In my previous post I outlined the strategy used by Exchange Traded Funds (ETFs) to create financial assets that offer both price stability and high liquidity. I defined price stability as the ability to hold the asset without gaining or losing purchasing power. And liquidity as the ability to buy or sell the asset on demand. Since this mechanism has been shown to work very well in the equity markets, I think it could be instructive for issuers of fiat currency, because fiat currency are also financial assets that are supposed to offer price stability and liquidity.
To that end I extracted four guidelines for a currency issuer to follow, based on what is already known about successful ETF operations:
- The issuer should only spend/create assets for those willing to earn/buy them.
- The issuer should only tax/redeem currency while earning it itself.
- The issuer should remain responsive to users desire for more or less currency in circulation.
- The issuer should not attempt to increase or decrease the supply of currency of its own volition.
The purpose of this post is to show how these guidelines differ with the recommendations of economists, which have served as guidelines for actual currency issuance until now. I will discuss each rule in turn.
- The issuer should only spend/create assets for those willing to earn/buy them.
ETF issuers do not issue new shares of the ETF unless you bring them them a basket of stock that perfectly matches the basket held by the fund. If they were to give away newly issued shares for free, the value of those shares would be diluted. But economists insist that holders of currency require free assets in the form of interest payments. Holders do not have to do anything other than register their desire for free assets by purchasing a special type of currency called government bonds. Their justification for these free assets is elaborate, but the net result is a belief that if you hold currency, the currency issuer should give you more of it as a reward for holding it. Needless to say, ETFs would be far less popular if the ETF issuer diluted its assets just to entice people into holding ETF shares. Furthermore, the existing popularity of ETFs indicates that no such enticement is necessary. For centuries, economists have argued that if government were to stop paying interest, no one would want to hold the currency they issue. However monetary policy experiments in the wake of the financial crisis have proven this theory incorrect. It turns out that there is strong demand for currency assets even without the promise of compensation to the holders. Just as there is strong demand for ETFs.
- The issuer should only tax/redeem currency while earning it itself.
In the world of ETFs, redemptions are what destroy shares of the ETFs. You approach the ETF issuer with shares in hand, and they give you back the fixed portion of the basket that your shares represent. In other words, they earn the shares back by delivering a fraction of the basket to the user. A consequence is that the basket controlled by the ETF shrinks along with the quantity of shares. Of course, the currency analog of redemption is taxation. And the currency analog of the basket is the real economy, which is just a pool of real assets that can be purchased in exchange for currency. For a currency issuer, this means that taxation should be tied to events that cause the pool of real assets to shrink! But in economic theory, taxation has nothing to do with shrinkage of the real economy. Instead, they believe that taxation is required to fund every single dollar of spending by the currency issuer, even in the presence of an expanding pool of real assets and increasing demand for the currency! This amounts to a forced “redemption” of assets with nothing offered in exchange. Needless to say, if ETFs operated this way, no one would want anything to do with them. You could even call it theft. I am not saying that all taxation is theft. I am saying that taxation beyond what is required to avoid dilution of the currency could be called theft. This means that any activity that shrinks the pool of real assets should be associated with taxes in kind. This includes war, which is the outright destruction of the wealth that markets create. It also includes consumption of non-renewable resources. The point is that the issuer should only tax what makes us permanently poorer. What leads to shrinkage of the real basket. It should never try to tax the growth of the basket because that means the currency issuer is putting the brakes on the creation of real wealth.
- The issuer should always remain responsive to users desire for more or less currency in circulation.
In the world of ETFs, users express the desire for a larger or smaller quantity ETF shares in circulation via the create/redeem process. In the world of currency, unemployment is the expression of desire for more currency. Inflation is often thought to be the expression of a desire for less currency. I don’t believe that but we will save that discussion for another post. The view of most economists, however, is that currency issuers should not respond to unemployment with increased production of currency. Instead the currency issuer should sit on its proverbial hands while wages and prices fall. Keynesians will tolerate some currency issuance in the short run, but only with the caveat that it must be bought back later. This is an extraordinarily unhelpful position because it makes the issuer look irresponsible later on when it cannot get its currency back, and actually needs to issue more. These ideas are in clear conflict with the notions of liquidity and price stability. Unemployment is fundamentally a failure of liquidity; it is the inability to buy/earn currency. And a currency that appreciates in value is a failure of price stability. It may be great for savers of currency who get a free ride, but it discourages production and consumption hurting both earners and spenders. Why invest in a productive business when you can get a real return from sitting on your hands? Remember, the operational innovation behind ETFs that enables them to be stable and liquid is that the quantity of ETF shares is allowed to float. If we want our currency to offer price stability and liquidity, the quantity of that currency must be allowed to float. And that requires an issuer that is responsive to the demands of its users. It simply is not compatible with the contention of mainstream economists that the currency issuer should avoid interacting with and responding to signals from the private sector.
- The issuer should not attempt to increase or decrease the supply of currency of its own volition.
ETF issuers always stand ready to redeem shares in response to demand from users, not because they believe that the ETF is too big and therefore needs to be made smaller. ETF issuers want more assets under management, which means they want to issue more shares of the ETF. The ETF shares are liabilities to the ETF issuer, just as currency are liabilities to their government issuers. In both cases, the increased quantity of liabilities is necessitated by an increased quantity of real assets in the basket. To do otherwise would be inconsistent with price stability and liquidity. But in offering advice to currency issuers, economists believe that increasing the quantity of currency is dangerous and unsustainable. They want the currency issuer to become an active, net purchaser of currency. They believe it is possible for the issuer to run a perpetual surplus of the currency that only it can create. But the role of an apple orchard is to be a net seller of apples in the market. The role of an ETF issuer is to be a net seller of ETF shares in the market. And the role of a currency issuer is to be a net seller of currency in the market. But under the advice of economists, currency issuers try to become active, net buyers of their own product. It is hard to overstate how detrimental these policies have been to the goal of creating a stable and liquid currency. The result is that government is always active in the market, competing with households and firms to earn the currency. If you want to know why it is easier to spend money than to earn it, it is because you are in competition with government when you try to earn, but not when you try to spend. If only the currency issuer would restrict itself to a passive role in the marketplace, where it create/redeems currency only in response to the expansion/contraction of the real basket, then the currency would be equally earnable and spendable. The currency would not be subject to dilution or inflation; it would be stable in value.
The conclusion is that we can create currency that is both liquid and stable, or we can follow the recommendations of mainstream economists, but we cannot do both. That is because their advice is in conflict with the strategy for creating liquid, stable financial assets. Specifically, they want to spend too little, they want to tax too much, they do not want to respond to currency user demands for more currency, and they want the currency issuer to be an active market participant where it should be a passive one. We have tried the recommendations of economists without success. May we now try what works?
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