Abstract
This chapter surveys how government policy decisions have influenced the evolution of the financial system that monetary policy seeks to influence, and how major economists have formulated theories to frame policy analysis. It concludes with some possible alternative scenarios for the design of the financial system and the policy appropriate to their influence.
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Notes
- 1.
To “normalise monetary policy … means a tightening of financing conditions by raising key interest rates, among other things. Central banks are shifting from unconventional monetary policy measures towards conventional interest rate policy. The steps to tighten monetary policy are therefore visible as an increase in the general level of interest rates.” “What is monetary policy normalization,” Bank of Finland Bulletin, https://www.bofbulletin.fi/en/2022/3/what-is-monetary-policy-normalisation/.
- 2.
“Having behind us the producing masses of this nation and the world, supported by the commercial interests, the laboring interests, and the toilers everywhere, we will answer their demand for a gold standard by saying to them: You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold” (Bryan, 1897, 199–206).
- 3.
Luigi Einaudi noted that this problem had already been solved by Ferdinando Galiani in his 1750 Della Moneta by proposing that one could opt out of the officially fixed gold-sterling rate (Einaudi, 1937).
- 4.
“Mony is an artificial Thing or rather No Thing … but Is rather ye Sign of a Thing. For If men were excellently Versed in accompts Mony were not necessary at all and many places as Barbados &c have made shift without it & and so they do in Banks” (Matsukawa 1977, 33–50).
- 5.
In his “Proposals for an Economical and Secure Currency Ricardo noted the existence of payments […] made by checks on bankers; by means of which money is merely written off one account and added to another, and that to the amount of millions daily, with few or no bank notes or coin passing” (Ricardo, 1816, 58).
- 6.
“Considerable economy of the precious metals arises, as we have seen, from passing about pieces of paper representing gold coin, instead of the coin itself. But a far more potent source of economy is what we may call the Cheque and Clearing System, whereby debts are, not so much paid, as balanced off against each other. The germ of the method is to be found in the ordinary practice of book credit. If two firms have frequent transactions with each other, alternately buying and selling, it would be an absurd waste of money to settle each debt immediately it arose, when, in a few days, a corresponding debt might arise in the opposite direction. Accordingly, it is the common practice for firms having reciprocal transactions, to debit and credit each other in their books with the debt arising out of each transaction, and only to make a cash payment when the balance happens to become inconveniently great” (Jevons, 1876, 251).
- 7.
Although critics noted that exchange stability achieved in this manner would require a domestic adjustment process that produced substantial instability in domestic prices.
- 8.
The problems created by the increased importance of monetary relative to fiscal policies implied by the single currency are analyzed in Savona (2018).
- 9.
Recommended readings including Fisher’s publications appear on Keynes (1978, 725–729). In his lectures Keynes is concerned with the mechanism by which an expansion of gold supplies influences different types of activity and their prices, through the influence on lending and interest rates, noting that the process will be different in different countries and differ as institutions change over time (Keynes, 1978, 776ff.).
- 10.
Keynes also notes that the implicit insurance provided to banks engaging in short-term financial arbitrage by the existence of the gold points would disappear in the absence of the gold standard, and proposes the creation of forward markets to provide hedging for banks’ arbitrage, develo** the interest rate parity theorem to show how changes in interest rates will have an impact on exchange rates and interest rates. Intervention in forward rates had been a stabilization technique already under the gold standard, and was also widely employed for example in the 1998 Asia crisis.
- 11.
Not to be confused with Hayek’s “neutral money” proposal in Prices and Production (Hayek, 1931) which says interest rates should be set as if the system did not have a fractional reserve bank credit system.
- 12.
In the absence of adopting Keynes’s proposals “The restoration of the gold standard (whether at the pre-war parity or at some other rate) certainly will not give us complete stability of internal prices and can only give us complete stability of the external exchanges if all other countries also restore the gold standard” (Keynes, 1971, 173).
- 13.
Keynes recommends central banks to “pursue bank-rate policy and open-market operations a outrance, That is to say, they should combine to maintain a very low level of the short-term rate of interest, and buy long-dated securities either against an expansion of central bank money or against the sale of short-dated securities until the short-term market is saturated” (Keynes, 1930, Vol. II, 347), a proposal surprisingly similar to the modern “zero interest rates policies” of the 2000s. See Kregel (2013).
- 14.
“In those early days of the Depression, Fisher persistently provided a basic orientation of monetarism in analysis and in policy prescription. “The chief direct cause of the depression” was the one-third reduction of the money stock between 1929 and 1933, and “the only sure and rapid recovery is through monetary means.” He provided a stream of detailed proposals: devalue the dollar, most immediately in connection with raising prices generally; pursue aggressive open market operations in order to increase the money stock; provide governmental guarantee of bank deposits; use dated stamp scrip in order to maintain or increase monetary velocity; and, rather outside the realm of monetary policy, subsidize firms that increase their hiring of labor for minimum periods” (Allen, 1993, 704).
- 15.
Macauley would go on to provide the definitive critic of Fisher and Gibson’s statistical work and the definitive definition of duration in Chapter VI on Interest Rates and Commodity Prices in Macauley (1938).
- 16.
And require real-time management since duration changes as interest change, requiring “gamma” hedging.
- 17.
- 18.
It is in this context that Minsky follows Keynes in interpreting liquidity preference as a theory of asset prices, although he paid more attention of bank assets and firms’ fixed interest liabilities than to equity prices.
- 19.
In some periods ECB acquisition of German bonds led to negative interest rates which created perverse incentives in which non-German investors could be thought of paying German debt service on its outstanding debt or providing a subsidy to German deficit spending when they were facing EU restrictions on their domestic financing decisions.
- 20.
An example is represented by the Federal’s purchase of mortgage backed securities during quantitative easing which now have to be returned to the market under quantitative tightening. Over half of these holdings carry interest rates between 2.5 and 3.5%. Rising rates produce a sharp decline in prepayment rates, roughly doubling average life and tripling duration. The losses on these securities raise the cost to the Fed, but, if these securities had been in private portfolios they would have been hedged or sold, which would have put upward pressure on 10–20 year interest rates and further exacerbated mark to market losses. See Whalen (2023).
- 21.
Albert Wojnilower, after thirty years of experience in financial markets notes: “the demands for credit are inelastic (or at times even perversely positive) with respect to the general level of interest rates. The growth of credit is therefore essentially supply-determined. In particular, this has meant that cyclically significant retardations or reductions in credit and aggregate demand occur only when there is an interruption in the supply of credit-a ‘credit crunch’” (Wojnilower, 1980).
- 22.
Fazzari et al. (1988) suggest that firms without ready access to capital markets may have “excess sensitivity” to internal finance represented by cash flow.
- 23.
See Barbosa-Filho (2015). The long-run Phillips curve has usually represented a benchmark to the non-inflationary rate of expansion, but after Greenspan’s decision to ignore labour market rates and focus on innovation in the period after 1995 the US potential growth rate increased dramatically.
- 24.
As an example consider the statement of the head of Silicon Valley Bank who pointed out the a bank’s policy of holding high duration reserves was motivated by the fact “that up until late 2021, the Federal Reserve had indicated that interest rates would remain low and that rising inflation was merely transitory.” “Former Silicon Valley Bank CEO says rate hikes, withdrawals sank firm,” By Pete Schroeder and Hannah Lang, https://www.reuters.com/business/finance/former-silicon-valley-bank-chief-becker-says-interest-rate-hikes-social-media-2023-05-15/.
- 25.
- 26.
A stimulus in the development as the creation of microlending in develo** countries such as the Grameen bank, again based on the view that the costs of small, high credit risk lending was too expensive for large banks. Eventually, however traditional banks moved to occupy this space and eliminated most of the development benefits of the system.
- 27.
“Money itself, namely that by delivery of which debt contracts and price contracts are discharged, and in the shape of which a store of general purchasing power is held, derives its character from its relationship to the money of account, since the debts and prices must first have been expressed in terms of the latter. Something which is merely used as a convenient medium of exchange on the spot may approach to being money, inasmuch as it may represent a means of holding general purchasing power. But if this is all, we have scarcely emerged from the stage of barter. Money proper in the full sense of the term can only exist in relation to a money of account” (ibid.).
- 28.
It is interesting that while governments have been slow to recognize the advantages of such a system, there is already a private sector equivalent of Schumaker’s proposal which provides a clearing house for virtually all types of financial transaction. See https://finance.yahoo.com/news/webtel-mobi-us-subsidiary-wm-120900804.html.
- 29.
See for example Savona (2022).
- 30.
“In our system, payments banks make for customers become deposits, usually at some other bank. If the payments for a customer were made because of a loan agreement, the customer now owes the bank money; he now has to operate in the economy or in financial markets so that he is able to fulfil his obligations to the bank at the due dates. Demand deposits have exchange value because a multitude of debtors to banks have outstanding debts that call for the payment of demand deposits to banks. These debtors will work and sell goods or financial instruments to get demand deposits. The exchange value of deposits is determined by the demands of debtors for deposits needed to fulfil their commitments. Bank loans, while ostensibly money-today for money-later contracts, are really an exchange of debits from a bank's books today for credits to a bank's books later.” In simple terms, “bank liabilities are held because borrowers have debts denominated in those same liabilities and thus they have value because they can be used to extinguish those liabilities” (Minsky, 1986, 258).
- 31.
On the other hand, it would require a restructuring of securities market regulations as private markets responded with innovations to replicate the risk free government currency. In a sense the CBDC solution is a return to the binary Glass-Stegall system with the equivalent of 100% reserves; its success was in providing a guaranteed income through Regulation Q interest rate management; it came grief because of the failure to adequately limit innovative competition from the non-regulated investment banking sector.
- 32.
This is the type of system tested by the Project Hamilton of the Federal Reserve Bank of Boston in collaboration with MIT: https://www.bostonfed.org/news-and-events/news/2022/12/project-hamilton-boston-fed-mit-complete-central-bank-digital-currency-cbdc-project.aspx. There is no reason why permissionless stable coin structures could not use CBDC as reserves for the issue of their own liabilities.
- 33.
Henry Simons (in a letter to Paul Douglas) reports that he had been “a little upset lately about the banking scheme-trying to figure out how to keep deposit banking from growing up extensively outside the special banks with the 100% reserves. Just what should be done, for example, to prevent savings banks (a) from acquiring funds which the depositors would regard as liquid cash reserves or (b) from providing through drafts a fair substitute for checking facilities” (Allen, 1993, 708). This precisely the threat to the system presented by permissionless digital currency platforms.
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Kregel, J. (2023). Concluding Remarks: Is It Possible to Return to a “Normalization” of Monetary Policy?. In: Savona, P., Masera, R.S. (eds) Monetary Policy Normalization. Contributions to Economics. Springer, Cham. https://doi.org/10.1007/978-3-031-38708-1_10
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