The Quality Theory of Money: Understanding Transaction Costs and Instability

1. The Quality Theory of MoneyDe-Xing GuanDepartment of EconomicsNational Taipei UniversityMay 28, 2018

2. Money as a Human Device Created to Minimize Costs in Market Transactions • Money is a measuring rod of the value in exchange, but the value of money is unstable • Unstable money results in transaction costs • Business cycles are largely a phenomenon of the instability of money and transaction costs • Baumol, Tobin, Goodfriend, McCallum, Lucas, and Wallace, among others, had included various transaction costs in monetary models

3. Quantity Theory of Money • The most influential theory of money • Proposed by David Hume in two articles of the Political Discourses: Of Money and Of Interest • A modern interpretation was given by Milton Friedman as a “stable money demand function” • Quantitative easing (QE) was an application of the quantity theory of money • Opposed by both Adam Smith and John Maynard Keynes, but for different reasons

4. Real Bills Doctrine • Proposed by Smith in the Wealth of Nations (Bk. II, Ch. II); named by Lloyd Mints (1945) • Actually a quality theory of money • Unfortunately considered fallacious by Mints and Friedman, among others, since Mints thought it was created by John Law, the originator of the Mississippi bubble • Friedman was heavily influenced by Mints when studying at the University of Chicago

5. Real Bills Doctrine (continued) • When a bank discounts to a merchant a real bill of exchange drawn by a real creditor upon a real debtor, and which, as soon as it becomes due, is really paid by that creditor; it only advances to him a part of the value which it would otherwise be obliged to keep by him unemployed and in ready money for answering occasional demands. (Wealth of Nations, Bk. II, Ch. II) • [A] great circle of projectors, who find it for their interest to assist one another in this method of raising money, and to render it, upon that account, as difficult as possible to distinguish between a real and fictitious bill of exchange…for which there was properly no real creditor but the bank which discounted it, nor any real debtor but the projector who made use of the money.

6. History of the Debate and Volcker’s Deflation • Quantity Theory of Money (Hume)  Bullionist (Ricardo)  Currency School (Overstone)  Monetarist (Friedman) • Real Bills Doctrine (Smith)  Anti-Bullionist (Torrens)  Banking School (Tooke)  Keynesian (Tobin) • A modern application of the quantity theory of money was happening on 1979/10/6 when Paul Volcker announced that Fed would increase federal funds rate to stop inflation. • Real bills doctrine was written into the law when Federal Reserve Act was enacted on 1913/12/23. But after Bretton Woods System was suspended on 1971/8/15, the real bills doctrine faded away, and Fed was becoming more active.

8. Keynes on Risk as Cost, and the Cost of Bringing Lender and Borrower Together • It is often supposed that the costs of production are threefold, corresponding to the rewards of labour, enterprise, and accumulation. But there is a fourth cost, namely risk; and the reward of risk-bearing is one of the heaviest, and perhaps the most avoidable, burden on production. (1923, pp. ix-x) • There is, finally, the difficulty…of bringing the effective rate of interest below a certain figure, which may prove important in an era of low interest rates; namely the intermediate costs of bringing the borrower and the ultimate lender together, and the allowance for risk, especially for moral risk, which the lender requires over and above the pure rate of interest. (1936, p. 208)

9. Great Depression and the Quality of Money • In mid-1920s Ben Strong of the Fed had helped Montagu Norman of the Bank of England to restore the gold standard in Britain by lowering interest rates in the United States • But lowering interest rates in normal time might have encouraged speculation in stock and housing markets • Adolph Miller, an adherent to the real bills doctrine (for Eichengreen, not for Friedman), opposed Strong’s policy • Though disagreeing with Fed’s contractionary policy in September 1931 when Britain departed from the gold standard, Friedman and Schwartz did not oppose Strong’s expansive policy in mid-1920s. Their emphases were, in effect, on the quantity instead of the quality of money.

10. Great Recession and the Quality of Money • Goldman Sachs created…the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation…The rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms…pronounced 80 percent of the new tower of debt triple-A…The goal of the innovation, in short, was to make the financial markets more efficient. Now, somehow, the same innovative spirit was being put to the opposite purpose: to hide the risk by complicating it. (Michael Lewis, The Big Short, 2011, pp. 72-74) • CDO/CDS (credit default swap) had become fictitious bills • What central banks did was creating more money through QE, emphasizing the quantity rather than quality of money

11. Quantitative Easing and Its Social Cost • The Bank of Japan initiated the world’s first QE in March 2001, which was followed by the QQE in April 2013 • Fed launched its first QE in late 2008 and three more of it before Fed finally decided to exit in December 2015, when the interest rate was raised for the first time after the crisis. • Even though providing liquidity service to the market, QE has at least two social costs: (1) it would have encouraged Wall Street firms to take more risks and pass them on to investors and taxpayers, (2) it has encouraged speculation in stock, housing, and high-yield bond markets and might have sowed the seeds for the next financial bubble

12. Japan’s Lost Decades and the Balance Sheet Recession • The Heisei bubble burst in January 1990, and had left huge debts to many firms and banks. • The first priority of these firms had been to pay back the debt to banks such that their balance sheets could be fixed as soon as possible. • Firms were therefore not maximizing profits but minimizing debts, as emphasized by Richard Koo • In April 2013 the Bank of Japan initiated QQE, which paid more attention to the quality of money.

13. A Model of the Quality Theory of Money • There are four agents in our model: consumers, banks, firms, and the central bank. • The central bank issues fiat money for consumers and firms to make transactions in the market. • Consumers deposit money in banks for real deposit rate r’. Following Goodfriend and McCallum (2007), banks use monitoring labor effort and collateralized capital to make loans at a real loan rate r for firms to produce final goods. • The rate of return of firms is marginal efficiency of capital (MEC) which would satisfy the inequality: MEC>r>r’>0.

14. Banks, Firms, and Loanable Funds Market • Loanable funds are assumed to be an intermediate input to the production of the final good. • Financial markets are supposed to be more efficient in making loans if they are monitored (or real). Firms can also finance their investments through homemade leverage. • Following Modigliani and Miller (1958) firms are assumed to minimize the cost of capital. This is also consistent with Japan’s experience as described by Koo (2009). • Monitored loans are better than unmonitored ones because they have higher quality: with real creditor and real debtor.

15. Banks, Consumers, and the Central Bank • The government wishes to maximize the rent of printing money net of transaction costs of implementing monetary policies: (R’-C(g))M0, where C(g) is Friedman’s (1986) resource cost of irredeemable paper money. M0 is monetary base. • Friedman’s optimum quantity of money (zero nominal interest rate) is a special case of our model in which R’=C(g)=0. • The optimum of Maurice Allais was to let the real interest rate be zero. Neither Friedman nor Allais is optimum if there are transaction costs.

16. A Model with Coasian Transaction Costs

23. Cash: A Curse or a Blessing? • The cost of using cash is not just the cost of replenishing cash as in the Baumol-Tobin model. The implementation of the third-party payments, mobile payments, and digital currencies needs the establishment of economic and legal frameworks. These are costs of enforcing contracts. • With digital currency, such as bitcoin, China’s corrupted money has been secretly transferred abroad because CNY (renminbi) is not an international currency. This was why China would banish bitcoin last year. This is not the case for the United States because U.S. dollar is much more internationally accepted, as emphasized by Rogoff (2016). • A curse for America might be a blessing for China. For hiding corrupted money, USD is a better choice than CNY.

24. Is ZLB or RZLB the Real Lower Bound? • Zero lower bound (ZLB) came from Keynes’s idea of liquidity trap. It is a lower bound for nominal interest rate. • As long as there is cash, ZLB would be real lower bound because banks couldn’t charge negative interest rates. • But if cash were going to disappear, negative nominal interest rates would no longer be a problem, and the real lower bound for nominal interest rates must be smaller. • An application of our model is that if there are transaction costs, then the lower bound might be the real zero lower bound (RZLB) where the real interest rate is zero.

25. It’s Quality, not Quantity, of Money that Matters • The quality of money is very important because fictitious money might generate transaction costs large enough to induce financial bubbles. • Quantity-based monetary policies, such as QE, might solve the short-run problem of liquidity crisis when bubble burst, but this is often at the cost of long-run financial instability. And the long run is usually much shorter than anticipated. If this is the case, then in the long run we might not be dead. We might all live well to see another bubble.

26. Digression on Silver in Ming’s China • The quality theory can be applied to the study of China’s silver standard (1436-1935), especially in Ming dynasty. • Ever since the unbacked paper money was issued in 1375, Ming dynasty had experienced inflation and fiscal deficits. • This was one of the reasons why the last voyage of Zheng He ended in 1433, just three years before the paper money was suspended in some provinces in 1436. • Though de facto in 1436, silver standard was established de jure in 1581 when households were required to pay both land and poll tax with the so-called “single-whip method”. • The quality theory of money was therefore important for us to explain some interesting problems in Ming’s China.