# Construction of a Fiat Currency

In this section we examine the construction a fiat currency. The purpose is to understand how such a currency’s value is controlled, given that it has no intrinsic value.

### Working Assumptions

Given the complexity of the topic, we choose the set of assumptions that allows us to work through this in the simplest possible manner. We’ll discuss, nuance and outright relax most of these later.

1. The price-level (average prices of a basket of goods) is observable daily, with no lag.
2. The overnight Wicksellian natural real rate of interest is observable daily, with no lag.
3. Money is lent into existence by the central bank, at a rate of interest that we’ll call the lending rate against sufficient collateral leaving the central bank with negligible risk of loss (see Repos)
4. Money is destroyed when the central bank loans are repaid
5. All money is electronic
6. Holders of money get paid a rate of interest called the deposit rate on their balances at the central bank

### Determination of the Price-Level

Start by assuming that the deposit rate is equal to the lending rate, and the central bank sets the deposit rate to be equal to the Wicksellian rate of interest (r) + the observed rate of inflation (i). Just to be clear, that means that the actual amount of interest won’t be known until it is time to repay the loan.

Example: I borrow \$1000 from the central bank on Monday. At that time, the Wicksellian rate r was 3% and the price level was 100. On Tuesday, we observe a price level of 100.005; that’s an annualized rate of inflation i of about 20%. The amount I have to repay the central bank to avoid default and get my collateral back is: \$1000 * ( 1 + ( r + i ) / 360 )  = \$1000.64. I can get a new loan from the central bank on the next day for the same amount (i.e. “roll” the loan) or different amount, provided that I can post collateral.

The central bank pays a rate of interest on deposits of r + i as well (the deposit rate) so that holders of currency are guaranteed the same real return (risk-adjusted) that they would earn if they were holding a real asset in the market.

What does that tell us about the price level? Absolutely nothing. The price level could be all over the place. Holders and borrowers of money could not care less since they get made whole through the interest rate that’s essentially indexed on inflation.

Ok, then how does the central bank control the price level? Simple, it announces its price level target and “tweaks” the interest rate to reward those that help bring money in line with the target and punish those that push it away. Rather setting the nominal rate of interest of n = r + i, they set it to nri + f(p – p*) where is the observed price level, p* is the target and is a some strictly increasing function.

Example: Assume the price level target p* is 100 and f(p – p*) = 1% x (pp*). If the price level were to rise to 101 (excess inflation), holding money would now yield r + i + 1% * (101 – 100). That is, 1% over holding a real asset. At that point, people are happy to hold money and as they attempt to get their hands on it, it’s value rises, and the price level drops back to target. And conversely if prices are too low.

### Determination of the Quantity of Money

Just above I wrote that holders of money would be indifferent between money and other real assets. As money becomes the socially accepted medium of exchange, this no longer holds true: people will demand it in excess of what its yield would suggest when compared to other assets. Keynes called this liquidity preference. Woodford calls it non-pecuniary return. JP Koning calls it convenience yield.  The bottom line is that at a pecuniary return that’s equivalent to other assets, there is an enormous quantity of money demanded by the market.

The central bank can mitigate this effect quite simply by charging the holders of money for this liquidity benefit. This is done by introducing a spread between the lending rate and the deposit rate.

The lending raten = r + i + f(p – p*)

The deposit ratend = r + i + f(p – p*) – l, where l is a liquidity charge.

### Model Summary

The model is now complete:

1. The central bank can target any price-level, time-dependent or state contingent (in order to target the path of NGDP growth for instance)
2. Simultaneously, it can target whatever quantity of money it wants. For instance, it could target a monetary base of 5% of GDP–i.e. a velocity of 20x

### Relaxing Assumptions

Alright so we made some pretty big assumptions. Let’s see if we can relax them sufficiently for our model to be used to think about real world currencies.

First, we know that the price-level and the Wicksellian rate aren’t observable daily. Moreover, the nominal interest on central bank loan is fixed at the inception of the loan, not after observing the realized inflation. In practice, central bankers run fancy models to forecast inflation (contingent on their policies) and estimate the Wicksellian rate. They adjust the policy rates monthly as a result. I, for one, have no problem making the leap of faith that they’re going to do a decent enough job and that monthly vs daily is no big deal. When they do make mistakes, there will be small deviations from the target path which they can fix in subsequent periods.

Second, money isn’t always lent into existence via repurchase agreements. It should be, if you ask me. But in practice, central banks also purchase assets. Most often, these assets are short term government bonds,so let me first address that case specifically: having a central bank purchase a government bond maturing in a month is functionally identical than having the central bank lend the funds for a month to someone else so that they purchase the government bond (which is in fact demanded as collateral) except that in the former case the central bank isn’t exposed to sovereign credit risk (that’s a nice plus).

Now onto the general case (warning: there’s a bit of financial at work here). An asset purchase can always be decomposed into: (a) a loan collateralized by that asset made to the seller and (b) a transfer of risk in derivatives form with said asset as underlier. The loan part is close enough to the repos we assumed were being traded. The derivative part serves no interesting purpose other than transferring risk from the private sector to the central bank. And since central bank profits and losses are remitted to the government, that’s the same as if the government was executing derivative trades itself.

Let me clarify with an example: when the Fed purchases \$1bn worth of gold, it’s the same as if it had lent \$1bn of currency against gold collateral and the department of the treasury had bought \$1bn worth of gold futures on the Chicago Mercantile Exchange. This would distort the gold market slightly but wouldn’t have much of an effect other than that. Why would the treasury ever do that? It wouldn’t! And neither should the Fed. Central banks should limit themselves to purchasing riskless assets. The closest thing there is to a riskless asset is a repurchase agreement (repo) on good collateral with appropriate haircuts.

### The Zero Bound

The last assumption (“all money is electronic”) takes us right to the heart of the zero bound issue. If you paid close attention above, you notice that I never assumed that the policy rates (the lending rate n and the deposit rate nd) are positive. Given that the Wicksellian rate can drop pretty low into the negative range, there’s a need for the policy rates to be able to do so as well. Given the current institutional setup, if the central bank were to move nominal rates in the negative range, folks would rush the ATMs and turn their electronic currency into physical currency since no deposit rate is charged on physical currency.

There are two ways to solve this issue. The first is for the central bank to commit to keeping nominal rates at 0% until NGDP (or whatever target) is back on its trend path. To be very clear, that means it has to be back on whatever path it was before, not simply start growing at the same rate it used to. The message here is that money, at some point in the future, will yield less than the Wicksellian rate. This threat should discourage people to hold it today and therefore help push prices up.

When using this solution, the target’s growth rate should be increased if the zero-bound is hit too often. I see a few drawbacks from this solution:

1. It’s possible that (the fear of) extended periods of time spent at the zero bound with high unemployment actually push the Wicksellian rate lower thereby making the zero bound a somewhat stable/sticky equilibrium
2. The central bank has to be able to credibly convey that it will let inflation run high on its way back to trend path. That it will not chicken out in spite of political pressure. It will not be easy to convince the market of that.

For these reasons, I prefer another solution…

### Negative Nominal Interest Rates

If the zero bound bothers you, just shatter it.

In order to do that, the central banks will have to plug the physical currency loophole. That would involve clarifying that all contracts and financial instruments denominated in the currency it issues are really denominated in electronic currency. (This may require quite a bit of legal legwork).

Physical currency can continue to exist but will trade at an exchange rate set by the central bank vs digital currency. The exchange rate can easily be computed as:

xt+1 = min{ 1, xt (1 + nd / 360 ) }

Most of the time, the exchange rate will be 1 (just like we’re currently used to), but during times when interest rates are negative, the value of physical currency will drop at just the rate that’s needed to discourage people from hitting the ATM.

### Summary

The key insight from this section is that central banks have ultimate control over the price-level. There is nothing that fiscal policy, commercial banks, or the private sector can possibly do that cannot be offset by the right interest rate policy. Another way to say this is that fiscal policy and the private sector may drive the Wicksellian rate, but central banks can always make sure that the return on money matches it.

Next we look a at how member banks work in the Modern Banking System section.

[This section was rewritten on September 7, 2013 to expose the newer, clearer monetary model]

## 38 thoughts on “Construction of a Fiat Currency”

1. Max

I’ve gradually come around to the “backing theory” of money. Money has value because it’s either convertible into something valuable, or theoretically could be convertible into something. This encompasses floating exchange rate fiat money, because although fiat money is by definition not convertible, there is nothing permanent about that. Offering to convert is a “sure fire” method of stopping a hyperinflation. Raising interest rates is not, because if money is worthless, it doesn’t matter how much more of it you will have in the future.

Try this analogy. Stocks are valued for the dividends they pay, and yet a stock like Berkshire that has a policy of never paying dividends still has value. That’s because even though it doesn’t pay dividends, nothing prevents it from paying dividends. Likewise, nothing prevents a solvent central bank from giving its “fiat” money value by offering to convert it. That possibility makes the central bank’s commitment to price stability credible.

1. DOB Post author

“Offering to convert is a “sure fire” method of stopping a hyperinflation.” ->

Offering to convert to what? Most of what the central banks owns is nominal assets. If you fear inflation, you don’t care too much that the central bank is redeeming your money and giving you another asset exactly like it in return.

“[..] if money is worthless, it doesn’t matter how much more of it you will have in the future.” ->

This is one case where the difference between actually worthless and almost worthless is very important.

For money to become worth exactly nothing, then at some point in time, the rate of inflation must have become infinite.

If the rate of inflation never becomes infinite, then the central banker can always set a nominal rate that’s sufficiently higher than it, such that the real rate of return on money is high enough to make people want to hold it.

Now, could the rate of inflation actually become infinite? In theory, it would mean that the holders of money would have to completely throw in the towel, and voluntary hand it over in exchange for nothing. Why would they ever do that? If it’s worth nothing they might as well keep it, no?

Besides, remember that for every unit of currency created, there’s a guy who borrowed it from the central bank. That guy must either repay the principal of his loan or continue to pay interest to the central bank. Lots of it if rates are very high. The only way for him to obtain principal or interest is to get it from the money holders (who receive the interest from the central bank). He’ll be willing to give them something of value, to avoid defaulting. And there’s your demand for money.

2. Max

“Offering to convert to what? Most of what the central banks owns is nominal assets. If you fear inflation, you don’t care too much that the central bank is redeeming your money and giving you another asset exactly like it in return.”

It’s OK that most of the assets are money IOUs as long as *some* of the bank’s assets are real.

Consider this modification of your scenario. Instead of starting out with nothing, assume the bank owns a house. It offers to sell the house for \$100. Now money has value, and the bank’s owner can purchase up to one house worth of goods for money – assuming he can be trusted to regard the money as his debt.

If the bank is owned by a government, it can use its tax power as an asset. It can say: give us your house, or give us \$100. It can then spend \$100 on one house worth of goods.

This theory neatly explains why hyperinflation happens in practice. It happens when a government (and with it its central bank) is insolvent, and the insolvency is cured by inflation rather than by defaulting on bonds.

Debt monetization in normal times is not inflationary, but monetization when the government is broke is inflationary, because it forecloses the possibility of default.

1. DOB Post author

“It’s OK that most of the assets are money IOUs as long as *some* of the bank’s assets are real.” ->

What happens when the bank has sold all of its real assets to prevent inflation and is now left with only IOUs? Now we’re back in my case.. so either it must work with all IOUs, or it will need all real assets. I think it works with just IOUs :)

“If the bank is owned by a government, it can use its tax power as an asset. It can say: give us your house, or give us \$100. It can then spend \$100 on one house worth of goods.” ->

If the idea was to tax the \$100 to create demand for money, spending them back immediately means undoing that. On a side note, MMT is deeply flawed but I’ll write a blog post on that soon.

“This theory neatly explains why hyperinflation happens in practice.” ->

You haven’t told me what’s wrong with my theory :) I think inflation happens when demand for nominal assets is less than supply because nominal rates are too low. It is true that taxation could create some demand for money, but lowering the nominal rates by some amount can always offset that. Likewise, government spending can help prop up inflation, but that can always be offset by the central bank setting the nominal rates appropriately higher. Ultimately, the in/deflationary impact of any fiscal actions can always be undone by a brave & independent central bank.

“Debt monetization in normal times is not inflationary” -> Agreed.

If the CB buys floating rate bonds issued by the government (assuming such a thing exists) and default is not a concern, that does nothing to in/deflation in a full reserve system.

If rates are at 0%, then that does nothing in a fractional reserve system either (since the banks could already source reserves at 0%).

If the bond is a fixed rate bond, then the central bank is pushing swap rates lower and that does something, but it also puts the taxpayer at risk.

Of course if the government is in fiscal troubles, having the central bank holding a ton of government debt puts the banking system at risk unnecessarily.

1. Max

“What happens when the bank has sold all of its real assets to prevent inflation and is now left with only IOUs? Now we’re back in my case.. so either it must work with all IOUs, or it will need all real assets.”

If the bank has sold all its asset (both IOUs and real) and still has money outstanding, then the value of the remaining money is zero.

“If the idea was to tax the \$100 to create demand for money, spending them back immediately means undoing that.”

The idea is not to create a demand for money. That is assumed to already exist. The idea is to create a value for money. In this example, \$100 liquidates a tax debt of one house, which establishes a value of \$1 = 1/100th of a house.

3. Max

I made it too complicated. Here’s a simpler and better way of looking at it.

The bank values houses at \$100. It offers to lend house owners \$50 (50% of the value of the house – less than full value to protect the bank from loss) and it receives a lien on the house.

Now the bank’s money is backed by real assets – house liens. The bank’s valuation of the houses determines the value of money. As long as it never changes its valuation, the price of houses will be stable. (At least I think so – it makes intuitive sense, but it cries out for a formal proof).

Note that if the houses were completely destroyed, the bank’s liens would be worthless and so would the bank’s money (no matter what the interest rate!). The liens are a real asset which backs the money. Or in other words, if the collateral is destroyed, everyone is delighted to default and the bank is incapable of removing its money from circulation.

I’m sure I’m reinventing stuff that some long dead economist figured out, but no matter – it’s fun. :-)

1. DOB Post author

Hi Nathan,

Thank you for the vote of confidence.

I have indeed read Soft Currency Economics and studied MMT fairly closely. After thinking about it long and hard, my conclusion is that it is deeply flawed but not for the reasons that most critics cite. I intend to write a series of post exposing why I think that is. Hopefully, the first one will come out within a week. Stay tuned :)

1. Vinny C

I think there is just one main flaw in MMT. They are not consistent in how they think about taxes, spending, bond sales, and bond payoffs. For spending they think about it as if it were all newly made money. Taxes they think of as destroying money. Since the government can print money it could destroy all money from taxes. So far this is ok. But they don’t do it the same way for bonds. If they imagined bond sales as destroying money and so reducing demand it would then be consistent with their idea that all government spending comes from newly made money. And if they imagined that bonds were paid off with newly made money, this would also then be consistent. If you do this then you could make an MMT that matches the real world.

http://pair.offshore.ai/38yearcycle/#chartalism

1. DOB Post author

Why wouldn’t you accept an asset that has the right risk-adjusted real return as payment? If people don’t accept it as payment, prices will rise, and that means it will offer an even higher return to compensate. At some sufficiently high return, sellers of goods will take the damn thing :)

1. Philippe

but the only ‘return’ your bank is offering is more of its own credits.

What if I am the saver in your example, and I want to make a payment to someone who isn’t a customer of the bank, or who is a customer at another bank. Why would they accept your bank’s credits? What is the means of settlement between different banks?

1. DOB Post author

Yes it’s offering more of its own credits, but real return is real return. It means that even if the credits are worth 10x less than the day before, the rate of interest will be high enough to make you whole.

There’s only one bank in my example and it’s the central bank. I’m not too worried about having multiple central banks in the same country since money is a natural monopoly (everyone benefits from there being a single currency). But if truly that’s a case you want to ponder, it could work the same way as international settlements work today with the world currencies (there’s a clearinghouse called CLS that handles daily simultaneous clearing of all FX spot settlements)

1. Philippe

It sounds far too flimsy for me. And this isn’t how money actually came about, so you’re imagining a counterfactual to try and explain why things are the way they are today.

1. DOB Post author

I’m actually rewriting this page. I’m keeping it simple not to claim that it’s how it originated but because there’s value in simplicity.

If money originated with little pieces of wood in babylonian times or cigarettes in prisons, it doesn’t mean that I need to have lumber and tobacco in my modern monetary model..

4. Philippe

“folks would rush the ATMs and turn their electronic currency into digital currency since no deposit rate is charged on physical currency.”

Do you mean “folks would rush the ATMs and turn their electronic currency into physical currency” ?

5. Philippe

I’m completely bamboozled by your explanation.

Apparently you have constructed a “fiat” currency out of thin air with some sort of interest rate stuff. And you have somehow built a “central bank” on the basis of this supposed “fiat” currency.

Let’s bring this back to basics. Let’s say you go out into the high street and set up a bench (a ‘banca’) and declare to the public that you are establishing a new “central bank”.

Why would anyone buy what you are offering on the basis of this sales pitch?

Your argument assumes that your new banca somehow becomes the central (monopoly) bank… for no real reason.

Somehow your new monopoly central bank is able to charge depositors negative yield… why exactly??

And for some reason your high street banca becomes the government’s central bank (why?), and people are willing to sell you government bonds for your bits of paper…. again I have no idea why.

What I would like to see is this theory re-written as a business plan. Then I would like to see you take this business out into the high street and try to get customers. You could call yourself “the sidewalk central bank”.

Good luck!

(all in good humour!)

1. DOB Post author

Ok, all very good points.

First of, I’m not trying to model a startup central bank, I’m trying to model existing central banks.

“Somehow your new monopoly central bank is able to charge depositors negative yield… why exactly??”

You make it sound like that negative yield is punishment. It’s not! Negative rates are used only to make the return on money line up with the natural real rate of return. Sometimes (not always), anything higher would be too high and therefore deflationary.

“people are willing to sell you government bonds for your bits of paper…. again I have no idea why.”

Because they find my bits of paper more convenient to transact with. But frankly, I couldn’t care less if nobody ever used my central bank and the monetary base was zero. What matters to me in determining the price level, is that if anyone EVER traded my currency, it would be at the price I’ve targeted.

That means that as long as the currency is the unit of account, I have control in the price level, of NGDP, etc. even with a base frozen at zero. And that’s all I care about. If people want to use cigarettes as their medium of exchange, I couldn’t care less..

1. Philippe

“First of, I’m not trying to model a startup central bank, I’m trying to model existing central banks”

But you haven’t explained why your central bank is the central bank in the first place. You’re just saying “assume the central bank exists for no reason. It then follows that x,y,z… etc”

1. Philippe

“You make it sound like that negative yield is punishment. It’s not!”

Yes it is!

I have deposited my money in your bank – i.e. I have lent you my money – and now you’re telling me that I have to pay you to get my money back…. or even that I’m no longer allowed to take my money out of your bank! Why would I ever consider this to be a good deal?

1. DOB Post author

You haven’t deposited your money in my bank, you’ve borrowed your money into existence from my bank. Or you’ve taken it as payment from someone else who did.

This money offers a return that’s sufficiently high for people to hold it and accept it as payment at a certain level of prices. It’s neither a good deal, nor a bad deal, it’s just a means of conducting business.

Sometimes, “sufficiently high” happens is negative and any higher than that is “too high”. And yes, there’s no way out, if you hold money issued by the central bank, the only way to get rid of it is to either find someone else who wants to take it or to repay a central bank loan with it.

People know that and still agree to hold some money because the pecuniary return, combined with the convenience of carrying transactions is just high enough.

6. Philippe

“Because they find my bits of paper more convenient to transact with”

Why?

“I couldn’t care less if nobody ever used my central bank and the monetary base was zero. What matters to me in determining the price level, is that if anyone EVER traded my currency, it would be at the price I’ve targeted”

So far your currency is worth zero so you can target any price level you want but why should anyone care?

“if anyone EVER traded my currency, it would be at the price I’ve targeted”

But why would they ever?

I can assume that I am JP Morgan, but that doesn’t make me JP Morgan. To be JP Morgan you have to do more than just assume that you are JP Morgan.

I am genuinely confused as to how you are making the leap from assuming that you are JP Morgan to actually being JP Morgan.

1. DOB Post author

“Why?”

Because without money, people have to resort to bartering in order to transact, which is inefficient because double coincidence of wants are few and far between.

“So far your currency is worth zero”

You may not want to hold this currency but trying to short it at a price that’s different than the target will be a very bad investment. It’s certainly not worth zero and at a sufficiently high return, a central banker could make it worth however much it wants..

7. Philippe

“as long as the currency is the unit of account”

Again, for no apparent reason.

Genuinely perplexed.

1. DOB Post author

“Again, for no apparent reason.

Genuinely perplexed.”

I don’t know why you expect a monetary model to explain how money becomes a societal standard. Is it because I used the word construction in my title? If so, please realize I mean mathematical construction, not an actual attempt to recount history.

But any way, here’s why people use the dollar in the U.S. as a medium of exchange:
– Using zero, or more than one currency is cumbersome, so you really just want one
– Payment of taxes is done in dollar
– Government spending is received in dollar
– Legal tender laws mandate that the dollar be used (though I’m not exactly sure of how the scope of these rules)
And the dollar is used as a unit of account because:
– It’s convenient to use the same thing as a medium of exchange and a unit of account
– Tax accounting probably requires that you keep your books in dollar units

None of this has to do with price-level determination, but I think it answers your question?

8. Vinny C

“The key insight from this section is that central banks have ultimate control over the price-level. There is nothing that fiscal policy, commercial banks, or the private sector can possibly do that cannot be offset by the right interest rate policy.”

What you miss is that the government has ultimate control over the central bank. The government appoints the people that run the central bank. The government makes the laws that govern the central bank. If the government needs the central bank to make money and buy government bonds, because the government is spending twice what it gets in taxes like Japan, then the government always gets the central bank to do this. If the government could not then it would fail once others were net sellers of their bonds. Time and time again the central bank is made to fund the governments deficit spending. This is how we get hyperinflation. When you see the politicians put their man in charge of the central bank, like in Japan, you should get worried. It does not matter how safe the rules seemed ahead of time. Like Japan had a “bank note rule” that should have prevented hyperinflation, they just ignore such rules when push comes to shove.

Google “Hyperinflation FAQ” to understand the positive feedback loops that make up hyperinflation.

1. DOB Post author

I agree that democracy and politics are riddled with inefficiencies and bad incentives which is why I like the idea of small government, or at least smaller than what would be considered optimal in a model that doesn’t account for the inefficiencies and the bad incentives.

I agree that separation of power is not perfect but it’s the best we’ve got and no, it’s not completely worthless. Government in western countries have taken steps to prevent themselves from interfering with their own central banks in the way that you describe. Again, not perfect, but I think it’s a decent system.

9. Vinny C

I have a very simple fiat currency model. It is a correction of MMT, so I call it CMMT. I can not link to it but just Google “vince fiat cmmt”.

1. DOB Post author

I thought MMT did say that money raised via bond sales was burned and vice-versa.

You don’t really mention interest rates anywhere in your model and I think that’s the biggest thing that MMT needs to fix.

10. Tom Brown

DOB, you might be interested in this: Nick Rowe’s going off on NK models:
“Thanks to Kevin who emailed me the relevant quote from Gali:

“Under the assumption that the effects of nominal rigidities vanish asymptotically [lim as T goes to inf of the output gap goes to zero]. In that case one can solve the [consumption-Euler equation] forward to yield…”

Bullshit. What he really means is “We need to assume the economy always approaches full employment in the limit as time goes to infinity, otherwise we will get explosive hyperinflation or hyperdeflation.”

Bullshit. Total bullshit.

Why aren’t the Old Keynesians screaming blue murder at this stuff?”

At least that’s what I *think* he’s doing: the whole discussion is a bit beyond me, but I thought you might care.

11. Philippe

DOB,

what do you reckon the fed funds rate should currently be?

How would you respond to austrians who claim the fed funds rate is “artificially low”, “artificially suppressed”, and that “in a free market interest rates would be much higher”…?

1. DOB Post author

I don’t have a quantitative model telling me exactly where fedfunds should be, but given where unemployment is, I’d say it should be a decent bit lower, somewhere around -2% In Europe I think -4% is a good ballpark.

Austrians are clueless about monetary theory. There is no way for markets to set nominal interest rates in a vacuum. There needs to be some kind of anchor to the price-level and nobody else other than the central bank can chose it.

Once the anchor has been selected (NGDP is a good choice), nominal rates follow from that. Given that money is too tight vs any reasonable anchor (output gap, GDP deflator, NGDP, unemployment), it’s idiotic for them to claim that rates are too low. Where do they think markets would set them and why do they think that?

1. Philippe

“There is no way for markets to set nominal interest rates in a vacuum”

The ‘austrians’ assume an imaginary situation in which there is no central bank or state monopoly, where the market somehow decides upon a type of money without any government interference. In this imaginary world they claim interest rates would be much higher than they are at present, given the same conditions.

It’s difficult to argue with an ‘austrian’ because they constantly conflate real and completely imaginary worlds that exist only in their imagination.

The ‘austrian’ argument I often encounter is essentially as follows: if you were to get rid of the central bank and government currency monopoly, and reduce government involvement in the economy to bare minimum, then the market would spontaneously create its own monetary system and in that system interest rates would be much higher than they are at present, because no market system would ever generate such low interest rates.

They would no doubt argue that no market system would ever generate negative short term interest rates either.

What would you say in response to such arguments?

1. DOB Post author

Well the key is, what is their counterfactual? And are they assuming money is neutral (i.e. no real impact on the economy on both short and long term)?

If they assume money is neutral, then why the hell do they even care what the central bank does? Let it inflate, deflate, whatever.. it has no real impact.

I obviously don’t believe in money neutrality, and I don’t think they do either. Then that means there are good and bad monetary policies and we must pick one.

“…and in that system interest rates would be much higher than they are at present, because no market system would ever generate such low interest rates.”

If we assume that the right monetary policy is NGDP level targeting, and that it was somehow achieved by their free banking system (I’d love to see how), then I claim that interest rates (real and nominal) would be no different in their world than in my world.

If they compare an NGDPLT world vs a fixed-price-of-gold world, then of course interest rates are going to be different! Nominal rates will differ because the target is different. Real rates will differ because they will be subjecting their economy to massive monetary shocks as supply/demand for gold moves around which means they will get wild variations in output, unemployment, and therefore their real rates won’t be the same as mine. Theirs won’t necessarily be higher though.