Rudolph Havenstein, independent central banker during the Weimar inflation

Lars Christensen's excellent post about the necessity of having a monetary constitution includes an interesting point about central bank independence:

We want central banks to stop the ad hoc’ism. In fact we don’t even like independent central banks – as we don’t want to give them the opportunity to mess up things.

Central bank independence has become the standard approach to structuring the nexus between government service-provider and central bank liquidity-provider over the last fifty years. I think a degree of independence makes a lot of sense. Running a monopoly clearing house (which is really what a central bank is) while simultaneously operating other businesses and charities (which is what a government does) presents a tremendous conflict of interest.

For instance, imagine that General Electric was granted a monopoly to operate the U.S. clearing system. Wouldn't we worry that GE might use that clearing system to support its appliance or turbine manufacturing businesses? It might, for instance, require that those borrowing clearing balances submit GE securities as collateral but not those of GE's competitors, thereby giving GE an unfair financing advantage. Or why not have the clearing house give GE an interest free loan? Member banks can't leave the clearing house for another—it's a monopoly, after all—so there are no counterbalancing forces to discipline GE should it choose to abuse its clearing house duties.

A government is no less conflicted than GE in running a nation's monopoly clearing house. In recognition of this, we hive off central banks from government by establishing strict central bank acts and operating procedures.

But as Lars points out, we shouldn't make an idol out of central banking. Without a monetary constitution, independent central banks can screw up royally. The German Reichsbank from 1921-1923, which I wrote about in How To Stop a Hyperinflation, is a great example of this.

With prices rising at around 100% a year, Rudolph Havenstein, the President of the Reichsbank, was discounting bills at a mere five percent up until July 1922. By April 1923, Havenstein had increased the discount rate to 18%, and in September to 90%, yet by then prices were doubling every two days. Businessmen only had to take out a loan from the Reichsbank, buy and hold goods, stocks, gold, or US dollars, and when the loan was due, sell whatever had been bought for devalued reichsmarks in order to settle the loan. Even with the loan costing 90% per annum, returns on these assets were so many multiples higher that the profits on this trade were huge.

Havenstein and the board of the Reichsbank had adopted a theory that the mark was depreciating due to external circumstances. According to Laidler (1998), this theory went something like this. An adverse balance of payments (due in part to reparations requirements) was causing the reichsmark to fall in international markets. This resulted in higher local wages and prices, which created a shortage of money. The Reichsbank was only resolving the shortage by passively meeting the demand for credit. Conveniently, this theory absolved the bank's low interest rates of any responsibility for the inflation.

By the fall of 1923 Germans had had enough and voted in a government who promised monetary reform. But the government ran into a problem—they couldn't get control over Havenstein. Hjalmar Schacht notes in his autobiography Confessions of "The Old Wizard" that Havenstein was not on good terms with the government and despite indications that it wished Havenstein to retire, the Reichsbank President had resisted.

Havenstein was able to dig his heels in because in May 1922, the Reichsbank's Autonomy Law had come into effect. This law effectively enshrined the Reichsbank's independence from the government and installed Havenstein for life. Germans were effectively held hostage to a 66-year old independent central banker who refused to acknowledge his responsibility to raise interest rates in order to stop a hyperinflation. Its options limited, the government decided to try hacking around the Reichsbank by creating an entirely new currency, the rentenmark. Schacht was asked to run the bank that issued these notes, the Rentenbank. Liaquat Ahamed explains this unusual situation as it stood in mid-November:

Saddled with Von Havenstein, Stresemann had simply bypassed him by creating the independent Currency Commissionership outside of the Reichsbank [to manage the Rentenbank]. And so, when the new currency was introduced on November 15, 1923, Germany found itself in the curious position of having two official currencies—the old Reichsmark and the new Rentenmark—circulating side by side, issued by two uniquely parallel central banks. At one end of town was Schacht, operating from his converted broom closet; at the other, Von Havenstein, holed up and increasingly isolated and irrelevant in the Reichsbank’s imposing red sandstone building on Jagerstrasse. Although the Reichsbank had now stopped providing money to the government, its printing presses still continued to roll out trillions of Reichsmarks to private businesses. (Lords of Finance, Chapter 10)

As I wrote in my previous article, what stopped the reichsmark inflation cold by the end of November 1923 was not the debut of Schacht's rentenmarks on November 15 but an abrupt change in the Reichsbank's policy. This rapid reversal could only happen because of the sickness and sudden death of Havenstein on November 20th from a heart attack. Hjalmar Schacht immediately exerted his presence. He ceased the Reichsbank's acceptance of notgeld and tightened credit, thereby halting the mark's slide by the end of November, a week after Havenstein's death.

The point of this story is that independent central banking is not a panacea. Yes, it's probably a good idea to set limits in order to minimize the potential for conflicts of interest between government and the monopoly clearing house. But if an independent central banker is left to follow whatever ad hoc rule (or lack thereof), the consequences can be disastrous. A monetary constitution of the sort that Lars describes is one way to solve this problem. Even better is to open up the clearing house business to competition and choice. That way irresponsible central bankers can be disciplined by the same forces that discipline irresponsible grocers, farmers, salesman, and the rest of us great unwashed—just cease doing business with them.

Would Bernanke accept a trillion dollar platinum coin?

The idea behind the trillion dollar platinum coin goes something like this. According to law, President Obama is permitted to take an ounce of platinum, which is worth around $1,500 in the market, and mint it into a collector's coin that says $1 trillion on its face. Obama then heads off to the Federal Reserve and deposits the coin at face value, his $1,500 worth of platinum having been exchanged for $1 trillion worth of fresh Fed deposits.

What is being exploited here is the difference between a collector coin's intrinsic value and its legal tender face value. Anyone who has collected American Eagle's will be aware of this difference. On its face, an Eagle is worth $50. But the coin's intrinsic value due to its gold content is well over $1600.

Do Eagle's pass at their face value or at intrinsic value? Head on over to the US Mint and you'll see that the Mint is selling $50 Eagles at their intrinsic price of $1,900 or so. Coin dealer American Gold Exchange is hocking 1 oz Eagles for $1750.  Aren't the Mint and and American Gold Exchange breaking the law in selling coins so far from face value? Not really. Legal tender laws stipulate the sorts of payment media required in the discharge of debt obligations. In selling collectors coins in retail spot transactions, the Mint isn't engaged in the activity of discharging debts. Nor is American Gold Exchange.

Think about the implications of requiring coin dealers and the US Mint to sell Eagles at face value to all comers. Both would be providing the world with the a great risk-free arbitrage opportunity—and destroying their balance sheet in the process.

Here's another interesting anecdote about collector's coins circulating (or not) at face value. From 1997 to 2003 Robert Kahre, a resident of Las Vegas and owner of 6 construction companies, ran a scheme in which he paid wages with gold eagles at their legal tender face value. Rather than hiring someone for say $50,000 a year payable by check, Kahre paid with 45 ounces of  Eagles with a total face value of $2,250 or so. Their declared income of $2,250 was so low that Kahre's workers didn't have to report their income to the IRS. At the same time, Kahre saved on payroll tax. Win-win. Except for the IRS. In May 2003, Kahre's businesses were raided by the tax authorities. Kahre was at first acquitted in 2007, but in 2009 he was found guilty of tax evasion and sent to prison.

The implications of the Kahre case are that despite what's said on their face, collectors coins pass at intrinsic value in the US.

The ability, indeed requirement, to ignore a collector coin's face value when engaging in transactions with these coins is a matter of common-sense self-preservation. If private coin shops like American Gold Exchange, the US Mint, or the IRS were required to let eagles pass at face value they would all suffer tremendous losses. Likewise, if the market price of an ounce of gold fell to $2, those obliged to accept Eagles at their $50 face value would quickly go bankrupt. Face value on collectors coins is merely symbolic, not obligatory.

With the rest of the US already passing collector coins at their intrinsic value, why would Ben Bernanke be expected to accept a platinum collector coin worth $1,500 at its face value of $1 trillion? He has no obligation to do so. As I pointed out, legal tender refers to the types of media that can be used to discharge debts, and Bernanke is not indebted to Obama in any way. All he does is administer the Treasury's account at the Fed.

Nor can Bernanke choose to forgo self-preservation. Section 16.2 of the Federal Reserve Act obligates him to protect the Fed's balance sheet by stipulating the rules concerning Federal Reserve note collateralization. The Act requires that all notes must be backed by

collateral in amount equal to the sum of the Federal Reserve notes thus applied for and issued pursuant to such application... In no event shall such collateral security be less than the amount of Federal Reserve notes applied for.

This means that notes cannot be backed by an insufficient amount of collateral security. There is a long history behind section 16.2. I've discussed it before here and here. 16.2 has been liberalized over the decades. In the old days, only a small range of assets could stand as collateral, but now almost any asset can back the note issue. Nevertheless, the 16.2 requirement for sufficient quantity of security remains. If a collector coin's market value is only $1,500, then Section 16.2 presumably prevents Bernanke from depositing the coin in exchange for anything over $1,500 in Fed notes and deposits. Any larger amount of notes and deposits applied for and the coin fails the collateral test.

The case could be made that Bernanke would accept the trillion dollar coin if it were to represent a binding debt of the government to repay the $1 trillion loan. But in this form the coin is no more than a bond or promissory note. Instead of being written on paper, the promise is embossed on platinum. Bernanke can't directly accept government debt, no matter if its inscribed on platinum, paper, or a mere digital entry. He can only bring government debt onto his balance sheet after the market has already purchased it. These limits can be found in sections 13 and 14 of the act. Section 13, which governs the Fed's lending powers, does not give the Fed power to lend to the government, while section 14, which governs open market purchases, only allows the Fed to purchase government bonds on the open market.

Of course, we can speculate about the possibility of Bernanke accepting the trillion dollar coin until we turn blue. We only really know what he'd do when the time actually comes. Bernanke might accept the trillion dollar coin at face value, but he'd surely have both tradition and law on his side in questioning his obligation to do so. However, laws and conventions often bend and morph when circumstances dictate. The Bear Stearns transaction via Maiden Lane I and the AIG bailout via Maiden Lane II and III somehow went through, despite what would seem to be explicit warnings against such actions in the Federal Reserve Act. Until it gets minted, I've got to hand it to the Beowulf, the originator of the trillion dollar coin idea, in having created what seems to be the econ blogosphere's most influential idea of the New Year.

[Update: In the comments with Bill W., I mentioned another bit of legalese indicating that the Fed needn't accept coin from either the government or a member bank. See section 13.1 of the Federal Reserve Act: “Any Federal reserve bank may receive from any of its member banks, or other depository institutions, and from the United States, deposits of current funds in lawful money, national-bank notes, Federal reserve notes, or checks.”  More evidence that Bernanke can say no to a government deposit request. May≠must.]

The final draft on Fed-Treasury overdrafts

Marriner Eccles

There is an idea floating around on the internet that the US Treasury can finance itself indefinitely by borrowing directly from the Federal Reserve. All the President need do, goes the story, is order the Fed to credit the Treasury's account with fresh money, and voilà – the Treasury can spend willy-nilly. This is called the Treasury's overdraft facility.

In actuality, the above operations are impossible since the Treasury is legally prevented from borrowing directly from the Fed. The result is that the Treasury can only spend by ensuring that it has already obtained funding through the collection of taxes or the issuance of securities in the open market. The overdraft facility is a myth.

But this wasn't always the case. Marriner Eccles's March 1947 hearing before the House of Representative's Committee on Banking and Currency is a great source of US monetary history. In it we learn that from 1914 to 1935, the Federal Reserve had the power to lend directly to the Treasury by purchasing newly created government debt. This was called direct-purchase authority, and it amounted to a Treasury overdraft privilege with the Federal Reserve. This overdraft facility found legal expression in section 14(b) of the act, which permitted the Fed to "buy and sell, at home or abroad, bonds and notes of the United States, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months." The interpretation of this bit of legalese was that the Fed needn't limit purchases of government debt to the open market, it could buy directly from the government.

As I pointed out in an earlier post, section 16 of the Federal Reserve Act prohibited the Fed from using government securities as collateral for note backing until the passage of the first Glass Steagall Act in 1932. So even though the Fed could lend directly to the Treasury during this early period, its ability to do so was significantly crimped by the ineligibility of government bonds as backing.

We learn from the Eccles document that in 1935, the Federal Reserve Act was modified to prevent the Fed from making direct purchases of Treasury-issued securities. This was done by inserting a provision into section 14(b) of the Act requiring all purchases of government debt to be carried out in the open market. As a result, the overdraft privilege ceased to exist.

The overdraft facility was re-instituted in March 27, 1942, only a few months after the US entered World War II. The War Powers Act provided the Fed with the temporary authority to directly buy up to $5 billion of government securities from the Treasury. Specifically, the new wording of section 14(b) allowed the Fed to purchase

any bond, note, or other obligation which are obligations of the United States, or which are fully guaranteed by the United States as to principal and interest, may be bought and sold without regard to maturities either in the open market or directly from or to the United States, but all such purchases and sales shall be made in accordance with the provisions of section 12 (a) of this Act and the aggregate amount of such obligations acquired directly from the United States which is held at any one time by the 12 Reserve banks shall not exceed $5,000,000,000.

This was only a temporary power, which is why we find Fed Chairman Marriner Eccles visiting Congress in 1947. He was lobbying Washington to make the overdraft facility a permanent part of the Fed's arsenal. Eccles justified the overdraft by pointing out that it might save the taxpayer money. After all, overdrafts provided the Treasury with cheaper temporary funding than the open-market did. We know he was unsuccessful in his efforts to make the authority permanent, since this 2006 Government Accountability Office (GAO) document notes that:

Intermittently between 1942 and 1981, Treasury was able to directly sell (and purchase) certain short-term obligations to (and from) the Federal Reserve in exchange for cash. Congress first granted this cash draw authority temporarily in 1942, allowed it to lapse several times, and extended it 22 times until 1979, when it modified some of the terms and added controls.

We also learn from the GAO document that in 1981 Congress allowed the overdraft authority – referred to as "draw authority" – to permanently expire. Thus ended 39 years of Treasury overdrafts. The GAO report provides some interesting statistics on this period. Between 1942 and 1981, the Federal Reserve held Treasury certificates purchased directly from the Treasury on just 228 days, mostly during times of war. So while overdrafts were permitted, they weren't used often, and not for long periods of time. The largest amount  of certificates issued by the Treasury to the Fed on a single day was $2.6 billion in 1979. By 1979, $2.6 billion didn't amount to much, but in 1942, with the Fed's liabilities amounting to $25 billion, an extension of a $5 billion overdraft would have dramatically increased the Fed's balance sheet.

Below is a handy chart I've pinched from the GAO report which illustrates the use of the overdraft facility over time.

Note the large interwar gaps when draw authority was never used.

Section 14(b) of the modern Federal Reserve Act, amended in 1981, includes a strict "open market" provision that limits Fed purchases to "any bonds, notes, or other obligations which are direct obligations of the United States or which are fully guaranteed by the United States as to the principal and interest may be bought and sold without regard to maturities but only in the open market". This change is indicative of the broader trend to independent central banking. In a 1978 subcomittee meeting on the Fed's draw authority, Congressman George Hansen expressed this sentiment quite well:

This authority is a leftover from the days of explicit Fed support for Treasury financing, when monetary policy was clearly subordinated to the Treasury's aim of cheap deficit financing. I hope we are all agreed that monetary policy should not be thus subordinated, and that we can do without the mechanisms through which the Treasury called the shots for Federal Reserve open market operations.

And that's where we are today. The Treasury can't finance itself directly via the Fed. Yes, there may be indirect routes, but that's another post. Anyone who operates under the assumption that the direct route exists are assuming a monetary structure that became extinct in 1981.

Corporations are currency issuers, governments are not

Corporate stock: a perpetually inconvertible currency

In this post I play around with the distinction between a currency user and a currency issuer.

Modern Monetary Theory (MMT) draws a line between currency issuer and currency user. Households and businesses are currency users. They can "run out of money" and become insolvent. Central banks, on the other hand, are currency issuers. Issuers can never run out of money and, as such, face no solvency constraint. As long as the government is not legally separated from the nation's central bank, it too enjoys the benefits of being a currency issuer. After all, the government can always have the central bank issue liabilities to pay for all governmental obligations. The only constraint on a currency issuer is inflation, not solvency. For if a central bank's liabilities inflate to worthlessness, they can no longer be used to meet either the government's or the central bank's obligations.

While MMT associates currency issuance with the state and currency use with the private sector, this needn't be the case. Private businesses can be thought of as currency issuers facing an inflation constraint, whereas governments are almost always currency users facing a solvency constraint.

My translation of these MMT ideas is that the key to escaping the solvency constraint is this: can the institution under consideration issue perpetual inconvertible liabilities? If so, the institution can never become insolvent and qualifies as a currency issuer. The beauty of perpetually inconvertible liabilities is that they never expire, nor can their holder take the initiative and force the issuer to redeem them for some underlying asset. Lacking any revenues whatsoever, an institution can function indefinitely as long as its perpetually inconvertible liabilities have some positive value and can be sold to obtain resources. If these liabilities inflate to nothing, the issuer loses its ability to function.

Consider central banks first. Say that a central bank issues perpetual liabilities convertible into gold. This central bank is not a currency issuer, for if the gold is not forthcoming, the central bank will be rendered insolvent. Modern central banks, on the other hand, are safe from the solvency constraint because they no longer issue perpetual liabilities convertible into gold. Rather, modern central bank liabilities are inconvertible. The central bank can simply spend these liabilities into the economy, thereby financing its continued existence. Only when these liabilities are worth zero will the bank have breathed its last.

Modern corporation can also issue perpetual inconvertible liabilities. This is called equity. Much like a central bank, modern corporations face no solvency constraint because they can always meet their obligations with new equity issuance. Only when a corporation's equity has inflated away to nothing i.e. the price of the stock they issue is worth zero, have corporations finally hit the wall. Fledgling companies with no revenues and large expenses can function for many years by constantly issuing perpetual inconvertible equity.

Unlike businesses, individuals can't issue equity in themselves. Society has rendered it taboo to alienate shares in one's self, even if this is done in a voluntary manner. People can only issue personal IOUs that must be paid back at some point in time, or debt. Because individuals can't issue perpetual inconvertible liabilities they face a solvency constraint and therefore qualify as currency users.

Modern governments are very much like individuals. They can't issue equity. Nor can modern governments rely on their central bank to meet governmental obligations. The practice of independent central banking puts a strict divide between state and central bank, rendering it illegal for the central bank to use its perpetual inconvertible liabilities to finance the government and shelter it from the solvency constraint.

In sum, the line between a user facing a solvency constraint and an issuer facing an inflation constraint is defined by the ability to "print" perpetual inconvertible liabilities. Both corporations and modern central banks have the ability to issue these instruments and therefore face only an inflation constraint. Governments and households, on the other hand, are prohibited from issuing these instruments and therefore qualify as currency users that face solvency constraints.

$42.22: Not quite the meaning of life, but a number worth remembering

One of the more archaic features of the US monetary system is that the price of gold continues to be set at $42.22. Ever wondered why that is? This post will work through some monetary history to show why, unlike most countries, the US doesn't mark the gold price to the market price of $1750 or so. I'll give a quick hint. Marking the gold price to market wouldn't be a mere cosmetic change—rather, it would require the Federal Reserve to hand over hundreds of billions of free money to the President. Here's how it all works.

The Fed currently holds 261 million ounces of gold. At the archaic price of $42/oz, this stash is valued at a mere $11 billion. With modern day gold trading at $1750, the market value of 261 million oz is actually $457 billion. Doesn't that mean that the Fed would show a huge mark-to-market gain if gold were revalued?

No. If you read the fine print, the Fed doesn't actually own gold ounces. Rather, it owns gold certificates that have been issued to it by the Treasury. There is a long history behind this. At the end of 1933, the Fed owned some 195 million ounces comprised entirely of physical gold. Valued at the then official price of $20.67, this stash would have been worth around $4 billion. The Gold Reserve Act, passed on January 30, 1934, required the Fed to transfer all of this gold to the Treasury in return for $4 billion worth of gold certificates.

Here's the kicker. Unlike most gold certificates, the ones issued by the Treasury to the Fed were not payable in a fixed quantity of physical gold. Rather, a $10,000 gold certificates simply promised to pay to the bearer $10,000 worth of gold.

Let's trace what happened the very next day. On January 31, 1934 the official price of gold was increased by the authorities from $20.67 to $35 per ounce. The Fed's certificates, which the day before had provided a claim to $4 billion worth of gold held at the Treasury, still provided the same $4 billion claim. But with gold having been revalued, $4 billion worth of gold certificates was now the equivalent of a mere 115 million ounces, far less than the day before when these same certificates could lay claim to 195 million ounces.

So by tweaking the gold price, the Treasury had "transferred" itself some 80 million ounces (195m less 115m) from the Fed. Valued at $35/oz, this 80m oz amounted to $2.8 billion. Using its newly-acquired 80 million ounces as collateral, the Treasury printed up fresh gold certificates, brought these certificates to the Fed, and had the Fed issue it $2.8 billion in newly printed currency.

Back in 1934, $2.8 billion was a lot of money. The Treasury would go on to use these funds to create the Exchange Stabilization Fund (ESF), a reserve fund that the Treasury uses to this day to circumvent congressional oversight over spending.

Let's zoom forward in time. The US revalued gold from $35 to $38 in May 1972, and again in February 1973 to $42.22. This is the price which stands today.

Just as in 1934, the benefits of a modern revaluation would accrue entirely to the Treasury. At the official price of $42.22, the Fed’s $11 billion worth of gold certificates currently lay claim to 261 million ounces of gold ($11b divided by $42.22). Say the official gold price was increased to $1750. The Fed’s certificates would still be worth $11 billion in gold, but these certificates would now represent a claim on a measly 6.3 million ounces of gold, far less than the current 261 million ounces.

After our hypothetical revaluation, around 255 million ounces (261m less 6.3m) sitting in Treasury vaults would be free and unencumbered. The Treasury might choose to just sit on its new treasure trove. But most likely it would proceed directly to the Fed without passing go, deposit $450 billion worth of gold certificates (255m oz. x $1750), and receive in return a massive $450 billion stash of Federal Reserve notes or deposits.

This odd result has created what I think is one of the more amusing equilibriums in monetary politics. Hard money types would like nothing more than to see their favorite asset, gold, revalued. But they don't actively pursue the idea because of the expansionary effects a revaluation would have on the Fed's balance sheet. Easy money types would like nothing more than to see the government get billions in free cash, but don't like the idea of the barbaric metal getting a leg up. The upshot is that gold stays valued at its archaic price of $42.22.

The always tedious US debt ceiling season is upon us, so don't expect this blog to be the only one to point to gold revaluation or other various loopholes as a way to hack the limit. The folks at MMR, I see, have come up with an odd trillion dollar platinum coin idea. In any case, by drawing attention to either of these loopholes don't assume that I'm recommending them.

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.