The Fallacy of Krugman’s Baby Sitter Money Economy

Back in 1998 Paul Krugman wrote an interesting article [1] recounting the story of a baby sitting collective on Capitol Hill to draw lessons about how a money system works and what problems can befall a mismanaged system.  The article describes an arrangement where a group of parents, mainly lawyers and economists, created a babysitting group, and to facilitate its operation they also created a fixed amount of script that parents would use to pay for baby sitting time. Krugman goes on to describe how at first the couples hoarded script, so they would have some on hand just in case they needed it, so little actual baby sitting was taking place.  Then, recognizing the problem, the group tried to regulate the use of script by requiring a minimal amount of going out per month, but that didn’t work.  Then they expanded the amount of script by releasing another lot of script into circulation, and the result was a kind of inflation where some parents were going out too much and paying the script far more than they were to provide sitting services.  Neither situation was optimal, so the lesson that we are supposed to take from this story is that fiat money needs to be carefully managed by a disinterested authority.  Krugman was, of course, making a comparison to a real national money system, and the central bank that manages it, and how the wisdom and independence of the central bank coupled with a flexible money supply was necessary for a functioning money system. Another view is that this example is a perfect exposition on why a fiat money system is so unworkable.  It also prompts some thoughts about what is money, and how should it work?

At first glance the whole idea of issuing script, which Krugman calls a “fairly natural solution”, is kind of bizarre to ordinary folks.  It’s the kind of solution that overly educated people might try (this author not included).  The obvious thing that regular people would do is issue IOUs.  E.g. Betty sits for Kathy for one hour, so Kathy issues Betty an IOU that says Kathy owes one hour of babysitting and signs it.  Each IOU lists the person who owes and is signed to show authenticity.  Betty holds on to this IOU for when she needs a sitter.  Betty then sits for Ann for an hour and gets an IOU with Ann’s name on it.  Similarly, other parents do the same.  Kamal sits for Jane and gets an IOU from Jane with her name on it.

Later, Betty needed a sitter and called Ann, who sat for an hour.  Betty gave the IOU with Ann’s name on it to Ann in payment, which Ann then ripped up as the IOU was satisfied.

Then something a bit different happens.  Betty needs a sitter and neither Ann or Kathy are available, so she calls Jane who agrees to sit.  Betty, instead of issuing her own IOU, gives Jane one of the IOUs that she collected previously.  In this case, the one from Kathy.  So now Kathy owes Jane an hour of sitting rather than to Betty.  In effect, Betty has used the IOU as a kind of money. 

This IOU money is specifically tied to the real economy (baby sitter economy).  It was created by performing real work (one hour of sitting).  These IOUs are not conjured into existence like the fiat script of the Capitol Hill group (or our money today) that is disconnected from the real economy.  In the IOU system of money, any amount may be issued by simply performing more real work (hours of sitting).  And any number of IOUs may be redeemed by appointment with the appropriate sitter.  Neither action causes recessions or booms.  Any time you need some IOUs you just need to do some work (sitting for others), and you get paid in the IOUs.

In this system money, the IOUs, are created by new work and destroyed by redeeming for work.  So, the supply fluctuates as needed.  The supply is not controlled by a central authority like the script was controlled by the Capitol Hill group.  So, one never needs to appeal to an outside authority to get IOUs. The amount of IOUs in the system is self regulating.

Now, this situation is not perfect.  Perhaps the value of an hour of babysitting is different for various people?  Maybe sometimes, say around holidays, its hard to find someone willing to babysit?  Maybe some people will babysit at a time of high demand for greater compensation, say sit one hour but get paid IOUs worth two hours?  The two parties just need to agree on the deal.  In this case two IOUs are issued for an hour each.  Regardless of the deal, the IOUs are still each worth one hour of babysitting.  In any case, the situation is self-rectifying and does not lead either shortages or surpluses of IOUs. 

Another problem is that the IOUs are tied to specific individuals.  Those that owe babysitting time.  So, while the IOUs can be exchanged among the members of the economy (the sitter group), the specific person listed on an IOU must be available to perform the owed sitting duty.  But, that is not such a problem in practice as you must call around to find someone willing to sit anyway.

Perhaps this idea of the IOU is the lesson for a money system?  Money that is based on production in the real economy.  Money that represents real economic activity rather than moving around financial instruments.  

Money, in all cases, is essentially an IOU.  Money itself has little value to the holder in that it can’t be eaten, worn, lived in, provide transportation, etc.  So, it’s a holder of value for acquiring those things in the future.  But, unlike script, work or creation of real value, proceeds the creation of the IOU money, whereas script is simply issued and taken for granted that it has value by fiat.

The moral then is: don’t have a fiat currency that is independent of the real economy with a central bank that tightens and eases as it sees fit.  Rather, have a currency that is tied to actual, productive economic activity.

How could this work in practice?  One way is to have the federal government issue currency rather than debt.  The currency would pay for the expenses of the government and flow into the economy.  As Thomas Edison said “If the Nation can issue a dollar bond it can issue a dollar bill. The element that makes the bond good makes the bill good also.” [2]  (For those readers who say, hey that’s just MMT.  That’s almost right.  This is equivalent to MMT with the condition that the Fed buys up all the bonds issued by the government.)  The government would pay for all the services it provides by printing currency and spending it into the economy.  It would also require all taxes to be paid in the some currency. The government could carry out Keynesian stimulus if it pleases by spending more (issuing more money) during a downturn, and spending less (withdrawing money) during a boom.  Banks would simply be loan arrangers that take deposits, pool them, determine credit worthiness and lend the money without a fractional reserve system of money multiplication.  Commercial banks would be separate from other, speculative, institutions to ensure that only sound loans are made into the real economy.  Investment banks would simply pool investors money to make investments.

[1]  https://slate.com/business/1998/08/baby-sitting-the-economy.html

[2] New York Times, December 4 and 6, 1921

The Federal Reserve should stop paying interest on reserves

In the aftermath of the financial crisis of 2008 the Federal Reserve took many extraordinary measures to prop up the financial system.  Among these was the decision to pay interest on funds held in reserve at the Fed by member banks as authorized by the Emergency Economic Stabilization Act of 2008.

This policy may have been prudent at the height of the crisis, but now, more than ten years later, the banks have returned to stability and this support is no longer needed.

In the almost one hundred years before the 2008 crisis the Fed has only paid interest on reserves very recently for only two short months, first after the 9/11 attacks and second at the beginning of the crisis in 2007.  Despite two world wars, a Great Depression, periods of strong growth, and other gyrations of the economy and financial system no justification was found for paying such interest during these historic events.

Banks have been clamoring for interest on reserves since the beginning of the Fed.  But, there are no good reasons to pay interest on reserves outside of crisis periods.  Reserves held at the Fed and elsewhere are created by the Fed itself as so called “high-powered” money, and in a sense belongs to the Fed. 

Early in the crisis the interest rate paid on reserves was only 0.25%, but now the rate has risen to 2.35% [1].  In June 2019 the total reserves held at the Fed totaled $1577B [2].  At straight interest that equates to $37B in interest paid for the year.  This is an enormous amount of money that the banks have done nothing to earn.

The interest paid is not just a Fed accounting mechanism.  Rather, these are real funds that would otherwise have been deposited with the US Treasury and been available for Congress to spend.  These funds are paid on a kind of autopilot mode without annual Congressional appropriations authorization. So, they have and will continue to grow without any Congressional appropriation or additional authorization.  

If the banks still need this money, then there is something fundamentally wrong with the banks that needs to be resolved.  But, it the banks have recovered, as is evidenced by their strong profitability, then they no longer have need of these funds and Congress should rescind the payment of interest on reserves.

[1] https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

[2] https://www.federalreserve.gov/releases/h3/current/

  

No new currency is needed to pay interest on fiat currency

Often one hears claims that fiat currencies are intrinsically inflationary and ever expanding because more currency is needed in the future to pay the interest on current fiat currency.  At first glance this seems reasonable, but this is actually a specious argument.

A simple example will make this clearer.  Consider a case where an amount of currency has been created through loans, but no more will be created in the future.  Thus the money supply is constant.  Furthermore, let's assume that only the interest on these loans is paid by the borrowers so that the loans themselves will never be paid back, and the money supply will stay constant.

In this case, the interest to pay on the loans must come from the available money supply, which we've already said is fixed in amount.  So, if the claims about needing an ever expanding money supply are correct then this system will quickly grind to a halt as no more currency is being created.  For this to happen the banks would need to hoard all the interest that they receive and never pay it out in any way into the economy.  By doing this the banks would be creating a deflation in the economy as the amount of currency in circulation is ever decreasing as the interest is paid to the banks year after year.  In effect, the banks are increasing their reserves by this hoarding action.

In reality, the banks that receive interest on their loans also pay out those funds in the form of salaries, costs, and profits.  So, the interest payments that come into the bank also go out in the same amount.  This is where the funds for paying the interest comes from.  The interest payments simply circulate in the economy with payments made to the banks as interest and the funds spent back into the economy by the banks.

In a real banking system, as we have in the US, banks are required to hold reserves by regulation at the Federal Reserve.  Moreover, the Fed provides these reserves to the banks. The banks could increase or decrease their reserves as previously mentioned and this would change the money supply in circulation.  But banks have little incentive to increase their reserves as this would reduce the amount they can lend and the resulting interest payments they receive.  Changes in the money supply are closely monitored by the Fed and it acts through its open market operations to influence the money supply by buying or selling assets in the market.  So, there are always funds to pay interest on fiat currency.  The amount of funds may vary according to reserves held by banks and the Fed actions, but nothing is specifically expansionary in the money supply due to interest payments alone.

Best Description of Banking and Finance Today

Professor Richard Werner gave an interview recently where he very concisely describes how our financial and banking system currently works, and more importantly, why it doesn't work well and is unstable.

See: https://www.youtube.com/watch?v=EC0G7pY4wRE

Of particular interest is his comments on bank lending for speculation and how this leads to bubbles and crashes in markets.  How preventing bank lending to speculators, including investment banks, eliminates these boom bust cycles.

In the US we had a law that implemented this principle called Glass-Steagall.  This Depression era law was part of the New Deal separated commercial banking from investment banking and other FIRE industry sectors so that bank lending was not available to these other sectors.

The professor points out the bank lending creates money.  If that money is created against existing assets such as securities and fine artworks then the only result is to increase the amount of money in the economy without creating any new value.  This only leads to increased prices as more dollars chase the some goods.  The reverse is also true.  As lending is withdrawn the money supply falls and asset prices follow suit.  The boom and the bust.

Single Currency Trade Mechanism

Trade has been in the news quite a bit lately due to the Trump administration's focus on the trade deficit, particularly that with China, and its desire to significantly reduce the size of the deficit.

The source of the trade deficit is often presented as one of strong and weak currencies, and an imbalance in demand, with a desire in the US for imports greater than the desire in other countries, again in China in particular, for US goods.  American consumers buy foreign goods with US dollar with the result that US currency builds up in the accounts of the surplus nations.  Up until now these surplus countries have been content to either sit on these large piles of cash, or more likely invest them in US bonds, thus leading to even greater deficits in future as the interest that is also accruing adds to the deficits.  Ultimately, these balances of US dollars must be spent in the US in some form at some time.  How and when appear to be up to the surplus countries, and the US is simply ceding control over trade and currency to those countries, and their intermediaries.

True trade deficits were not possible under the old Bretton Woods system, as surpluses of currencies were re-balanced by the transfer of gold from the deficit country to the surplus country.  In effect the surplus country was buying gold from the deficit country using the surplus currency thereby eliminating the surplus.

Another mechanism is possible for facilitating and settling trade balances that eliminates ongoing trade imbalances.  That of the single currency trade mechanism.  Under this system all trade between two nations is carried out in the currency of one of the nations.  E.g. trade with the US would be performed using only the US dollar.  Sales of an export nation (US imports) would accrue US dollars, and purchases from the US (US exports) would consume those dollars.  Under this mechanism, the US would set up an account for each trade partner nation in the export/import bank of the US.  Exports to the US would generate funds in US dollars which would be deposited in the nation's account.  All exports from the US to that nation would be paid for with US dollars from that account.  A limit on the size of the balance held in the account will limit the trade deficit with that nation.  Once the limit is reached no further sales to the US are allowed.  The trade partner nation will need to spend down the account balance by purchasing US exports in order to regain the right to import to the US.  In this way, the trade imbalance with the US never exceeds the set account limit.

The account limit can also be used to eliminate existing trade balance deficits by setting it to a negative value, which implies that the trade partner nation must itself run a trade deficit with the US to create a negative balance.  This negative limit can be reset periodically, say every month, so that the existing trade balance deficit will be progressively paid down by the surplus nation refunding the account each month from its holdings of existing trade deficit US dollars.  When the accrued trade deficit balance is paid off the set account limit will be set to zero or some relatively small amount that is fixed rather than reset monthly.  Thus, the trade from that point on is essentially in balance.

A great advantage of this system is that it completely eliminate currency exchange rates from trade, as all trade takes place in the single currency.  Indeed, exchange rates may then be set by using the price of a basket of goods traded in both countries as a standard, and comparing the price in US dollars for those goods to the price in the foreign currency.  The resulting ratio is the currency exchange rate.  Any alternative mechanism to set the exchange rate, such as a floating exchange rate or a rate set by the trade partner nation, would require that it result in a demand for imports in the trade partner nation equal to the value of exports from that nation.  Issues of currency manipulation by nations or by intermediaries and speculators are eliminated.  In essence, trade is de-financialized, and returned to the barter model that ultimately underlies trade between nations that use differing currencies.