been established earlier that year to improve liquidity of the UK banking system. All Bank of England funding via the SLS was indemnified by the Treasury, so any loss that resulted from supporting Bradford and Bingley up until nationalization would have been absorbed by the Treasury, first by taking on the loan itself and funding that loan via ways and means advances from the Bank of England, and then paying the Bank back by April.

The FSCS, the UK's deposit insurance authority, was able to make good on B&B's deposits through a short term loan from the Bank of England, which was quickly replaced by a government loan financed by Ways and Means advances, which in turn was paid down by the government by April.

Just as Ways and Means mechanism provides the government with the ability to meet sudden spending requirements during war, it provided the same during a period of financial crisis.

Where does the Bank of England stand relative to other central banks?

Although the Bank of England has secured itself a significant degree of financial independence relative to the 1990s and Pitt's era, compared to the Federal Reserve/US Treasury relationship the Bank of England/HM Treasury is much tighter. The Fed has been legally prohibited from granting overdrafts to the government since 1980, as I've outlined here. While Bank of England Ways and Means advances are no longer the modus operandi, they haven't been legally struck out of central bank law as they have in the US. Direct advances to the government could be back one day, with a vengeance.

Compared to the Bank of Canada/Department of Finance relationship, the interface between the Bank of England and HM Treasury is fairly tight. As I've outlined here, the Bank of Canada has the ability to directly lend significant amounts to the government over long periods of time. Indeed, the Bank of Canada is currently purchasing record amounts of bonds in government debt auctions, providing the Finance Department with a continuous overdraft of sorts. Few governments in the western world have the ability to harness their central bank in such a manner.

In general I think it's healthy to establish well defined boundaries between a nation's central bank and its executive branch. Ever since John Law's Banque Royale was nationalized in 1718 and then looted by King Louis XV, scholars have been attuned to the dangers of excessive state control over the issuing power of a nation's monopoly monetary body.

That being said, central bank overdrafts needn't necessarily lead to the sorts of hyperinflation seen in Law's day. The Bank of England provided overdrafts to the Treasury for centuries without igniting prices. The gold standard acted to discipline excess use of the overdraft facility, but in modern days a well-publicized inflation target should be sufficient to reign in any silliness. Absent the discipline imposed by inflation targets, the ability to enjoy central bank financing may be too tempting for a sovereign to forgo. Strict limits or all-out bans on overdraft facilities may provide a needed degree of redundancy.

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[1] Most of the information concerning the Pitt era comes from Eugene White and Michael Bordo's British and French Finance During the Napoleonic Wars, as well as Henry Dunning Macleod's excellent Theory and Practice of Banking, Volume I.
[2] I get this from Sayers's The Bank of England, 1891-1944.

Is legal tender an imposition on free markets or a free market institution?

Robert the Bruce: Scottish  £20 issued by Clydesdale Bank. Not legal tender

This is my last post on legal tender. It builds on my initial posts on legal tender, various comments, and discussion at Bob Murphy's blog. If you're getting to the debate a bit late, here are the first two posts.

1. Legal Tender 101
2. How do legal tender laws affect purchasing power?

Are today's legal tender laws an imposition on monetary freedom?

My short answer: not really. In the US, legal tender is comprised of Federal Reserve notes and United States coin. That means that all debts can be discharged with government coins and notes. It might seem that this would impose the circulation of coins and notes on the marketplace. But as I pointed out in my initial post, debtor and creditor can easily get around legal tender rules by negotiating their own settlement media into the terms of a debt contract.

As commenter MF points out, there is one debt obligation that's tough to negotiate around: the government's tax obligation. Since citizens must pay taxes, and the government sets legal tender, surely notes and coin are forced upon the populace. In theory yes, but in practice no. The IRS asks that people do not send notes or coin to discharge their tax obligation. As a result, most taxes are paid with non-legal tender like cheques, direct deposit etc. Legal tender laws, it would seem, have no bite since the IRS itself ignores them.

But let's assume the government did indeed require tax payments in legal tender coin and notes. Let's return to my favorite McDonald's analogy (see here and here). Imagine that McDonald's Corporation forces customers to pay their "Big Mac tax" with McDonald-issued coupons. This is equivalent to a government that requires people to submit legal tender in order to discharge a tax obligation.

As I pointed out, people don't have to submit to McDonald's tax requirements, insofar as they are willing to eat at Burger King which (let's say) doesn't require coupons to pay for Whoppers. The same goes for US legal tender. If the US government requires citizens to settle their taxes with US legal tender (which, as I've pointed out above, is not the case in practice), then people can avoid this imposition by no longer doing business with the US. Go live in Scotland, which like Burger King, has no legal tender rules. Or find some other nation that doesn't have legal tender. You'll still have to pay taxes, of course, but settlement media won't be dictated to you.

As we know from Lawrence White's Free Banking in Britain, Scotland has a long history of free banking. Even today the majority of bank notes that circulate in Scotland are issued by three private banks—The Bank of Scotland, the Royal Bank of Scotland, and the Clydesdale Bank. These notes aren't legal tender. Nor are Bank of England notes, which also circulate in Scotland. For a brief time between 1954 and 1988, Bank of England notes with denominations below £5 were legal tender. But the withdrawal of the £1 notes from circulation in 1988 left Scotland with no paper legal tender. Scots accept both local Scottish notes and Bank of England notes as settlement media not because they must, but because it's convenient.

Legal tender as a free market institution?

Having shown that modern legal tender laws aren't necessarily a huge imposition on the free choice of payment media, I'll go one further and say that in a world characterized by free banking and governed by lex mercatoria (i.e. private merchant law) legal tender laws might evolve naturally as the result of market choice.

Huge amounts of debts are created in a day’s worth of business. Negotiating settlement media into each and every contract takes time, so transactors may choose to omit that bit. If so, a subsequent situation may arise in which a debtor arrives to pay a creditor, but the creditor refuses to accept the proffered settlement media, thereby forcing the debtor into unnecessary default. To avoid having court rooms being swamped by frivolous default cases, I could imagine merchant law evolving a list of common media that must always be accepted in the settlement of those debts for which a settlement medium was not already specified. If the marketplace were to accept these laws, then legal tender rules would arise in the same way that VHS beat Beta—they provide a cheap and useful set of standards around which everyone can coordinate their plans and actions.

Naturally, all sorts of interested parties would lobby jurists to have that list include their preferred asset. Nevertheless, there seems to me to be a certain “market” logic to legal tender. The real barriers to monetary freedom are not legal tender laws, but laws that restrict the issuance of notes to a monopoly issuer, and laws that force private banks to join a monopoly clearing house. But that's a different post.

A history of the pound sterling's medium-of-account

Shillings issued during Queen Elizabeth's reign

There are plenty of rumours that Mark Carney will implement some sort of NGDP targeting regime when he arrives at Threadneedle Street. If so, this will mark the seventh medium-of-account used to define the pound sterling since the pound's establishment in the early part of the last millennium. This storied list of media-of-account includes silver, silver/gold, gold, the US dollar, the Deutsche Mark, CPI, and perhaps NGDP.

First, some definitions. The pound sterling is a unit-of-account. Think of it as a word, a unit, or a brand name. The unit-of-account is generally defined in terms of some other good. This other good is called the medium-of-account. Some quantity x of the medium-of-account equals the unit-of-account. (See this older discussion of the definition of the word medium-of-account.)

1. Silver

The pound's first medium-of-account was silver.  A pound sterling was defined as 5,400 grains of 92.5% fine silver. We don't use grain measurements much these days, but a grain was legally defined as the weight of a grain seed from the middle of an ear of barley. So whatever weight of silver equated to 5,400 grain seeds defined the pound sterling.

The pound's 5,400 grains of silver was subdivided into a smaller unit of account, the shilling. Twenty shillings made a pound, each shilling equal to 270 grains. Over the centuries, monarchs redefined the unit-of-account by increasing the amount of shillings in each pound. For instance, Henry V divided the pound unit into 30 shillings, not 20, while Henry VII increased the amount of shillings in a pound to 40. This allowed the monarchy to issue more shilling coins from the same 5,400 grains of silver. By Queen Elizabeth I's time, a shilling only had 93 grains of silver, down from 270 grains a few centuries before. This meant that instead of coining just 20 shillings from 5,400 grains of silver, Elizabeth could issue 62 shillings from that amount.

2. Silver & gold - bimetallism

Gold coins called "guineas" were issued in 1663. Each guinea containing 118.6 grains of pure gold. While the value of the guinea was allowed to float relative to silver, this policy changed in 1696 when the monarchy declared one guinea equal to 22 shillings. Since 5,400 grains of silver was defined as 62 shillings, and 22 shillings was now defined as 118.6 grains of gold, the shilling was now dually-defined. Enter bimetallism, a system in which both silver and gold were the medium-of-account. The dual definition would be slightly modified by Sir Isaac Newton so that a guinea equaled 21.5 shilling in 1698 an 21 shillings in 1717.

3. Gold

In 1816, the bimetallic standard officially ended. The pound continued to be defined in terms of a quantity of gold grains and silver grains, but silver was confined to serving as the medium-of-account on payments below two pounds. For all practical purposes, gold had taken over the task of serving as the pound's medium-of-account. From 1816 to 1931, the pound would be defined as 113 grains of pure gold.

4. US dollar

After going off the gold standard in 1931, the pound had no publicly-disclosed medium-of-account until 1940, when it was redefined as US$4.03. While the USD served faithfully as the pound's medium-of-account, the specific amount of USD used in this definition changed three times over the next decades. In 1949 the pound dropped to $2.80 and in 1967 to $2.40. After Nixon closed the gold window in 1971, the ensuing Smithsonian Agreement redefined the pound upwards to $2.6057. This definition would only last for a few months when in June 1972 it became impossible to defend that rate. The dollar ceased to be the pound's medium-of-account.

5. Deutsche mark

In October 1990, John Major entered the European Exchange Rate Mechanism by defining the pound as 2.95 deutsche marks. As a result, the deutsche mark was now the pound's medium-of-account. The Bank of England was allowed to let the pound diverge from this underlying definition by a band of +/-6.5%, but the pound fell out of this band in September 1992 due to massive speculation by the likes of George Soros.

6. CPI

Since September 1992, the pound unit-of-account has been defined in terms of the consumer price index (CPI). In short, the medium-of-account is now the CPI basket, and an ever-shrinking basket at that. For the first few years, the pound was defined such that it bought a basket that declined in size by 1-4% each year. After 1997, the rate of decline was made more precise, 2.5% each year. The Bank of England is held accountable should the pound-denominated liabilities it issues fail to fall in the line with the ever shrinking medium-of-account.

7. NGDP?

If a switch is made to NGDP targeting, then the pound's medium-of-account will be updated from a variably-sized CPI basket to a varying NGDP basket. A pound sterling will be equal to a trillionth (or so) of UK nominal output. One could do so even more formally by adopting an NGDP futures market. Here is Scott Sumner describing such a scheme as "analogous to a gold standard regime, but with NGDP futures contracts replacing a fixed weight of gold as the medium of account."

You'll notice there are plenty of large gaps in the above history where the pound had either no public definition or was undefined altogether. Perhaps it's not necessary to always have a medium-of-account. Changes in the medium-of-account tend to be acrimonious and attract intense public attention. The bimetallism debates defined the 1896 US election, as evinced by the famous cross of gold speech. The drive to adopt NGDP as a medium-of-account seems no less controversial, at least if the debate  in the blogosphere is any sign.

We'll miss that Mark Carney squint

Mirroring Nick Rowe, here are some quick comments on the departure of Mark Carney from the Bank of Canada to the Bank of England.

Canadian monetary policy is set via an ongoing conversation between the Prime Minister, his/her agent the Minister of Finance, and the Governor of the Bank of Canada. This joint conversation happens because unlike Japan, Europe, or the US, the Finance Minister has the legislated power to fire the Governor of the BoC before his/her term is up. The minister must provide a public (and potentially embarrassing) explanation for doing so. As a result both minister and governor are incentivized to cobble policy jointly.

So whatever policy we've had in Canada since 2008, you can be sure that there's a bit of PM Harper and Finance Minister Jim Flaherty mixed in with the Carney. Did we ever really know the man? With Carney leaving but the other two sticking around, will there be much of a difference going forward?

As for the UK, Carney's term at the BoE runs for five years, but as far as I can tell there seems to be no ability to remove him from power before then. Without this leash, Bank of England watchers will be more likely to see an unadulterated version of  Carney than we ever saw here in Canada.

Bimetallism redux

Isaac Newton, Master of the Mint

Miles Kimball's proposal for subordinating paper money to electronic money sounds to me a bit like abandoning bimetallism.

Beginning in 1717, Isaac Newton, Master of the Royal Mint, put England on a bimetallic standard. Under bimetallism, the pound sterling was defined as a fixed quantity of silver or gold. In other words, where before England's medium of account was a certain quantity of silver, the new medium of account was a certain quantity of both metals. The unit of account through all of this remained pounds. As the market prices of gold and silver varied due to technological advances and new discoveries, the fixed silver-to-gold ratio meant that one or the other would be undervalued relative to its actual market price. As a result, the entire nation's stock of circulating coin would either flip to gold (if gold was overvalued by the mint) or silver (if silver was overvalued). After all, why bring your silver to the Royal Mint in London when you might sell it for more overseas? The overvaluation of gold, which in England's case was accidental and not intended, quickly moved the nation from a mixed standard to a gold based monetary system.

Just as England once fixed the quantity of gold equal to a quantity of silver, the modern Bank of England declares a fixed relationship between a paper pound and an electronic deposit at the Bank. The relationship is 1:1. This fixed relationship causes significant problems at the zero-lower bound. Say interest rates on BoE deposits fall below zero. At this point, the entire nation's stock of circulating pounds will be converted into paper pounds. Why hold a -2% deposit when you can hold cash at 0%? Very quickly, England will have moved from a mixed deposit/currency standard to a straight paper currency standard. It's exactly like the old bimetallic flips of yore.

The way to solve the bimetallic switching problem was to periodically adjust the fixed ratio between gold and silver to approximate actual market rates. That way neither of metals would ever be undervalued and, as a result, England would have been able to stay on a mixed standard with both silver and gold coinage. Miles's proposal is very much the same. If you relax the 1:1 ratio between Bank of England deposits and Bank of England paper currency, then as rates fall you can prevent the flip to paper currency from happening. Say rate on deposits falls to -2%. The Bank can declare that paper currency is now only worth 0.98 of a deposit, nipping at the bud the incentive to switch into paper currency. With neither asset superior to the other, people will choose to hold the same mix of currency and deposits as before.

The other way to solve the switching problem was to simply get rid of bimetallism altogether. Define the pound in terms of only one metal and let the free market take care of dealings in the rest. This is Bill Woolsey's answer to the modern zero-lower problem (here and here). It's similar in nature to Miles's. Have the central bank cease all dealings in paper currency and define the pound only in terms of deposits at the BoE. Private banks will take over the business of issuing 0% paper money. When rates fall to zero, private banks will immediately contract their issues of outstanding paper currency to nothing since maintaining a stock of 0% liabilities when the assets that support them are also paying 0% is not profitable.

In either case, you can get below the zero-lower bound pretty easily. The long gone era of bimetallism isn't as dead as we think. Differentiating between currency and deposits is very much like differentiating between silver and gold.