The Fedcoin experiment
"If there still are cows."
The other day I made, in my prosy way, two simple if unusual economic points. First: once anyone has the power to create money, the supply of money cannot be measured. Second: in a soft monetary system, the best way to measure inflation is not to measure either money creation or consumer prices, but personal net worth.
Inflation should be measured by personal net worth because personal net worth equals purchasing power. Inflation, measured in any currency, is the increase of aggregate purchasing power in that currency—regardless of asset class.
Most “passive” investors, though they know they are not adding any informational value to the market, see their portfolio gains as a natural, organic, and virtuous effect unrelated to government action. Actually the government is just printing money and giving it to them, because they are rich.
This is necessary and cannot be stopped. Our economy works by giving rich people money to spend, then trickle down through the withered remains of the middle class to a socially-disconnected helot class of foreign and imported labor. You don’t have to like this situation to understand that it is our reality, and cannot just be wished away.
Printing money and giving it to rich people has bad optics. Magic, broadly defined, is the creation of any illusion which conceals the optics of some prosaic reality.
If you doubt the presence of magic in our current financial system, here is a thought-experiment which should bring home the first point: the immeasurability of a soft currency. We’ll just replace the soft currency with a hard one—and see what happens on stage when the magic smoke-machine stops working.
Fedcoin: a hard CBDC
A “hard” currency is one whose supply is inelastic. In the thought-experiment, the Fed creates a “central-bank digital currency” with a fixed supply, like Bitcoin: “Fedcoin.”
A real “CBDC” as we know it today is just a digital fiat currency, built using 1990s rather than 1970s software, without any batch-processing or paper-belt legacy. We’ll be building something different.
Our “Fedcoin” will be mathematically fixed in supply, like Bitcoin, possibly with some help from a Constitutional amendment. We must concede that God could still create a Fedcoin—but we know neither why, nor how. The Fed certainly cannot do it.
A Fedcoin is a dollar. There are 6 trillion dollars in the world today—the “monetary base.” Therefore, we will create 6 trillion Fedcoins. Lately this number (aka “M0”) has been going up a lot, due to covid. Usually it is pretty stable. Let’s imagine, with sweet optimism, that covid is over and the monetary base is back to being stable.
Obviously, since we are converting the whole financial system, contracts are converted as well—just as debts in Deutschemarks became debts in euros, debts in dollars become debts in Fedcoins.
Now: what is the impact of this simple technical change in our financial plumbing? There are two ways to answer the question, both correct.
The first is that the Fed has restored a transparent free-market financial system, in which there are no informal securities and interest rates are set by market forces.
The second is that the Fed has created a hyperdeflationary economic disaster which will terminate almost all productive activity, probably kill tens of millions of people, and perhaps even usher in a new planetary dark age.
The free-market apocalypse
In a free-market financial system—not a state of affairs that anyone living has seen—the interest rate, which is the price of future money (not one price, but a price of money for each date in the future—a curve, the “yield curve”), is set by supply and demand.
The interest-rate curve in a free market is set by the supply of lenders willing to defer their spending, and demand from borrowers willing to promise the profit from some productive use of capital.
Such promises also carry risks. Often they are rolled over, a pernicious practice, which means that the borrower cannot in fact repay the loan at its maturity, but rather relies on taking out a new loan. Any system of this kind has a self-reinforcing systemic risk, because it can fall into a new equilibrium where no one lends and all borrowers fail.
It is easy to see systemic dependence on unlimited borrowing. Once loans and interest rates are unhooked from the supply of lenders, including the supply of lenders at the actual term of the loan, debt can increase without respect to money supply. When this connection is suddenly restored, the economy must prepare itself for a violent shock. It has returned to reality in the simplest possible way: by colliding with it at full speed.
The first rational actors to respond to Fedcoin will be the holders of M1: money “in the bank.” Though there are only 6 trillion Fedcoins in the world, the world’s banks have issued promises to pay their account holders 18 trillion Fedcoins, on demand, right now. Right now, in fact… right now might be the right time to make that demand.
These banks are “solvent.” They have assets worth more than 18 trillion Fedcoins. But “worth,” in a free-market economy, is whatever the market will bear, right now. First, right now, everyone is selling promises of future dollars, and no one is buying.
Second, these assets themselves—are future promises totaling more than 18 trillion Fedcoins. When there are only 6 trillion Fedcoins, how can all these promises be made good? Obviously, they can’t be—without rolling them over and inflating them away. Which now can’t happen. So these promises actually can’t all be good.
These M1 “deposits” (really zero-term loans from you to the bank) are “insured.” To be exact, 18 trillion in promises of Fedcoin is “insured” by about 100 billion Fedcoins. Or would be, if FDIC held dollars. Instead it holds Treasury notes, which, well, you know.
It is a good assumption that any promise of future payment is worthless. Since more or less no one is ready to trade a promise of future payment for present money, interest rates are more or less infinity. There is not even a way to measure risk-free interest rates—since that amendment, even US government bonds are no longer risk-free. The ratio of USG debt to Federal Reserve base money is, as usual, ridiculous.
Everywhere you look, everything is a game of musical chairs. Everyone’s rational incentive is to convert all financial assets into base money, as rapidly as possible. The entire financial galaxy is sucked instantly into this black hole and anyone who is even slightly late is converted into X-rays and radiated across the event horizon. This is the result of your “Austrian economics.”
Everything financed is ruined. Everyone with debt is ruined. All savings not held in cash are destroyed. Even other hard currencies, like gold and bitcoin, are rekt by the savage deflationary suck—while a fixed store of value is hard, a contracting store of value, like the dollar, is harder than hard.
And personal net worth shrinks by at least 10x, contracting to little more than the monetary base. This is hyperdeflation by any standard. You’ll be able to buy a hamburger for a quarter. If you know someone with a cow. If there still are cows.
Moreover, this dollar shortage does not just affect America—it affects the rest of the world even more, because the rest of the world has gotten in the habit of issuing dollar liabilities backed by promises that have all the risk of a normal bank investment, plus currency risk.
When the dollar deflates and becomes more valuable, all these loans go up in flames—they can only be bailed out by a local foreign-exchange reserve or sovereign wealth fund, with its own stash of dollars. Of course, normally these funds don’t keep base money, either… so now they don’t have any Fedcoins either.
Merely by disabling the creation of new dollars, we’ve destroyed an entire invisible world of informal options, which were the glass pillars holding up what we believed was a solid and organic financial structure. With those pillars shattered—well, now, it does seem odd to owe $18 trillion dollars, when there are only $6 trillion dollars. Who could credibly promise 60 million Bitcoins?
But… it all seemed to make sense at the time. Also, it seemed to kind of work. Whereas now, with the Fedcoins… all we have is this hyperdeflationary zombie apocalypse. It is wonderful for economics to be rational, but not so rational that everyone gets eaten.
Reconstructing hard money
The lesson of the Fedcoin thought-experiment is not that reality is bad—just that any restructuring should land gently on reality, not crash violently into it.
When we cut off the magic virtual money, we found that the price of assets dropped. Therefore we conclude that our asset markets are highly monetized—enough so that demonetizing them, according to orthodox Austrian economics, by fixing the money supply, acted as a gigantic, hyperdeflationary wealth tax, creating a new, biblical Extreme Depression that vaporized all existing businesses, bankrupted all existing nation-states, and generally made the Bronze Age Collapse look like Jimmy Carter’s bad swamp-rabbit afternoon.
Fortunately, it was just a thought-experiment. This thought-disaster is not the result of Austrian economics—just of applying Austrian economics too literally.
An effective financial reconstruction has an additional constraint. It needs to have no dramatic effect on anyone’s incentives or behavior. It should create no winners and no losers, and change no one’s life for better or for worse. However, it should terminate in a situation in which prices are stable, the money supply is fixed, and there are no informal financial instruments.
A practical restructuring plan should (a) be portfolio-neutral (it should not affect personal net worth) and (b) reprice all capital assets at stable free-market prices.
The only reasonable way to achieve both these results is to go forward, not back, and fully monetize all capital assets. The government (a) closes all financial markets and (b) buys back all financial and financed assets, for new dollars, at the market’s last price.
This means everyone’s personal net worth is converted into hard cash dollars, and the government owns everything. If you owned a house, you rent it now. This transition is portfolio-neutral by definition.
The government then sells all these capital assets, auctioning them to the public, for dollars. Maybe you get a discount on the house you live in—but in any case, it will now be much cheaper. This auction is portfolio-neutral, apart from some inevitable chaos.
Then, so as not to create another wave of monetary instability, the government burns all the dollars received in the auction. This too is portfolio-neutral. If the whole economy was losing money, it may be advisable to keep a restructuring buffer. However, at this point, Fedcoin works: the supply of dollars can be permanently fixed.
Having used this auction to establish the preference of savers and entrepreneurs, thus setting an interest rate for risk-free assets and a risk schedule for risk ones, there is now no significant predictable force that will destabilize financial prices—at least so long as the financial industry does not return to destabilizing practices which amplify demand for debt.
We observe that the ratio of money to promises is now much more reasonable—the total valuation of all assets has a reasonable relationship to the total volume of money. While there is no clear way to calculate what that relationship will be, entrepreneurs will profit by estimating it correctly, so markets should predict it well.
And while ideally, regulators would be intolerant of 20th-century financial techniques of currency, maturity and risk transformation, these manipulations would eventually blow up and teach the market their necessary lesson, were private financial actors not gifted with the informal options (from the Fed’s protection of FDIC, to the “Greenspan put”) which, as we see, comprise most of the market’s present value. For if voiding these options makes the market much less valuable, the options must be very valuable.
A regulator is better than a teacher, but an explosion is still a good teacher. Uninsured bank runs are one path to a financial system that doesn’t have bank runs. Make sure the explosion isn’t bigger than the system, though.
The lessons of the thought-experiment
What we’ve done with this restructuring design—essentially a national bankruptcy—is to reverse the systemic monetization and inflation of securities, neither by denying the reality that securities markets are monetized, nor by denouncing it, but by admitting it—and starting not from where the financial system should be, but from where it is.
This approach generalizes to many forms of restructuring. For instance, a common view among normal conservatives is that journalism should not be official—the First Amendment gives the same rights to all. Therefore, Julian Assange or James O’Keefe has just the same right to steal government secrets and sell them as any NYT reporter. (Note that “amateur journalism,” contrary to the pride of all bloggers, was already a thing over a century ago—paper is a pain in the butt, but paper still kind of works.)
One way to fight this reality is to deny it. This is a great way to (at best) produce tired, ineffectual imitations of the official press, without impact or interest, or (at worse) end up where Julian Assange is. Another approach is to denounce it, calling for everyone to have the right to steal and publish secrets—a reform that is impossible and literally makes no sense, as it would have to privilege bad actors with intents far more sordid than the NYT has ever imagined.
But once we admit that the mainstream press is an informal government agency, or we admit that the financial system is propped up by a river of informal subsidies, we find it quite possible to imagine practical reforms.
These reforms will always require more power than any actor in an oligarchical system can possess. They will usually be too recondite for most voters in a democratic system to understand.
But this reveals the path through which any actual solution must pass—“once you eliminate the impossible, whatever remains, however improbable, must be the truth.”