I finally had some time to read George Selgin's excellent Floored! over the Christmas
holiday.
Some family members saw me reading the book and asked me what it was about.
The subject that George is tackling—two types of central bank operating
systems—is quite technical, so I wasn't sure how to break it down for them.
But in hindsight, here's how I would go about it. I'm going to explain what
the issues are in terms of an instrument we all use and understand: good ol'
fashioned banknotes.
Imagine that when you go to your bank this morning to withdraw $200 in cash,
you can only get $100 out of the ATM. The bank manager says that it is
expecting another shipment of cash later in the day, so come back then. But
be early, he warns, since a lineup is sure to develop.
What explains this odd situation? The central bank has started to ration the
amount of banknotes it issues. For instance, the Bank of Canada currently
supplies Canadians with $85 billion in banknotes. But say it has decided to
only provide half that, $45 billion.
A world in which banknotes are rationed would be very different from our
actual world. When we march up to an ATM, we are accustomed to getting as
much cash as we want. If everyone in my neighbourhood were to suddenly decide
that they wanted to cash out their bank accounts, the Bank of Canada will
print whatever amount of currency is necessary to meet that demand. Central
bank don't keep cash scarce, they keep it plentiful.
Strange things happen in a world with rationed cash. Imagine that everyone
wants to hold $200 in banknotes in their wallet but can only get $100 from
the ATM. Further, assume that people need to hold a bit of cash because
certain transactions can only be consummated with banknotes. To cope with
this chronic cash shortage, a spare-cash market will emerge. For a fee, those
who have a bit of extra cash on hand will lend to those who are short.
The spare-cash market would look a bit like this. To top her existing cash
balance of $100 up to her desired $200, Jill makes a deal with Joe to lend
her $100 in cash. She provides security for the loan by transferring $100
from her bank account to Joe's bank account. A day later Jill repays Joe with
$100 in banknotes, and he returns her $100 security deposit, less a $1 fee.
Jill has effectively paid $101 to get $100. Or put differently, she has paid
Joe 1% in interest to get $100 in cash for a day.
We could even imagine informal person-to-person trading posts springing up
outside of popular ATMs where those who are short of cash meet up with
lenders like Joe who specialize in locating and lending spare cash. An Uber-style
app would be created where the credit history of borrowers are documented,
reducing the risk to lenders. People might be able to order up cash from
home, delivered by bike courier.
The spare-cash market that I've just described is not a market we are
accustomed to. As I said earlier, central banks keep cash plentiful. But it's
similar to another market we are all familiar with: the secondary market for
concert tickets. Tickets are necessarily rationed because there are only so
many seats in a concert venue. Professional ticket scalpers line up ahead of
time and buy these tickets so they can on-sell them at a premium.
Like the scalped ticket market, the spare-cash market is a natural response
to scarcity. Those who can't spare enough time to stand in an ATM queue but
need banknotes, like Jill, can pay those with spare time to stand in line,
like Joe. Both are made better of. Joe's lot has improved because he earns
more standing in ATM lines and lending cash than he did in his previous
occupation. Jill is better off because she attains her desired amount of
cash.
Once cash stops being a free good, cash payment delays emerge. Say that Jill
prefers to go shopping in the morning for groceries and other necessities,
before her hair dressing salon opens. But because acquiring cash is costly,
she sometimes delays her shopping trip till later in the day, in the hope
that someone might walk into her salon and pay with cash. That way she can
avoid paying interest to Joe.
However, if over the course of the day no one pays Jill with banknotes, she
will have to borrow in the spare-cash market at the last minute. If everyone
is following the same strategy as Jill, there will be an end-of-day spike in
cash demand. Joe may run out of cash to provide his customers, and so Jill
may have to go without food that night.
So now that we've outlined the contours of a world where cash is rationed and
ATM lineups develop, would it be preferable to a world in which cash is
plentiful and there are no lineups?
Let me start by arguing why an alternative world in which cash is rationed
might be more desirable than our current world with plentiful cash.
Thanks to cash rationing, Joe and Jill are forced to transact with each
other. Perhaps a 'citizen-lender' like Joe can get additional incites into
Jill's capacity to bear credit, the sorts of incites that a banker cannot.
This extra bit of person-to-person monitoring may prevent folks like Jill
from over- or underborrowing.
This oversight function that Joe fulfills never emerges in the plentiful cash
world since the two aren't forced into an economic relationship. And thus the
credit market in a plentiful cash world may be less efficient than it would
be if cash were rationed.
Now let me argue the opposite, why the world of plentiful cash may be
superior.
There is an underlying logic to rationing concert tickets. A venue has just x
seats, and so only x tickets can be sold. But there is no equivalent reason
for a central bank to limit the size of its banknote issue. It does not face
a capacity restraint, and the extra cost involved in printing new banknotes
is tiny. And so any decision to ration cash is a purely arbitrary one.
Under rationing, citizens are forced to engage in a host of time-consuming
activities that they wouldn't otherwise have to engage in, including locating
a reliable cash lender, providing personal and potentially intrusive credit
data to this lender, and then setting up an appointment to settle the debt at
a later date. To avoid the hassles and expenses of dealing in the spare-cash
market, folks like Jill may try to avoid making cash trades until later in
the day, but that means she can't follow her preferred shopping
schedule.
If cash were plentiful, the millions of citizen-hours spent in coping with
these annoyances would be freed up for alternative uses. Jill might be able
to enjoy the extra minutes she now has with her children, or work on
upgrading her salon. Instead of paying for Joe to stand in an ATM line-up,
she can hire him to help in the construction, surely a much more socially
useful activity than lining up.
So which world do you prefer? Joe's extra credit monitoring is certainly
beneficial. But does it outweigh all of the costs and nuisances that a cash
shortage imposes on people's lives? This is a tough calculation to make. If
you support cash rationing because you like the fact that it leads to a
secondary market in cash loans (and thus more credit monitoring), why not
create shortages in other financial markets, say by forcing banks to also
ration deposits?
Let's wrap this all up. We've explored the difference between a world in
which cash is rationed and one in which it is plentiful.
But George's book isn't about cash, it's about another instrument issued by
central banks: reserves. Unlike cash, reserves are an exclusive financial
instrument. Only banks can hold them. Since reserves aren't part of our
day-to-day experience, I've tried to explain things in terms of banknotes, a
far more mundane central bank-issued instrument.
George argues in his book for rationing reserves. It would be as-if he were
arguing for the rationing of cash in the scenario I sketched out above. Note
that I am not saying that George wants cash to be rationed (as a free banker
he would probably be against it), but I am saying that many of his arguments
in favor of reserve rationing can be recast in terms of a banknote rationing.
In particular, George speaks favorably of the secondary market in reserves
that springs up thanks to rationing. In the U.S., this is usually referred to
as the fed funds market, but more generally it is known as the interbank
market. The interbank market is exactly like the spare-cash market that I've
described above. Just as Joe lends to Jill in the spare-cash market, banks
lend reserves to each other in the interbank market. George provides much
evidence that the self-monitoring that banks engage in by transacting in the
interbank market is a valuable function.
What George doesn't touch on is that this increase in the amount of credit
monitoring, far from being free, comes at the cost. Like Jill, banks must
spend time and resources coping with a perpetual reserve scarcity. If this
artificial shortage was removed, banks could stop allocating internal resources
to this coping effort and deploy it instead to other uses. In the same way
that plentiful money meant that Jill could hire Joe to upgrade her salon
rather than paying him to stand in line, a bank can move employees from its
defunct fed funds department to bolster its lending department, or customer
service, or technology effort.
The question shouldn't be: do we want interbank peer monitoring? Rather, do
we want interbank peer monitoring at all costs? I think this makes the
calculation much more difficult.
