In this section we will construct a trivial fiat currency. The purpose is to understand:
- Why the currency has value
- How the issuing authority controls the value (can it stop inflation? can it stop deflation?)
A lot of simplifications are made in this section for clarity. In the next section, we will kick complexity up a notch to make the system a lot more realistic.
Step-by-step construction of the system
- We start from a world were there is no money, no government, no taxes, etc.
- There is only one asset class, call it “housing”
- The folks in our simplified fictitious nation are divided into two categories: the wealthy, who own two houses each, and the not-so-wealthy that own no house. Historically, the latter have been renting a house each, from the former and paid for rent in kind, since there is no money
- One day, a credibly altruistic entity called “the central bank” pops out of the ground and offers to broker private credit deals
- In such a deal, a not-so-wealthy agent purchases a house from a wealthy one. The wealthy agent gets credited money on his account at the central bank, while the not-so-wealthy one has “negative money”, or debt. On a net basis, the central bank is always flat and the transaction does not change the level of wealth of either agents.
- Every day, the central bank (altruistically) decides the rate of interest paid by the borrower (not-so-wealthy) to the saver (wealthy). In this simplified model, we will ignore the credit spread needed compensate future defaults, or the issue of term (all loans are overnight and rolled)
- Now scale this up and imagine there are many borrowers and just as many savers performing this operation. Loans and cash are fungible and intermediated by the central bank. That is, a borrower does not owe directly to a saver. The borrowers all owe to the central bank and the central bank owes to all the savers.
- If the saver no longer wishes to be part of this system, he can simply go out and buy a house in the open market with his credited money
- If a borrower no longer wishes to be part of this system, he can simply sell his house and pay back his debt to the central bank. If the buyer of the house is a not-so-wealthy agent, then the loan effectively just gets transferred to him. If the buyer is a wealthy agent that paid cash, then the loan gets terminated and netted off against the cash that the wealthy person was previously sitting on
Value of the Currency
In step 5, the wealthy agent agreed to replace a real tangible asset (the house) by some electronic credits on the central banks hard drive. Who’s to say that these will be worth anything? The central bank publicly commits to a certain price-level target. For the sake of this example, let’s just say it commits to keeping house prices flat forever.
Because the central bank was assumed to be altruistic, we know it has the will to achieve its target. But does it have the means?
The only lever the central bank control in this whole system is the overnight interest rate. Let’s look at whether that knob is powerful enough to provide a credible price-level control:
First, let’s assume the currency starts to run away and hyperinflation sets in at say, 200% per year (making it extreme just to illustrate). The central bank, in an effort to contain this sets interest rates to say, 500% per year. In that situation, the trade-off between owning cash and a house is as follows: if I own a house, I will still own that house in a year (so 0% capital gains in terms of “houses”) and I will have collected rent, however much that is. If I own cash instead, I will own 6 times more cash at the end of the year (500% nominal interest rate) but it will be worth 3 times less in terms of houses (200% inflation). In other words, I will own the equivalent of two houses. Unless real rental yields are stupidly high (100%), this is an absolute no-brainer and every rational agent should rush into it. As those guys sell houses and hoard cash to benefit from the high real yield, the inflation spiral will be thwarted.
Conversely, let’s assume the system enters a deflationary spiral, the central bank can always lower the real yield enough that houses will look much more attractive than cash. Any time real rental yield (in terms of houses) is higher than real cash yield (also in terms of houses since that’s how we defined inflation), people should be flocking from cash to housing, thereby stopping the deflationary spiral. Note that that this step is predicated on the central bank having the ability to set the nominal interest rate to arbitrary large negative values. Without this, the central bank does not have a credible way to stop deflationary spirals and the system will be prone to get stuck in liquidity traps. More on that below.
Combining the last two results, we conclude that the central bank can credibly achieve whatever inflation target it wishes. Since the system is credibly stable, there is no reason for nominal rates to ever need to get as humongous as in the above examples, although leaving that door open is necessary for the system to be able to resist any arbitrary shock.
If the central bank wishes to target something other than house prices, say the price of the CPI basket, it can do so as long as there’s some elasticity between the price of houses and the price of the basket. That is, if they achieve a doubling the price of houses, the price of the CPI basket will not remain unchanged. Any well behaved utility function will lead to a higher relative consumption of the CPI basket if its price relative to the house halves, so this is a pretty innocuous assumption.
Negative Interest Rates and Liquidity Traps
As seen in the above example, without the use of negative nominal interest rates, the economy can get stuck in Liquidity Traps. In a nutshell, return prospects are so bad that even at 0% nominal yield, agents do not believe they can profitably borrow to invest. Japan has been stuck in this kind of vicious cycle for decades and other developed economies are joining the party.
When negative nominal interest rates get mentioned, there’s always someone to throw his hands up in the air and say: “this cannot work as people will just stash physical cash to circumvent the interest rate penalty”.
While this is a correct observation, the “money under the mattress” option can easily be killed by either of these two solutions:
- Eliminate physical currency altogether. It’s no longer necessary given the electronic alternatives that we could put in place, from anonymous keychain money holders to strongly authenticated mobile phone transaction. As a side benefit, this puts kidnappers, drug dealers and bank robbers out of business. Or:
- For the libertarians among you that prefer to keep a physical currency in circulation, banks can use a conversion ratio when withdrawing/depositing physical currency at banks (businesses will have to use the same conversion ratios when transacting with physical cash). The conversion ratio will have to be consistent with the compounded overnight interest rate. Obviously, the central bank can just compute and publish that number.
It is important to note that (other than the physical currency issue which is a technicality), the 0% boundary is purely in our head. There is nothing special about 0%. Chinese mathematicians started using negative numbers some 2000 years ago, it’s time for central bankers to embrace them too.
Limitations of the Trivial Model
Clearly, this model is very simplistic. Let’s outline the main limitations:
- The central bank has to make all credit worthiness decisions
- There is only one asset class
- No credit spread is charged to borrowers to reserve against losses
- All loans and all deposits are overnight
Moving right along to the Modern Banking System section where we address those limitations.