User:JRSpriggs/Optimal monetary policy

"Optimal Monetary Policy" by James Richard Spriggs, email jrspriggs2000@gmail.com.

The Optimal Monetary Policy is to achieve the maximal sustainable deflation of prices. The way to do that is to maximize the worth of the reserve assets divided by the monetary base.

The more a currency increases in value over time, the more desirable it is to hold it. The Fed should change its policy to increase the value of the dollar as rapidly as possible. The Monetary Base should be made equal to the sum of the prices of the reserve assets. Only pro-cyclic assets should be held in the reserve.

The purpose of money
In most cases, it is far more efficient for a person to produce what he is good at producing and trade it for what he needs than to directly produce the things he needs for himself. However, barter is still not efficient enough, because it would require two people to each produce what the other needs and exchange. A special intermediate good called money is needed to allow a person to sell his product or service to the person who is willing and able to pay the most for it and then take the proceeds and use them to buy what he needs from the person who produces it most efficiently.

For something to be useful as money it needs several properties including: safety, durability, portability, quantifiability, fine divisibility, and general acceptability. However, the only property which will concern us here is that it must be a good store of value. One acquires money by a sale which occurs at one time, and then spends it in a purchase which occurs at a later time. If the value of money declines during this period (i.e. prices rise), then the individual is receiving less for his efforts than would otherwise be the case. On the other hand, if the value of money rises during this period (i.e. prices fall), then the individual is receiving more for his efforts. Clearly the individual who uses money should prefer the value of the money to increase as much as possible. So if there are two or more competing forms of money available, the individual will try to sell his product or service for the stronger currency. Also he might not be willing to sell at all, if the currency offered is depreciating rapidly.

The success of a currency depends on the choice of people to accept and hold it in preference to other currencies. A person makes this choice when he sells a good or service for money in the hope that he can later use it to buy other goods or services of greater value to himself. Naturally he will prefer the form of money which maintains or increases its value the most because this will allow him to purchase the largest amount of goods and services with his savings. Thus we can predict that the the most deflationary currency would ultimately triumph in a free competition among various currencies.

The purpose of a Monetary Authority
In the future, there will be a completely free market for money. The history of globalization of markets makes this apparent; and it is necessary to maximize the efficiency of the market and thus to achieve the greatest rate of economic growth. Consequently, there will be free competition among currencies and it will be intense.

The Federal Reserve System (FRS) is the Monetary Authority (Central Bank) of the United States. It is responsible for creating and managing the dollar. The physical dollar (coins or notes) is produced at the Mint, but FRS is charged with introducing it into the economy in such a way that it can function as money. In view of purpose of money described above, this means that FRS should manage the dollar in such a way that it maintains and increases its value. Otherwise people will reject it and it will fail to function as money which would result in the failure of FRS as a Monetary Authority. Indeed, if FRS is to avoid extinction, it must beat out its competitors by strengthening the dollar as rapidly as possible.

To produce the most deflationary currency, FRS must assume a responsibility to the owners of dollars to maximize the value of the dollar. The dollar will become like a share of stock in FRS which will function like a holding company or mutual fund.

Ethical constraints on the Monetary Authority
Some Monetary Authorities have been tempted to cheat in various ways. For example, they try to use political power (police) to exclude competing currencies from the jurisdiction of their host government. Or they try to compel producers to accept their currency in trade under conditions dictated by the government. Ultimately these attempts fail because they cannot change the underlying economic reality that you cannot get something for nothing.

Another temptation has been to try to buy off the government to get political protection from hostile forces e.g. leftists and shorted-sighted debtors. But paying protection to one's enemies is self-defeating because it makes them stronger and you weaker. Some Monetary Authorities plunder their reserve assets and lie about it. But the truth comes out and causes a collapse of the currency as in the Asian financial crisis of the late 1990s. Or they try to maintain an unsustainable exchange rate, that is, one for which they do not own sufficient reserve assets to entirely redeem the outstanding currency. Again this eventually leads to failure.

The optimal strategy for managing the quantity of money
The monetary base (M0) is defined as the quantity of Federal Reserve Notes and U.S. coins in circulation outside FRS plus deposits in FRS. In other words, it is the dollar-denominated liabilities of FRS.

A reserve asset is an asset held by the FRS for the purpose of allowing it to take dollars out of circulation, when necessary, and thus prop up the value of the dollar. A rational monetary policy will cause the value of a dollar to tend to approach the sum of the values of the reserve assets divided by the monetary base. Let us call this ratio the target. Our objective is to increase the target at the fastest sustainable rate, and thus cause the value of the dollar to rise at the fastest sustainable rate.

If there is too much money in circulation (i.e. credit is too loose), then prices rise excessively which makes the sum of the prices of the reserve assets rise above the monetary base. That is, the value of a dollar will fall below the target. Current prices on the auction market should be used for this calculation. When this happens, FRS should sell assets to take dollars out of circulation and raise the dollar's value.

If there is not enough money in circulation (i.e. credit is too tight), then prices fall excessively which makes the sum of the prices of the reserve assets fall below the monetary base. That is, the value of a dollar will rise above the target. This is an unsustainably high value of the dollar. When this happens, FRS should take advantage of the opportunity to buy more reserve assets while they are relatively cheap. These purchases will also provide the additional money needed by the economy.

In both cases, these transactions increase the target. That is, they earn a profit (per "share") for FRS. This enables the value of a dollar to be higher in the long run which makes it more useful and attractive as a currency.

Selecting reserve assets
A good reserve asset should satisfy three criteria:
 * it should be liquid, that is, it should be possible to sell it quickly for nearly the same amount that one paid for it;
 * it should grow in value as rapidly as possible; and
 * its price should be relatively low when FRS has to buy it, and relatively high when FRS has to sell it (buy low and sell high). That is, it should be pro-cyclical rather than counter-cyclical.

The third criterion maximizes the effectiveness and profitability of FRS's open market operations. Assets should be bought when prices are generally low, so the assets selected should have especially low prices in that case. Assets should be sold when prices are generally high, so the assets should have especially high prices in that case. In other words, the assets' values should have a negative correlation to the dollar's value.

For example, bonds denominated in dollars are an unsuitable asset. When the value of the dollar falls, such bonds would also tend to fall in value which would undermine the ability of FRS to prop up the dollar by selling them.

The ideal reserve asset is common stock in companies whose value has a negative correlation with the value of the dollar. Such companies include: exporters, manufacturers of durable goods (e.g. refrigerators), and companies with more dollar liabilities than dollar assets. In any case, the business must be in good condition with prospects for growth or income. If ownership of common stock presents a political problem, then near-equivalents could be bought such as: mutual funds, stock index futures, warrants, and call options. Commodity futures and options to exchange dollars for foreign currency (e.g. call options on Yen) are also good reserve assets. Bonds denominated in something not correlated to dollars (say gold or foreign currencies not linked to the dollar) are not ideal, but acceptable. As are bonds whose value is adjusted by a price index, such as: the consumer price index (CPI), the producer price index (PPI), the GDP deflator, the price of gold, the price of silver, etc..

Also the FRS should seek to diversify its reserve assets &mdash; perhaps choosing roughly equal proportions of all suitable asset classes. This serves to minimize risk and avoid driving up the prices of the assets any more than is unavoidable.

Formulas
Defining the variables which describe the Reserve:
 * $$B_i \, = \, \text{Price at which FRS can buy an asset of type i} \, + \, \text{commissions, taxes, etc.}$$
 * $$S_i \, = \, \text{Price at which FRS can sell an asset of type i} \, - \, \text{commissions, taxes, etc.}$$
 * $$W_i \, = \, \text{How much an asset of type i is worth,} \, \frac{S_i}{cpi} \, \text{, if suitable and held for 5 years; 0, otherwise.}$$
 * $$q_i \, = \, \text{Quantity of assets of type i currently held by FRS}$$
 * $$R \, = \, \text{Worth of the reserve} \, = \, \sum_i q_i W_i \,$$
 * $$M_0 \, = \, \text{dollars cash in circulation} \, + \, \text{dollar deposits in FRS}$$

The strategy is to maximize the target
 * $$\frac{R}{M_0} \, \to \, + \infty \,$$

which is approached by the value of a dollar.

When an asset of type i is bought, we require that
 * $$\frac{R + W_i}{M_0 + B_i} \, > \, \frac{R}{M_0} \,$$
 * $$(R + W_i) M_0 \, > \, R (M_0 + B_i) \,$$
 * $$W_i \cdot M_0 \, > \, R \cdot B_i \,$$
 * $$W_i \cdot \frac{M_0}{R} \, > \, B_i \,$$

When an asset of type i (for $$q_i > 0 $$) is sold, we require that
 * $$\frac{R - W_i}{M_0 - S_i} \, > \, \frac{R}{M_0} \,$$
 * $$(R - W_i) M_0 \, > \, R (M_0 - S_i) \,$$
 * $$- W_i \cdot M_0 \, > \, - R \cdot S_i \,$$
 * $$W_i \cdot M_0 \, < \, R \cdot S_i \,$$
 * $$W_i \cdot \frac{M_0}{R} \, < \, S_i \,$$

How do we get from here to there?
To make the transition from current monetary policy to the optimal policy described above, FRS should do the following:

(a) Immediately announce this new monetary policy to give economic actors as much time to prepare for it as possible. This will minimize the costs imposed by economic miscalculation during the transition to the new policy.

(b) Cease activities which: violate individual rights, distract from the purpose of a Monetary Authority, or are otherwise irrational. These include: setting a minimum margin for brokerage accounts, enforcing anti-discrimination rules in lending, encouraging community reinvestment, etc..

(c) Presently FRS earns money on its reserve assets and turns most of it over to the United States Treasury. Such payments reduce the reserve assets available to support the value of the dollar. They are the reality behind the 'inflation tax' and are harmful, like a tax. FRS should stop these payments.

(d) Redeem the paid-in-capital which banks have been forced to contribute to FRS. Each member bank should also receive a prorated portion of the surplus (proportional to its paid-in capital). As a result, the net-worth of the FRS will be reduced to zero for the moment, i.e. $$M_0 = \sum_i q_i \frac {B_i + S_i} {2} \,.$$ This will settle the question whether the member banks or the owners of dollars are the proper beneficiaries of FRS's actions. Henceforth, the owners of dollars will be the beneficiaries in proportion to the amount of dollars they hold.

(e) Replace its current reserve assets with a more appropriate kind of asset. Presently FRS assets consist primarily of U.S.Treasury securities; with smaller amounts of: gold, securities of the IMF, foreign currency, rediscounted bank loans, etc.. Some of these assets provide a substandard return which implies that their worth ($$W_i \,$$) will be low relative to their price. This will naturally cause them to be eliminated from the reserve. Most U.S.Treasury securities are denominated in dollars. Assets which are dollar denominated, invested in unethical activities, or otherwise unsuitable should be sold and the proceeds used to buy the appropriate type of asset. This could be accomplished by setting the worth of such inappropriate assets to an artificially low value (0) thus causing them to be selected for sale and not purchase.

(f) Start applying the new monetary policy. It seeks to maximizing the target and thus the value of the dollar.

Answers to some likely questions
(a) Q: Will there be enough money? A: Yes. When there is too little money, then there will be surplus goods and services, then prices will fall, then reserve assets will fall below the monetary base, then more reserve assets will be purchased, then the money supply will increase until the problem is solved.

On the other hand, when there is too much money, then there will be shortages of goods and services, then prices will rise, then reserve assets will rise above the monetary base, then reserve assets will be sold, then the money supply will decrease until the problem is solved.

(b) Q: How can deflation be reconciled with sufficient money? A: This policy produces the maximum sustainable deflation. However, deflation can be higher in the short run if tight money occurs and FRS does not purchase more reserve assets. This would indeed cause a recession, but it is not what I am advocating. The policy advocated here would result in a greater real value of the money supply than could be realized by the usual inflationary policies because people would be willing to hold a larger fraction of their wealth in dollars.

(c) Q: What about the business cycle and the Great Depression? A: The business "cycle" is the response of the economy to shocks from changes in: government policies, demographic and environmental conditions, and technology. One of the causes of the Great Depression was a contradictory monetary policy. The monetary policy of that period tried to do two inconsistent things: maintain convertibility of the dollar to a fixed amount of gold; and use re-discounted bank loans and U.S.Treasury securities as additional reserve assets in order to expand the money supply. Eventually the convertibility of the dollar became at risk, so monetary and fiscal policy was tightened excessively. This triggered bankruptcies, fear, and the liquidity trap. Misguided interventions made things much worse.

(d) Q: Why not use gold exclusively as the reserve asset? A: Many conservatives, having a justified distrust of government, ask this question. Unlike stocks and bonds, gold is not a productive investment &mdash; it just sits there and racks up storage fees. It does not grow in value as a good reserve asset should. As a result, the real value of the monetary base would always be too small and the dollar would lose out to other forms of money and near-money. If government prevented the use of these other forms of money (as governments have often done), then repeated recessions would result.

That is, gold suffers from two problems: (i) A share of stock or a bond can be held by a person as a kind of near-money while simultaneously the physical capital which it represents is also used by a business firm to create more wealth. In contrast, gold cannot simultaneously be used for its industrial applications and as money. (ii) The elasticity of demand for gold is too low make its value stable throughout a business cycle. Consequently, people try to supplement their gold with other financial assets which can make them vulnerable to losses when those inflated assets lose their value.

(e) Q: Is not Price Stability the proper goal of Monetary Policy? A: No. Some people, not understanding the proper purpose of monetary policy, have seized on price stability. Why? Because stable prices would make it easier for people to plan their economic activities. However, conditions are always changing and price changes are necessary to communicate this information to economic actors. At least, the policy advocated here is more predictable than the subjective thinking of the Open Market Committee of FRS which controls policy today.

(f) Q: Does not this policy require government intervention in the market for stocks and corporate bonds, thus picking winners and losers? A: This policy does not involve coercion, which would be inconsistent with ethics. However, picking winners and losers is an unavoidable feature of ANY policy. Since the existing policy uses U.S.Treasury securities as the main reserve asset, the existing policy is already favoring the United States Government over the private sector. Using gold as money would favor companies which mine gold and process it into coins.

(g) Q: Would not the burden of debt become unbearable and trigger chain-reaction bankruptcies as in the Great Depression? A: One of the motives which led me to discover this policy was a desire to stop monetization of debt. Monetization of debt and inflationary policies have encouraged excessive use of debt. Ending the policies which favor debt will make existing debt more burdensome which will pose a problem for debtors. This will be offset somewhat by purchases of stock in companies with debt &mdash; allowing conversion of debt to equity. In the long run, the reduction in debt will result in a healthier economy.

(h) Q: What about FRS's check clearing function? A: This and other actions which help settle accounts denominated in dollars tend to support the usefulness of dollars as a form of money. Thus it is appropriate for FRS to engage in them. I do not propose any change in them.

(i) Q: What about reserve requirements on member banks and other rules intended to ensure that they fulfill their obligations? A: Rules dealing with the solvency of a member bank, such as reserve requirements or capital requirements, should be the responsibility of the Federal Deposit Insurance Corporation (FDIC) or other insurer. FRS should merely require that member banks have adequate insurance as a condition of membership. But, if a member bank funds terrorists, commits fraud, or other crimes, then it should be suspended from participation in FRS mediated activities and reported to the FBI.

(j) Q: Would not FRS be insolvent when reserve assets dip below the monetary base? A: No. Insolvency means that you lack the ability to fulfill your promises. This new policy would promise nothing except to make sales and purchases of reserve assets at current prices when indicated. Assets would only be sold when their prices are more than sufficient to redeem the entire monetary base. Assets could always be purchased because FRS can create money by fiat. Perhaps your confusion is caused by thinking of FRS as if it were a normal bank. I now think of it as more like a mutual fund or holding company. It would trade in a mix of its own shares (dollars) and shares of other companies; always seeking to maximize the net asset value per share outstanding.

(k) Q: What about the dividends earned by stock in the reserve assets? What about interest and return of principal of bonds in the reserve assets? Do not these amount to involuntary sales which might occur even when money is tight and FRS should not be making sales? A: When money is tight or neutral, these amounts should be rolled-over immediately into purchases of more of the same kind of reserve asset. The expected cost of roll-overs should be taken into consideration when estimating the rate of return on that type of asset. The rate of return would be used in selecting which type of assets to hold as reserves.

(l) Q: What if a security in the reserve assets becomes worthless because the company goes bankrupt? A: Then its price becomes zero and it does not contribute to the calculated amount of reserve assets. The downside (and upside) risks should be taken into consideration when estimating the rate of return of a type of asset.

(m) Q: How rapidly should the sales or purchases of reserve assets be done? A: Rapid sales ('fire sales') or purchases would cost more due to higher administrative costs and limits on the ability of other traders to respond quickly. On the other hand, one has to consider the opportunity cost that might occur if the tightness or looseness of money corrects itself spontaneously before FRS has a chance to carry out its transactions; and the cost due to time preference (sooner is better than later). The guide should be to maximize FRS's profit per dollar.

(n) Q: How do you calculate the profit on these transactions which you say that FRS should be maximizing? A: Roughly, at the end of each accounting period (year?), sum up the prices of the reserve assets. Then subtract the dollar equivalent of any liabilities of FRS not denominated in dollars (thus not in the monetary base). Divide this by the consumer price index to convert it to 'value' units. Divide the quotient by the monetary base to get the target. Divide the target at the end of the period by the target at the beginning. Then take the natural-logarithm of the ratio, and divide that by the duration of the period to get the rate of growth of the target. This measures FRS's success over the accounting period. Additional details of the calculation would require more knowledge of accounting than I have.

(o) Q: Usually FRS has sought to achieve a specific value of the federal funds rate using the Taylor rule. If they abandon that policy, what is to prevent interest rates from becoming painfully high? A: Trying to set interest rates is inconsistent with the optimal monetary policy described above. However, interest rates are addressed implicitly because they affect the prices of stocks and bonds and the expected rates of return from them. Milton Friedman has proved that the optimal nominal short-term risk-adjusted rate of interest is zero. I believe that this policy would normally achieve that. In exceptional situations, when the nominal interest rate rises significantly above zero, FRS could use a modified form of the Taylor rule
 * $$i_t = 1.5 \pi_t + (50\%/\operatorname{year}) ( y_t - \bar y_t ) + 3.0\%/\operatorname{year} \,$$

where $$\,i_t\,$$ is the target for the federal funds rate, $$\,\pi_t\,$$ is the rate of inflation as measured by the GDP deflator, $$\,y_t\,$$ is the natural logarithm of real GDP, and $$\bar y_t$$ is the natural logarithm of potential output, as determined by a linear trend. If the federal funds rate rises above the larger of 0.50%/year and the target given by this rule, then sales of reserve assets would be suspended and purchases (when consistent with $$W_i \cdot \frac{M_0}{R} \, > \, B_i \,$$) would be accelerated.

(p) Q: What if money is tight and the supply of potential reserve assets of adequate quality is exhausted so that you cannot make the necessary purchases? A: If one assumes that the government does not cheat by giving FRS preferential treatment compared to the private sector, this could only occur if FRS was a better manager of the means of production than the aggregate of entrepreneurs and capitalists in the private sector. That would mean that socialism was superior to capitalism. History and Ludwig von Mises have decisively disproved that notion. In any case, what would other policies do in this situation to loosen money?

(q) Q: If money remained loose until the sales of reserve assets had redeemed the entire monetary base, would not FRS be out of business? A: Yes. Even adopting this strategy would not guarantee the survival of FRS, merely give it a chance. If other Monetary Authorities adopted the same strategy and did a better job of implementing it, then FRS could fail anyway. But do not worry too much; there would still be those other forms of money. If the dollar were the only viable currency, its disappearance could not occur without money first becoming very tight which would stop and reverse the shrinkage.

(r) Q: What is the essential difference between this proposed Monetary Policy and other proposals? A: The other proposals seek to manipulate the economy, i.e. other people and their property, to achieve someone's idea of the 'public good'; or they pretend to do so while pursuing a corrupt hidden agenda. This proposal is based on individuals and Monetary Authorities pursuing their own rational self-interest in the context of a free market. Then Adam Smith's 'invisible hand' will take care of the 'public good'.

(s) Q: You say that the owners of dollars are the proper beneficiaries of FRS's actions; and you say that Monetary Authorities including FRS should act for their own interest. Is this not a contradiction? A: No. A businessman works directly for the benefit of his customers, but indirectly for himself because he can only profit if he sells his product or service. Managers of mutual funds work directly for their shareholder's benefit, but indirectly to get the management fees and other benefits of their employment. The same would be true of FRS.

(t) Q: How would FRS account for its costs of operations, such as: salaries, commissions, payments to the Mint for printing cash, payments to the secret service for catching counterfeiters, rent on its offices, office supplies, etc.? A: If the cost is attributable to services provided to a particular member bank or other depositor, then that entity would be charged an appropriate fee. If to a particular reserve asset, then it would reduce the effective return on that asset. Otherwise, it is general overhead and would affect them all proportionately.

(u) Q: Would not your policy lead us into the infamous liquidity trap? A: Nominal interest rates would be about zero, so many people would be unwilling to lend money. Deflation might make real interest rates high enough so that many people would be unwilling to borrow money. But a liquidity trap should be defined as a situation where money is tight and cannot be loosened. When conventional monetary policy has been unable to loosen tight money, this is because the Monetary Authority was unwilling to buy the correct type of reserve assets (see the third criterion) in sufficient quantity. Buying dollar denominated bonds is almost useless in this situation, if even possible. Buying stock in companies whose value is depressed by the tightness of money would be effective, if done in sufficient volume. This would cause capital formation to be increased to offset a temporary lull in consumption spending.

(v) Q: Would you still allow rediscounting of bank loans? If so, would they not be a reserve asset denominated in dollars? If not, how would FRS help troubled banks? Or would it? A: If the bank is failing due to a long-term problem such as bad management, then it should be allowed to fail, not propped up. If it has a temporary problem due to factors beyond its control, say a hurricane puts some of its investments out of business and there is a run on the bank, then FRS might consider buying part ownership in the bank to infuse funds until the crisis is over. But only if it is a good investment and only temporarily.

(w) Q: What about other types of assets, such as: preferred stocks, convertible bonds, warrants, puts, calls, index futures, commodity futures, real estate, mortgages, etc.? A: If they meet the three criteria, why not? Real estate and mortgages are illiquid, thus not appropriate. Also mortgages are usually denominated in dollars, so again not appropriate. But stock in a company which holds mortgages in foreign countries might be OK. Preferred stock and convertible bonds are usually linked to the dollar, so no good as a reserve asset. Calls are good. Puts in foreign countries might be OK. And so on.

(x) Q: Do we really need reserve assets? If other forms of money were prohibited and the monetary base held fixed, then would not the scarcity of dollars be sufficient to maintain the value of a dollar? A: First, the prohibition would: violate individual rights; hurt people by preventing them from taking actions which advance their interests thus hurting the economy; and consequently provoke political and even violent opposition. Second, people would find ways to work around the prohibition by substituting near-money (financial assets and liquid commodities) for money. Third, there are fluctuations in the demand for money because people sometimes want to save (say when they are young and working) and sometimes want to dissave (say when they are sick, unemployed, or retired). To cushion these fluctuations, it is necessary to have net creation of capital in some periods and net consumption of capital in other periods. My policy does that. The policy suggested by the question would not, so it would cause a series of deflationary recessions alternating with stagflation (stagnation plus inflation).