George Selgin

Economists, and central bankers especially, are inclined to treat financial innovations as something that makes managing the money stock more difficult, thus increasing the need for monetary discretion. Financial innovations, the argument goes, tend to lead to unpredictable changes in the “money multiplier” or in the demand for particular monetary aggregates or both. Consequently, the more innovations that occur, the less merit there is in monetarist arguments for binding the hands of monetary authorities, making them obey strict rules, and monetary base growth rules in particular. The emergence of new electronic means of payment, or “e-money,” is only the latest private financial-market wrinkle to excite the anxieties of central bankers, giving them grounds for asserting their right to improvise.

But there is another way to think of financial innovations, including e-money, that leads to quite opposite conclusions. Financial innovations can often be understood as the private market’s way of supplying new and improved alternatives to central-bank issued payments media. The more such innovations succeed, the less the public has to rely on central banks as direct sources of exchange media. And, the less the public has to rely on central banks, the more it can afford to deny such banks discretionary powers. This seems to me to be particularly obvious in the case of e-money.


Privatizing the U.S. Money Stock

For most of this century the Federal Reserve, like most other central banks, has had a monopoly of hand-to-hand currency. Regulations, including a prohibitive tax on state bank notes and bond-collateral requirements for National Bank notes, both dating back to the Civil War, have long prevented private financial firms from directly challenging the Fed’s currency monopoly even when they might have been able to offer more attractive and efficient alternatives–private bank notes were last issued in the United States in the 1930s. The public has therefore had little choice but to allow the Fed the freedom to issue too much money, or bear the consequences of being stuck with too little.

The development of electronic money, and cash cards especially, holds out the promise that the public may one day cease to be hostage to the Fed. E-money amounts to a technological end-around play, circumventing long-standing restrictions on private bank notes. In principle at least, cash and debit cards together could entirely take the place of Federal Reserve notes presently circulating within U.S. borders.[1An unknown but very substantial part of the outstanding stock of Federal Reserve Notes is held outside the United States. The chances of e-money supplanting such foreign holdings of Federal Reserve Notes seem relatively slim.] The U.S. money stock in public hands would then be fully privatized, with the Fed serving only as a source of bank reserves.


E-Money and the Merits of a Monetary Base Rule

Far from making a strict monetary base rule less workable, such a privatized money stock would make it more workable than ever, because the Fed would no longer have to have the power to adjust the amount of base money in response to changes in the public’s demand for cash.

A little algebra helps clarify the argument. As any student of money and banking knows, up to now our monetary system has been one in which the money multiplier–the ratio of total public deposit and currency holdings to the monetary base (the outstanding amount of Federal Reserve notes and bank reserve credits at the Fed)–depends on at least two variables. These are (1) the public’s desired currency-to-deposit ratio (c) and (2) the bank’s desired reserves-to-deposit ratio (r). The formula for the multiplier is m = (1 + c)/(r + c), where the total money stock, M, is equal to mB, and B stands for the monetary base. In this formula, B is the only thing that the Fed controls with any degree of precision: to expand B by $100 million, the Fed only has to arrange to purchase an equal value of government securities in the open market.

The great virtue of a monetary base rule is, therefore, that the Fed could not fail to abide by such a rule except through outright negligence or caprice. In contrast, with any other sort of rule (including a zero inflation rule), the Fed could always appeal to unforeseen changes in factors beyond its control as its excuse for failing to keep its promise.

A long-standing argument against a monetary base rule is that such a rule would not allow the central bank to adjust the base in response to unforeseen changes in the public’s desired currency ratio. Historically, changes in the public’s desired currency ratio have been a major determinant of both cyclical and seasonal changes in the money stock. Unpredicted changes in that ratio have, in the absence of some offsetting Fed response, led to undesired changes in the money stock, nominal spending, and prices–most notoriously during the banking crises of the early 1930s.[2Prior to 1933, the public’s increased demand for currency did not reflect any general loss of confidence in private circulating exchange media–as evidenced by the widespread use of scrip and by the continued strong demand for National Bank notes. There is every reason to believe, in other words, that some further relaxation of restrictions on bank note issuance would have helped banks to protect their reserves. (The bond-deposit requirements limiting the issuance of National Bank notes were in fact relaxed temporarily, but only enough to allow an extra $230 million in such notes to be issued.) Things changed in early 1933, when rumors of a devaluation led to a run on the dollar.] The emergence of e-money strengthens the case for a strict monetary base rule by, in effect, helping to eliminate the currency ratio as a factor influencing the money multiplier. The multiplier would then simply be the reciprocal of the banking system reserve ratio. The challenge of monetary control would be simplified accordingly: with one less variable to worry about, the Fed would not need so much freedom to improvise.

That at least would be true if e-money could completely take the place of Federal Reserve notes, making further issues of such notes unnecessary, and allowing the Fed simply to “sterilize” old notes turned in by banks for reserve credits.[3The Fed could do this by automatically reducing its base-money growth target by the factor (1-r) times the value of returned notes.] In fact, with perhaps $100 billion in Federal Reserve notes still circulating within U.S. borders, we have a long way to go before we can afford to shut down the Bureau of Printing and Engraving. In particular, persons who do not currently have bank accounts, and who could not easily afford digital wallets, may need some encouragement to induce them to make do without greenbacks. Perhaps the government might help things along by equipping needy applicants with free e-wallets, financing the operation with funds diverted from the printing presses. But do not expect the government to jump at this idea: the Treasury stands to lose billions of dollars of revenue from any reform that lessens the demand for government paper money.[4Those who insist that this revenue is too small to be of great concern to the Treasury are invited to explain that agency’s outspoken opposition to the plan–endorsed by the Federal Reserve–for payment of interest on bank reserve deposits.]



Even a thoroughgoing privatization of the money stock is not enough to make a strict (no-feedback) monetary base rule work perfectly. Undesired fluctuations in nominal incomes and prices could still occur as a result of unforeseen changes in bank reserve ratios or the demand for money. But the case for a strict monetary rule has, after all, never been based on the claim that such a rule would be perfect. It is based on the claim that an imperfect rule would be better in practice than any imperfectly used central bank discretionary powers. Monetarists ought to welcome e-money, as a development that may help to bring a strict monetary base rule one step closer to perfection.


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