Friday Links

Actually, this is a pretty good idea.

The new Archbishop of Canterbury wants to help not-for-profit credit unions put payday lenders out of business:

I said to him quite bluntly, ‘We’re not in the business of trying to legislate you out of existence, we’re trying to compete you out of existence’.

He’s a businessman, he took that well.

Test scores are bad at predicting performance at Google... but probably not for the reason you think:

Google likely doesn’t have much variability among those hired with respect to test scores and grades. And when there is no variability, there is no correlation with anything. [Furthermore,...] If someone is hired despite their lower test scores, it usually means some compelling compensating characteristics made that person look like a good bet. That is why the correlation between a valid selection instrument and job performance can be dramatically depressed when only looking at the hired sample.

Finally, here's a pinterest page that blurs the line between pop culture and fine art.

The Ascent of Money by Niall Ferguson

Money allows us to move value, especially the value of our labor and perishable products, across space and time. Banking allows us to move money across space and time. Bonds and stocks go beyond banks and allow us to finance longer term investments, an essential component of economic progress and wealth creation; of course, they also allow us to gamble with both our own and other people's money. Betting on the future is risky, which is why we have insurance markets; and few bets are as important for both financial health and living standards as betting on houses. All these components come into play in the global financial history Niall Ferguson weaves together in The Ascent of Money.

The book was written as the financial panic, housing bust, and global recession of 2008 were still snowballing. Ferguson offers a historical perspective on what he considers the key markets influencing the unfolding crisis. From the clay tablets of Mesopotamia to the silver mines of Cerro Rico to the international exchange machinations of George Soros, the book walks a sweeping path through thousands of years to the first few months of that fateful year.

The style of the book is, unsurprisingly, a bit rushed, but generally enjoyable. Ferguson freely bounces between the ludicrously anecdotal and the abstractly mathematical. Consider this passage, introducing the founders of the Scottish Minsters' Widows' Fund (now the insurance & pension fund Scottish Widows):

We tend to think of Scottish clergymen as the epitome of prudence and thrift, weighed down with an anticipation of impending divine retribution for every tiny transgression. In reality, Robert Wallace was a hard drinker as well as a mathematical prodigy, who loved to knock back claret with his bibulous buddies at the Rankenian Club, which met in  what used to be Ranken's Inn. Alexander Webster's nickname was Bonum Magnum; it was said to be 'hardly in the power of liquor to affect Dr. Webster's understanding or his limbs'. Yet no one was more sober when it came to calculations of life expectancy.

With my Presbyterian background, I had to chuckle; I'm like to think that Ferguson, himself a Scot, must have done so when he wrote it.

On the whole, I was quite pleased with the book. I actually assigned it as required reading for my money and banking students before I had finished it, and am looking forward to in-class discussion on it in a few weeks. On the other hand, I also learned that there is a 6-hour BBC miniseries version, so a number of students might not read it at all. I'm still undecided if that's a bad thing or not.

I recommend the book to anyone who wants a broad historical background to understanding either the recent recession or modern finance. There are other sources with more detail and more focus, and as I mentioned earlier, the flow suffers a bit from trying to release the book in medias res. But I get the sense that this is Ferguson doing what he does best, and he's quite good at it.

Why a Central Bank? Part 3: Modern Debates

This post was prompted by this review of Ron Paul's End the Fed and a subsequent online discussion. By virtue of my economics background, a friend asked me to chime in on why Ron Paul's solution to various economic problems should be discarded as easily as his opponents suggest. Parts 1 and 2 are here and here.

Having covered the background on what money does and how it does it, and followed that by looking at the long history of problems and attempted solutions to a well functioning monetary system in the US, we can consider Ron Paul's arguments. I have to admit up front that my knowledge of them is second hand; I have not read End the Fed for myself, although I have seen the list of consequences in the review and spoken to his supporters. As such, my responses below will be general, and I admit there is a margin of error. If any reader wishes to buy me a copy of the book, though, I promise to read it and respond in more detail (with a shout out to the purchaser as well).

What follows is the nine point list of consequences from ending the Fed mentioned in the review, with my own responses.

1. "It would bring an end to dollar depreciation." Not having read this sentence in context, I do not know whether this refers to the exchange rate between the dollar and other currencies or to problems of inflation. If the latter, then we have seen that eliminating the central bank does not guarantee the end of inflation, since matters of inflation and deflation then depend entirely on what controls money, whether it be commercial banks of the Congress or metallurgical market developments. Based on US history, eliminating the central bank would likely lead to an average deflation rather than average inflation, but this is at least as problematic as inflation and is more historically associated with recessions. If Paul means the former (exchange rate depreciation), then he is complaining about a problem that isn't even a problem. When the dollar deflates relative to other currencies, importing becomes expensive but we reap the gains of increased exports (as any seller on etsy can testify). What we need is a reliable trend in prices, whether it be up, down, or constant; there are many good substitutes for cash as a long-term store of value.

2. "It would take away from government the means to fund its endless wars." As we have seen, governments in general, and the US government historically, have never needed central banks to fund war debt. As long as the government has the Mint, they will have the power to fund wars, and as long as the government has guns, they will have the Mint. Actually, by putting a layer between the Congress and the ability to create money, a central bank actually reduces the capacity to fund endless wars, as long as the Bank is well managed. At its worst, though, a central bank fully accommodating the Congress acts as if no bank were intervening; we can't do much worse on this front than we have done in the Revolutionary War, War of 1812, and Civil War (both North and South) without any central bank. And in so far as expanding the money supply also funds the welfare state (a claim I would want empirical justification for, but it is plausible), what the Mint could do for war it could just as easily do for welfare.

3. It would "stop the business cycle." Given what we talked about last time, I think this requires little response. The complex reinterpretations of Murray Rothbard notwithstanding, I can't really see how anyone can look at the history of money and banking, especially US history, and not see that the business cycle is not at all caused by central banking. At its best, we have solid examples of well led banks, such as the second Bank or the Fed after Volcker's corrective measures, in which the bank greatly reduced the negative impact of the business cycle. It's true, a poorly run or politically associated central bank can make recessions worse, but that is an argument against crappy governance, not against governance itself.
 
4. It would "end inflation." I think I've basically covered this one under 1 above. Let me just reiterate that a predictable, low level of inflation is not actually a real problem in an economy, especially if the alternative is unstable deflation, as would almost certainly be the case in a growing economy with the gold standard. And while the ensuing political struggles could yield great literature like the next Wizard of Oz, I don't see how the economy would be improved by fighting to see who gets to control the monetary system.

5. It would "build prosperity for all Americans." I think we've seen through US history that the only way that the monetary system can help real prosperity is by being relatively stable and allowing citizens to reliably use money for its functions. A central bank that is well governed can do this, while a poorly governed central bank can hurt money's ability to function. Historically, turning over the monetary system to the whimsy of the Congress or the shifts in the gold market don't do much better than a poorly operated Fed could.

6. It would "end ... the corrupt collaboration between government and banks that virtually defines the operations of public policy in the post-meltdown era." We didn't talk about this much, but I think we're all aware that alliances between government and corrupt businessmen has always been a problem. Why Ron Paul thinks a central bank is needed to move money between the hands of businessmen, criminals, and politicians I have no idea. This is a great argument for making the central bank as independent of political and commercial influence as possible, but it is a poor argument for eliminating the Fed and directly turning over the power of printed money to politicians or businessmen.

7. It would "put the American banking system on solid financial footing" and "customers' deposits would be safer than they are today." Again, for banking systems to be solid and deposits to be safe, we need movements in prices to be steady enough that any changes can be written into contracts. If the ideal is constant prices, we need the amount of money in the economy to grow at the same rate as the rest of the economy, which is something gold can't accomplish. Only money that is designed to match output growth can do this effectively, which is after all why the US colonies started letting chartered banks print notes in the first place. What we need is reliable, good governance.

8. It would "end the way in which our electoral cycles have been corrupted by monetary manipulation." As mentioned in 6 above, criminals don't need a central bank to manipulate politics with their dollars. It's true that a poorly led central bank could make this worse, and there is some evidence of it at the Fed: in the 1970's, Arthur Burns seemed particularly susceptible to political pressure. But all this shows is that the man in charge matters, as Nixon himself demonstrated in a similar position. One wonders when Ron Paul's next book End the Presidency or a more pastoral End the Priesthood is coming out.

9. "The national wealth would no longer be hostage to the whims of a handful of appointed bureaucrats whose interests are equally divided between serving the banking cartel and serving the most powerful politicians in Washington." As I've mentioned a couple of times, this is a legitimate concern about how the Fed is managed. But why turning "the national wealth" over exclusively to the whims of either banking cartels, mining company managers, or powerful politicians makes things better.


As we've seen, the money supply will be governed by someone, one way or the other. The question is not whether to govern it, but who should be doing to governing. One of the brilliant results of having a central bank is that it can be managed by a Nicholas Biddle or a Paul Volcker, who resisted the powerful interests seeking control over the money supply. At their worst, central banks manage the money supply in the manner it would be managed if there were no central bank at all.

Given these constraints, and the fact that the president appoints the head of the Fed, I think we should be at least as concerned with who presidential candidates would appoint as Fed chairmen as we are with who they would appoint to the Supreme Court. But "ending the Fed" doesn't seem to really accomplish anything good, especially if you dislike politicians and businessmen having power over your life. In my view, the nature of money and the history of US banking speak out against eliminating the central bank in simpler, clearer language than even the eloquence of Ron Paul can counter.

Why a Central Bank? Part 2: Banking Experiments

This post was prompted by this review of Ron Paul's End the Fed and a subsequent online discussion. By virtue of my economics background, a friend asked me to chime in on why Ron Paul's solution to various economic problems should be discarded as easily as his opponents suggest. Part 1, in which I discuss the origins and nature of modern money, is here.

Now that we have an understanding of what central banks are about controlling, we need to see some history of  the problems banking systems have faced and how they've tried to solve them. To facilitate this discussion, I'm again drawing from Walton and Rockoff's History of the American Economy tenth edition.

Once colonial governments started issuing paper as a substitute for gold and silver (recall that Britain had extracted most of the gold from colonial circulation, making money transactions harder to manage), they found it hard to stop. This led to the market value, or the rate of exchange between colonial paper money and the metal money of Europe, differing substantially from the face value printed on the paper. This was no problem for either colonists or English merchants as long as transactions were based on the market value, ignoring face value. But colonial governments required all merchants in the colonies to accept the paper at face value; essentially, colonial legal tender laws cheated foreign merchants, because when they got back to England the paper would only exchange for the market value. Eventually the British government made it illegal for colonies to force private payments in paper at face value. The colonists were none too happy with these new rules, so (SPOILERS) they had a revolution.

(Yes, I know the Revolutionary War was precipitated by much, much more than not being allowed to cheat British merchants anymore. But that was a non-trivial part of it, despite its exclusion from the Bob Jones curriculum.)

In hindsight, not the best curriculum I've ever used.

Of course, paper money that is not backed by a commodity has its own problems, which the colonies discovered while using this system during the Revolutionary War (and subsequently during the War of 1912 and the Civil War). Even when paper money is issued but is not backed by a more trusted form of money, it still has a market value in terms of all other goods: we economists call them prices. When governments just print money to pay off debts, the market value of money falls, meaning prices of all goods have to go up; in other words, we have inflation. Inflation can be a problem since it affects money's ability to function as a store of value, since the market value is falling. Because money functions as the unit of account, lenders that don't account for inflation lose out, since they are paid back with money based on its face value rather than its market value.

If inflation is low and relatively constant, contracts and loans can easily be written to compensate for these issues. However, If inflation is very high and variable, then people won't want to use money as a store of value or unit of account, making it less desirable in exchange. In other words, money ceases to be money since people don't believe it's money anymore.

It's kinda like fairies in that way.















Similar problems occur when prices fall, too, which is called deflation. Actually, deflation can be even more costly than inflation because deflation tends to steal value from borrowers rather than lenders. Since borrowers tend to be poorer already, surprise deflation very quickly leads to failed businesses, foreclosed farms and homes, and general economic decline. Although not always the case, deflation is associated with slowed economic growth or recession since in order to function effectively as a medium of exchange, the money in circulation needs to grow at roughly the same rate as the real economic activity it is designed to facilitate. And because high deflation causes losses on the side of the poor, it can leads to economic panic and bank runs easier even than high inflation.

But I digress. After the Revolutionary War, the inflationary problems with paper convinced the US government to use a metal standard. Actually, they used a sort of double standard: gold was used for high-denomination money, while silver was used for low-denomination money. The US Mint decided to assign a face value exchange rate between gold and silver at 15 to 1, the prevailing market value at the time. But market values change, and it didn't take long for silver to be "overvalued" relative to its market price in gold (or alternatively, gold was "undervalued"). The face value / market value problem led to gold be exported to Europe, sold for silver, and the silver re-imported. In practical terms, then, the US system became a silver-only standard as the overvalued metal drove out the undervalued (a principle economists call Gresham's Law after a guy named Gresham).

At this stage, the individual states tried to help smooth out wrinkles in the monetary system by chartering corporations known as commercial banks with the power to issues their own notes (redeemable, of course, for gold or silver). It turned out that banks had a tendency to over-issue the notes, just as the colonial governments had, and it was somewhat risky to accept notes printed by banks on the other side of the state (the banks couldn't operate across state lines). Because of this, these commercial bank notes would usually have to be converted to local currency at a risk-compensating discount, which varied depending on distance, how well established the bank was, and so on.

Alexander Hamilton's solution to the problem of having a reliable medium of exchange was the first Bank of the United States. This one bank would regulate the face value of paper money, it would produce money that was easily and credibly exchangeable across state lines, and its strong-handed influence and ability to lend to banks that are temporarily short on deposits (the lender of last resort power) would help avoid major inflations, deflations, and bank panics. That, and by buying Treasury bonds when the government needed temporary funds (like in wartime) Hamilton hoped the Bank could prevent the government from just printing money.

The main objections to the bank were that (1) it wasn't in the constitution, (2) it threatened personal liberty, and (probably most importantly) (3) it benefited the North but not the agricultural South (and later the West). These objections didn't prevent George Washington, corporate stooge, from signing the first Bank's 20 year charter in 1791. The bank worked pretty much as Hamilton had envisioned, and the US economy functioned pretty well until the opposition finally won out by refusing to renew the charter in 1811. Then along came the War of 1812, and the government had no Bank to borrow money from. So what did it do?

Yeah, pretty much.















Deciding (after the fact, of course) that Politicians + Printing Presses = Bad News, Congress granted a 20 year charter to the second Bank of the United States in 1816. The second Bank decided to regularly present state banks with their notes in exchange for metal, which effectively reigned-in the banks' desire to over-print notes. The second Bank also acted more systematically as lender of last resort preventing several banking panics from building up.

Unfortunately, Andrew Jackson hated the Bank. Possibly because Jackson was a player-hater. He vetoed the Bank's charter renewal on the grounds that the Bank (A) was unconstitutional, and (B) was too influenced by foreigners and people from the north-east. The Bank, Jackson thought, helped the rich at the expense of the poor, as evidenced by the fact that interest rates were too high and inflation rates too low. Ironically, Wall Street helped Jackson oppose the Bank, because the Bank had been raining on Wall Street's parade. Inflation did rise near the end of the second Bank's charter (brought on by gold and silver inflow from Mexico, mostly), though. This, combined with new federal laws requiring payments for government lands be in gold, led to runs on the gold and silver reserves of the state banks. In the absence of a lender of last resort, this led to the depression of 1837, which lasted at least two years, and by some accounts until 1843.

The government maintained the bimetal standard until the Civil War, when both north and south quickly abandoned it in favor of unbacked paper to pay war debts. After the war, the government decided to return to a metal standard, this time just using gold. A few states experimented in free banking, meaning anyone who met some simple standards could start a bank; it worked well as long as the gold requirements for starting a bank fell into a narrow band, but worked more disastrously if the state required too much or too little of new banks. The gold standard led to a steady deflation from 1865 to 1896, but only a few years in the mid-1870s and early 1890s were recession years.

Of course, that didn't stop the poor, especially in the South and West, from favoring increased inflation through coining silver, which became a major issue in the Presidential election of 1896, between William "I like northern factories and my front porch" McKinley and William Jennings "You shall not crucify mankind upon a cross of gold" Bryan. You can read all about it in a little book called the Wonderful Wizard of Oz.

Front porch won.

At this point, you can begin to see some of the ups and down the monetary system in the US has taken. I apologize for the length of this post, but I think it's important to get the broad sweep of how money and banking worked pre-Federal Reserve. Next week we'll consider some of Ron Paul's claims as mentioned in the review, thinking about the claims in terms of our understanding of the nature of money and the history of the US monetary system.

Why A Central Bank? Part 1: Why Money?

This post was prompted by this review of Ron Paul's End the Fed and a subsequent online discussion. By virtue of my economics background, a friend asked me to chime in on why Ron Paul's solution to various economic problems should be discarded as easily as his opponents suggest.

In order to understand how a central bank affects the economy through its control of money, we first need to understand money itself. Therefore, this first post will explore the nature of money, as well as some historical facts regarding modern forms of it. Much of what follows builds on Walton and Rockoff's History of the American Economy tenth edition.

The first thing we need to realize about money is that money is not paper and coins; in the 1930s Germany had paper and coins that failed as money. It is not something that has "intrinsic value" (whatever that means); if anything has intrinsic value, it would be human lives, but using them as money is generally frowned upon. Money is also not "legal tender"; legal tender is just a nice label by governments to indicate what sorts of goods they'll help you try to use as money by getting Big Brother on anyone who disagrees about whether it's money.

Money is a good that provides certain functions to those in an economy who want to engage in trade. If you live by yourself, surrounded by no one, and you subsist on your own produce, then money doesn't mean anything to you. Money only becomes useful when you have something someone else wants, or they have something you want. That is, money functions as a medium of exchange. To get a sense of why people might use a good as a medium of exchange, consider an economy in which there are a several goods you might want.

Yes, like that. Now, suppose you want all of these, but all you have right now is the wheel of cheese. You've got plenty of cheese. More cheese than you could possibly want for yourself... as if that were possible. Maybe you'd be willing to give up some of your cheese if you could have some bread instead. You can then engage in a direct trade of one good for another, barter. Or rather, you could, if you could find someone with bread who would rather have cheese.

It turns out, you can't. You find a guy who would rather have a stylish hat than his bread, though. Problem is, you don't have a hat, you have cheese. Despite the best efforts of Wisconsin, cheese doesn't work well as a hat. What you're missing here is what we call a double coincidence of wants: for the trade to happen, you have to have what the other guy wants, and the other guy has to have what you want. Otherwise, no deal.

Now, you could try to get what the breadman wants--a hat. Now instead of looking for a market between bread and cheese, you need to look for a market between hats and cheese. Maybe you find a guy with a hat who wants beer. So you look for a market between beer and cheese. This continues until you find someone who wants your dang cheese, then you trade your way back to the guy with bread. It's like a convoluted video game.

In fact, in order to successfully barter, you need to be able to participate in a market for every combination of two goods. If there are 6 goods in the world, that's 15 different markets. If there were 100 goods (and of course there are a lot more than that), that's 4,950 separate markets!

It gets pretty ugly.









This is a pretty good description of early colonial America. Traders in furs, corn, cows, whiskey, and any other good tried to trade back and forth with everyone else. It got pretty annoying, especially since you had to travel from on buyer to the next, making the act of getting from cheese to bread quite costly.

For this reason, people started to convert goods into a common good, which would then be easily exchangeable for any other goods you could think of. One of the earliest monies used was polished beads called Wampum, although a number of other goods were used, especially (in Virginia and Maryland) tobacco. Everyone generally agreed that they would trade their goods for tobacco, thus making it the medium of exchange. Why did everyone agree to this? Paradoxically, because they believed they would be able to exchange it for any other good they wanted. That's right. Tobacco (and any other good, actually) became money because people believed it was money. And having money made life a lot easier.

But using tobacco as money presented problems, because money does more than just function as a medium of exchange. Because it is generally accepted in exchange, money also functions as a convenient unit of account, or numeraire in economics jargon, for representing the value of all other goods. You know how much a hat costs because you know how much money the seller wants to exchange for it.

Tobacco presented a problem here, because not all tobacco is created equal. And that's bad, because if you use a good for money that others use as the good itself, then what the money will buy is related to (but not necessarily the same as) what users of the good would trade for other goods. If the goods that function as money aren't all the same, this can cause serious trouble and confusion in trading (we'll come back to this at a later date). In order to use money as a unit of account, you need to be able either to easily differentiate the quality of the good or to only use a good which is standardized.

Tobacco also presents a third problem, because part of the reason you might sell a good for money is so that you can spend the money tomorrow. In this way, money acts as a store of value, particularly one that is easily and quickly converted into any other good you want. Goods used to store value that are better at being converted into other goods are said to be liquid: they flow easily. Money is as liquid as you can get, so tobacco (as money) should make a great liquid store of value. The problem is, tobacco goes bad after a while. It rots, or to use a more general term, it depreciates and loses value.

In order to find a good that would work well as a medium of exchange, unit of account, and store of value, the American colonies eventually came to accept the Spanish dollar, or "piece of eight" (so called because it was worth eight Spanish "bits"; that's where the phrase shave and a haircut... two bits comes from), as money. They chose Spanish over English money because the Spanish dollar was made of silver, while the British pound was made of gold, a metal in very short supply in the colonies (it's hard to have a medium exchange if no one has any to exchange).

However, because the British colonial system was essentially designed to extract precious metal-based currencies from its colonies, even the silver Spanish coins became difficult to come by. It was around this time that many colonial governments (and private citizens to some extent) decided to reinvent something previously created by the Chinese: paper notes that could be exchanged for money. Because these notes could supposedly be exchanged for money at any time, people began to use them in exchange instead of silver coins. They also held onto the notes as a store of value, and since the notes had numbers written on them indicating how much money the were worth, they were held as a store of value.

That's right, folks: paper money is an All-American invention.

Next week we'll look at some of the problems of this new paper money, as well as some of the attempts to solve these problems in the history of banking in the US.