Monday, June 29, 2020

Is fiat money to blame for the Iraq war, police brutality, and the war on drugs?

I often encounter memes claiming that fiat money is to blame for all sorts of government evils. Here is one example from Kraken bitcoin strategist spokesperson & bitcoin meme factory Pierre Rochard:

The rough idea behind this family of memes is that the Federal Reserve, the world's largest producer of "fiat" money (i.e. irredeemable banknotes), is responsible for financing all sorts of examples of government over-reach, say foreign invasions, police brutality, and the twin wars on terrorism and drugs. It does so by producing seigniorage, or profit, which it passes on to the state. Replace fiat-issuing central banks like the Fed with bitcoin or a gold standard, and seigniorage would cease to exist. With the government's purse strings having been cut, a relatively peaceful society would be the result.

This meme's premise is wrong. In practice, central bank seigniorage in both the U.S. and other developed nations is a very small part of overall  government revenues. And so even if fiat money were to be displaced, say by bitcoin or a gold standard, it wouldn't change the state's ability to fund the war on drugs and adventures in the Middle East.

Let's look at the U.S. Below are two charts showing how much income the Federal Reserve has contributed to the Federal government's overall receipts going back to 1950. (Beware. One chart relies on a regular axis, another a logarithmic axis. But they use the same data). The Fed's contribution has been steadily growing over time. In 2019, it sent about $53 billion to the Federal government.

You may be wondering how the Fed generated $53 billion in profit, or seigniorage, in 2019. Most of this income comes from issuing banknotes, or cash. For each $1 in banknotes that it issues to the public, the Fed holds an associated $1 of bonds in its vault. These bond have typically yielded 3-4% in interest. But the Fed only pays 0% interest to the owners of its banknotes. Which means that it gets to keep the entire 3-4% flow of bond interest for itself. It forwards this income to the Federal government at the end of the year.*

Seigniorage tends to grow over time. (But not always. Below I'll show how Sweden's seigniorage has been shrinking). The larger the quantity of banknotes that the public wants to own, the more interest-yielding bonds the Fed gets to hold, which means more seigniorage. In general, banknote demand increases with economic and population growth.

Interest rates are another big driver of seigniorage. If bond interest rates rise from 4% to 8%, the Fed earns more on the bonds it owns in its vault. Banknotes continue to yield 0% throughout, so the Fed keeps the entire windfall for itself (and ultimately for the Federal government).

By the way, a big driver of nominal interest rates is inflation. If inflation is expected to double, then bond owners will require twice the interest to compensate them for inflation risk. So inflation boosts seigniorage (because it boosts the interest rate that the Fed earns on the bonds in its vaults), and deflation hurts seigniorage (because it reduces interest rates). In the chart above, the one with the logarithmic axis, you can see how the Fed's seigniorage increased during the inflationary 1970s. It flatlined from the mid-1980s to the early early 2000s, which coincides with inflation subsiding.

US seigniorage is relatively small. In addition to enjoying revenues from the Federal Reserve, the U.S. Federal government also gets money from individual and corporate income taxes, social insurance and retirement receipts, excise taxes, duties, and more. Below I've charted the relative sizes of these contributions.

As you can see, the Fed's contribution (the grey line) is a rounding error.

Below is a chart showing what percentage of total government revenue is derived from the Fed.

In 2019 the Fed contributed just 1.5% of total U.S. Federal government receipts. This contribution has hovered between 1% to 3% over the last four decades. So the meme that fiat money abetted the Iraq War, the expansion of the police state, or the U.S.'s military industrial complex is mostly hyperbole.

What about other developed nations?

The Bank of Canada provided $1.2 billion in earnings to the Canadian Federal government in 2018. But the Federal government took in $313 billion in revenues that year, which means that the Bank contributed a tiny 0.4% fraction of total revenues. The reason for the big gap between the Bank of Canada's tiny 0.4% contribution and the Fed's 1.5% contribution is the global popularity of the US$100 bill. Canadian cash doesn't enjoy a big foreign market.

I mentioned Sweden earlier. Below is a chart of seigniorage earned by the Swedish central bank, the Riksbank.

Sweden is one of the only countries in the world where banknote ownership has been falling. This de-cashification is compounded by interest rates that have fallen close to 0%. Which means that the Riksbank's bond portfolio isn't earning as much as it used to. This combination has just decimated the Riksbank's seigniorage. In 2018 its seigniorage amounted to a paltry SEK 267 million (US$29 million). This is just 0.00003% of all Swedish central government receipts.

So in sum, central banks in places like the US, Canada, and Sweden are not a big source of government funding. If you want to stop governments from engaging in bad policies like the war on terror, the war on drugs, and foreign meddling, you've got to work within the system. Vote, send letters, go to protests. Sorry, but buying bitcoin or gold in the hope that it somehow defunds these activities by displacing the Fed is not a legitimate form of protest. It's a cop-out.

P.S. By the way, I am not saying that control of the nation's money supply hasn't been used to finance wars in the past. Obviously it has. Greenbacks helped pay for the Union's war against the Confederates. Henry VIII paid for his wars by dramatically reducing the supply of silver in the English coinage.

*The Fed enjoyed a big spike in seigniorage after the 2008 credit crisis. This is because it issued a bunch of deposits to bank (known as reserves) via quantitative easing. The Fed only had to pay 0.25% interest on these reserves, but the bonds that backed them were earning 2-3%. This QE-related income has declined as the Fed has unwound QE (since reversed) and long-term interest rates have declined.

Wednesday, June 24, 2020

Banks are slow to increase rates on savings accounts, but quick to reduce them

Chase Sunset & Vine, 2012. Painting by Alex Schaefer

There is a fundamental asymmetry to banking. Banks don't like to share higher interest rates with their customers who have checking and savings accounts. But they are quick to pass off lower interest rates to us.

This asymmetry is good for bank shareholders, but bad for customers.

To illustrate this asymmetry, I'll start by showing how banks modified interest rates on savings and checking accounts as the Federal Reserve, the U.S.'s central bank, went through a long period of hiking interest rates from 2015 to 2019.

The Federal Reserve's first rate increase (from 0.25% to 0.5%) was in December 2015. It increased rates once more in 2016 and three times in 2017. But the interest rate on the average U.S. savings account and interest checking account didn't start to rise till spring 2018, two and a half years after the Fed's first rate hike.

This irked me and I tweeted about it over a year ago:

If you're like me, you'd assume some sort of direct linkage between: 1) the interest rate that the Federal Reserve pays its customers (i.e. banks) and 2) the rate that these same banks pay their customers, you and me. Just like we have a checking account at a bank, banks maintain checking accounts at the Federal Reserve. They earn interest on balances held in those accounts. This rate is known as the Fed's interest rate on reserves, or IOR. As the Fed increases the interest rate that it pays on these checking accounts, the banks earn more from the Fed. But for some reason the banks are slow in passing these earnings on to the public.

Although the delay in pass-through irked me, I didn't take it too seriously, figuring it was due to some sort of institutional inertia. Banks are slow monolithic beasts. If they're slow to increase rates, at least they're slow to chop them, too, right? So on net, we customers aren't any worse off over the full economic cycle.
But if banks are slow to increase rates, is it indeed the case that they are also slow to reduce rates? Well, the results are in. The Fed began to cut rates in mid-2019, just around the time of my initial tweet. There were another few cuts in the latter half of 2019. Then COVID-19 hit in March, and the Fed rapidly ratcheted the rate it pay banks down from 1.6% to 0.1%. Banks went from earning around $38 billion in interest on their checking accounts at the Fed (in fiscal year 2018) to almost nothing.

If banks are generally lethargically about passing on rate changes to their customers, it should have taken them three or four years to reduce rates on savings and checking accounts back to where they had started. Nope. In just a month or two, the banks obliterated all the interest rate gains that customers with savings account had enjoyed since 2018:

So no, banks aren't lethargic beasts that are universally slow to change interest rates enjoyed by savers. They seem to have a strategy of increasing rates slowly, and then reducing them rapidly. Assholes.

Note that the savings rate I am using is from the Federal Deposit Insurance Corporation's website. FDIC takes the simple average of rates paid by all insured depository institutions and branches for which data are available.

By the way, this data probably doesn't represent the experience of the minority of financial sticklers who make an effort to locate high-interest rate savings accounts at online-only banks. JP Morgan's Goldman Sachs's Marcus currently offers 1.03%, much higher than the 0.10% that the Fed pays to Goldman JP Morgan. Ally offers 1.10%. But the average savings account holder doesn't bank at these institutions. They stick to Bank of America or Wells Fargo, which both offer a measly 0.01%.

This asymmetry is not a new phenomenon. In "Sticky Deposits", Federal Reserve economists John Driscoll & Ruth Judson found that rates are "downwards-flexible and upwards-sticky."

More specifically, the authors used proprietary data from 1997 to 2007 to show that interest rates on bank accounts and other retail deposits adjust about twice as frequently during periods of falling Fed interest rates as they do in rising ones. They estimate that this sluggish pass-through from rising Fed rates to customer rates costs American consumers around $100 billion per year!

My favorite chart from Driscoll & Judson is below:

Source: Judson & Driscoll

At left, we see the number of weeks it takes for banks to decrease the rate on interest checking accounts in response to a cut in the Fed's interest rate. At right we see the converse, how long it takes increase rates in response to higher Fed rates. Decreases tend to happen quickly (the purple bars in the left chart congregate closer to zero weeks) whereas increases are slow (the purple bars in the right chart congregate close to 100 weeks).

More specifically, during Fed easing cycles, checking deposit rates are updated on average every 22 weeks, but during tightening cycles it takes an average of 50 weeks.

So what explains this asymmetry? A lack of competition perhaps? If I had to guess, I'd say low financial education and dearth of customer attention. Banks can afford to be assholes because most customers either don't understand what is happening, or don't notice.

If the banks are taking advantage of their customers' ignorance and inattention to the tune of $100 billion per year, should something be done?

One option would be to provide a government savings option that 'corrects' for this asymmetry. Like digital savings bonds. Or maybe a government prepaid debit card with a built-in savings account. These cards would offer an interest rate that is linked to the Federal Reserve's interest rate, but only available to those below a certain income ceiling.

Or what about setting statutory minimum interest rates on savings accounts? In Brazil, for instance, banks are obligated to link the rate they pay on savings accounts to the central bank's interest rate:

Or maybe it starts with education. As part of its new financial literacy drive, Ontario will teach children how to identify Canadian coins and bills and compare their values in Grade 1, saving and spending from Grade 4, how to budget starting in Grade 5, and financial planning starting in Grade 6. If the result is a more savvy population, banks may face more pressure to pass on higher interest rates.

Or maybe nothing. In which case one hopes that over time the combination of better financial technology, branchless banking, and competition from Silicon Valley will eventually result in better pass-through and more symmetry in interest rates.

Friday, June 5, 2020

Want to open an account at the central bank? I'll pass, thanks

The only type of central bank-issued money that we hoi polloi can own are banknotes. But over the last few years, researchers at central banks have been increasingly toying with the idea of issuing digital money for public consumption. I count 380,000 search results on Google for the term "central bank digital currency," up from zero just a few years ago.

There are two types of proposed central bank digital currencies, or CBDCs. The first, Fedcoin, is implemented on a blockchain. I wrote about it here. But the odds of Fedcoin happening are minuscule. This post will be about the second type.

The second is a basic bank account, sort of like PayPal except run by a central bank like the Federal Reserve (or the European Central Bank or the Bank of England.) Just like you go to PayPal's website to register for an account, you'd head over to the Fed's website to open an account. A Fed version of PayPal would let you pay your friends, accept donations and business income, and buy stuff at stores. Except you'd be using Fed money, not PayPal money.

I'm not philosophically or ideologically opposed to the idea of a Fed PayPal. If the Fed (or any other central bank) wants to get into providing payments services to regular folks, fine. The same goes for Walmart. If it wants to start providing retail bank accounts, great. Ditto for Facebook. I think Libra is an admirable project. Oh, and I also want more co-operative banks and credit unions. What about community currencies? By all means, let's get more alternative systems like Ithaca Hours and the Bristol Pound up and running. And while were at it, commercial banks, credit unions, and municipalities should be allowed to issue banknotes. Heck, why not a Nike banknote?

In short, the more payments options people have, the better. (My one caveat: If a central bank is going to introduce a central bank version of PayPal, it should be obligated to recover its costs. FedPal shouldn't have an advantage over regular PayPal, the Michigan First Credit Union, or a commercial bank like Wells Fargo.*)

All that being said, I'm not terribly optimistic about the prospects for a central bank version of PayPal.

With paper money, central banks already have an incredibly popular product. Banknotes are anonymous. People can use them for activities that might be frowned on, and this is a pretty big market. Bills have another nice property; they are ungated. Anyone can accept a dollar without needing to open an account. This accessibility has made paper dollars, which can move fluidly across borders, wildly popular in nations with poorly functioning banking and monetary systems. Most importantly, central banks have a monopoly on the business of issuing cash. So they don't have to worry about competition.

But the success of central banks' cash line of business won't translate into success for a central bank version of PayPal. Given the current state of anti-money laundering regulations, we probably wouldn't be able to open a Fed PayPal account anonymously. Furthermore, it's unlikely that the Fed, or any other central bank for that matter, would open up eligibility to non-citizens living in foreign countries.

So forget about catering to the huge market of anonymity seekers and foreigners who would love to hold a U.S. dollar account directly at the Fed. FedPal would probably be a US-only product. (Likewise, the Riksbank's e-krona would be a Sweden-only product).

But this is a crowded field. Whereas cash is a government-run monopoly, thousands of competitors offer digital payments accounts. Can the central bank differentiate itself from a slew of other digital account options? I'm skeptical.

1. Features?

You've gotta keep in mind that CBDC is a brainchild of macroeconomic theoreticians, not product designers. Macroeconomists don't have any expertise in designing retail banking products. And so I'm not terribly bullish on the Fed or the Bank of England coming up with new features that would differentiate a central bank account from any other payments accounts.

2. Safety?

Not really. In the U.S. (as in most developed countries), bank accounts and prepaid debit cards are already insured up to $250,000. For most regular folks, dollars held at the Fed won't be any safer than those held in banks.

3. Fees?

The Fed might try to offer a low-fee option, perhaps to the unbanked or the underbanked. But in the U.S., this is getting to be a crowded field. Chime, Varo, Ally, and Simple offer no-monthly fee accounts. There are plenty of no-fee prepaid debit cards out there, too. Just last week, I spotlighted the PODERcard, which is marketed to unbanked immigrants.

The public sector is already active in this field, too. The Federal government already offers a no-fee prepaid debit card, the Direct Express card, to over 60 million Americans who receive Federal benefits. And state governments often provide no-fee debit cards for tax refunds, unemployment, and other state benefits. It's hard to see what a CBDC can bring to the table.

4. Higher interest rates?

Might a CBDC be able to offer higher interest rates than the competition? A few commentators have suggested that a Fed version of PayPal offer regular Americans the same interest rate that the Fed pays large banks that keep accounts at the Fed. Banks maintain accounts at the Fed so that they can make interbank payments and meet reserve requirements.

In the chart below, the Fed pays banks the blue line, interest rate on reserves. This rate has historically been far higher than the two red lines in the chart: the average rate that banks pay customers on a checking or savings account. (For its part, PayPal pays its customers 0%).

Were the Fed to pay FedPal account holders the blue line, i.e. the same interest rate it pays banks, this would effectively convert a FedPal account into an incredibly high-yield checking account. No doubt it would become a wildly popular product.

But serving millions of retail customers is a lot more expensive than serving a couple of hundred banks. Think customer help lines, fraud prevention, advertising, paper check processing, ATM network fees, and more. As I stipulated at the outset, FedPal shouldn't be allowed to operate at a loss. This would be unfair to the thousands of community banks, credit unions, fintechs, and commercial banks that are trying their hardest to provide payment services to the public.

To recover its costs of serving a retail customer base, the Fed would have no choice but reduce the interest rate it offers. How low would it go? As a monopoly, the Fed is unused to the rigors of competition. I wouldn't expect it to be able to run a tight enough ship that it could afford to pay customers an especially high interest rate.

5. Speed?

Nope. With the introduction of Zelle, it's possible for Americans to make free instant payments, 24/7. Many other nations (like Sweden) also have real-time payments. We've got it here in Canada, too.


So central bank version of PayPal would be just another middling bank account. Sure, roll it out. But don't expect it to change the world. 

Funny enough, central bank macroeconomists are worried about the opposite: that CBDC could change everything. In the papers they write on the topic, macroeconomists fret that any CBDC they introduce will be so attractive that consumers will rapidly desert their regular bank and open an account at the central bank. This would cause the whole banking system to implode.Without a stable base of deposits, banks would be unable do any lending.

In my view, the real threat is the opposite. Given the institutional constraints I listed above, a central bank version of PayPal is destined to be a middling payments product. But it gets worse. Because central bankers are so worried about the macroeconomic effects that a FedPal will have on the economy, they will inevitably underdesign these accounts, turning a middling product into a crappy one. Adoption will never occur, and so FedPal will be wound down. This failure will go on to undermine the reputations of central banks.

The lesson is, either do a stellar job designing these things... or don't do it at all.

* If the U.S. government is going to get more actively involved in offering low cost payments services to the public, there's a better way to get there than starting up a new CBDC-based system from scratch. Just offer government-sponsored prepaid debit cards. 
The neat thing is, it already does this. Millions of Americans who receive Federal benefit payments like social security already use the Direct Express card, a no-fee debit card issued by the government in partnership with Comerica. And to help disburse coronavirus relief payments, the government recently issued millions of EIP card, a no-fee prepaid debit card in partnership with Metabank. As I suggested here, why not make these cards better by letting card owners send/receive real-time payments via Zelle, attaching a savings account to the card, and giving users the in-app option of buying Treasury savings bonds.

In a recent article for the Sound Money Project, I suggested that the IRS start issuing debit cards too.