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Central Bank Journal
and Finance
Year III, no. 1, 2016
The Central Bank Journal of Law and Finance is coordinated
by the National Bank of Romania – Legal Department,
Director Alexandru-Nicolae Păunescu, PhD
Academician, Romanian Academy,
Corresponding member of Real Academia de Ciencias Económicas y
Financieras, Barcelona, Spain
Professor, DoFIN, Academy of Economic Studies, Bucharest, Romania,
Romanian-American University, Bucharest, Romania
Professor, West University of Timişoara, Romania
Professor, Babeş Bolyai University, Cluj, Romania
James Ming CHEN
Professor, Justin Smith Morrill Chair in Law, Michigan State University, USA
Professor, DoFIN, Academy of Economic Studies, Bucharest, Romania
Professor, Romanian-American University, Bucharest, Romania
M. Peter van der HOEK
Professor, Academy of Economic Studies, Bucharest, Romania,
Erasmus University (EM), Rotterdam, Netherlands
Iftekhar HASAN
Professor, E. Gerald Corrigan Chair in International Business and
Finance, Fordham University’s Schools of Business, New York, USA
Dumitru MIRON
Professor, Academy of Economic Studies, Bucharest, Romania
Professor, Academy of Economic Studies, Bucharest, Romania
Professor Emeritus
Professor, Stern School of Business, New York University, USA
PhD, Researcher, Centre of Financial and Monetary Research,
Bucharest, Romania
Adrian - Ionuţ
PhD, Associate Professor, Academy of Economic Studies,
Bucharest, Romania
PhD, Senior Lecturer, Academy of Economic Studies,
Bucharest, Romania
PhD, Researcher, Centre of Financial and Monetary Research,
Bucharest, Romania
Constantin MARIN
PhD, Researcher, Centre of Financial and Monetary Research,
Bucharest, Romania
Beatrice POPESCU
Adviser to the Deputy Governor of the National Bank of Romania
PhD, Lecturer, Faculty of Law, University of Bucharest, Romania
Cover by Romeo Cȋrjan, PhD
The opinions expressed in this publication are those of the authors and do not necessarily
reflect the views of the National Bank of Romania, nor do they engage it in any way.
© 2016 National Bank of Romania. All rights reserved.
Published by the National Bank of Romania, 25 Lipscani Street, 030031 Bucharest |
ISSN 2392 – 9723
ISSN-L 2392 – 9723
Oluwole Owoye
Advances and Lessons in Monetary Economics
Rainer Kulms
Bitcoin – a Technology and a Currency
Max Danzmann
Stabilizing the Euro through Sovereign Money?
Wilhelm Salater
The Changing Faces of the Maastricht Criteria:
from a Shortcut to Heaven to Just Another Exam via a Procrustean Bed
Andreea Oprea
An Analysis of Gold and Bond Market in the Context of
Quantitative Easing Policy and Market Turmoil
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Advances and Lessons in Monetary Economics
Oluwole Owoye*
The advances and lessons learned from monetary economics are numerous to the extent
that it is virtually impossible to document in a journal article. This essay reviews the
foundation of monetary economics based on the contributions of eminent scholars. In the
past decades, we learned about the dimensions of financial innovations that led to the
introduction of different financial products that are demand-induced, supply-induced, and
regulation-induced, which benefited consumers and the financial intermediaries. In
addition, we have also learned that economic conditions could force Central Banks to go
beyond the conventional monetary policy tools in order to stabilize the economy.
quantity theory, Keynesian revolution, monetarist counter-revolution, rational expectations,
new classical revolution, financial institutions and innovations, quantitative easing
JEL Classification:
E12, E13, E19, E50, G21, G28
Professor of Economics, Department of Social Sciences/Economics, Western Connecticut State
University, Danbury, CT 06810 USA.
Email: [email protected], tel: 203-837-8456, fax: 203-837-3960
Central Bank Journal of Law and Finance, No. 1/2016
Advances and Lessons in Monetary Economics
Monetary economics focuses on the effects of monetary institutions and policy actions on
aggregate variables that are of importance to individuals and organizations across the world.
When monetary economics is broadly defined, it includes the theoretical and quantitative
work on money and monetary policy, as well as research on banking, payment systems, and
other related areas. It is a difficult task to discern the advances and lessons learned from
monetary economics from the developments of modern macroeconomics since the
publication of John Maynard Keynes’s The General Theory of Employment, Interest and
Money (hereafter, The General Theory) in 1936. The main reason for the difficulty in
discerning between both fields is because both areas focus on how money, monetary policies,
and institutions affect the economy.
The paper provides a survey of some of the contributions and lessons from monetary
economics. The selection is at the discretion of the author with the sole criteria being those
contributions that enhance our understanding of monetary economics. This selection may
focus more on the theoretical developments in that they are at the core of our understanding.
The empirical investigations are also important because they further enhance our knowledge,
more so when these theoretical formulations are subjected to empirical tests elsewhere in
order to ascertain their universal validity. In some or many instances, the empirical
techniques shed more light on key aspects of the theory that we argue about and they aid in
differentiating between alternative theories, therefore, the empirical contributions will be
highlighted where necessary. It is important to note that this is not a chronology of all the
major advances and lessons in monetary economics or an attempt to critically assess in
details the central tenets underlying monetary economics. The overlap between monetary
economics and macroeconomics will make such an attempt a daunting task, therefore, this is
an attempt to provide a background discussion of the early contributions starting from the
classical quantity equation and quantity theory in order to help place the Keynesian
revolution, monetarist counter-revolution, the rational expectations/new classical revolution,
financial institutions and financial innovations, and other pertinent contributions and
lessons in monetary economics in the proper context.
The rest of this paper will be organized as follows. Section 2 provides a background
discussion of the classical quantity equation and quantity theory of money. The discussion in
this section is limited to the contributions of Irving Fisher (Yale University–the American
school), A.C. Pigou (Cambridge University–British school), and Knut Wicksell. The main
objective of the section is to show that the development of the classical quantity theory
occurred on both sides of the Atlantic, but more importantly, these studies formed the
foundations and show that modern monetary economics owes its roots to the works of these
Central Bank Journal of Law and Finance, No. 1/2016
Oluwole Owoye
early eminent scholars. Section 3 discusses the Keynesian revolution and its contributions to
modern monetary economics. In Section 4, the discussion will focus on Milton Friedman’s
monetarist counter-revolution with particular reference to his restatement of the quantity
theory and the role of monetary policy because both stand out as some of the significant
advances in monetary economics. Section 5 discusses the rational expectations
revolution/new classical monetary macroeconomics, which owes its origin to the pioneering
work of John Muth in 1961. Section 6 discusses advances to monetary economics from the
financial systems and institutions with respect to the money supply process. In addition, this
paper will be incomplete without highlighting the advances from financial innovations of the
past two or more decades. Section 7 highlights the vital lessons from monetary economics
and Section 8 concludes this paper by drawing some important implications or lessons from
these contributions.
The debate about the role of money in the determination of prices and nominal income in the
economy has a long tradition. Handa (2008) pointed out that this extremely long heritage
extended back to Aristotle in ancient Greece, but the explicit formulation of theories on
money occurred later in the mid-17th century. One cannot over-emphasize the relevance of
the quantity equation and the quantity theory because they formed the bedrock of modern
monetarism. The transformation of the former to the latter constitutes one of the three
distinct pillars of current monetary economics along with the Keynesian and the monetarist
one. The quantity equation as an identity was the foundation from the classical era to modern
monetary economics. As an identity, the quantity equation relates the goods-producing sector
of any economy to its monetary sector. Since its 18th century background, the main
proposition of the quantity equation has been that a change in the money supply causes
proportionate change in the aggregate price level. This proposition is deeply rooted in the
classical notion that even though capitalist market economies may experience periodic
shocks, the market mechanism would operate instantaneously and efficiently to restore full
employment equilibrium. In such instances, “government policy interventions to stabilize the
economy would neither be necessary nor desirable”. Although, the quantity equation is not a
theory of the determination of prices, income, and velocity, several variants such as the (i)
commodities approach to the quantity equation, (ii) transactions approach to the quantity
equation, (iii) disaggregation among the components of money, and (iv) quantity equation in
terms of the monetary base show it as a very versatile tool for analysis (Handa, 2008, Chapter 2).
Central Bank Journal of Law and Finance, No. 1/2016
Advances and Lessons in Monetary Economics
Over the years, the quantity theory has had different versions, just as there are different
versions of the quantity equation, based on researchers and periods, however, the discussion
in this section will be limited to those versions based on the early works of Irving Fisher, A.C.
Pigou and Knut Wicksell because these studies provided the general foundations for modern
monetary economics. In Fisher’s book, The Purchasing Power of Money, published in 1911,
he used the transactions approach to present a thorough examination of the quantity theory
with the quantity equation as the starting point. According to Handa (2008, p. 40), Fisher
transformed the quantity equation into the quantity theory with two propositions about
economic behaviour, which stated that
the velocities of circulation of ‘money’ [currency] and deposits depend on technical
conditions and bear no discoverable relation to the quantity of money in circulation.
Velocity of circulation is the average rate of ‘turnover’ and depends on countless
individual rates of turnover. These depend on individual habits. The average turnover
will depend on the density of population, commercial customs, rapidity of transport,
and other technical conditions, but not on the quantity of money and deposits or on the
price level,
(ii) [except during transition periods] the volume of trade, like the velocity of circulation of
money, is independent from the quantity of money. An inflation of the currency cannot
increase the production of firms and factories, or the speed of freight trains or ships.
The stream of business depends on natural resources and technical conditions, not on
the quantity of money. The whole machinery of production, transportation and sale is a
matter of physical capacities and technique, none of which depends on the quantity of
On the basis of these two propositions, many authors attributed the constancy of velocity to
Fisher. In addition, Fisher’s analysis not only showed that the volume of trade, velocity, and
production are independent from the quantity of money, but he also demonstrated the direct
transmission mechanism of money to price or money to nominal income, as compared with
the indirect transmission mechanism. It is important to add that the transmission
mechanism of the effects of money supply on nominal income has a rich tradition that dated
back to the era of David Hume [Mishkin (2003), Chapter 25]. Overall, Fisher’s contributions
to monetary economics came from his use of the quantity theory to explain price
determination and the direct transmission of money to prices or to nominal income.
In contrast to Fisher, A.C. Pigou used the cash balances approach to the quantity theory to
examine the determination of prices from the perspective of the demand and supply of
money. This was an approach that reflected the views of several proponents, including Alfred
Marshall, John Maynard Keynes, and other classical economists of that era. In his 1917
article, The Value of Money, Pigou cast the quantity theory as a theory of the demand for
Central Bank Journal of Law and Finance, No. 1/2016
Oluwole Owoye
money based on two major characteristics of money - the medium of exchange and the store
of value. He referred to these characteristics of money as ‘object’ of transaction, and ‘object’
of security. In other words, “Pigou’s basic reasons for the demand for money balances were
the ‘objects’ of the provision of convenience and the provision of security.” According to
Pigou’s analysis, the ratio of money demand to resources (income) depends on “the internal
rate of return (market interest rate) on investments and of the marginal satisfaction forgone
from less consumption”. In effect, the higher the internal rate of return, “the less attractive is
the production use and the more attractive is the rival use of resources.” In essence, this
indicates that the demand for money balances is a function on income and market interest
rate. In addition, Pigou’s analysis also demonstrated that the elasticity of price with respect to
money is unitary. Basically, this further confirmed the main proposition of the classical
quantity theory that the price level varies proportionately with the supply of money.
Furthermore, his analysis showed that both the money demand and velocity functions
depend on the market interest rate.
Wicksell’s (1907) treatment of the quantity theory in his article, The Influence of the Rate of
Interest on Prices, differed remarkably from the works of other classical writers such as
Fisher and Pigou. A part of his focus was on the transmission mechanisms which related the
changes in money supply to the changes in the price level in a pure credit economic where the
public held no currency and all transactions were made with checks drawn on banks. In
Wicksell’s pure credit economy, the emphasis was on saving, investment, the normal rate of
interest that equates saving and investment, and the natural rate of interest or internal rate of
return. According to his analysis, an inflationary process begins when the natural rate of
interest exceeds the market rate of interest because firms will continue to finance more
investment by borrowing more from the banks. The implication here is that the banks could
put an end to inflationary pressures if they curtailed further increases in credits or loans to
firms. Wicksell’s analysis, just as those by Fisher and Pigou, did not focus particularly on the
changes in national output that might occur in the cumulative process, but did conclude that
changes in money supply will lead to price changes sooner or later.
An important aspect of Wicksell’s analysis was the emphasis on the equilibrating process
between saving and investment, which paved the way for the treatment of the investmentsaving relationship in modern macroeconomics and monetary economics. Furthermore, the
distinctions between the rate of interest on loans and the productivity of physical capital, and
the assertion that loans are made in money and not in physical capital were fundamental to
the fields of modern monetary economics and macroeconomics. Most importantly, these
ideas led the way in terms of the modern view of the roles of financial institutions and the
central banks, particularly, how they can influence the market interest rates if they want to
control nation income, employment, and inflation (Handa, 2008, p. 51).
Central Bank Journal of Law and Finance, No. 1/2016
Advances and Lessons in Monetary Economics
Overall, to put the contributions of these scholars (and many others not mentioned) to
monetary economics and macroeconomics in the proper perspective, one needs to reflect and
attempt to put together a detailed chronology of the volume of studies on the demand for
money and all the different versions of money demand functions (e.g. buffer stock, partial
adjustment model), and the transmission mechanisms of monetary policy. While this may or
may not be an impossible task, and while on that mission, it will not take too long before the
realization that in the case of money demand functions, income or wealth or permanent
income as a scale variable and interest rates as opportunity costs have continued to feature
prominently as part of the explanatory variables in the money demand functions till today,
even though some studies use different proxies for these explanatory variables and the
controversies as to the proper specification of money demand are well documented in the
literature [see Goldfeld and Sichel (1990)].
In the attempt to discuss the Keynesian revolution and modern monetary economics, a
couple of the usual questions come to mind: Was John Maynard Keynes a quantity theorist
before the Great Depression? What were his contributions to monetary economics? The
answers to these questions are succinctly provided in Handa (2008) that “Keynes in his earlier
writings had proved to be an able and innovative exponent of the heritage of the quantity
theory in its Cambridge School version. In The Treatise on Money published in 1930, Keynes
extensively explored the effects of changes in the money stock within the classical quantity
theory tradition. He departed from the classical tradition considerably in The General
Theory, published in 1936. The General Theory was an important milestone in the
development of monetary theory. Among its departures from the 19th century classical
tradition was its rejection of the validity of the quantity theory. Contrary to the assumptions
of the quantity theory, The General Theory asserted the absence of full employment in the
economy and argued that output and income velocity in the economy depended on the
money supply. These contributions are fundamental to monetary theory.” [see Handa (2008),
pp. 52-63] Keynes formulation or reformulation of the money demand function was an
important landmark contribution to monetary economics because it added a new dimension
to the money demand function that was Cambridge in terms of origin. According to Keynes,
people hold money balances for transactions, precautionary, and speculative purposes.
Essentially, the transactions and precautionary motives corresponded to Pigou’s ‘objects’ for
the provision of convenience in carrying out transactions and the provision of security (store
of value). Keynes departed from the traditional Cambridge money demand function by
adding the speculative motive. According to Keynes, the speculative motive was “the object of
Central Bank Journal of Law and Finance, No. 1/2016
Oluwole Owoye
securing profit from knowing better than the market what the future will bring forth” [Handa
(2008), p. 56; Keynes (1936), Chapter 13, p. 170].
Based on the assumption that the portfolio choice of an individual consists of money balances
or bonds, in effect, Keynes’s speculative motive introduced risk and uncertainty into the
money demand function; therefore, expectations about the rate of interest and the expected
prices of bonds now become paramount in portfolio choice [see Keynes (1936), p. 168]. In
Keynes’s own words (1936, Chapter 13), “the expected bond yields and equity prices depend
on the mood of the market participants, their perceptions of the future based on very limited
information, as well as herd instincts.” The implication is that the demand functions for
bonds and equities (or money) will be subject to constant shifts and therefore, unstable.
According to Handa (2008), “this would introduce a considerable degree of instability into the
aggregate demand, prices and output in the economy, and could also make the pursuit of
monetary policy, which could trigger changes in the investors’ expectations, very risky.”
As indicated, early traditional money demand functions were deeply rooted in classical cash
balances approach. With Keynes’s introduction of the speculative motive into the money
demand function, some studies showed that the transaction and precautionary motives were
also influenced by interest rates. For example, Baumol (1952) and Tobin (1956, 1958)
reformulated Keynes’s speculative motive in terms of portfolio theory by assuming that
people choose between holding money balances, which was treated as a riskless asset and
securities (i.e. bonds and equities) with uncertain returns. In other words, by assuming that
people trade-off money balances for securities, or vice-versa, they demonstrated the effects of
interest rates on transactions and precautionary motives. This implied that higher market
interest rates increase the opportunity cost of holding real money balances for transaction
and or precautionary purposes. The result is that individuals hold less money; therefore,
income velocity of money will rise. The converse is true for a decrease in market interest rate.
Recently, David Romer (1986) expanded on the Baumol-Tobin approach to address the
effects of shifts between money and nonmonetary assets in the economy. Further, there were
other significant contributions that provided different directions to analyse the “short-run
fluctuations around the trend” as well as the “long-run movement of output by identifying the
determinants of the trend and ignoring fluctuations around the trend” (Snowdon and Vane,
Over the years, some studies have incorporated money into the general equilibrium models
with the assumption that money yields direct utility, therefore, it should be incorporated into
the direct or indirect utility functions and the production functions [see Sidrauski (1967),
Clower (1967)]. The models with money-in-the-utility (MIU) functions assume that
consumers derive direct utility when money proxies for the services it produces by facilitating
certain types of transactions. The cash-in-advance (CIA) and/or shopping time models
Central Bank Journal of Law and Finance, No. 1/2016
Advances and Lessons in Monetary Economics
assume that time and money can be combined to produce transaction services necessary to
obtain consumption goods and services. Similarly, the models with money-in-the-production
(MIP) functions assume that the holding of real balances by firms allows them to economize
on workers they would have diverted to carry out various payment transactions. In recent
studies, some economists have proposed the overlapping generation (OLG) models of money
as the viable alternative to MIU and MIP models. It is important to point out that “other
economists do not consider the OLG models in their standard form to be valid or useful for
modelling the actual role of money in the economy” [see Handa (2008), Chapters 3, pp. 88105, and Walsh (2003): Chapters 2-3]. In other recent developments, a number of studies,
such as Kiyatoki and Wright (1989, 1993), Trejos and Wright (1993, 1995), Ritter (1995), Shi
(1995, 1997, 1999), and Rupert (2001), have employed the search-theoretic models to
emphasize the medium of exchange function of money. For example, in the Kiyatoki-Wright
model, the assumption is that direct exchange is costly, therefore, the existence of fiat money
which can be traded costlessly for commodities highlights the exchange properties of money.
These recent developments are useful in studying a variety of critical issues in monetary
economics [e.g. the relationship between money and prices (see the discussion with respect
to Fisher, 1911), the effects of inflation on equilibrium, and the optimal rate of inflation].
Some economists such as Lucas and Sargent (1978) have argued that Keynesian economics
lacked certain fundamentals and, as a result, some contributions during the period were
readily adopted by the traditional Keynesians to fill the void inherent in the Keynesian
framework. For example, the IS-LM model assumed a fixed price level at less than the natural
rate of output/unemployment so that aggregate demand shocks would only affect the level of
output and employment with no inflationary pressures. Snowdon and Vane (1997) pointed
out that when the publication of A.W. Phillips’s (1958) statistical investigation into the
relationship between the level of unemployment and wage inflation came out, and Lipsey
(1960) provided the theoretical rationale for what became the Phillips curve (Santomero and
Seater 1978; Wulwick 1987), orthodox Keynesian economists quickly adopted it for three
main reasons. First, it provided an explanation of price determination and inflation, which
was missing in the then prevailing Keynesian macroeconomic model. In other words, the
Phillips curve provided the missing link between the theory of output and employment
determination and the theory of wages and price inflation (Lipsey 1978). Second, the Phillips
curve appeared to provide a rare evidence of a stable relationship between unemployment
and inflation that had existed for almost a century. Third, the Phillips curve provided an
insight into the problem that policymakers face when they try to achieve high levels of
employment with price stability simultaneously, given the theoretical trade-off between wage
inflation and unemployment (Samuelson and Solow 1960, McCallum 1989, Chapter 9, p. 179).
Central Bank Journal of Law and Finance, No. 1/2016
Oluwole Owoye
As for the significance of Keynes’s contributions to monetary macroeconomics, this has been
and will continue to be the subject of extensive debates among economists of different
schools of thought. Many economists agreed that Keynes’s analysis of the Great Depression in
The General Theory “turned economists’ attention away from the classical emphasis on
supply-side factors.” Deutscher’s (1990) study provided evidence of the dominance of Keynes
and Keynesian economics between 1920 and 1944. Between 1920 and 1930, the data on
citation of top economists had Irving Fisher ranked at the top, followed by W.C. Mitchell,
A.C. Pigou, Alfred Marshall, W.S. Jevons, R.G. Hawtrey, D.H. Robertson, H.L. Moore, Carl
Snyder, and lastly, J.M. Keynes. Between 1931 and 1944, Keynes consistently ranked at the
top, and even Pigou argued that “Keynes was the first economist to bring together real and
monetary factors in a single scheme, through which their interplay could be coherently
investigated.” Also, Solow (1986) concurred that The General Theory was “certainly the most
influential work of economics of the 20th century, and Keynes the most important
economist.” Based on these statements, it is not difficult to conclude that Keynesian
economics shaped the landscape of monetary macroeconomics for almost four decades until
the stagflation of 1973-1975.
During the stagflation period, inflation rate and unemployment rate rose simultaneously, and
the perceived trade-off between the two vanished. Since Keynesian economics had no policy
prescriptions for the stagflation of the 1973-1975, some economists saw this as the demise of
Keynesian economics. Today, if we look at the policy prescriptions of many developed and
underdeveloped countries, it is difficult to argue that there has been a substantial shift away
from policy activism since the period of stagflation [see Blinder (1988)]. In other words, the
significance of Keynesian economics and contributions to monetary economics can be viewed
as sparking off a long period of strong policy activism that allowed policymakers to trade-off
inflation rate for unemployment rate using activist policy. Policy activism led economists to
examine the relative effectiveness of the monetary policy relative to fiscal policy [see M.
Friedman and Meiselman (1963), Andersen and Jordan (1968), B. Friedman (1977), Owoye
and Onafowora (1994)].
The instability and the apparent volatility introduced into the money demand functions by
Keynes and his disciples were at the core of monetarist counter-attack on Keynesian
economics. In the mid-1950s and 1960s, Milton Friedman began a steady monetarist counterrevolution through a systematic three-way assault on Keynesian economics in the attempt to
“re-establish the quantity theory of money approach to macroeconomic analysis, which had
been usurped by the Keynesian revolution.” Friedman’s initial assault started with the
Central Bank Journal of Law and Finance, No. 1/2016
Advances and Lessons in Monetary Economics
restatement of the quantity theory of money in 1956 to counter the three motive-specific
analysis of money demand that Keynes provided. In Friedman’s view, the demand for money
balances should not be specified based on the functional characteristics of money, which
Keynes did. Friedman’s restatement was meant to limit the quantity theory to a theory of the
demand for money as well as the proposition that money matters, and not just a theory of
the general price level or money income (Laidler 1981). As we may recall from the earlier
discussion, Keynes’s addition of the speculative motive to the money demand introduced risk
and uncertainty, which could subject money demand to shifts and instability. To ensure the
stability of the money demand function, Friedman included permanent income as the scale
variable because it does not vary much with the business cycle. Based on this, he asserted that
the money demand and velocity functions were highly stable and would only change in a
predictable manner if any of the variables in the demand for money function should change
(Laidler, 1993).
As part of the continued assault on Keynesian economics, Friedman and Schwartz (1963)
provided the most persuasive evidence to support the notion that “changes in the stock of
money play a largely independent role in cyclical fluctuations.” According to Friedman and
Schwartz, episodes of absolute fall in money stock corresponded to the six periods of major
economic contractions between 1867 and 1960. In Friedman and Schwartz’s (1963) view, the
Great Depression was as a “consequence of the failure of the Federal Reserve Bank (also
called the Fed) to prevent a dramatic decline in the money stock between October 1929 and
June 1933.” They interpreted this as a demonstration of the potency, rather than the
ineffectiveness of monetary changes and monetary policy [see Friedman (1958, 1961, 1968),
and Hammond (1996)]. Furthermore, Friedman considered the length and variability of the
time lag involved between the implementation of monetary policy and its effect on money
income as too long; and as such, he argued that discretionary monetary policy could be
destabilizing to the economy. As a consequence, Friedman (1968) argued that monetary
authority (the Fed) should follow a fixed growth rate rule (constant money growth rule) that
will be in line with the underlying growth of output to ensure long-term price stability. The
attack on Keynesian aggregate demand management policies changed towards the end of the
1960s. Towards the later part of the 1960s, Friedman used the expectations-augmented
Phillips curve (also known as Friedman’s Fooling model of wage determination) to argue that
the expected rate of inflation should be considered as an additional variable that could
determine the rate of change of money wages and prices. Earlier, Phelps (1967) presented the
ideas in a non-monetarist fashion. Based on the data for the United States at the time,
Friedman argued that no long-run trade-off exists between inflation and unemployment.
Instead, he put forward the natural rate hypothesis as a tool to emphasize the destabilizing
implications of stabilization policies.
Central Bank Journal of Law and Finance, No. 1/2016
Oluwole Owoye
The final assault for the recognition and development of orthodox monetarism came in the
1970s with the incorporation of the monetary approach to the balance of payment theory as
well as the exchange rate determination into monetary analysis. This made monetarist
analysis that, up to that time, had been implicitly developed in the relatively closed economy
context of the United States economy under Bretton Wood system, relevant to open
economies such as the United Kingdom and other developed countries. It also provided an
explanation of the international transmission of inflation in the late 1960s (Frenkel and
Johnson, 1976). It is not far-fetched to think of these assaults as the main stages in the
development of orthodox monetarism. Most significantly, these attacks led to five important
policy implications that
“the authorities can reduce unemployment below the natural rate only in the short-run
because inflation is not fully anticipated, that is, workers are fooled,
(ii) any attempt to maintain unemployment permanently below the natural rate will result
in accelerating inflation,
(iii) if governments wish to reduce the natural rate of unemployment in order to achieve
higher output and employment levels they should pursue supply-management policies
which are designed to improve the structure and functioning of the labour market and
industry rather than demand-management policies,
(iv) the natural rate is compatible with any rate of inflation which in turn is determined by
the rate of monetary expansion in line with the quantity tradition, and
(v) in a world of fixed exchange rates, inflation is an international monetary phenomenon
explained by an excess-demand expectations model” (Snowdon and Vane, 1997).
In discussing the contributions to modern monetarism, one cannot downplay Friedman’s
unwavering stance in terms of his clear and forceful advocacy for monetary policy discipline.
Many economists considered Friedman and Schwartz’s (1963) book to be very influential in
monetary economics and macroeconomics [see Lucas (1994) and Miron (1994)], and almost
three and a half decades ago, Robert Gordon (1981) described Friedman’s (1967)
“presidential address to the American Economic Association (AEA), which he later published
with the title, “The Role of Monetary Policy” in 1968, as probably the most influential article
written in the previous twenty years.” James Tobin (1995), who many considered as the “most
eloquent, effective and long-standing critics of Friedman agreed with the assessment of
Friedman’s contributions” to modern monetary macroeconomics.
As we consider Robert Gordon’s (1981) statement regarding Friedman’s presidential address
before the AEA, two major questions come to mind. First, what were the issues raised or
discussed in this article that set it apart from other articles written twenty years prior to
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Gordon’s (1981) assertion, and perhaps thereafter? Second, how influential was this article in
monetary economics and macroeconomics? Based on a careful analysis and evaluation, one
could wholeheartedly concur with Gordon (1981) that Friedman’s (1968) article was a
significant landmark contribution to monetary economics and macroeconomics. In a straight
forward and persuasive argument loaded with historical evidence of past performances of
Federal Reserve Bank (Fed), Friedman (1968) dissected and laid out, without any esoterically
sophisticated monetary model, the following areas for the Fed:
the goals of monetary policy: high employment, stable prices, and rapid economic
(ii) what monetary policy cannot do: monetary policy cannot be used “to peg interest rates
for more than very limited periods”, and also, it cannot be used to “peg the rate of
unemployment for more than very limited periods.”
(iii) what monetary policy can do: “monetary policy can prevent itself from being a major
source of economics disturbance (avoid major mistakes), monetary policy can provide a
stable background for the economy (keep the economy machine engine well oiled)”, it
can be used to mitigate against major disturbances in the economic system that may
arise from other sources, and monetary policy can be used to ease transition from
wartime to peacetime production without going too far.
(iv) how should monetary policy be conducted?: monetary authority should guide itself by
magnitudes and control only what it is capable of controlling, they should avoid sharp
swings in policy and be time consistent, which highlights the importance of consistency,
commitment, and credibility, and that monetary authority should adopt a constant
money supply growth rule to promote economic stability — i.e., monetary policy rule.
What made this article a masterpiece for monetary economics was that even though the
address focused on the Fed of the United States, its uniqueness and significance lie in the fact
that the four areas highlighted above reached far beyond the U.S. Fed. One can objectively
argue that it is no stretch to call Friedman’s address a worldwide address to monetary
authorities or central banks, particularly for developing countries where central banks may
see their roles and past performances in the same or different light as the Fed. One may agree
or disagree [see Don Patinkin (1965, 1969)] with Friedman’s assertions or the call for constant
money growth rate rule on monetary policy issues, but one cannot dismiss the fact that this
article was pivotal to the volume of literature on dynamic time-inconsistency, commitment to
rules, credibility, central bank independence, monetary policy targeting, game-theoretic
approach to monetary policy, and monetary policy rules that have emerged since then [see
Kydland and Prescott (1977), Blackburn and Christensen (1989), Fischer (1990), B.M.
Friedman (1990), Cukierman (1993), Taylor (1993), Clark (1994), Mishkin and Posen
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(1997), Bernanke and Mishkin (1997), Kahn and Parrish (1998), Tetlow (1999), Kozicki (1999),
Poole (1999), Aron and Muellbauer (2000), and Ball and Sheridan (2003)]. For example, we
now know from some of the studies cited above that the time inconsistency problem of
discretionary policy arises because monetary authorities do not expect economic agents to
change their expectations. Further, studies using game theoretic approach to monetary policy
also showed the effects of private information and asymmetric information on monetary
policy [see Calvo (1978), Canzonerri (1985), Canzonerri and Gray (1985), Shubik (1990)].
Let us end the discussion in this section by highlighting some of the key areas of controversy
or debate between Friedman’s monetarism and Keynesian economics. Also, it is important to
point out that these debates, more than the differences they attempt to show, contribute
more to our knowledge of monetary economics. If we begin with one of the issues at core of
the debates, which is the demand for money, one can see that they both incorporated
portfolio allocation motives in their theories of money demand even though both functions
differed. This explains why some economists saw no difference between the two, and some
even referred to Friedman’s quantity theory as “The Theory of Liquidity Preference - A
Restatement” [see Harry Johnson (1962), and Don Patinkin (1965, 1969)]. While Keynes
considered only money and grouped together all other assets as bonds, Friedman allowed for
portfolio substitution among money, bonds, equities, and durable goods. Friedman’s
inclusion of different rates of return including expected inflation in his money demand
function provided households with a ray of options in their portfolio choice. For example, if
consumers expect high inflation, which means low return on money balances, they could
invest more of their wealth on real estate (land and housing) and other durable goods, such
as art work, to hedge against inflation. In Keynes’s model, the return on money was assumed
to be zero, but according to Friedman’s model, the return on money is influenced by services
provided by banks on deposits such as receipts in the form of cancelled checks (cheques),
automatic payment of bills, interest payments on NOW (negotiable order of withdrawal)
accounts (Mishkin 2003, 537-561).
Other key areas for debate between the monetarist and Keynesian camps, which included the
stability or instability of the money demand function, interest sensitivity of money demand,
the constancy or variability of income velocity, the efficacy of monetary policy vis-à-vis fiscal
policy, and monetary transmission mechanisms continued to dominate the empirical debate
in the literature. These issues dominate the empirical literature because they have important
implications for monetary policy and fiscal policy in influencing aggregate economic activity.
As for the case of the instability of the demand for money, the theoretical argument is that if
the money demand function is unstable and subject to unpredictable shifts, the velocity will
be unpredictable, and as a result, the monetary aggregate may not be able to predict income
[see Owoye (1997a)]. More importantly, this would make monetary policy targeting an
uneasy task for central banks. Empirical evidence from money demand studies in the 1960s
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and early 1970s confirmed its stability when M1 was used [see Meltzer (1963), Laidler (1966),
and Goldfeld (1973)]. By 1974, the M1 money demand function began to overpredict the
demand for money; and this phenomenon labelled “the missing money” (see Goldfeld, 1976)
sparked off an avalanche of empirical studies to this effect.
The empirical search for “the missing money” went in two directions. In one direction, the
main objective was to re-define the monetary aggregates to include the financial innovations
of the 1970s, and in the other direction, the idea was to add new variables to the money
demand functions. The search to re-define monetary aggregates yielded promising results as
Garcia and Pak (1979) found that re-defining money to include overnight repurchase
agreements “reduced the degree to which money demand functions overpredicted the money
supply.” In terms of adding new variables to the demand function, Hamburger (1977) did
exactly that by including the average dividend-price ratio – a proxy for interest rate – as an
explanatory variable. He found the money demand function to be stable. In similar fashion,
Heller and Khan (1979) added the entire term structure of interest rates in their estimated
demand function and found it to be stable. Also, several researchers at the Federal Reserve
Bank in the United States joined in the search for “the missing money.” The hope to find “the
missing money” was restored as some studies, Small and Porter (1989), found that M2 money
demand functions performed better than M1; however, the study by Ragan and Trehan
(1998) cast further doubt about the stability of money demand function. This search also
raised some methodological issues as well. For example, Cooley and Roy (1981) were critical
of these techniques and the state of empirical studies on the demand for money, and Judd
and Scadding (1982) questioned the theoretical justification for adding any conceivable
variable in the regression equation and whether this would lead to continuing stability of
money demand in the future (see Hafer and Hein, 1979).
While the discussion is still on the demand for money, another factor that would pose a
serious challenge to policymakers is the problem of international currency substitution,
which became a central issue in monetary economics and one whose importance and impact
would increase in the 21st century. Given the level of globalization and improved technology
in telecommunication, the distinction between national and international use of money is
blurred, therefore, domestic financial markets are susceptible to external shocks, and this
remains a potential source of instability to money demand functions. For example, in a study
by Doyle (2000), he estimated the amount U.S. dollars, Deutsche Marks, and Swiss Francs
held in foreign countries between the 1960s and 1990s and found a significant sharp increase
in international currency substitution during the 1990s. Furthermore, economists now
recognize that empirical studies of money demand can no longer neglect the international
factors, and because of this, they now include explanatory variables to capture the effects of
capital mobility and international currency substitution in the money demand functions [see
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Miles (1978), McKinnon (1982), Cuddington (1983), Giovannini and Turtelboom (1994), De
Nicolo et al (2003), Ize and Yeyati (2003), and Detragiache et al (2006)].
As for the interest sensitivity of money demand and income velocity of money, Milton
Friedman (1959) found money demand to be insensitive to interest rate, however, when
Laidler (1966) examined the same issue using the same data as Friedman, he found that
Friedman’s findings were due to faulty statistical procedure. Other studies in this area found
results that were more consistent with Laidler’s (1966) findings than with Friedman’s (1959)
results with respect to the interest sensitivity of money demand. As for the constancy or
variability of velocity, Friedman and Meiselman’s (1963) test as to whether monetary or fiscal
policy was more important for the determination of nominal income had established a much
more stable and statistically significant relationship between output and money, and thus
constant velocity. During the 1980s, the United States experienced a decline in velocity, which
Milton Friedman attributed to the 1979-1982 monetary policy experiment of the Fed under
Paul Volcker - variability of money growth. The policy shift by the U.S. Federal Reserve Bank
in 1979 led researchers to examine what caused the decline in velocity. The studies by Judd
and Motley (1984), Hall and Noble (1987), Raj and Siklos (1988), Goodhart (1986, 1989),
Bordo and Jonung (1981, 1990), Brocato and Smith (1989), Mehra (1989), and Thornton
(1991) for many advanced countries including the U.S. yielded conflicting results. Earlier
studies of velocity in developing economies by Ezekiel and Adekunle (1969), Park (1970), and
Melitz and Correa (1970) before the U.S. experienced the decline in velocity showed that
income velocity of money differed internationally. They found that developing countries are
usually characterized by higher variability in velocity. In other studies of velocity in
developing countries, empirical results are inclusive [see Driscoll and Lahiri (1983), and
Owoye (1997)].
Another important area of debate has been the issue of the direct and indirect transmission
mechanisms of monetary policy, which owed their origins to the studies of David Hume,
Irving Fisher, and Knut Wicksell. Some economists agree that Keynesian analysis was more
specific about the channels (indirect transmission) through which money supply affects
economic activity and that monetarists had no specific ways of monetary transmission.
Economists have gained and continue to gain immense knowledge on monetary transmission
mechanisms from these debates because each debate added new dimension to the existing
body of knowledge. For example, in 1995, The Journal of Economic Perspectives (JEP)
featured a five-article symposium on the monetary transmission mechanisms [see, Mishkin
(1995), Taylor (1995), Bernanke and Gertler (1995), Meltzer (1995), and Obstfeld and Rogoff
(1995) in JEP]. In the lead article of the symposium, Mishkin (1995) provided a detailed
explanation of the exchange rate channel, other asset price effects, and the credit channel of
monetary transmissions in addition to the standard interest rate mechanism in the basic
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Keynesian model. According to Mishkin’s assessment, the studies by Taylor (1995) and
Obstfeld and Rogoff (1995) “emphasized the importance of the exchange rate channel of
monetary transmission because…..a framework for the conduct on monetary policy must be
inherently international in scope.” With respect to the credit channel, Bernanke and Gertler
(1995) did not “think of the credit channel as a distinct, free-standing alternative to the
traditional monetary transmission mechanism, but rather as a set of factors that amplify and
propagate conventional interest rate effects. For this reason, the term ‘credit channel’ is
something of a misnomer; the credit channel is an enhancement mechanism, not a truly
independent or parallel channel.”
From the studies cited in the previous paragraph and other similar studies by Dornbusch
(1976), Dornbusch and Giovannini (1990), Jaffee and Stiglitz (1990), Bernanke and Blinder
(1992), Miron, et al (1994), McCallum (1999), and Smal and de Jager (2001), we now know
that there are many other channels (credit view channels: bank lending, balance sheet, cash
flow, unanticipated price level, and household liquidity effects; and other assets price
channels: Tobin’s q theory, wealth effects, and exchange rate effect on net exports) of
monetary transmission mechanisms, apart from the traditional interest rate channel (see
Mishkin, 1995). The importance of these advances in monetary economics was aptly captured
by Meltzer (1995): that our knowledge of these transmission processes “helps to interpret
observations during the nervous interlude between policy actions and when their effects on
output and inflation become visible.”
As Keynesian economics was trying to regroup from the monetarist onslaught, the rational
expectations/new classical revolution struck with Robert Lucas and Thomas Sargent (1978).
These leading advocates of rational expectations argued that Keynesian models of the 1960s
were not only fatally flawed because they lacked sound microfoundations, but also because
they incorporated the adaptive expectations hypothesis, which they considered to be
inconsistent with the maximizing behaviour of economic agents. “In addition to these
theoretical flaws, they also argued that in the 1970s, Keynesian macroeconometric models
experienced econometric failure on a ground scale and that being subject to the Lucas
critique means that these models could not be used to guide policy” (Snowdon and Vane,
1997). The basic idea of the rational expectations/new classical school is the new classical
equilibrium models in which markets always clear and rational economic agents optimize.
This suggests that equilibrium models can account for the main features of the business cycle
with economic fluctuations being triggered by unanticipated monetary shocks. In other
words, fluctuations in output and employment reflect the voluntary response of rational
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economic agents who misperceive money price changes for relative price changes due to
incomplete information [see studies by Muth (1961), Lucas (1972, 1973), McCallum (1989),
Taylor (1975, 1977, 1979, 1980), Fischer (1977), and Blanchard (1990)].
The rational expectations/new classical economics can be viewed from three main subhypotheses. First, expectations are informed predictions of future events based on the
relevant economic theory; that is, economic agents’ subjective expectations of economic
variables will coincide with the true or objective mathematical conditional expectations of
those variables, with the crucial implication that the economic agent will not form
expectations that are systematically wrong over time. Second, new classical models are
Walrasian in that all observed outcomes are viewed as market-clearing at each point in time,
given the assumption that markets continuously clear, and that all possible gains from trade
have been exploited and utility has been maximized. Third, new classical models incorporate
an aggregate supply hypothesis based on two orthodox microeconomic assumptions, namely
that (a) rational decisions taken by workers and firms reflect optimizing behaviour on their
part, and (b) the supply of labour by workers, and output by firms, depend on relative prices
(Snowdon and Vane, 1997).
Within any school of thought, there are splinter groups, and the rational expectations school
is no exception to such division. There are two groups and both agreed on the long-run
equilibrium but differed with respect to short-run equilibrium. In one group, Lucas-SargentWallace-Barro (LSWB) combined the Friedman-Phelps natural rate hypothesis (NRH) with
rational expectations theory (RET) to argue that policies would not influence real economic
magnitudes. In the other group, Fischer-Phelps- Taylor-Gordon (FPTG) agreed with NRH
but differed from the LSWB camp in the short-run because of price inertia or gradual
adjustments of prices (GAP) [see Fischer (1977), Phelps and Taylor (1977), and Gordon
(1982)]. The FPTG group argued that because of GAP due to price inertia, it is possible that
policies may influence economic activity in the short-run before the adjustment to its longrun equilibrium values. In other words, when agents have rational expectations, fully
anticipated monetary policy can influence aggregate output in the short run if price
adjustments and supply of output are constrained by the presence of staggered explicit or
implicit wage and price contracts. The rational expectations theorists, particularly the LSWB
group demonstrated that the “short-run Phillips curve would result if inflation was
unanticipated due to incomplete information.” Given Lucas’s aggregate supply function,
which states that output deviates from natural rate only if the actual price level deviates from
the expected price level, the NRH-RET developed an equilibrium monetary
explanation of the business cycle (Lucas (1975, 1977). The combination of RET, continuous
market clearing with Lucas’s aggregate supply function and the new classical/rational
expectations models produced six highly controversial policy implications:
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that monetary policy is ineffective if fully anticipated, that is the policy ineffectiveness
proposition (PIP) [see Sargent and Wallace (1975, 1976],
(ii) that announced money supply changes, if credible, will evoke corresponding
adjustments from rational economic agents (see Blackburn and Christensen, 1989),
(iii) the dynamic time-inconsistency argument to support monetary policy being conducted
by rule rather than by discretion [see Kydland and Prescott (1977), and Fischer (1990)],
(iv) the Ricardian debt equivalence theorem, which limits the usefulness of tax changes as
stabilization instrument (see Barro 1974, 1989),
the choice of policies for authorities, and
(vi) Lucas critique of econometric policy evaluation (see Lucas, 1976).
To provide the empirical evidence to support the NRH-RET proposition of the LSWB group,
Barro (1977, 1978) subjected the NRH-RET proposition to an empirical test by decomposing
aggregate money growth into two components parts: anticipated and unanticipated money
growth rates. Barro’s empirical studies confirmed the PIP because only the unanticipated
components of money growth influenced real economic variables. This was another landmark
period in monetary macroeconomics for a couple of reasons. First, Barro’s empirical studies
and conclusions led to an unprecedented tidal wave of research for both developed and
developing countries during the late 1970s, 1980s, and early 1990s. Second, during the same
period, economists also recognized that expectations are extremely important to economic
decision making at both the micro and macro levels. In studies by Mishkin (1982a, 1982b,
1983) and Gordon (1982), for example, they found both the anticipated and unanticipated
money growth to influence real output. The Mishkin and Gordon results supported the
theoretical contention of the FPTG group. Furthermore, in order to ascertain the universal
validity of these findings, other studies by Barro and Rush (1980), Mussa (1980), Attfield
(1981), Canarella and Garston (1983), Canarella and Pollard (1989), Merrick (1983), Demery
(1984), Darrat (1985), McGee and Stasiak (1985), Chen and Steindel (1987) examined the
effects of anticipated and unanticipated money growth on real output for many advanced
countries. During the same period, other studies by Barro (1979), Hanson (1980), Edwards
(1983a, 1983b), Attfield and Duck (1983), Kormendi and Meguire (1984), Chopra and Montiel
(1986), Montiel (1987), Beladi and Samanta (1988a, 1988b), Al-Saji (1990), Owoye and
Onafowora (1994), Choudhary and Parai (1991) examined the same issue of anticipated and
unanticipated money growth for developing countries. While some of these studies found
results that are consistent with Barro’s original findings, others found results that are in line
with the findings of Mishkin and Gordon. In other words, the results are mixed and, in some
cases, inconclusive.
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Despite the inconclusive empirical results obtained from these studies during the late 1970s,
1980s, and early 1990s, RET remained and continues to be an important development in
monetary economics, more so for its contribution to more knowledge of the financial markets
since then. According to Mishkin (2003 pp. 691-694), “it is difficult to think of any sector of
the economy in which expectations exert no influence on the effects of policy and the way
markets behave.” The application of RET to the financial markets, known as the efficient
markets theory, is a case in point that emphasized Mishkin’s assertion. The theory of efficient
capital markets is based on the assumption that prices of securities in the financial markets
will fully reflect all available information so that the optimal forecast of a financial asset’s
return using all information would equal the financial asset’s equilibrium return. The
implication is that investors in the financial market should not attempt to outguess the
market by frequent purchases and sales of stocks from their portfolio because speculative
behaviours will not outperform the market; and if efficient market theory holds, then there
will be no need for policymakers to worry about speculative bubbles or market exuberance.
Mishkin (2003) provided a detailed explanation of areas of economic activities affected by
expectations, namely, asset demand and the determination of interest rates, risk and term
structure of interest rates, foreign exchange rates, asymmetric information and financial
structure, financial innovation, bank asset and liability management, money supply process,
federal reserve, demand for money, aggregate demand, and aggregate supply and inflation.
Before we come full circle in the discussion of advances and lessons learned in monetary
macroeconomics, it is important that we do not ignore the complexities of the financial
systems in terms of structure and functions throughout the developed and developing
countries. These complexities were further compounded by the waves of financial
innovations that occurred over the past three or four decades. However, before we discuss the
issue of financial innovations, let us examine the advances to monetary economics from the
financial institutions, particularly, the roles of the central banks, commercial banks, and the
public in the determination of money supply. Whether we define money supply as M1 or M2
or M3, economic theory suggests that three major participants determine the money supply
process. According to the conventional economic analysis, the central bank determines the
monetary base through its policy tools while the commercial banks determine their actual
demand for reserves based on their liabilities, and the public determines its currency
holdings relative to its demand deposits. The public’s determination of its currency-deposit
ratio is influenced by the following: charges on demand deposits, the average yield on
investment in bonds, interest rate on demand deposits, interest rate on time deposits,
nominal income, and credit and debit cards (also known as plastic or smart cards) in
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financially developed economies. In economies like the United States and United Kingdom,
credit and debit cards provided by commercial banks are major innovations in banking
during the past three or more decades because these plastic cards serve as alternative
payment methods, time-series data which show to have lowered the currency-deposit ratio
during the 1980s and 1990s (see Tatom, 1990, pp. 43-46).
Based on what we know about the behaviour of central banks with respect to the supply of
the monetary base, the commercial banks’ holding of required reserves and free reserves as
well as their borrowing practices from the central banks, and the behaviour of the public, it is
obvious that the general money supply encompasses the behaviour of these three
participants. Given the considerable interactions between these participants in the money
supply process, Cagan (1965), in his study of the United States, concluded that the
fluctuations in currency ratio had relatively large amplitude over the business cycle during
eighteen cycles between 1877 and 1954. Empirical evidence by Tatom (1990) found a
statistically significant relationship between financial innovations and currency-demand
deposit ratio, and based on this, he concluded that this affected the money multiplier during
the 1980s. The implication here is that the public can influence the money supply process
through its demand for currency and various deposits (which may include deposits in dollars,
pound sterling, and the euro) with the commercial banks.
In the case of money supply, the general observation since 1990 or so is a move by central
banks around the world to adopt different monetary policy rules as guides for monetary
policy rather than the conventional discretion. According to McCallum (1997, 1999, 2000) the
topic of monetary policy rules has a long and distinguished history in macroeconomic
analysis, with notable contributions coming from Wicksell (1907), Fisher (1911), Simon
(1935), Friedman (1948, 1960, 1969), and others. During the late 1980s and early 1990s,
McCallum (1988, 1993a, 1993b) illustrated the difference between discretion and monetary
policy rules in practice as well as the robustness properties of a rule for monetary policy.
From these studies, McCallum defined discretion to imply “period-by-period reoptimization
on the part of the monetary authority whereas a rule calls for period-by-period
implementation of a contingency formula that has been selected to be generally applicable for
an indefinitely large number of decision periods.” The choice of monetary policy rules over
discretion means that a central bank must be concerned with the appropriate variable on
which to target as the indicator that will provide information about current and future state
of the economy. For many central banks worldwide, monetary policy targets include:
monetary or reserve aggregates, interest rates, nominal income, deviation of output from full
employment, and the price or the inflation rate. In the case of inflation targeting, Mishkin
(2003, pp. 521-522) identified several required elements: (i) public announcements of
medium-term numerical targets for inflation rate (ii) an institutional commitment to price
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stability as the primary long-run goal of monetary policy and a commitment to achieve the
inflation goal [see Rogoff (1985)], (iii) an information-inclusive strategy in which many
variables and not just monetary aggregates are used in making decisions about monetary
policy, (iv) increased transparency of the monetary policy strategy through communication
with the public [see Geraats (2001, 2002a, 2002b], and (v) increased accountability of the
central bank for attaining its inflation objectives.
The resurgence of monetary policy rules was due to Barro and Gordon’s (1983) study, which
“built upon the insights of Kydland and Prescott (1977) in a manner that put an end to the
previously widespread notion that policy rules necessarily involve fixed settings for the
monetary authority’s instrument variable. This step served to separate the ‘rules versus
discretion’ dichotomy from the issue of ‘activist versus non-activist’ policy behaviour and
thus opened the door to possible interest in policy rules on the part of actual monetary
policymakers — i.e., central bankers. In fact, there has been a great increase in apparent
interest in rules by policymakers during recent years — say, 1990-1996.” As we may recall
from the study by Kydland and Prescott (1977), they suggested that central banks should
abandon discretionary monetary policy and commit to rules. About a decade later, and in a
game-theoretic approach to monetary policy modelling, Canzoneri (1985) and Canzonerri and
Grey (1985) addressed the issue of private information under commitment. They analysed
flexible targeting rules that allow central banks to respond to private information but reduce
the inflation bias caused by dynamic inconsistency.
Another development to monetary policy rules was Taylor’s rule, which Taylor (1993)
developed for the United States. The significance of this contribution to monetary economics
was manifested by the fact that Taylor’s rule quickly became an important topic for
discussion in speeches and papers by members of the Board of Governors (e.g. Blinder, 1996
and Tetlow, 1999) of the Federal Reserve Bank [see Brayton (1996), and Orphanides
(1996)]. In the United Kingdom, Taylor’s rule as well as the alternative, which McCallum
(1988, 1993b) developed, attracted considerable attention from the Bank of England and the
British press [see Stuart (1996)]. The upsurge in interest in monetary policy rules has led
central bank economists from a number of different countries to conduct analytical studies of
these rules. The renewed interest is related to the arrival of inflation targeting as a leading
candidate for the provision of a practical guideline for monetary policy. Inflation targeting as
a rule for monetary policy was introduced in New Zealand in 1990, and since then, Canada,
Finland, Sweden, United Kingdom, Australia, Spain, Israel, Chile, and Brazil have joined the
list of countries using inflation targeting as the monetary policy strategy. Not too long ago,
South Africa joined the list as one of the countries in Sub-Saharan Africa that targets inflation
rate as a monetary policy strategy. So far, empirical evidence has indicated success in New
Zealand, Canada, and the United Kingdom [see Bernanke, (1999)].
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Next, let us examine other advances in monetary macroeconomics; and at the same time, we
hasten to admit that it is virtually impossible to fully document the scope and dimensions of
financial innovations because of the continued introduction of hosts of financial products
(e.g. money market mutual funds – MMMF, money market deposit account – MMDA,
mortgage-backed securities – MBS), and the influx of numerous and more diversified
financial firms (e.g. Savings and Loans Associations, Mutual Savings Banks, Credit Unions,
Investment Banks), over the past four decades. According to Mishkin (2003, pp. 239-245),
financial innovations occurred in (a) responses to changes in demand conditions, and they
can be regarded as demand-induced financial innovations, (b) responses to changes in supply
conditions, which can be termed as supply-induced financial innovations, and (c) avoidance
of existing regulations, which can also be referred to as regulations-induced financial
innovations. In other words, financial institutions produced financial innovations as
responses to the prevailing financial system’s conditions and market opportunities. Each of
these financial innovations led to the introduction of new financial products which benefited
consumers as well as the profit maximizing objectives of the financial institutions. For
example, the supply-induced financial innovation occurred in response to the new
improvements in the use of computer and telecommunications technology which
substantially lowered transaction costs due to the use of bank credit and debit cards. With the
continued decrease in telecommunication costs, many individuals (including this author)
now conduct banking and other payment transactions from the convenience of their homes
and offices through the telephone or the internet. In effect, the developments and
improvements in information technology, data processing, and telecommunications have
facilitated the provision of banking services both nationally and internationally [see D.
Thornton (1994)]. For example, three or four decades ago, it was virtually impossible to remit
money from one country to the other outside the banking systems, but nowadays,
MoneyGram and Western Union provide easy access for remittances worldwide.
One of the most documented financial innovation was the “negotiable order of withdrawal”
(NOW) account, which was a form of regulation-induced financial innovation. Before
Regulation Q ceilings were phased out under the Depository Institutions Deregulation and
Monetary Control Act (DIDMCA) of 1980, commercial banks could not offer or pay interest
rates on checkable or demand deposit accounts, and as a result, many commercial banks lost
huge amounts of funds to other financial instruments that offered higher interest rates,
especially during the 1960s when interest rate rose sharply. The introduction of NOW account
was a skilful way to avoid the interest rate prohibition of Regulation Q. After many court
challenges in the state of Massachusetts where NOW account originally began, banks in the
state were allowed to pay interest rates similar to those paid on saving deposits. This privilege
allowed bank customers with NOW accounts to transfer funds freely between their savings
accounts (a component of M2) and NOW accounts (a component of M1). The ease with which
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individuals now transfer savings balances into M1 means that savings balances now comingle with the traditional transactions balances typically associated with M1. Another
important financial innovation was the introduction of electronic banking facility known as
the automated teller machines (ATMs). This has revolutionized commercial banking
practices because ATMs allowed for 24-hour banking year round. The introduction of ATM
was in response to the restrictions on branching banking, which regulated the numbers of
branches a commercial bank can open. With cheaper computers and telecommunications
technology, banks are now able to provide ATMs at low cost, thus enabling banks to provide
better services to their customers. Arguably, this was a significant advancement in
commercial banking because not too long ago, banking transactions occurred only during the
week at the designated official hours and half-day on Saturday.
In assessing the monetary economic effects, we need to consider the ramifications of financial
innovations. First, financial innovations have altered not only the absolute and relative costs
of holding various financial assets, but have also reduced the transaction costs associated
with exchanging one financial asset for another. Second, financial innovations have led to the
creation of new financial assets that now serve as close substitutes for the traditional “media
of exchange” assets included in M1 monetary aggregate, thus leading to higher elasticity of
substitution. Third, financial innovations have changed the traditional market structure and
the roles of financial intermediaries. In other words, the fundamental distinctions between
commercial banks and other financial institutions have nearly disappeared over the past
three or four decades. For example, Credit Unions and Mutual Savings Banks now perform
almost the same functions and offer the same services as traditional commercial banks in the
United States. Fourth and most importantly, financial innovations may have altered not only
the money supply process in many advanced countries, particularly the United States, but
also the ability of monetary authorities to control various monetary aggregates. In the United
States, for example, there is a general perception that the waves of financial innovations
contributed to the sharp decline or breakdown in the velocity of M1 money supply during the
1980s. The decline in the velocity of M1 was attributed to the nationwide introduction of
NOW accounts in January 1981. Even though financial innovations have lowered the costs of
transactions for economic agents and financial institutions, it may have also complicated the
job of monetary authorities in developed countries by further reducing their ability to control
the aggregate money stock [see Cagan (1979)]. For example, since the breakdown of the
velocity of M1 during the 1980s, the U.S. Fed continued to cite financial innovations as one of
the principal reasons for its de-emphasis of M1 targeting and its broad examination of
various intermediate targets for conducting monetary policy.
It is important to point out that many other financial innovations that emerged in the past
two and a half decades could be traced back to the early part of the 20th century. According to
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Geotzmann and Newmann (2010), the financial assets backed by real estate (known as
mortgage backed securities or securitization), which artificially supported credit markets
through the early 2000s, paralleled the scale and scope of the commercial real estate mortgage
bond market in the period surrounding the 1920s. In their view, the rise in popularity of
publicly issued financial instruments backed by real estate that we experienced in the 2000s
was not a recent phenomenon, and both had devastating effects. To highlight the connection
between both periods, they pointed to the “New York skyline as a stark reminder of
securitization’s ability to connect capital from a speculative public to building ventures.”
Similarly, quantitative easing (QE), which the Federal Reserve Bank used to stimulate the
economy post-2007-08 financial crisis because monetary policy was ineffective, paralleled a
form of quantitative easing that the Fed had used in the 1930s and 1940s to fight the Great
Depression. According to Bullard (2010), QE involves the purchasing of a set quantity of
bonds or other financial assets on financial markets from private financial institutions such
as investment banks. Some economists, financial analysts and pundits regarded the Fed’s use
of QE (QE1, QE2, and QE3) to fight the 2007-2009 Great Recession as unprecedented; and
this was actually a typical case of history repeating itself. Historical evidence shows that the
use of QE by the U.S. Fed was not unprecedented, given that it had been used during the
1930s and 1940s. In addition, the Bank of Japan (BOJ) used QE between 2001 and 2006 to
fight against domestic deflation because the BOJ has maintained interest rates at close to
zero since 1999, which was an indication of the “liquidity trap” [see Spiegel (2001), Fujiki et al
(2001), and Voutsinas and Werner (2010)].
There have been many lessons from monetary economics that economists can point to since
the 20th century. An obvious consensus among the eminent scholars is that money is the
main live wire of any economy, and that central banks and other financial institutions are
pivotal to any dynamic economy worldwide. First, from the quantity theory of money or
quantity equation, we know that Fisher did not assume the velocity of money to be constant
and that this was an assumption based on the habit persistent of economic agents during the
classical era, which ultimately formed the basis of the full-employment unemployment
output level. Many empirical studies have shown that the velocity of money is not constant.
Second, we have also learned that both Irving Fisher and Milton Friedman pointed out the
direct or strong relationship between money and prices. This relationship was aptly captured
by Milton Friedman’s quote that “inflation is always and everywhere a monetary
phenomenon.” We have seen this money-inflation nexus manifest in many developing
countries where the central banks are not independent, and thus, they can easily print money
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as dictated by the fiscal authorities. Third, we have learned over the years that the “liquidity
trap” was not just a theoretical construct as some critics argued, but a reality that countries
such as Japan, the United States, and others have experienced over the past two or more
decades. Fourth, another important lesson learned from monetary economics came from the
Lucas model (RET), which assumed market clearing, imperfect information, and rational
expectations; and which formed the basis of the policy ineffectiveness proposition (PIP). Over
the years, we have come to know that economic agents around the world are not
econometricians and statisticians who can make accurate predictions based on the prompt
availability of information; therefore, this calls into question the validity of rational
expectations theory.
Fifth, we have also learned that financial innovations and monetary policy ideas have
continued to emanate from the financial institutions in advanced countries such as the
United States, Japan, the United Kingdom, and others; and that the rapid rate of
globalization has accelerated the diffusion of these financial innovations. For example, plastic
cards (credit and debit) which are now a global phenomenon with respect to transactions
started in these advanced countries. In other words, economies are now connected more than
ever before, and this brings us to the final major lesson learned from monetary economics,
which is that along the global gains from the diffusion of financial innovations, financial
institutions contribute to several economic crises through financial crises. While some of
these financial crises are country-specific (e.g. Chilean Crisis of 1982, Bank Stock Crisis in
Israel of 1983, Bank Panics of 1901 and 1907 as well as the Savings and Loans Crisis in the
U.S. during the 1980s and 1990s, Mexico Peso Crisis of 1994, and Argentina Peso Crisis of
1999-2002 etc.), some financial crises are sometimes regionally (e.g. Latin American Debt
Crisis and the Asian Financial Contagion of 1997) and globally (e.g. Global Economic and
Financial Crisis of 2007-2009) contagious. From the global financial crisis, we now know that
QE, which economists, policy analysts and pundits considered as unprecedented, was
actually a repeat of history of the 1930s and 1940s in the United States, and that this also
paralleled the Japanese experience of the 2001-2006 period.
The recurrence of these financial crises calls into question whether or not countries
worldwide learned anything from past financial crises and whether their central banks are
performing their duties, which Friedman laid out in his 1968 seminar paper. In a recent
study, Blinder (2010) laid out the four traditional roles of a central bank, which paralleled
those of Friedman (1968). More importantly, Blinder (2010) concluded that a central bank
should monitor and regulate systemic risk because the preservation of financial stability is
closely aligned with the standard objectives of monetary policy, and that it should supervise
large financial institutions because its supervisory function is essential in order to achieve the
regulation of systemic risk. In a similar study, Feldstein (2010) echoed the same sentiments in
terms of monetary policy, lender of last resort, and bank supervision.
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The discussion in this paper shows that the advances in monetary economics came from
different schools of thought. In the early part of the 20th century, the quantity equation and
many variants of it transformed into the quantity theory. Over the years, the quantity theory
went through transformations and interpretations based on different writers, periods, and
schools of thought. Despite the controversies and debates between these different schools of
thought, they laid the foundations for modern monetary economics. Each controversy and
debate during the early stages of development enhanced our knowledge of monetary
economics. Similarly, each debate and controversy produced a unifying solid foundation for
subsequent debates and controversies, which gave us further insights into these theories. For
example, the proposition that proportional changes in money supply will lead to proportional
changes in the price level with no change in real output was firmly established from Fisher’s
quantity theory. This formed the bedrock for Friedman’s natural rate hypothesis, and later,
the policy ineffectiveness proposition of the rational expectations revolution. Furthermore, in
another debate on money demand function between Keynesians and monetarists, economists
have come to the agreement that income and interest rate, no matter how they are measured,
are key determinants of the demand for money balances. In addition, the debate about the
stability of money demand function or the variability of velocity also enhanced our knowledge
of the monetary policy implications of unstable money demand functions. Judging by the
waves of empirical studies over the past three or more decades to find a stable money
demand function because of the policy implications, and the worldwide application of the
rational expectations theory to different sectors of the economy, one would undoubtedly
conclude that the Keynesian-monetarist debates and the RET revolution have profound
effects on the development of monetary economics.
If we are in search of important contributions to monetary economics prior to the 1970s,
obviously, the studies by Fisher, Pigou, Wicksell, Keynes, Milton Friedman, and Milton
Friedman and Schwartz stand out. With the perceived demise of Keynesian economics
beginning with the stagflation episode of the 1973-1975, Lucas-Sargent-Wallace-Barro’s
rational expectations theory, which built on Muth’s (1961) pioneering work on expectations,
provided a viable alternative. This was a remarkable period in both monetary economics and
macroeconomics as studies applied RET to other countries around the world in order to
ascertain its universal validity. Furthermore, RET brought a wider dimension to monetary
policymaking during the late 1970s, 1980s, and early 1990s as studies examined the issues of
anticipated and unanticipated money growth on economic activity. Even though the
empirical evidence on policy ineffective proposition is mixed [see Mishkin (1982a, 1982b,
1983) and Gordon (1982)], RET has revolutionized the way central bankers and economists
now think about the conduct and implementation of monetary and fiscal policies and their
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effects on economic magnitudes. If we take Mishkin and Gordon’s results that anticipated
and unanticipated monetary policy can affect output, then there is hope that activist
stabilization policies may be beneficial if they are well designed and believable by the public.
In order words, RET’s emphasis on the importance of credibility, transparency, and
commitment to rules in policymaking has brought a wider dimension to monetary economics
since the 1970s.
For example, since the development of Taylor’s rule as guides to monetary policy, not only
have monetary policy rules become an important issue for discussion and critical analysis by
economists at central banks in many countries, but some central banks have actually adopted
inflation targeting as a rule for monetary policy with impressive results. In the area of
monetary policy rules versus discretion, the studies by Kydland and Prescott, Barro and
Gordon, McCallum, and Taylor stand out in their contributions to monetary economics along
this line. Finally, financial innovations and financial regulations have also revolutionized how
we view the traditional roles of commercial banks. Whether financial innovations are supplyinduced or demand-induced or regulations-induced, what we do know is that transaction
costs are lowered and may have affected the demand for monetary aggregates, therefore,
monetary authorities may be adversely affected. In all, economists from various schools of
thought agree that money, central banks, and other financial institutions in the developed
and developing countries are important with respect to economic dynamism. The events and
evidence in the past two or more decades also point out that financial institutions are
instrumental in many economic crises and perturbations. The global financial crisis of 200709 forced the U.S. Fed to use quantitative easing which some economists considered as
unprecedented, but which in actual fact was a repeat of similar measures used in the 1930s
and 1940s to fight the Great Depression; and this was also a measure the Bank of Japan used
between 2001 and 2006 to fight against deflation. In essence, this shows that economists need
to examine historical precedence before any major pronouncement or conclusion.
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Bitcoin – a Technology and a Currency
Rainer Kulms*
Bitcoin is an innovative form of digital money based on blockchain technology and a
decentralised ledger. Bitcoin is open to everybody and has brought forth rudimentary
organisational structures with the potential for creating externalities. This paper assesses
Bitcoin and its governance mechanisms. Recently, central and private banks have come to
emphasise the technological potential over the currency-related aspects. In what seems to
reflect the literature on the tragedy of the (anti) commons, the development of automated,
digital clearing systems, which are only accessible to interested parties, ushers in the
reprivatisation of ledgers. Apart from New York’s BitLicense, government intervention into
virtual currencies is still in its infancy. The transnational structure of the internet and
regulatory competition preclude national authorities from pursuing a comprehensive
regulatory policy. Regulators are currently assessing the benefits of private financial
networks against the fall-out from money laundering and tax evasion practices.
virtual currencies, regulation of private financial networks, distributed ledgers and clearing
system, the tragedy of the (anti) commons
JEL Classification:
Privatdozent, Dr. iur., LL.M., Senior Research Fellow, Max Planck Institute for Comparative and
International Private Law, Hamburg, Germany.
This paper is based on a presentation given at the Centre for Law and Economics of China University
of Political Science and Law, Beijing, on 14 April 2016. It updates and expands an article published in
Pravo i Privreda 51, 4-6 (2014), 288 - 309.
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Bitcoin – a Technology and a Currency
1.1. A Currency in a Legal No-man’s Land and a Technology
“Bitcoin is a decentralised, peer-to-peer network-based virtual currency that is traded on-line
and exchanged into US dollars and other currencies 1”. In an attempt to minimise bitcoinrelated risks, the European Banking Authority (EBA) has urged supervisory authorities in the
Member States to discourage financial institutions from buying, holding or selling virtual
currencies2. The United Kingdom (UK) government intends to explore the “potential of
virtual currencies and digital money” in order to foster innovation 3. The French Senate feels
that Bitcoin is more a technology, a protocol for verifying transactions than a currency 4. The
European Securities and Markets Authority (ESMA) acknowledges that market participants
are increasingly focusing on Bitcoin’s underlying technology5. Banks explore the potential of
electronic settlement mechanisms on the basis of blockchain technology without traditional
clearing institutions6. Late in 2015, Nasdaq introduced an automated electronic clearing
system for the sale and purchase of securities in private companies7. The Bank of England has
established a study group on the issuance of electronic money 8.
Bitcoin cannot exist without the internet. It is open to everybody and has brought forth
rudimentary organisational structures which have a potential for creating positive and
negative externalities. With respect to virtual currencies, the EBA identifies potential risks to
users, non-user market participants, financial integrity, payment systems and payment
service providers and regulatory authorities 9. Late in February 2014, the largest exchange for
bitcoins, the Tokyo-based Mt. Gox Co., Ltd., went bankrupt, citing losses of bitcoins and
customer funds10. In 2015, the Mycoin bitcoin exchange in Hong Kong disappeared and many
consumer-investors lost the funds they had deposited with the exchange11. A year later, the
New York Department of Financial Services promulgated a first set of comprehensive rules
on virtual currencies12. Under these rules, a ‘Bitlicense’ is required for trading in bitcoins or
offering bitcoin-related services13.
Bitcoin is not a new-comer in the field of privately sponsored virtual currencies. But it is the
first scheme for a private, digital currency which operates without a centralised steeringmechanism and without direct intervention of central private regulator 14. Bitcoin’s nature is
highly speculative since its ‘external’ value fluctuates; there is no direct linkage with any
traditional currency15. Supporters of Bitcoin highlight the beneficial effects of a digital
currency which is said to be largely inflation-proof16. They claim that Friedrich August von
Hayek would have approved Bitcoin 17, since Bitcoin is a private, denationalised currency,
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Rainer Kulms
totally independent of Central Bank intervention18 or government backing19. Bitcoin presents
a fascinating challenge to lawyers and financial market regulators 20. It appears to stand for
the benefits of private ordering, the fall-out from financial bubbles and its potential for
money laundering21, but also for innovation by automatic clearing systems without the
intervention of an institutionalised clearing-house. Over the past months, financial
institutions have intensified the efforts to develop blockchain systems which deliver
automated clearing22.
1.2. Outline of the Paper
This paper will first study the technical aspects of Bitcoin in order to ascertain the
organisational structure for administering a digital currency scheme. It will then place
Bitcoin and its specific internet features in the broader context of the literature on the tragedy
of the (anti-) commons in order to identify externalities which need to be addressed by
private contracting or regulatory action. Although current government strategies are still in
their infancy23, regulatory choices oscillate between an informed laissez-faire and a licenseoriented approach towards trading in bitcoins 24. Some jurisdictions take a hostile stance on
digital currencies, having introduced an outright prohibition of business transactions in
digital currencies25. A section on the technological potential of digital currencies for fully
automated electronic settlement mechanisms concludes.
2.1. The Making of Bitcoin
The 2008 Paper - Basics
At the outset, bitcoin is a technology based on a protocol which lays down certain ground
rules for the exchange and verification of value-related electronic information26. In 2008 a
paper on “A Peer-to-Peer System Electronic Cash System” for online transactions was
published27. The paper proposes a virtual currency without a central administrator. It claims
that the network will be able to police potential double-spending by relying on cryptographic
time-stamps which will generate computational proof of the chronological sequence of the
transactions undertaken in virtual currency units 28. An electronic coin is defined as an
electronic signature. In order to effectuate an electronic transfer of payment each owner of a
bitcoin will attach his or her electronic signature to the virtual currency unit so that the
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Bitcoin – a Technology and a Currency
recipient will not be supplied with electronic cash doubly spent 29. Each bitcoin received
carries its cryptographic history with it so that double-use problems can be avoided30. For
technical reasons the total amount of bitcoins cannot exceed 21 m bitcoins31. The current
amount of bitcoins in circulation is slightly less than 13.5 m bitcoins32 with a market value of
roughly 5 bn US $33.
From a functional perspective, the Bitcoin protocol operates as a mechanism triggering
subsequent ‘electronic contracts’34 which organise the exchange of digital money in
accordance with the underlying software code and the system protocol35. ‘Subscription’ to the
protocol and its digital payment network is realised by downloading the bitcoin software. The
Bitcoin software is open-source and non-proprietary. Each participant in Bitcoin acquires a
‘wallet’ at the time the protocol is downloaded 36. Participants will operate with a ‘public’ key
and a private one: The public key is a Bitcoin address under which a recipient receives
payments37. The private key allows individual access to the network to send units of digital
currency from one address to another38.
Since bitcoins are nothing more than electronic signatures, there is a technical need to store
the ‘memory of the system’ in a public ledger 39. The ledger records a ‘chain of electronic
signatures’ (with distributed time-stamps)40. The universal ledger will be stored on the
computers of the bitcoin ‘community’ as soon as the bitcoin software is downloaded 41. The
Bitcoin protocol provides for verification mechanisms attaching the ‘trading history’ to each
electronic signature which is sent across the bitcoin network. As soon as a new transaction in
bitcoins is initiated, it will be sent to all nodes across the network. These nodes will group
new transactions into blocks, updated every ten minutes 42. If a node identifies a transaction
as difficult to be verified, the transaction will be invalidated as an attempt to double-spend a
bitcoin. Conversely, once a node has ratified a block of transactions for payments purposes, it
will automatically create the next block.
Efficient verification procedures require complex computer facilities. Only sophisticated
specialists with appropriate means to acquire high-speed computers will be able to
participate in the verification ‘race’ although verification software can be purchased on the
market place43. Once the owner of a complex verification computer facility has the validity of
a block checked, a new bitcoin is earned as a commission, hence the qualification of ‘mining’
money by ‘miners’44. Bitcoin participants who do not have individual facilities to engage in
complex verification activities can join so-called ‘mining-pools’ which dispose of combined
verification and computer facilities 45. In return for pay-outs from the pool members have to
pay a fee between one and three percent per verified block of transactions. Moreover,
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Rainer Kulms
verification activities can be outsourced under a ‘hosted mining contract’ which reserves
verification or ‘mining capacity’ for twelve months or longer 46:
The Division of Labour: Bitcoin-related Services
The advent of bitcoin as a digital currency has generated a number of innovative activities at
the intersection between financial service and software industries 47. Individual customers,
who store bitcoins in a wallet on a personal computer, run the risk of losing everything
should the hard disk become dysfunctional. Currently, there are two types of software
providers which provide outsourcing services whereby the bitcoin wallet can be managed
with the help of external computer space. Under a complete outsourcing regime, the service
provider assumes custodian functions with respect to the wallet, managing the private and
public keys of the owner48. Other software providers just offer a second wallet whereas the
owner maintains complete control over the private and public keys and decryption 49.
Conversely, the owner of bitcoins may elect to have a bitcoin wallet and account with a local
bitcoin exchange where local currency has been exchanged for bitcoins 50. Additional bitcoins
are bought at the online exchange51 and stored in the bitcoin wallet if the owner establishes a
link with a traditional bank account52. In an attempt to enhance end-security, multi-signature
wallets have been set up whereby two keys to a wallet are located at separate institutions and
a third one rests in custody of a software firm 53. Although the software firm does not render
custody services it is nonetheless involved in the custody of funds 54. These services may be
supplemented by digital notary services which provide evidence that a document existed at
the time a related transaction in bitcoins was undertaken 55.
2.2. The Deficiencies of the Bitcoin Protocol
The Bitcoin protocol rests on behavioural assumptions which are difficult to reconcile with
the economic interests of those with the de facto power to change the ground rules of the
virtual currency. Although Bitcoin was devised as a peer-to-peer system free of hierarchies,
recent experiences suggest that both, developers of Bitcoin and the miners have the potential
for destabilizing the original consensus on network decentralization 56.
As soon as a mining pool57 or a group of miners acquire more than 50 percent of the
computational power, they will be able to interfere with transactions and reject those
validated by non-members of the cartel58. Moreover, deficiencies or delays in the verification
process currently go unpunished59. The technical ability of administering the mining process
creates property rights, hierarchical structures and requests for additional commissions 60.
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Bitcoin – a Technology and a Currency
Ultimately, this will require an amendment to the protocol in order to introduce a reward
system which fends off moral hazard61.
Bitcoin exchanges are decisive for maintaining liquidity in the system. Technically, these
exchanges may operate as an agent for a financial institution located in an EU Member
State62. Exchanges offer additional services such as accounts in bitcoins, but would convert
payment of fees in bitcoins into their respective domestic currencies due to the volatility of
bitcoin exchange rate63. Users who placed an order with an exchange for buying bitcoins have
voiced concerns that arbitraging opportunities under varying exchange rates for bitcoins have
been exploited64.
When hackers attacked Mt. Gox, the now defunct Tokyo bitcoin exchange, they stole 650,000
bitcoins65. Moreover, it appears that Mt. Gox used a version of the Bitcoin protocol which did
not address the ‘malleability’ problem66: Under the original Bitcoin protocol, when an
exchange transferred bitcoins to a client, the client could change the transaction hash (i.e. the
applicable mathematical function), claiming that the payment never arrived. The exchange
would then unsuccessfully trace the money and make a second attempt only to lose funds to a
fraudulent customer who hides the truth67. In 2013, most of the bitcoin exchanges and trading
platforms shut down deposits temporarily when different versions of the Bitcoin protocol
were used, inviting clients to double-spend their bitcoins because verification processes had
been malfunctioning68. When in February 2014 trading in bitcoins temporarily broke down, a
core group of six developers had to devise amendments to the software so that the process of
verifying transactions could be resumed 69. This confirms that the founding fathers and
developers of Bitcoin still retain control over the network as they can introduce upgrades to
the protocol to ensure operability70. Bitcoin is suffering, inter alia, from a small numbers
problem since only a small group of experts is sufficiently knowledgeable to repair the system
and abolish delays in processing transactions for verification71.
Current proposals for modification address the fallacies of the original Bitcoin protocol 72. A
modified threshold cryptography and a restructuring of the wallets are advocated to avert
signature falsifications and other malware attacks 73. Ultimately, a modified protocol will also
have to recalibrate the system for incentivizing and rewarding miners as transaction fees
replace commissions based on ‘digging’ for bitcoins 74. In this context, it should not be
overlooked that major amendments of the Bitcoin protocol are likely to trigger collective
action problems because a consensus has to be engineered 75. Nonetheless, if the founding
fathers propose changes to trading rules for bitcoins, most users are likely to accept in
appreciation of the know-how and the balance of power76.
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3.1. Virtual Currencies – Regulatory Challenges77
Bitcoin and National Jurisdictions
In view of Bitcoin’s transnational character, national regulators have to determine where the
virtual currency ‘touches down’ on a jurisdiction so that domestic trading standards can be
imposed78. The market for buying bitcoins is decentralized. Customers approach a local
trading platform or exchange in order to convert national currencies into bitcoins or vice
versa79. Such a local platform should qualify as a minimum-contact instrumentality which
creates jurisdiction over bitcoin-related trade80. Court cases in the USA have focused on
money laundering schemes with bitcoins81, manipulative and deceptive trade practices with
respect to bitcoin-related services82 and the aftermath of the breakdown of online payment
service providers83. Within the European Union, local exchanges for bitcoins qualify as
payment services providers84 and have to register under national laws implementing the EU’s
Payment Services Directive85. In opening an account with one of the national Bitcoin trading
platforms, the user will have to accept the General Terms and Conditions of Business as
framed under the respective national contract laws86. National consumer protection laws will
then control the interpretation of the contracts on opening an account. As Bitcoin gained
momentum, national regulators began to ascertain where exactly virtual currencies enter the
respective domestic jurisdictions in order to subject them to contract, capital market or
banking laws87. Last year, the Court of Justice of the European Union (ECJ) opined that
transactions in bitcoins are analogous to transactions in currencies and hence, exempt from
VAT (value-added tax)88.
The ECB’s Categories and the EBA’s Warnings
Bitcoin does not qualify as ‘electronic money’ under article 2 (2) of the EU’s Electronic Money
Directive89: Although it is an electronically stored monetary value, it does not necessarily
represent a claim against an issuer. Electronic money under EU law maintains the link with
the traditional money format as funds are always expressed in traditional currencies90. In this
context PayPal relies on virtual accounts, but still transfers traditional currencies 91.
The European Central Bank (ECB) distinguishes between three types of virtual currency
schemes92. Closed virtual currencies do largely ignore the real economy. They function as ‘ingame only’ schemes where users, upon payment of a subscription fee, may earn virtual
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Bitcoin – a Technology and a Currency
money to be spent within the virtual community. Frequent flyer-programmes by airlines
constitute virtual currency schemes with unidirectional flow. Real currency is spent for
purchasing virtual currency which cannot be exchanged back. By applying different regimes
of bonus miles, the airlines do actually control the supply of virtual currency 93. A virtual
currency scheme becomes bidirectional once the users are entitled to buy and sell based upon
exchange rates94. Like any other currency, a virtual (bidirectional) currency may be used for
purchasing real and virtual goods and services. It would seem that it is this stage where the
ECB sees potential for subjecting bitcoins to European and national laws on trading and,
eventually, on banking.
While the ECB has made an attempt to emphasize the novelty of virtual currencies, the EBA’s
approach towards virtual currency schemes is informed by an analogy with conventional
payment service providers. The EBA’s opinion on virtual currencies notes that these new
schemes have similar properties with their counterparts which still rely on a linkage with
traditional currencies95. It is against this background that the EBA embarks on an externality
analysis which evaluates the probability of risk materialization 96. By focusing on “risks and
their causal drivers” the EBA undertakes a two-fold risk analysis97. It assesses the fall-out of a
potentially deficient software technology for transmitting payments 98. But it also treats the
main actors in the trade (with virtual currencies) as a subcategory of financial services
providers and banks which have so far gone unregulated. The EBA expects market
participants to sustain losses due to regulatory uncertainty and inherent problems of
enforceability of contracts99. Unless a comprehensive regulatory scheme exists, the EBA feels
that regulated financial service providers in the EU should refrain from trading or holding
virtual currencies100.
The US Department of the Treasury on Virtual Currency Systems
In its Guidance on virtual currencies, the US Department of the Treasury emphasises the
administrative structure of virtual currency systems 101. Centralised virtual (convertible)
currencies revolve around a centralised repository. The administrator of this repository is
charged with transferring value between persons or locations102. This transfer of value may
also be based on a de facto sale of convertible currency to the extent that an exchanger credits
the user with an amount of convertible virtual currency on an account held with the
administrator103. The exchanger will then transfer this value to a third party at the user’s
instruction. From an economic point of view, this amounts to transmission of virtual money
to another person on the part of the exchanger. These financial processes radically change,
once a de-centralised convertible virtual currency scheme is implemented. Such a de-
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centralised virtual currency would dispense with a central depository and a single
administrator104. The necessary computing for transmitting (virtual) value is undertaken by
the very participants of this currency scheme.
The US Department of the Treasury applies a very fine distinction to decide whether the
participants of virtual currency scheme are subject to specific financial market regulations: In
a de-centralised scheme for a virtual currency this convertible virtual currency is created by
the users themselves who buy real or virtual goods with this new currency 105. Value to this
currency is attached by the very willingness of the parties to use this virtual currency as an
instrument for settling debt. As long as the person who creates units of this convertible
virtual currency operates on a person-to-person basis, he will not be deemed a money
transmitter under US Treasury regulations. However, if the creator of virtual currency units
sells them to another person for real currency or transfers virtual units to another person
upon instruction, the US money transmitter regime applies 106.
3.2. Virtual Currencies – Regulation107
United States – The New York State Regulations on Virtual Currencies
In the U.S., the regulatory powers for the virtual banking system are divided between the
Union and the states108. Rules on trading in bitcoins are governed by state law. In the end, a
certain degree of regulatory diversity will be found in view of the states’ competition for
attracting new businesses.
In August 2013, the New York State Department of Financial Services launched an inquiry
into virtual currencies in order to determine the need for regulatory action 109. Hearings were
held in order to ascertain at what stage of trading in bitcoin a regulator should intervene110.
In view of the sheer magnitude of transactions, the New York state superintendent of
financial services cautioned against comprehensive oversight for every single peer-to-peer
transaction unless specific criminal or civil wrongdoing could be established 111. He
acknowledged that domestic regulation should not frustrate innovation112. This approach has
enabled Nasdaq to establish online clearing systems which build on blockchain technology113.
Under the 2015 regulations114, a virtual business activity requires a license issued by the New
York superintendent of financial services 115. Persons with a New York banking license
approved by the superintendent, and merchants and consumers utilising bitcoins for the
purchase or sale of goods or services or for investment purposes do not have to apply for a
license116. ‘Virtual currency activities’ include the receipt of virtual currency for transmission
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or transmitting virtual currency (except for non-financial purposes), the storing, holding or
maintaining control or custody of virtual currency for others, buying or selling of virtual
currency as a customer business or controlling, administering, or issuing a virtual
currency117. The thrust of the regulations is extraterritorial; they apply to activities involving
New York or a New York resident118, including non-domestic trading platforms and service
providers which do business via New York State 119. The regulations are motivated by the
conviction that Bitcoin, its governance structures and bitcoin-related service providers are
unable to cure the network of its deficiencies. Thus far-reaching documentation duties are to
be imposed in order to introduce transparency and to avert money laundering and tax
Upon filing the application121 the New York State superintendent will examine the financial
and business experience of the applicant and the ability to conduct the business honestly,
fairly and efficiently within the framework envisaged by the regulations122. The license may be
revoked if the applicant is found to be in breach of the principles evinced in the regulation or
for failure to honour a judgment for damages 123. The regulations are inspired by regulatory
concepts for licensing banks and other financial institutions. The licensee will be under the
obligation to observe capital requirements which are conditioned upon the composition of its
total assets, liabilities and risk exposure124. Such capital shall be maintained in cash, virtual
currency or high-quality investments125. Material changes of the licensee’s business require
an approval by the New York State superintendent 126. This extends to plans for changing the
control of the licensee, including mergers and acquisitions127. With respect to documentation,
the licensee shall keep books and records in their original form or native file for each
transaction, including the physical addresses of the parties to a transaction and a general
ledger on assets, liabilities and all accounts128. In order to facilitate administrative oversight
the licensee shall file quarterly financial statements with the New York State superintendent
relating to the financial situation and eventual changes in ownership equity 129. Annual
statements must be certified by an independent auditor130.
The rules provide for a compliance programme against money-laundering131. Anti-money
laundering duties include the establishment of a customer identification programme to
facilitate identification of high risk customers, high-volume accounts or accounts with
suspicious activities132. In reaction to reports to Bitcoin’s failures in data security the licensee
will have to maintain a cyber security programme which averts unauthorized access to the
system and to appoint a chief information security officer enforcing the licensee’s cyber
security programme133. In staying faithful to banking regulation approach, the regulations
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insist on a ‘living will’: The licensee has to develop a ‘business continuity and disaster
recovery plan’ to ensure services in an emergency situation134.
Although the major part of the regulations is directed at converting the Bitcoin industry into
a regulated business with a license, the consumer will not go unprotected. Prior to the initial
transaction with a consumer, the licensee must disclose the material risks of Bitcoin and
bitcoins135. The items to be disclosed to the consumer read like a comprehensive list of
potential legal and economic deficiencies of virtual currencies. As a corollary to disclosing the
material risks to a consumer the licensee will be under a duty to establish complaint
procedures for resolving disputes fairly and timely 136.
Non-US Jurisdictions
When the UK Financial Conduct Authority held the annual public meeting in July 2014, its
Chief Executive commented on Bitcoin, emphasizing the EBA’s position on virtual currencies,
the risks on money laundering and the need for an international response 137. The Financial
Action Task Force has published a report on virtual currencies which weighs the legitimate
uses of bitcoin against its potential risks. Decentralised virtual currencies are seen “to exist in
a digital universe entirely outside the reach of any particular country” 138. So far law
enforcement appears to have concentrated on anti-money laundering139 and anti-fraud
actions140. Apart from crime prevention there is a great diversity in regulatory attitudes
towards Bitcoin and other virtual currencies 141. Some countries flatly outlaw transactions in
bitcoins since a virtual currency is not recognised as legal tender 142.
Canada is moving towards the recognition of the potential of virtual currencies while
attempting to contain their negative externalities 143. This includes registration duties as a
money transmitter and licensing or disclosure requirements to regulate trade in the interest
of the financial market and consumers. The attention of UK authorities has shifted towards
identifying the potential and risks of distributed ledgers 144. The UK government emphasises
the benefits of digital innovation for traditional payment services 145.
At the European Union level, no regulatory action has been taken so far. After the EBA
published its negative stance on virtual currencies 146, the then Commissioner for Financial
Services, Michel Barnier followed suit, announcing a study on the implications derived from
anonymity under virtual currency schemes147. Both ESMA148 and the European Central Bank
(ECB)149 have noted the potential of automatic clearing processes through ledgers. An ECB
paper highlights the need for harmonised governance structures to achieve the exchange of
information between ledger systems150.
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Bitcoin – a Technology and a Currency
France declares to be adopting a policy of “prudent liberalism” 151. Trading platforms for
bitcoins should be classified as financial service providers with the possibility of identifying
its users152. Moreover, the French Minister of Finance proposes to lift the anonymity of those
who use bitcoins to effectuate a purchase 153. Spain classifies Bitcoin as an electronic payment
system so that exchange platforms have to apply for a license 154. German authorities do not
plan any regulation. Bitcoin exchanges will have to register as financial service providers155,
but there is no licensing requirement. The Bundesbank has warned twice that bitcoin is a
highly speculative financial instrument 156. German tax authorities have recognised Bitcoin as
a unit of account in order to establish a basis for taxing income derived from trade in virtual
In June 2014, the Swiss Government issued a report on virtual currencies in order to assess
the urgency for a regulatory intervention158. In marked opposition to the EU the Swiss
Government undertakes a cost-benefit analysis of the new regulation for virtual currencies.
The Swiss government notes that bitcoins, due to their extremely limited use, do not
jeopardise the monetary policy of the Swiss National Bank 159. Although the Swiss authorities
are aware of bitcoin’s potential for criminal abuse, they emphasise that no major incidents in
Europe have been discovered160. The risk of anonymity and theft of wallets are acknowledged,
but as the report says, “much of the responsibility in dealing with Bitcoin lies with the users
themselves”161. As a consequence, the Swiss Government prefers warnings to consumers over
a regulatory action162.
From the perspective of regulators, any attempt to lay down ground rules for Bitcoin is bound
to be second-best. Bitcoin’s emphasis on decentralized governance structures defies any
attempt to get hold of ledger systems within one jurisdiction 163. A recent study by the UK
Government Chief Scientific Adviser recommends that public authorities should get involved
in influencing the technical code of distributed ledger systems, thereby paving the way for a
more formalised legal code164. In order to discern the legislative policy motivation behind this
recommendation, it is useful to make a reference to the literature on the tragedy of the
commons and explore its potential for analysing internet-based virtual currencies.
In law literature, ‘commons’ generally describe ‘the land owned by the government’ or
‘something free for everyone’165. So is Bitcoin: by downloading the software as envisaged by
the 2009 protocol, everybody can use the blockchain for transmitting (virtual) money.
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Charlotte Hess and Elinor Ostrom caution against a dichotomy between common-pool
resources and property regimes166. Ostrom is critical of traditional policy recommendations
in favour of private property rights to overcome the tragedy of the commons for a private
property rights regime is overly simplistic: She observes that commons problems have been
overcome by introducing a community-organisation which restricts the use of the commons
while maintaining its general accessibility without introducing private property rights 167.
Commons need not be privatised to be administered efficiently168. Incentive mechanisms are
easily reconcilable with the notion of an organised commons 169. Bitcoin’s intricate electronic
structure supplements the ‘commons of the internet’. In fact, commissions which accrue to
the ‘policemen’ of the organised commons, the bitcoin miners, are intended to support the
stability of the network.
Bitcoin, both as a currency and an organisation, is not free from deficiencies. It still has to
live up to Elinor Ostrom’s claim that community-based systems can manage the commons
efficiently by supplying an appropriate governance structure170. The New York regulations
aim at those who run the system and offer bitcoin-related services171, but they do not
interfere with Bitcoin’s governance structure. Instead, central and private banks have come to
emphasise the technology aspect of Bitcoin by exploring the potential of administered
blockchains. In what looks like an improvement of electronic ledgers, financial institutions
are moving towards creating property rights, thus reprivatizing ledgers. Although it is too
early to ascertain whether this ushers in a tragedy of the anti-commons, privately
administered ledgers are not per se immune from creating negative externalities172. Presently,
reprivatisation schemes are based on distinct regulatory policies and business strategies for
clearing institutions173.
The Bank of England explores the potential for a “central bank digital currency” 174. While
dispensing with the clearing houses or custodians, a distributed ledger should be organised
by the Bank of England. Verification processes would be undertaken via the ledger, using the
blockchain technology developed under the Bitcoin protocol175. There is much more centrality
than under Bitcoin: The Bank of England would steer and supervise the distributed ledger 176.
A “central bank digital currency” would facilitate shifting deposits from commercial banks to
the central bank; it would also improve the supply of credit 177. With a distributed ledger
technology bank deposits would be backed by liquid assets and no longer by risky lending, as
electronic transmission and verification would considerably accelerate the exchange of digital
and real money178. It should be noted that the proverbial vulnerability of Bitcoin’s money
storage system will be addressed by secluding the central bank’s distributed ledger from
outside interference.
Without asserting the role of a central bank, private commercial banks have also moved to
explore the potential of blockchains and distributed ledgers in order to speed up interbank-
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Bitcoin – a Technology and a Currency
financial transactions and the clearing process and to cut costs179. Like the central bankadministered distributed ledger, technologies with “permissioned” distributed ledgers are
envisaged, which could, in fact, restrict access to the clearing system to a number of
‘privileged’ participants180. Large investment banks have established a partnership to develop
an industry utility on the basis of distributed ledgers 181. These joint research activities have to
be put into perspective with the rapidly changing economics of the banking market. If a
distributed ledger is connected with a platform offering banking services, this combination
might operate to protect market shares. In October 2014, Goldman Sachs applied for a U.S.
patent for a ‘cryptographic currency for securities settlement 182’. The patent application
builds on a distributed ledger technology, a clearing mechanism and a virtual currency
(“SETLcoin”) designed to facilitate cross-border transactions183. Nasdaq Linq uses blockchain
technology for the issuance of private securities without having sought patent protection184.
In April 2016, the Hong Kong Financial Secretary encouraged the use of blockchain
technology in financial services to reduce costs and to stave off suspicious transactions185. It is
yet unclear whether the combination between distributed ledger services, a legal monopoly
(patent) and traditional internet platform mechanisms eventually triggers antitrust concerns.
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Rainer Kulms
1 US Federal Bureau of Investigation Intelligence Assessment, (U) Bitcoin Virtual Currency –
Unique Features Present Distinct Challenges for Deterring Illicit Activity, 24 April 2012
(available at
See generally, Pedro Franco, Understanding Bitcoin – Cryptography, Engineering and
Economics (Chichester 2015), 4 et seq.
European Banking Authority, EBA Opinion on “virtual currencies”, EBA/Op/2014/08 (4
July 2014) (available at, at p. 44 (sub No. 177). See also the FATF Report,
Virtual Currencies – Key Definitions and Potential AML (/CFT Risks (June 2014, available at
UK Chancellor of the Exchequer, George Osborne, MP, Speech of 6 August 2014,
London, Canary Wharf, “Chancellor on developing FinTech”, (available at, and HM
Treasury, Digital currencies: the call for information (London March 2015, sub 1.4.)
(available at
4 See the definition given in the report to the French Senate: “… plus encore qu’une
« monnaie », le bitcoin est une technologie, un protocole de validation des transactions
entièrement décentralisé, « auditable » par tous et très sécurisé”, in : Sénat, Session
extraordinaire de 2013-2014, Rapport d’information au nom de la commission des finances
sur les enjeux liés au développement du Bitcoin et des autres monnaies virtuelles, no. 767
rectifié, Paris July 2014 (available at
Verena Ross (Executive Director, European Securities and Markets Authority), Financial
innovation: towards a balanced regulatory response, Speech at the London Business School/Bank
of England Conference on ‚How Imminent is the real Fintech Revolution‘, London, 7 March 2016
(ESMA/2016/345) (available at
See infra sub IV.
See infra sub IV.
See R. Ali et al., The economics of digital currencies, 54 (3) Bank of England Quarterly
Bulletin (2014) (available at
EBA Opinion on ‘virtual currencies’, p. 23 et seq. (No. 68 et seq.)
Central Bank Journal of Law and Finance, No. 1/2016
Bitcoin – a Technology and a Currency
Times online 25 February 2014, B. McLannahan, Fate of Mt. Gox questioned after
Bitcoin trading suspended (available at; Reuters US edition 28 February 2014, “Mt.
Gox files for bankruptcy, hit with lawsuit” (available at
10 Financial
11 International Business Times online, 9 February 2015, Bitcoin exchange MyCoin disappears
with £stg 250m in suspected Ponzi scheme (available at; South China Morning
Post online edition, 9 February 2015, Investors fear HK $ 3b losses on closure of bitcoin
trading company (available at
New York Codes, Rules and Regulations, Title 23, Chapter 1, Part 200, Virtual Currencies
(available at
13 See also New York State Department of Financial Services, Excerpts from Superintendent’s
Lawsky’s Remarks on Virtual Currency and Bitcoin in New York City, 14 October 2014
(available at, and excerpts
from Superintendent Lawsky’s Remarks on Virtual Currency and Bitcoin Regulation at
Money 20/20, Las Vegas, 3 November 2014 (available at
See infra sub II.1.
See European Banking Authority, Warning to Consumers on Virtual Currencies
(EBA/WRG/2013/01, 12 December 2013) (available at
irtual%20Currencies.pdf)., and Wall Street Journal Europe online 5 December 2013, R.
Sidel et al., Central Banks Warn of Bitcoin Risks (available at;
Deutsche Bundesbank, Interview mit Carl-Ludwig Thiele, Bitcoins sind hochspekulativ, 7
January 2014 (available at
16 For a survey
see D. Groshoff, Kickstarter My Heart: Extraordinary Popular Delusions and
the Madness of Crowdfunding Constraints and Bitcoin Bubbles, 5 Wm. & Mary Bus. L. Rev.
489 (506 et seq.) (2014).
See F.A. Hayek, Denationalisation of Money – The Argument Refined, An Analysis of the
Theory and Practices of Concurrent Currencies (The Institute of Economic Affairs, London
3rd ed. 1990) (available at
J. Brito/A. Castillo, Bitcoin: A Primer for Policy Makers (Mercatus Center at George
Mason University (2013) (available at
Central Bank Journal of Law and Finance, No. 1/2016
Rainer Kulms
19 Cf. U.S. Department of the Treasury (Financial Crimes Enforcement Network), Guidance FIN-
2013-G001 of 18 March 2013 on the Application of FinCEN’s Regulations to Persons
Administering, Exchanging, or Using Virtual Currencies (available at; Statement of M. Raman,
Acting Assistant Attorney General, Criminal Division, before the US Senate Committee on
Homeland Security and Governmental Affair, “Beyond the Silk Road: Potential Risks, Threats
and Promises of Virtual Currencies”, Washington, D.C., 18 November 2013 (available at; Connecticut General Assembly,
Office of Legislative Research, Bitcoins – Virtual Currency (Research Report 2014 – R 0050), 28
February 2014 (available at
analysis: The Guardian online 25 November 2013, Is Bitcoin about to change the
world? (available at
20 See news
21 See Superintendent’s Lawsky’s Remarks on Virtual Currency and Bitcoin in New York City,
14 October 2014, supra FN 13, and survey by H. Eberwein, in: H. Eberwein/A.-Z. Steiner
(eds.), Bitcoins (Jan Sramek Verlag Vienna 2014), 13 (17 et seq.).
See infra sub IV.
The Library of Congress, Global Research Center, Regulation of Bitcoin in Selected
Jurisdictions (January 2014), p. 1 (available at
See infra sub III.3.
Ibid., country reports.
See the definition given in the report to the French Senate: “… plus encore qu’une
« monnaie », le bitcoin est une technologie, un protocole de validation des transactions
entièrement décentralisé, « auditable » par tous et très sécurisé”, in : Sénat, Session
extraordinaire de 2013-2014, Rapport d’information au nom de la commission des finances
sur les enjeux liés au développement du Bitcoin et des autres monnaies virtuelles, no. 767
rectifié, Paris July 2014 (available at
Available at
See Testimony of P. Murck, General Counsel, the Bitcoin Foundation to the Senate
Committee on Homeland Security and Governmental Affairs, “Beyond Silk Road: Potential
Risks, Threats, and Promises of Virtual Currencies, Washington, D.C., 18 November 2013
(available at
S. Barber et al., Bitter to Better – How to Make Bitcoin a Better Currency (available at, and G. Kaes in: H. Eberwein/A.-Z. Steiner
(eds.), Bitcoins, 1 (3 et seq.).
Thus a valid bitcoin which may be used for future transactions consists of two electronic
signatures: It is the personal signature of the owner of the wallet of bitcoins and a ‘public’
Central Bank Journal of Law and Finance, No. 1/2016
Bitcoin – a Technology and a Currency
signature will be attached as a consequence of the checking process undertaken with respect
to each block of transactions. A valid bitcoin documents its history of previous use. However,
in order to reclaim disk space the previous history can be discarded once the transaction has
been cleared in the ‘block-building’ process.
G, Kaes in: H. Eberwein/A.-Z. Steiner (eds.), Bitcoins, 1 (6). There is some controversy
when this cap on the production of new bitcoins will take effect: Speculations vary
considerably between 2025 and 2140. See N. M. Kaplanov, Nerdy Money: Bitcoin, the Private
Digital Currency, and the Case Against its Regulation – Student Comment, 25 Loy. Consumer
L. Rev. 111 (121) (2012); Banque de France, Les dangers liés au développement des monnaies
virtuelles : l’exemple du bitcoin, Focus no. 10 – 5 December 2013 (available at
As of 20 October 2014: Blockchain info (available at
33 As of 20 October 2014: Blockchain info (available at
M.B. Erlandson, Note – Revisiting Progressive Federalism: Voice, Exit, and Endless
Money, 68 U. Miami L. Rev. 853 (880) (2014).
P.J. Martinson/C.P. Martinson, Bitcoin and the Secured Lender, 33 No. 6 Banking & Fin.
Services Pol’y Rep. 13 (14) (2014).
36 P. Franco, Bitcoin, 17 et seq., 128 et seq. The Bitcoin Foundation Community Website sub
‘Securing your wallet’ (available sub For bitcoin
exchange rates into local currencies see For the exchange
volume distribution per market and per currency see
J. Lane, Bitcoin, Silk Road, and the Need for a New Approach to Virtual Currency
Regulation, 8 Charleston L. Rev. 511 (516) (2014); P. Franco, Bitcoin, 53 et seq.
Ibid., at p. 516 et seq, and G. Kaes in: H. Eberwein/A.-Z. Steiner (eds.), Bitcoins, 1 (3).
39 See Bitcoin, How does Bitcoin Work? (available at; P.
Noizat, Bitcoin Book (in French, edition 2012, Pierre Noizat), p. 19 et seq., and N. Godlove,
Regulatory Overview of Virtual Currency, 10 Okla. J.L. & Tech. 71 et. seq. (2014).
I. Pflaum/E. Hateley, A Bit of a Problem: National and Extraterritorial Regulation of
Virtual Currencies in the Age of Financial Intermediation, 45 Geo. J. Int’l. L. 1169 (1174)
(2014); L. Trautman, Virtual Currencies: Bitcoin & What Now After Liberty Reserve, Silk
Road, and Mt. Gox?. 20 Rich. J.L. & Tech. 13 (53) (2014).
41 Testimony of P. Murck to the Senate Committee on Homeland Security and Governmental
Affairs, “Beyond Silk Road: Potential Risks, Threats, and Promises of Virtual Currencies,
Washington, D.C., 18 November 2013; see also P. Noizat, Bitcoin Book, p. 25 et seq., 71.
See generally on blockchains: P. Franco, Bitcoin, 85 et seq.
This can also be done by signing a ‘Cloud Hashing Contract’ for three to six months (see
Bitcoin Cloud Hashing, Mining Contracts (available at
Central Bank Journal of Law and Finance, No. 1/2016
Rainer Kulms See also the
facts of Alexander v. BF Labs, Inc., 2014 WL 5406890 (D. Kan., 2014).
See P. Franco, Bitcoin, 46 et seq., 143 et seq.
See P. Franco, Bitcoin, 149 et seq.
See Weusecoins Homepage sub ‘What is Bitcoin Mining?’ (available at and Butterflylabs, BFL Cloud Mining –
Cloud Mining Contracts (available at
47 J.
Brito/E. Dourado, Comments to the New York Department of Financial Services on the
Proposed Virtual Currency Regulatory Framework, Mercatus Center George Mason
University (14 August 2014, available at, at p. 3. See generally P. Franco, Bitcoin, 39 et seq., on business applications with
J. Brito/E. Dourado, Comments, at p. 5.
Ibid., at p. 5, and Blockchain info sub ‘My Wallet’ (available at
See e.g. Homepage of Coinbase at and
See P. Franco, Bitcoin 40 et seq.
See Coinbase informations at
J. Brito/E. Dourado, Comments, at p. 5.
Ibid., at p. 3, and P. Franco, Bitcoin, 45 et seq.
56 See J.A. Kroll/I.C. Davey/E.W. Felten, The
Economics of Bitcoin Mining, or Bitcoin in the
Presence of Adversaries, The Twelfth Workshop on the Economics of the Information
Society, Washington, D.C., 11-12 June 2013 (available at, at p. 11; S.
Bayern, 108 Nw. U. L. Rev. Online 257 (262) (2014); L. Trautman, 20 Rich. J.L. & Tech. 13 (58)
(2014); I. Eyal/E.G. Sirer, Majority is not Enough: Bitcoin Mining is Vulnerable, Department
of Computer Science, Cornell University (November 2013) (available at
See supra sub II.1.b.
58 See EBA opinion on virtual currencies, at p. 15; I. Eyal/E.G. Sirer, Bitcoin Mining; G. Kaes
in: H. Eberwein/A.-Z. Steiner (eds.), Bitcoins, 1 (10).
Central Bank Journal of Law and Finance, No. 1/2016
Bitcoin – a Technology and a Currency
29. For P. Noizat, Bitcoin Book, 64 et seq.,
a system of commissions would be sufficient to incentivise miners to check expeditiously. On
the other hand, miners will only amend the verification process if significant competitive
advantages are to be expected (P. Noizat, ibid., at p. 65).
59 Cf. S. Barber et al., Bitter to Better, supra sub FN
65, who emphasises that without a commission regime there is
a risk of delay in the verification process which might amount to three days.
60 See P. Noizat, Bitcoin Book,
61 Cf. on the emergence of new governance structures J.A. Kroll/I.C. Davey/E.W. Felten, at p.
17 et seq.
62 See Bitcoin Vox at,
and BIPS Denmark (available at
EBA on virtual currencies, at p. 14.
See the discussion on the Bitcoin Forum on Bitcoin Exchange Arbitrage Opportunities
(available at
Forbes online 21 March 2014, “$ 116 Million Bitcoins Found and How to Protect your
wallet” (available at
For an analysis see N. Godlove, 10 Okla. J.L. Tech. 71 (2014) (text after FN 66) and p.
Franco, Bitcoin, 119 et seq.
S. Gruber, 32 Quinnipiac L. Rev. 135 (163 et seq.) (2013).
Financial Times online, 14 February 2014, Bitcoin’s volunteer army tested by attack
(available at
Cf. S. Bayern, 108 Nw. U. L. Rev. Online 257 (262) (2014).
See Financial Times online 14 February 2014, Bitcoin’s volunteer army tested by attack
(available at
29. In this context, it is suggested that a more
demanding burden of proof should be imposed for the verification process. See also I.
Eyal/E.G. Sirer, Bitcoin Mining, and J.A. Knoll/I.C. Davey/E.W. Felten, at p. 15 et seq.
72 S. Barber et al., Bitter to Better, supra sub FN
See S. Barber et al., Bitter to Better, supra sub FN 29.
Cf. J.A. Knoll/I.C. Davey/E.W. Felten, at p. 16 et seq.; I. Eyal/E.G. Sirer, Bitcoin Mining.
See passim on collective action problems in decentralised networks: N. Plassaras,
Comment – Regulating Digital Currencies: Bringing Bitcoin Within the Reach of the IMF, 14
Chi. J. Int’l. L. 377 (406) (2013).
76 See White Paper, A Next-Generation Smart Contract and Decentralized Application
Platform, ethereum wiki (available at, and CNN Money
Central Bank Journal of Law and Finance, No. 1/2016
Rainer Kulms
21 January 2014, Bitcoin is not just a digital currency. It’s Napster for Finance (available at
For literature survey on alternative currency concepts, see: P. Degens, Alternative
Geldkonzepte – ein Literaturbericht, Max Planck Institute for the Study of Societies,
Discussion Paper 13/1 (2013) (available at
For a survey over national enforcement actions with respect to virtual currencies: FATF
Report, Virtual Currencies (June 2014, supra FN 2).
79 When traded at exchanges,
Bitcoins float against currencies on the basis of demand: N. M.
Kaplanov, 25 Loy. Consumer L. Rev. 111 (121 et seq.) (2012).
Cf. the studies on Internet Jurisdiction: D. Jaeger-Fine et al., Internet Jurisdiction: A
Survey of German Scholarship and Cases, Center on Law and Information Policy at Fordham
Law School (30 June 2013) (available at and J. R. Reidenberg et al.,
Internet Jurisdiction: A Survey of Legal Scholarship Published in English and United States
Case Law, Center on Law and Information Policy at Fordham Law School (30 June 2013)
(available at
See U.S. v. Ulbricht, 31 FS 3d 540 (S.D.N.Y., 2014).
82 See e.g. Meissner v. BF Laboratories, Inc, 2014 WL 2558203 (D. Kansas, 2014); F.T.C. v.
Johnson; Hussein v. Coinabul, LLC, 2014 WL 7261240 (N.D. Ill., 2014); Securities and
Exchange Commission v. Shavers, 2014 WL 4652121 (E.D. Tex., 2014).
See e.g. Greene v. Mizuhuo Bank, Ltd., 2016 WL 946921 (N.D. Ill., 2016).
See The Guardian 7 December 2012 online, Virtual currency Bitcoin registers with
European regulators (available at
85 Directive 2007/64/EC of the European Parliament and of the Council of
13 November 2007
on payment services in the internal market amending Directives 97/7/EC, 2002/65/EC,
2005/60/EC and 2006/48/EC and repealing Directive 97/5/EC, O.J. L 319/1 of 5 December
2007. For an analysis of the compatibility of bitcoins with the European Monetary Union see:
A.-Z. Steiner in: H. Eberwein/A.-Z. Steiner (eds.), Bitcoins, 23 (24 et seq.).
86 See e.g. the Standard Conditions of Bitcoin Deutschland GmbH (Geschäftsbedingungen der
Bitcoin Deutschland GmbH) (available at From the
perspective of Austrian consumer protection law: N. Aquilina/A. Stadler in: H. Eberwein/A.Z. Steiner (eds.), Bitcoins, 97 (105 et seq.).
Cf. N. Kaplanov, 25 Loy. Consumer L. Rev. 111 (130 et seq.) (2012); G. Spindler/M. Bille,
Rechtsprobleme von Bitcoins als virtuelle Währung, 68 Wertpapier-Mitteilungen 1357 et seq.
(2014) (on German law).
88 Court of Justice of the European Union, judgment of 22 October 2015 (Fifth Chamber), case
no. C-264/14, Skatteverket v. David Hedqvist (available at,T,F&num=264/14).
Central Bank Journal of Law and Finance, No. 1/2016
Bitcoin – a Technology and a Currency
89 Directive 2009/110/EC of the European Parliament and of the Council of 16 September
2009 on the taking up, pursuit and prudential supervisions of the business of electronic
money institutions, O.J. L 267/ of 10 October 2009. See also the definition in UK Financial
Conduct Authority, The Electronic Money Regulations 2011 (sub 2) (available at
90 European Central Bank (ECB), Virtual Currency Schemes (October 2012), at p. 16 (available
Cf. ECB, Virtual Currency Schemes, at p. 17 et seq.; I. Kobayashi, Private Contracting and
Business Models of Electronic Commerce, 13 U. Miami Bus. L. Rev. 161 (209 et seq.) (2005) ;
Comb v. PayPal, Inc., 218 FS 2d 1165 (1166 et seq.) (N.D. Cal., 2002).
ECB, Virtual Currency Schemes (October 2012).
ECB, Virtual Currency Schemes (October 2012). On the scope of airline discretion to
create property rights under a bonus programme see judgement of the German Federal
Supreme Court (Bundesgerichtshof) of 28 October 2014 (X ZR 79/13), Press Release No.
154/2014 (available at
ECB, Virtual Currency Schemes (October 2012).
EBA opinion on virtual currencies, at p. 8.
Ibid. at p. 24 et seq.
Ibid. at p. 21 et seq.
Ibid. at p. 23 et seq.
Ibid. at p. 26.
Ibid. at p. 44.
101 See U.S. Department of the Treasury (Financial Crimes Enforcement Network), Guidance
FIN-2013-G001 of 18 March 2013 on the Application of FinCEN’s Regulations to Persons
Administering, Exchanging, or Using Virtual Currencies (available at; Statement of M.
Raman, Acting Assistant Attorney General, Criminal Division, before the US Senate
Committee on Homeland Security and Governmental Affair, “Beyond the Silk Road: Potential
Risks, Threats and Promises of Virtual Currencies”, Washington, D.C., 18 November 2013
(available at; Connecticut
General Assembly, Office of Legislative Research, Bitcoins – Virtual Currency (Research
Report 2014 – R 0050), 28 February 2014 (available at; cf. passim J. S. Gans/H. Halaburda,
Some Economics of Private Digital Currency, Bank of Canada Working Paper 2013/38
(available at
U.S. Department of the Treasury, Guidance FIN-2013-G001 (See FN 101).
Central Bank Journal of Law and Finance, No. 1/2016
Rainer Kulms
See supra FN 19.
See supra FN 19.
See supra FN 101.
See supra FN 101. See also Texas Department of Banking, Supervisory Memorandum –
1037 of 3 April 2014 on Regulatory Treatment of Virtual Currencies Under the Texas Money
Services Act (available at
For a survey over the various national regulatory approaches towards virtual currencies:
FATF, Virtual Currencies – Guidance for a Risk-based Approach (June 2015, available at
FATF, Virtual Currencies – Guidance for a Risk-bases Approach).
See Conference of State Bank Supervisors/North American Securities Administrators
Association, Model State Consumer and Investor Guidance on Virtual Currency, 23 April 2014
(available at
New York State Department of Financial Services, Notice to Hold Hearing on Virtual
Currencies, Including Potential NYDFS Issuance of a ‘BitLicense’, 14 November 2013
(available at
See the agenda of the hearing: New State Department of Financial Services, NYDFS
Outlines Additional Details on Witness and Panels for Currency Hearing on January 28 and
29 in New York City (available at
111 Remarks of Benjamin M. Lawsky, Superintendent of Financial Services for the State of
New York, on the Regulation of Virtual Currencies at the New Age Foundation in
Washington, D.C., 11 February 2014 (available at
For the delicate regulatory balance between regulation and openness for innovation see
the excerpts from Superintendent’s Lawsky’s (New York State Department of Financial
Services) Remarks on Virtual Currency and Bitcoin in New York City, 14 October 2014
(available at
See infra sub IV.
New York Codes, Rules and Regulations, Title 23, Chapter I, Part Virtual Currencies
(available at
Sections 200.2 (q), 200.3.
Section 200.3 (c).
Section 200.2q (1-5).
Section 200.2 q.
Central Bank Journal of Law and Finance, No. 1/2016
Bitcoin – a Technology and a Currency
See the comments filed with the New State Department of Financial Services by
representatives of China’s bitcoin exchanges, reprinted in: E. Calouro, “China’s “Big Three”
Bitcoin Exchanges Jointly Comment on NYDFS BitLicense Proposal” (21 August 2014)
(available at
120 See Press Release of 17 July 2014, “NY DFS Releases Proposed BitLicense Regulatory
Framework for Virtual Currency Firms” (available at
For details see section 200.4 (a) of the Regulations.
S. 200.6 (a) of the Regulations.
S. 200.6 (c) of the Regulations.
S. 200.8 (a) of the Regulations.
S. 200.8 (b) the Regulations.
S. 200.10 (a) of the Regulations.
S. 200.11 (a), (b) of the Regulations.
S. 200.12 of the Regulations.
S. 200.14 of the Regulations.
S. 200.14 (b) of the Regulations.
S. 200.15 of the Regulations.
S. 200.15 (c) of the Regulations.
S. 200.16 of the Regulations.
S. 200.17 (a) of the Regulations.
S. 200.19 (a) of the Regulations.
S. 200.20 of the Regulations.
137 Martin Wheatley, in Financial Conduct Authority, Annual Public Meeting, London 17 July
2014 – Transcript Question and Answers Session (available at
FATF Report, Virtual Currencies – Key Definitions and Potential AML/CFT Risks (Paris
June 2014) (available at, at p. 10.
FATF Report on Virtual Currencies, at p. 10
Attorney R.B. Zabel of 29 January 2014 at
the New York State Department of Financial Services Hearing on Law Enforcement and
Virtual Currencies (available at
nciesHearing2014.php).Testimony of R.B. Zabel and US SEC, Office of Investor Education
and Advocacy, Investor Alert – Ponzi Schemes Using Virtual Currencies (SEC Pub. No. 153
140 See with respect to Ponzi Schemes: of Deputy US
Central Bank Journal of Law and Finance, No. 1/2016
Rainer Kulms
(7/13)) (available at, and U.S.
FTC v. BF Labs, et al., Case No 4:14-cv-00815-BCW (W. D. Mo., 2014) (available at
141 See comparative surveys in: The Library of Congress, Global Research Center, Regulation
of Bitcoin in Selected Jurisdictions, Washington, D.C. (January 2014) (available at; Schweizerische Eidgenossenschaft,
Federal Council report on virtual currencies in response to the Schwab (13.3687) and Weibel
(13.4070) postulates, of 25 June 2014 (available at, p. 22 et seq.,
and French Senate, Rapport d’information, supra sub FN 4, at p. 45 et seq.
See Library of the U.S. Congress, Regulation of Bitcoin in Selected Jurisdictions; see also
Perkins Coie LLP, Virtual Currency Report – Russia Issues Draft Legislation Prohibiting
Virtual Currencies (9 October 2014) (available at; Financial Times online 2 April 2014, Bitcoin set for fresh Chinese
regulatory attack (available at
See s. 256 (2) of Bill C-31, 62-63 Eliz. II (14 June 2014) (available at;
Duhaime Law Notes, Canada implements world’s first national digital currency law; regulates
new financing technology transactions (22 June 2014) (available at
144 See R. Ali et al. (Bank of England), Innovations in payment technologies and the emergence of
digital currencies, 54 (3) Bank of England Quarterly Bulletin (2014) (available at
145 See HM Treasury, Digital currencies: the call for information (London March 2015, sub
1.4.), supra sub FN 3.
See supra sub FN 3.
Reuters online, 4 July 2014, EU executive to look at regulating Bitcoin currency
(available at
See supra, sub FN 5.
A. Pinna/W. Ruttenberg, Distributed ledger technologies in securities post-trading –
Revolution or evolution. European Central Bank Occasional Paper Series no. 172 (April 2016)
(available at
Ibid., at p. 27 et seq.
Central Bank Journal of Law and Finance, No. 1/2016
Bitcoin – a Technology and a Currency
French Senate, Rapport d’information, supra sub FN 4, at p. 15.
Ibid., at p. 16.
Le Monde online, 11 July 2014, A. Fournier, Comment la France veut régler le bitcoin
(available at
Noticias de Bitcoin del día: 12 septiembre 2014, España : presentan nuevo marco
regulatorio para Bitcoin (available at
155 See on the German regulatory approach towards bitcoin service providers: Bundesanstalt
für Finanzdienstleistungsaufsicht (BaFin), J. Münzer, Bitcoins, Aufsichtsrechtliche
Bewertung für Nutzer, BaFin Journal 1/2014, 26 et seq. (available at
Interview with Carl-Ludwig Thiele in the Handelsblatt, 7 January 2014, Bitcoins sind
hochspekulativ (available at
ml), and Wirtschaftswoche online 16 March 2014, Bundesbank warnt abermals vor Risiken
durch Bitcoin (available at
Bitcoin recognized by Germany as ‘private money’ (available at and Handelsblatt online 17 August 2013,
Finanzministerium erkennt Bitcoins an (available at; see also V. Falschlehner/P.
Klausberger in: H. Eberwein/A.-Z- Steiner (eds.), Bitcoins, 37 (48 et seq.) comparing the
German and Austrian regulatory approaches.
158 Schweizerische Eidgenossenschaft, Federal Council report on virtual currencies, of 25 June
2014 (available at
Ibid. at p. 18.
Ibid., at p. 18 et seq.
Ibid., at pp 21, 26.
Ibid. at p. 26.
Cf. J.R, Hendrickson/T.L. Hogan/W.J. Luther, The Political Economy of Bitcoin, 2015
Economic Inquiry 1 (3).
UK Government, Office for Science, Distributed Ledger Technology: beyond block chain, A
Report by the UK Government Chief Scientific Adviser, p. 44 et seq. (London 2016, available at
Central Bank Journal of Law and Finance, No. 1/2016
Rainer Kulms
C. Hess/E. Ostrom, Ideas, Artefacts, and Facilities: Information as Common-Pool
Resource, 66 L. & Contemp. Probs. 111 (114 et seq.) (2003).
C. Hess/Ostrom, Ideas, 66 L. & Contemp. Probs. 111 (121 et seq.) (2003).
167 E. Ostrom, Governing the Commons
– The Evolution of Institutions for Collective Action
(New York, Cambridge University Press 1990), at p. 29 seq.
E. Ostrom, Governing the Commons, p. 33 on organising ‘common-pool resources’. See
also B. Hudson/J. Rosenbloom, Uncommon Approaches to Commons Problems: Nested
Governance Commons and Climate Change, 64 Hastings L.J. 1273 (1284 et seq.) (2013).
E. Ostrom, Governing the Commons, pp. 61 et seq., 69 et seq.
170 See the comments on Bitcoin governance structures by I. Eyal/E.G. Sirer, Bitcoin Mining,
and J.A. Kroll, I.C. Davey/E.W. Felten, 15 et seq.
See supra sub III.2.a.
172 See M.A. Heller, The Tragedy of the Anticommons: Property
in the Transition from Marx
to Markets, 111 Harv. L. Rev. 621 (667 et seq.) (1998); L.A. Fennell, Common Interest
Tragedies, 98 Nw. U. L. Rev. 907 (934 et seq. (2004).
Cf. New York Times online, 17 February 2014, N. Popper, Regulators and Hackers Put
Bitcoin to the Test (available at, see also The Economist
15 March 2014, Bitcoin’s Future – Hidden Flipside – How the Cryptocurrency could become
the internet of money (available at, on
global banks exploring Bitcoin-like currencies for money transfers between subsidiaries.
Ben Broadbent (Deputy Governor for Monetary Policy, Bank of England), Central banks
and digital currencies, London School of Economics, 2 March 2016 (available at
See generally: Bank of International Settlements, Committee on Payments and Markets
Infrastructures, Digital Currencies, p. 16 et seq. (November 2015, available at
175 See Ben Broadbent (Bank of England), speech 2 March 2016; and Minouche Shafik
(Deputy Governor, Markets & Banking), A New Heart for a Changing Payments System,
Speech, Bank of England 27 January 2016 (available at
See M. Shafik (Bank of England), speech of 27 January 2016. For the intellectual
underpinnings see G. Danezis/S. Meiklejohn, Centrally Banked Cryptocurrencies (2016,
available at
Cf. The Economist, 2 March 2016, Central Bank digital currency – Bankable? (available at China’s
central bank is also considering the issuance of a state-run virtual currency: South China Morning
Post online edition, 22 January 2016, China’s central bank aims to issue a digital currency
Central Bank Journal of Law and Finance, No. 1/2016
Bitcoin – a Technology and a Currency
(available at
See Ben Broadbent (Bank of England), speech of 2 March 2016.
179 Financial Times online 14 July 2015, FT Explainer: The blockchain and financial
markets (available at; 15 September 2015, Blockchain initiative backed
by 9 large investment banks (available at
Times online 14 July 2015., 15 September 2015, Blockchain,: Wo sogar
UBS und Credit Suisse einen gemeinsamen Nenner finden available at
180 Financial
Financial Times online, 15 September 2015.
United States Patent Application Publication Walker et al, No. 2015/0332395 A1
(published 19 November 2015, available at
32395). J. McKay et al., Goldman Sachs Files Patent for Cryptocurrency “SETLcoin” (16
January 2016, available at, 3 December 2015,
Blockchain. Goldman Sachs Takes the Lead (available at
Nasdaq Press Release, 30 December 2015, Nasdaq Linq enables First-Ever Private
Securities Issuance Documented With Blockchain Technology (available at
Hong Kong Legislative Council Press Release (ISE15/15-16), 20 April 2016, Blockchain
technology (available at
Central Bank Journal of Law and Finance, No. 1/2016
Stabilizing the Euro through Sovereign Money?
Max Danzmann*
Above all, the abolishment of private bank money creation is a matter of distributive justice.
Why should banks earn interest with self-created money? However, there are other
important matters such as the design of the sovereign money system within the European
Monetary Union (EMU) and the sovereign money system’s effect on financial stability.
Potentially, a sovereign monetary reform could stabilize the Euro. In the following, these
matters shall be analysed taking into account the state sovereignty of the members of the
EMU, the competitive relationship between the sovereign money system and the private
(bank) money systems as well as the independency of the European Central Bank (ECB).
sovereign money, money creation, financial stability
JEL Classification:
Ph. D. in economics, finance lawyer in an international law firm in Frankfurt, Germany.
The author thanks Dr. Joseph Huber, Dr. Timm Gudehus, Dr. Wolfgang Freitag and Thomas Betz for
their input.
Central Bank Journal of Law and Finance, No. 1/2016
Stabilizing the Euro through Sovereign Money?
Sovereign money means money as legal tender which was created solely by the state
(sovereign) accounts unlike private bank money as a mere money surrogate which only
qualifies as a claim of the bank customer against the bank for payment of central bank
money. The sovereign money system’s main difference from the current private bank money
system is that, not only on the primary money market among the central bank and the banks,
but also on the secondary money market among banks and non-banks, solely money created
by the central bank is the permitted payment instrument and no longer privately created
bank money. Hence, money may generally not be created privately and must be created by
either the central bank or the parliament resolving fiscal policy together with the public
authorities administering household and public finances (the fiscus) as sovereign money.
1.1. Abolishment of Private Bank Money Creation
Currently, the most part of the money supply is privately created by banks through granting
sight deposits on current accounts. Through sovereign monetary reform, sight deposits on
current accounts with banks will be transformed to central bank money on sovereign money
accounts and will be, thereby, upgraded as legal tender. This implies that new sight deposits
on current accounts (which then qualify as sovereign money accounts) must not be created by
banks any longer1.
Upon a sovereign monetary reform, deposits on and payments from sovereign money current
accounts require either a debiting of another sovereign money current account or a cash
deposit or are made through sovereign money creation. Therefore, sovereign money current
accounts of bank customers have to be separated from bank’s balance sheets and will be
directly assigned to the bank customer’s legal estate. The bank then only holds the sovereign
money deposits and administers the sovereign money current account as trustee for the bank
customer as beneficiary. This systematic reform changes the equity and liability side of the
banks’ balance sheets: Banks cannot create the money required for granting loans, but have
to finance the loans by way of debt or equity (e.g. (long-term) savings deposits or term
Cf. J. Huber, Vollgeld. Beschäftigung, Grundsicherung und weniger Staatsquote durch eine
modernisierte Geldordnung, 1998, p. 259 et sqq.
Cf. J. Huber/J. Robertson, Geldschöpfung in öffentlicher Hand, 2008, p. 25 et sqq.
Central Bank Journal of Law and Finance, No. 1/2016
Max Danzmann
1.2. Money Creation by the Fiscus and the Central Bank
There are two alternatives through which sovereign money can be created which can also be
combined. Sovereign money is either brought into the monetary system by the fiscus or
directly by the central bank.
If newly created sovereign money is brought into the monetary system by the fiscus
(Alternative 1), the central bank credits a certain amount to the fiscus’ current account with
the central bank first. In the following, the deposits on the fiscus’ central bank account will be
introduced to the rest of the monetary system (in a democratic, legitimized order) by the
fiscus through withdrawals and direct debit orders as public expenditure. Through this,
money creation has a direct impact on economic demand (e.g. to be applied for a Keynesian
policy) and not – as currently – only depending on the credit supply and credit demand 3.
Alternatively, the central bank could also control the sovereign money supply without the
fiscus’ assistance (Alternative 2). Under this alternative, the central bank creates sovereign
money either temporarily by extending loans to the fiscus, banks or other economic actors or
permanently through open market transactions, such as by way of real estate, sovereign bond
or private bond purchases. Such money creation may also be utilized for the purpose of the
final deposition of financially destabilizing losses4. However, open market transactions of the
central bank can have heavy competition distorting and redistribution effects to which
central bank policy might not have sufficient democratic legitimacy.
The EMU as a sovereign monetary system could be operated either centrally, on EU or
Eurozone level, or locally, on member state level. Depending on the design of such system,
this will have different implications for the member states’ sovereignty.
2.1. Central Operation: Foundation of the European Financial Union?
If the sovereign monetary system is centrally operated by the European System of Central
Banks (ESCB) and sovereign money is brought into the monetary system through national or
EU fiscal policy (Alternative 1), it is questionable whether the individual member states of
Cf. J. Huber, Monetäre Modernisierung. Zur Zukunft der Geldordnung: Vollgeld und Monetative,
2012, p. 126 et sqq.
Cf. M. Danzmann, Final Deposition of Losses through the European Central Bank's Balance Sheet as
a Financial Stability Policy Tool, Central Bank Journal of Law and Finance, 2/2015, p. 4 et sqq.
Central Bank Journal of Law and Finance, No. 1/2016
Stabilizing the Euro through Sovereign Money?
the EMU could maintain their fiscal sovereignty. For any member state, the answer to this
question depends on the relation of public spending through sovereign money creation and
its overall public budget since, in a central operation scenario, a pre-determined issuance
amount would be assigned to each fiscus and no fiscus would have the right to issue
sovereign money on its own. If, what is currently not intended, such central assignments of
sovereign money creation cover for a major part of the public budget, the consequence is a
factual foundation of the European Fiscal Union and the loss of the individual member state’s
Furthermore, whether a member state loses its sovereignty depends on the fiscal redistribution effects of sovereign money creation among member states. These redistribution effects
depend on the criteria for allocation of the sovereign money creation among member states.
The state’s share in the aggregate population of the EU, GDP-share, ECB capital share or a
mix of these factors could, among other things, serve as such criteria. Moreover, it would be
of significant relevance for the member states’ fiscal sovereignty whether, besides the
amounts of sovereign money creation, also a specific purpose is regulated towards which the
created money has to be applied.
In contrast, if sovereign money is issued by national central banks or the ECB (Alternative
2), it will depend on the specific design of the issuing channels for sovereign money whether
they require the Fiscal or Financial Stability Union or the member states can keep their
sovereignty. For a temporary, credit issuance of sovereign money, comparable to today’s
refinancing operations of the ESCB with credit institutions (Alternative 2a), a Fiscal Union
would not necessarily be required. Despite the fact that the main parameters of the central
banks’ refinancing operations are centrally controlled, a Fiscal or Financial Union could be
required due to redistribution effects, if the location of the sovereign money creation is not
determined by bank demand (with reallocations through national central bank’s emergency
liquidity assistance), but is rather centrally controlled by the ESCB through inflexible quotas
for each of the national central banks.
However, a Fiscal or Financial Union will in any case be required if the ESCB issues sovereign
money temporarily (through the acquisition of debt) or permanently (through the final
deposition of financially destabilizing losses, social expenditures, equity contribution to
private corporations or long term infrastructure investments) (Alternative 2b). This can
lead to significant redistribution effects not only among economies but also among certain
economic sectors and competitors. Due to the tremendous economic power the ECB has, the
ECB would need a strong mandate which could not be assigned towards the ECB without
binding the ECB to parliamentary decisions considering requirements of the democratic
Central Bank Journal of Law and Finance, No. 1/2016
Max Danzmann
2.2. Decentralized Operation: Currency Split
A decentralized operation of the sovereign money system in the EMU 5 could lead to a split of
the currency union, contrary to the basic principle which the ECB applies to all of its financial
stability policy measures (i.e. safeguarding the currency union). The members which
undertake a full sovereign monetary reform by themselves would have to leave the Eurozone.
Only by themselves, could they, if at all, introduce sovereign money as a parallel currency
which is prohibited under the current currency regime in the EMU pursuant to Art. 3 para. 4
TEU6 and Art. 128 para. 1 TFEU7.
Alternatively, a sovereign monetary reform might potentially as well be made by all Euro
members with the monetary operation and control of the sovereign money system in the
discretion of each of the national fiscuses and central banks. However, such sovereign
monetary reform could, if at all, work if the issued sovereign money Euros could be
distinguished by the member state that issues any specific sovereign money Euro. Otherwise,
each member state could issue sovereign money Euros anonymously, independently, without
the other member states’ control and at the other member states’ cost. In contrast, if the
sovereign money Euros were to be distinguished by the issuing member state, their value
would diverge due to which the currency union would factually be abolished. Due to this, the
TARGET2-system would have to be shut down since TARGET2 as a single currency transfer
system must treat every Euro technically equally. Such separate systems could only work
together through the implementation of national sub-systems of TARGET2 which would be
brought together by TARGET2. Despite this, such separate systems would provide the
national fiscuses only with seigniorage in their national Euros even though their current
public debt would still be denominated in old Euros.
Notwithstanding its specific form and kind, a sovereign monetary reform in the EMU should
imply positive effects on the stability of the European financial system.
Cf. J. Huber, Monetary Reform in the Eurosystem, 2012, p. 7 et sqq.
The Treaty on European Union.
The Treaty on the Functioning of the European Union.
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Stabilizing the Euro through Sovereign Money?
3.1. Fiscal Stability
If new sovereign money is constantly issued by the fiscus (Alternative 1), fiscal stability
improves through the constant seigniorage raised by the issuing fiscus. In addition, the
transition from debt money to asset money (following from central bank balance sheet
changes, in case of a sovereign monetary reform) will result in tremendous profits of the
central bank which might eventually be transferred to the fiscus and decrease public debt. In
order to avoid a transition related liquidity overflow, central banks should transfer the
described transition profits to their fiscuses only gradually, as soon as and to the extent the
banks repay their transitions asset money loans to the central banks, which central banks
have granted the banks for the purpose of exchanging their debt money with asset money. On
the other hand, liquidity gaps in the monetary system should also be avoided by gradually
transferring the banks' repayment amounts to the fiscus rather than transferring the
transition profit as a whole upon final repayment of such loans 8.
Such transition profits (which are transferred by the national central banks to their own
fiscuses) should fiscally stabilize in the short and medium term, even though the amount of
the profit transfers would be determined by the national central bank’s share in the ECB
capital and not its actual fiscal stability needs.
By way of financing public expenditures (e.g. following the application of a Keynesian
economic policy), the profits which are made through the transition to a sovereign money
system and the seigniorage could not only be used for lowering public debt, but also for
stabilizing the real economy. Depending on the development of EMU member states’ fiscal
policies, it seems possible that the main interdependency between fiscal policy and financial
stability policy disappears through stabilizing public debt and public bonds 9.
3.2. Stabilizing Financial Institutions
A sovereign monetary reform leads to a situation in which money on sovereign money
current accounts will be extracted from the private bank’s balance sheets, assets and
insolvency estate and thereby made bank money bank insolvency resistant. Bank customers
would have no incentive for a bank run in insolvency or illiquidity scenarios of their banks.
Furthermore, it should be expected that the financial system develops less over-liquidity
bubbles due to the fact that banks may no longer create the money themselves for loans they
Cf. T. Gudehus, Neue Geldordnung, 2016, p. 11.
Cf. M. Danzmann, Das Verhältnis von Geldpolitik, Fiskalpolitik und Finanzstabilitätspolitik, 2015, p.
232 et sqq.
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Max Danzmann
extend, but rather have to fully refinance such loans with debt or equity themselves.
Currently, the overshooting private bank money creation often leads to price bubbles
especially in real estate markets, since the self-created liquidity by banks is often used for
financial speculation on the basis of debt and credit.
Normally, banks increase their credit issuance pro-cyclically during asset price booms
whereby the quality of bank financed assets in relation to their prices deteriorates and debt
levels rise over the cycle. Since the banks have to refinance the loans they grant in a sovereign
money system, the pro-cyclicality of banks’ credit issuance and the volatility of the money
supply should decrease. On the downside, the economic development might become less
dynamic due to such restrictions. On the other hand, financial instabilities and financial
crises become less likely.
Moreover, sovereign money should even have further stabilizing effects as money issuance is
made by the fiscus and no longer mainly on interest bearing credit, but rather through public
expenditures which do not imply any economic growth pressure or compulsion caused by
credit interest, like in a private bank money system 10. Under a bank money creation regime,
every loan debtor has to earn the difference between the amount it owes and the actual loan
amount in order to pay its interest liability. Despite this, interest with its capital allocation
steering function is not eliminated by a sovereign money reform at all. The sovereign money
reform only removes one interest element in the course of financing real economy.
3.3. Monetary Stability
In a sovereign money system, the central bank has the ability to control and steer the money
supply directly (or indirectly with the fiscus' assistance). Particularly, the central bank can
determine how much money is to be issued (by the fiscus) in a given timeframe. By way of
such a money supply control, inflation rates can be controlled more directly than through
base interest rates. Currently, most central banks aim at controlling price levels by way of
increasing (decreasing) bank loan costs through base interest rates, thereby reducing
(increasing) demand for bank credit and private bank money creation.
Vice versa, base interest rates are reduced in order to stimulate the granting of bank loans
and private bank money creation. However, the central bank does currently not have the
ability to force and effect an increase of the secondary money market money supply (i.e.
private bank money creation) through decreasing base interest rates, if banks do not extend
loans due to balance sheet adjustments or recession concerns (as currently experienced in the
Cf. J. Kremer, Vollgeld, 2014, p. 2.
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EMU). To such extent, the sovereign money system outclasses the private bank money
system as a consequence of the abolishment of the separation of the primary and secondary
money market. In contrast to base interest rate instruments, the central banks (and the
fiscus) can effectively control the money supply for non-banks in a sovereign money system.
Considering such effective money supply control options, it should be quite controversial of
such money supply control should be rule based and/or be discretionary or whether the
central bank should remain inactive in a sovereign money system. A point in favor of an
inactive monetary policy, which maintains money supply levels even in times of weak
economic activity, is that bank loan interests decrease in such times as a consequence of a
decreasing bank loan demand which then, on the other hand, stimulates the bank credit
demand. Since the money supply is exposed to a continuously changing environment, it can
be useful to adjust the money supply in a rule-based manner (e.g. proportionally to the GDP
growth rate). But it is also possible to manage business and trade cycles with an active and
discretionary monetary policy and to fight a recessive development with public expenses on
the basis of an extension of the sovereign money supply.
One of the main reasons for a stable development of the sovereign money supply is to
stabilize the exchange rates. Due to the debt-free nature of its monetary base and the
aforementioned stabilizing effects of sovereign money, an increasing demand of sovereign
money abroad might be expected which would result in a stability premium in the form of a
currency appreciation and an improvement of exchange rates.
A sovereign monetary reform within the EMU might come at the cost of financial stability
risks following from potential inflexibilities of money supply control and due to fact that it
might be undermined by foreign exchange transactions, parallel currencies or private money.
4.1. Central Money Supply Control
The transition from an endogenous to an exogenous money supply causes financial stability
risks. Generally, banks reduce their credit supply at times of a weakening economy and
decreasing asset prices, whereby private bank money supply is lowered. This endogenous
money supply with a decentralised and flexible accommodation of the overall amount of
money in the financial system to a variable demand is the greatest strength of the current
monetary system11. In case of a conversion to a sovereign monetary system, the private bank
Cf. T. Gudehus, Dynamische Märkte, 2nd edition, 2015, p. 420.
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Max Danzmann
money creation can no longer function as buffer in the overall money supply, if short term
expenses could be financed by private bank money. An endogenous monetary is
advantageous, if an economy is in need of quick growth12.
Economic actors have to face a relatively inflexible money supply in a sovereign monetary
system, since the money supply can only be adjusted centrally by the central bank and the
fiscus. The central creation of sovereign money leads to a very direct control of the economy
by the state. In addition, an inflexible money supply tends to be financially better for savers
and depositors, since they can dispose over liquidity, which is a limited resource during
economic upswing. Banks have to compete then for saving deposits, triggering an increase of
interest premium on savings. The risk and liquidity premiums, as integral parts of interest,
should rise. All this could lead to redistribution effects in favour of savers and lenders.
Important reasons for a sovereign monetary reform are considerations of distributive justice
and redistributive effects. For instance, an increase of the private money supply favours, first
of all, the banks as first users of the new private bank money according to the Cantilloneffect. Furthermore, financial products which are leveraged with private bank money tend to
redistribute more towards financial incomes than work incomes. It is generally difficult to
justify the bank's ability to earn interest with money they create themselves. However, it
should be noted that this ability does not come for free. Banks bear – notwithstanding public
bail-outs – credit risks through their balance sheets and have to hold minimum levels of
(expensive) equity and liquidity as required by banking regulation authorities. Besides this, a
sovereign monetary reform is not the only way to circumvent the redistributive effects
described before. For instance, the bank money creation could effectively be restricted by
minimum reserve requirements and financial advantages could be skimmed through taxation
of bank money creation. Further, it should be noted that during times of decreasing bank
profits due to low interest rate levels caused by the application of the central banks'
quantitative easing policies, the abolishment of private bank money creation could cause
bank insolvencies and further financial stability risks.
4.2. Foreign Trade and Foreign Exchange Trade
Monetary stability also depends on the behaviour of foreign actors. As an example, the money
supply control itself is also in a sovereign money system not sufficient in order to ensure
stable price levels due to the phenomenon of imported inflation. Despite money supply
Cf. T. Betz, Geldschöpfung, Vollgeld und Geldumlaufsicherung, 2014, ZfSÖ 180/181, p. 38 (43).
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Stabilizing the Euro through Sovereign Money?
control, increases in foreign price levels influence domestic inflation rates through price
increases in relation to imported goods.
Moreover, central banks are generally obliged during times of free movement of capital to
convert foreign currency income, resulting from foreign trade surpluses in the current
account balances, into their domestic currency. The central banks receive foreign currencies
in exchange which could either be held as reserves or be invested in foreign economies. Such
foreign trade surpluses are often completely invested in the economies where they were made
due to which the trade surplus is compensated in the current account balance by a capital
outflow in the same amount. If this is, however, not the case, the amount which has not been
invested abroad has to be deducted from the amount, which the relevant central bank would
have intended for the creation of sovereign money otherwise. In other words, the surplus in
foreign currency reserves limits the sovereign money issuance and reduces the state's
In contrast, the central bank and the fiscus can increase their seigniorage if there is a great
demand for their sovereign money currency abroad. However, this might cause monetary
instability issues, if there is hoarding of sovereign money abroad and a great portion of such
hoarded sovereign money suddenly comes back into the domestic economy within a short
period of time. Such risk would for instance realise if the status of the sovereign money
currency Euro, as an international reserve currency, would be (partially) revised due to an
adverse development of European economies. The described capital flows could hardly be
avoided in the Eurozone due to the statutory worldwide freedom of capital movement in EU
4.3. Parallel Currency
For the time being, a sovereign monetary system, if introduced, would have to compete with
private money systems. As most banks operate in different currencies and are refinanced
with more than one central bank nowadays, banks are incentivised to shift their business
activities to private bank money systems, if they lose their ability to create money under a
sovereign monetary order. However, such circumvention requires that bank customers
actually demand bank services in another currency. Especially, if banks are willing to pass
financial advantages resulting from private bank money creation (partially) on to its
customers (e.g. by lowering interest margins), the bank customers would also have incentives
to shift (even) their (domestic) transactions to foreign currency.
Especially, during a shortage of the domestic sovereign money currency resulting from a
central bank policy aiming at an increase of the exchange rates of the domestic currency or a
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Max Danzmann
decrease of domestic price levels without further public expenses, domestic economic actors
are incentivised to obtain financings through a private bank money system. For example, a
German corporation could get a US dollar loan from a US bank in the USA, which will be
utilised on a current account with such a US bank. A parallel foreign currency would then
ensure an expansion of the (private bank) money supply endogenously to the extent the
domestic sovereign money system (exogenously controlled by the central bank) is not
sufficiently flexible and cannot be adjusted to an increased money demand in the short-term.
A foreign currency could even become a parallel currency if foreign capital providers not only
(as has already been the case for a long period of time) exchange their foreign currency into
the domestic (sovereign money) currency (thereby causing exchange rate adjustments) in
order to furnish the domestic actors in need of capital with the domestic (sovereign money)
currency, but rather the domestic economic actors use foreign (private bank money) currency
for payments from a foreign bank account to another foreign bank account, even for their
domestic transactions. Through foreign bank accounts in a private bank money system, there
would be domestic demand for foreign private bank money creation by an economy with a
sovereign money system. Nowadays, a lot of corporations have foreign bank accounts. Due to
this, two German corporations could settle payments for instance in US dollar through US
dollar bank accounts in the USA. Online banking and worldwide freedom of capital
movement allow for a cross-border private bank money system even today.
If domestic actors from the sovereign money economy use the foreign parallel currency
frequently, banks will then earn more interest for their lending and profit for their services
abroad, which could well result in a shift of bank businesses activity and an exodus of
domestic and international banks from the sovereign money economy. In addition, it can be
expected that the external value of the foreign private bank money currency, which is
frequently used as parallel currency, rises. The foreign central bank can fight against
unfavourable exchange rate rises by expanding the monetary base and the money supply.
However, the (partial) assumption of payment system and financing functions from the
sovereign money system by the private money system might undermine the private bank
money system's central bank's ability to effectively influence the economy and control the
money supply. On the other side, the sovereign money system's central bank could only
restrict the use of a parallel currency and capital flight only by way of capital controls and a
prohibition of foreign exchange13. Furthermore, the ECB, for example, would currently have
Cf. T. Gudehus, Neue Geldordnung, 2016, p. 45.
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no right under EU law to request minimum reserves abroad or to stop (derivative)
transactions with its (sovereign money) currency.
Despite this, the usage of a parallel currency implies significant exchange rate risks for the
actors of the sovereign money economy to the extent that not only payments but also the
underlying agreements and transactions are made in such foreign parallel currency. Such
usage could further be problematic due to the fact that corporations stemming from the
sovereign money economy will still have to use the sovereign money currency for their
balance sheets, even though they do their transactions in a foreign currency and, therefore,
bear exchange rate risks. Whether or not the described financial risks resulting from a
parallel currency in fact materialize, this depends on the domestic and foreign economic
actors' trust in the sovereign money currency and system. The competitive relationship
among the sovereign money system and foreign private bank money systems could also be
decided in favour of the sovereign money system in the long run provided that the advantages
of a sovereign monetary system outweigh the risks it imposes on financial stability.
4.4. Private Money
A sovereign money system does not only compete with parallel foreign private bank money
systems, but also with parallel private (corporation) money systems. For the purpose of this
article, private money shall be defined as money which is issued by a private corporation that
is, at least until the issuance of private money, not a bank (private money issuer) and which
gives the holder of such private money a claim against the private money issuer for a specific
payment or other performance. The fungibility and transferability of such claim is required so
that its holder can use such claim for the purpose of payment towards its own creditor and
such claim can fulfil money functions. In order to ensure such fungibility, the private money
issuer must have a certain level of creditworthiness and the issuer needs to consent to the
transferability of its debt which is essentially embodied by such private money. Generally,
only big corporations cater for a sufficient creditworthiness to trigger demand for their
private money and so that their private money can be used and transferred by its holders in
their transactions without having to seek the issuer's consent.
As one alternative of private money, private money issuers issue their private money in
consideration of payment of financial funds as deposits which would generally be sovereign
money in a sovereign money system (Alternative 1). Such deposits could be used or
invested by the private money issuer profitably. By way of accepting deposits, the private
money issuer would functionally become a bank and legally become a regulated credit
institution. Such acceptance could cause financial stability risks due to the maturity
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Max Danzmann
transformation undertaken by the private money issuer provided that the private money
issuer on-lends or invests the deposits for a longer term compared to the term in which its
own indebtedness is due and payable towards the private money holder. However, it is likely
that the private money issuer has to pay comparably high interest rates for such deposits,
since the depositors and holders could always choose to deposit their money with a regular
bank instead. The competitive relationship between private money under this alternative and
a sovereign money system should structurally not be problematic, since such private money
is reconnected with the sovereign money system, as long as private money issuers have to
obtain funds on the markets when and if they have to repay the deposits to the private money
holders upon withdrawal of their deposits. In contrast to a bank money system, the private
money issuers do not have the ability, under this alternative, to generate interest profits on
the basis of self-created bank money by way of granting a loan through its own creditworthiness and without having to refinance its money issuance at all.
As another alternative, private money could also be issued by its issuer on the basis of a loan
towards another economic actor (Alternative 2). In this scenario, the issuer grants and
transfers its private money to another actor, without a preceding performance by the private
money receiving holder, merely on the basis of such holder's performance commitment. The
holder has to pay to the private money issuer interest for such private money (as it
constitutes a loan and credit). As a consequence of the fact that such private money is based
on credit, it qualifies as credit money comparable to private bank money. Since issuing such
private money constitutes a lending business, it requires a banking license. However, it might
be useful to restrict or prohibit such private money issuance to protect the sovereign money
system against competition within the own monetary system, if the private money system
undermines the sovereign money system or poses other financial stability risks.
There are additional forms of private money, such as private money that is not based on the
issuer's commitment to repay (sovereign) money, but rather on the holder's claim against the
issuer for another performance equal or similar to a voucher or coupon issued by shops.
These forms could also be based on preceding deposits or payments by the holder in
consideration of such private money (Alternative 3) or based on a credit of the private
money issuer towards the holder without any upfront payment by the holder (Alternative
4). Alternative 3 constitutes an advance payment from the private money holder to the issuer
whereas private money in accordance with Alternative 4 represents security in relation to a
claim for future performance. However, these alternatives should not pose any risks for
financial stability and the stability of the sovereign money system, since the demand for such
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Stabilizing the Euro through Sovereign Money?
private money should be limited due to their illiquidity, their little fungibility and their
specific performance restrictions.
If the private money term is defined more broadly, it could also capture other private money
systems such as the Bitcoin-system. The Bitcoin-system is structured with an ex ante limited
money supply and Bitcoins, as fiat-money, embody nothing but a claim for payment of other
Bitcoins as replacement of the Bitcoins returned. The parameters of the distribution of such
private money are usually determined by its originator. Money systems such as the Bitcoinsystem do not constitute a credit money system since its money issuance is not based on (an
interest bearing) credit. It is possible that such private money systems are value stable due to
their pre-determined and limited money supply and the private money they issue is fungible
due to their embeddedness in high-tech systems. Up to now, such private money systems still
do not pose any risks to the stability of a sovereign money system considering their size and
their distribution so far. If this situation were to change and such systems were to jeopardise
monetary or financial stability, states could consider restrictions of such private money
systems as a matter and consequence of their monetary, fiscal and financial sovereignty.
4.5. Final Deposition Instruments
A sovereign monetary reform does not eliminate the central bank's ability to finally deposit
financially destabilizing losses in its balance sheet on the basis of – despite currency
devaluation – its unlimited money creation capacity and its unlimited capacity to absorb
losses14. In a sovereign money system, the fiscus and/or the central bank purchases
financially destabilizing assets with sovereign money. The Outright Monetary Transactions,
the Extended Asset Purchase Programme or Quantitative Easing of the ECB could (factually)
be implemented in the same manner in a sovereign money system as currently done by the
ECB in today's credit money system.
However, the final deposition tool based on the eligibility of inferior assets for monetary
policy refinancing can no longer be applied by the central bank as a financial stability policy
tool since there will be no credit refinancing of banks with the central banks upon the
abolishment of the private bank money system, unless the sovereign money system uses the
issuing channel described under Alternative 2a above. Due to this, the central bank can no
longer act as lender of last resort as in today's credit money system. This also implies that no
members states of the ESCB can implement Emergency Liquidity Assistance operations to
Cf. M. Danzmann, Final Deposition of Losses through the European Central Bank's Balance Sheet
as a Financial Stability Policy Tool, Central Bank Journal of Law and Finance, 2/2015, p. 2 et sqq.
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Max Danzmann
stabilize its domestic banks and provide them with liquidity any longer. Nevertheless, the loss
of such final deposition tool could be compensated by means of an extension of the other
main final deposition tool of purchases of financial destabilizing assets.
A sovereign monetary reform has major implications for the interaction of monetary and
fiscal policy and, therefore, consequences for the central bank's independence from fiscal
policy and the parliament. It depends on the specific design of the sovereign money system, if
it implies a monetary or a fiscal policy dominance.
If the central bank has the sole competence to issue sovereign money and to introduce it to
the business cycle directly by way of its own demand or indirectly by way of lending of
sovereign money loans towards banks, the central bank's sovereign monetary policy
dominates the fiscal policy or does at least implement its sovereign monetary policy
independently. Considering requirements of democratic principles, it could be quite
problematic (especially in the EMU due to the member states' fiscal sovereignty) if an
independent central bank makes decisions on the application of public expenses which
actually fiscal policy is competent and responsible for.
Vice versa, fiscal policy would dominate monetary policy if the central bank would require a
resolution of the parliament as the main fiscal policy actor for each and every emission of
sovereign money as well as the reduction of the sovereign money supply. If the sovereign
monetary system would be designed like this, the central bank would factually become a subdepartment of the fiscal administration and the parliament and lose its independence. All
public expenditures as well as all budget cutbacks would have direct implications for the
money supply. Furthermore, it must be expected that, especially in economies with a long
history of fiscal instabilities, the money supply will be increased rather than reduced since the
central bank cannot reduce the money supply on its own and fiscal policy as the competent
authority will, empirically and from experience, most likely not be willing to do so. A
dependency and subordination of the central bank towards fiscal policy will be difficult
particularly in unstable parliamentary scenarios in which, for example, no resolutions for
monetary policy measures can be made due to lacking majorities.
In order to reduce fiscal policy dominance, certain measures and modifications could be
implemented whereby the central bank gets tools to incentivize the fiscus for an increase of
the money supply by way of public expenditures or a reduction of the money supply by way of
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Stabilizing the Euro through Sovereign Money?
withholding of sovereign money (financed by budget surpluses or public debt). The central
bank could be furnished with competences and powers to enable the central bank to decide
independently. The sovereign money system could be structured in such a way that the
central bank and fiscal policy can only control it together.
For example, the fiscus' sovereign money issuance could be limited in a way that sovereign
money may only be retrieved by the fiscus for a pre-determined period of time and/or for
pre-determined amounts. Furthermore, the central bank could also be furnished with a
legislative initiative right in relation to fiscal policy matters in order to balance the fiscal
policy's co-determination rights in monetary policy through the implementation of a right in
the opposite direction (especially in case the minister of finance or secretary of the treasury
blocks the central bank's policy measures). Following such a legislative initiative by the
central bank, the parliament decides on the sovereign money creation and thereby
determines the sovereign money supply. However, the central bank may generally not make
further conditions for parliamentary decisions bearing in mind democratic principle
For the interaction of central bank and fiscal policy, it must be noted that there are usually
several fiscuses within a state or a currency area. In Germany, the federal state, the federal
states and the municipalities administer (among other sub-divisions) their own budgets.
Sovereign money issuing rights could be assigned to each of the relevant fiscuses and each of
them could be provided with current accounts held by the central bank in the name of the
relevant fiscuses. The central bank could thereby act as a moderator of such fiscuses.
However, it has to be expected that the interactions and dependencies among monetary and
fiscal policy will be aggravated following a sovereign monetary reform. The central bank's
moderation tasks will even be more complex on EMU level where not only the member states
themselves have fiscuses, but also the member states' sub-divisions each have their own
A sovereign monetary reform overcomes the current credit money system. Therefore it
requires not only a fundamental economic policy decision, but also, within the EMU, a
deeper integration of the member states' financial policies, as a consequence of aggravating
interdependencies between monetary and fiscal policy, especially when considering that the
Euro as a uniform currency can probably only be set up in a monetarily stable manner, if it is
controlled and steered centrally.
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Max Danzmann
Although transition profits resulting from a sovereign monetary reform should have fiscally
stabilizing effects in the medium term, a sovereign monetary reform is only likely to succeed
if it sufficiently ensures monetary stability and the financial stability of its financial
institutions. Otherwise, foreign credit money or private money systems could jeopardise the
sovereign money system's stability. In any case, only questions on the legitimacy of the bank's
interest profits, which are based on self-created private bank money, will not ensure the
sovereign monetary reform's success in the long run.
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Stabilizing the Euro through Sovereign Money?
1. Betz, T., “Geldschöpfung, Vollgeld und Geldumlaufsicherung”, 2014, ZfSÖ 180/181, p. 38
2. Danzmann, M., “Das Verhältnis von Geldpolitik”, Fiskalpolitik und Finanzstabilitätspolitik,
2015, p. 232 et sqq.
3. Danzmann, M., “Final Deposition of Losses through the European Central Bank's Balance
Sheet as a Financial Stability Policy Tool”, Central Bank Journal of Law and Finance,
2/2015, p. 2 et sqq.
4. Gudehus, T., “Neue Geldordnung”, 2016, p. 11, 45.
5. Gudehus, T., “Dynamische Märkte”, 2015, 2nd edition, p. 420.
6. Huber, J., “Monetäre Modernisierung. Zur Zukunft der Geldordnung: Vollgeld und
Monetative”, 2012, p. 126 et sqq.
7. Huber, J., “Monetary Reform in the Eurosystem”, 2013, p. 7 et sqq.
8. Huber, J., “Vollgeld. Beschäftigung, Grundsicherung und weniger Staatsquote durch eine
modernisierte Geldordnung”, 1998, p. 259 et sqq.
9. Huber, J.; Robertson, J., “Geldschöpfung in öffentlicher Hand”, 2008, p. 25 et sqq.
10. Kremer, J., “Vollgeld”, 2014, p. 2.
Central Bank Journal of Law and Finance, No. 1/2016
The Changing Faces of the Maastricht Criteria:
from a Shortcut to Heaven to Just Another Exam
via a Procrustean Bed
Wilhelm Salater*
In 25 years of existence, the Maastricht criteria have generated heated debates, being
vividly criticised and vigorously defended. They have been seen by some economists as
rather pointless tests, mutually inconsistent or harmful to real convergence, whereas others
viewed them as excellent tools for assessing the preparedness to join the euro area. The lines
of reasoning used in this academic battle have substantially varied over time. This essay
aims to investigate how and why the approach to the nominal convergence criteria has
changed from their very adoption to present-day and to reveal their merits and limits in
post-crisis Europe.
Maastricht criteria, euro area, nominal convergence, real convergence, monetary policy
JEL Classification:
E31, E52, E58, E60, F15
Expert, Economics Department, National Bank of Romania
Central Bank Journal of Law and Finance, No. 1/2016
The Changing Faces of the Maastricht Criteria: from a Shortcut to Heaven to Just Another Exam via a Procrustean Bed
Although the Maastricht criteria have remained unchanged since their adoption in 1992, the
story of how they have been treated over time by academia and policymakers is a very
complex and spectacular one. These criteria have been interpreted, applied, assessed and
reassessed in many ways. They have been overrated or underrated, feared or ignored, praised
(for all the right and wrong reasons) or blamed (for being too severe as well as for not having
enough relevance for gauging the overall level of economic convergence).
Not only the criteria per se (the indicators on which they are based, the reference values, the
wording) had a major bearing on the debates regarding their appropriateness, but also the
shifting perceptions about the euro area, which went from the Promised Land to a roofless
house. As a result, numerous papers arguing in favour of easing the nominal convergence
criteria were published at a time when the euro area membership almost looked like a free
lunch, but the subject was virtually abandoned after the global crisis had revealed some
major flaws in the architecture of the EMU, entailing a “wait and see” approach in many noneuro EU countries. It is therefore important to understand how the attitude towards the
Maastricht criteria evolved amid a changing economic and financial environment in Europe
and to draw some lessons relevant for improving the capability to accurately tell when a
country is ready to successfully join the euro area.
The essay is structured as follows. The second section describes the “shortcut to heaven”
approach to the Maastricht criteria widespread during the 1990s and early 2000s, when they
were regarded as benchmarks to be observed as soon as possible in order to join the euro
area. The “Procrustean bed” phase in the attitude towards these criteria, characterized by the
focus on their imperfections perceived as making the strict adherence to them harmful to the
economies of the euro-area candidate countries, is explored in the third section. The fourth
section deals with the post-crisis re-evaluation of the desirable coordinates of a successful
euro adoption process: as it has become increasingly obvious that the euro area is not the
convergence club it once promised to be, the manner in which the preparedness of an
economy to join the monetary union should be assessed was subject to major revisions,
additional tools being developed for gauging the sustainability of economic convergence. The
last section concludes with some reflections on how to keep the process of taking on the
single currency on the right track and why a lasting nominal and real convergence needs to be
ensured in order for an economy to perform well after joining the euro area.
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In the 1990s, when Euroland looked like the Promised Land, most EU countries were eager to
get there sooner rather than later. The safe haven of the single currency was seen as the place
to be, even though until 1999 it had been just a project.
The four Maastricht criteria (see Box I) were largely regarded as mere benchmarks to be
observed as soon as possible in order to join the euro area and take advantage of its benefits.
The necessity to ensure the sustainability of the convergence was much less emphasized.
The achievement of a high degree of price stability, measured as at most
1.5 percentage points higher consumer price inflation than that of the
average of the three best performing member states of the EU;
The sustainability of the government’s financial position, as reflected by
the lack of an excessive deficit procedure, which, in turn depends on the
fulfilment of two criteria: the budget deficit should not be higher than
three percent of GDP, unless either the ratio has declined substantially
and continuously and reached a level that comes close to the reference
value, or, alternatively, the excess over the reference value is only
exceptional and temporary and the ratio remains close to the reference
value; the government debt should not be higher than 60 percent of GDP,
unless the ratio is sufficiently diminishing and approaching the reference
value at a satisfactory pace;
The observance of the normal fluctuation margins provided for by the
exchange-rate mechanism of the European Monetary System, for at least
two years, without severe tensions, and in particular, without devaluing
against the euro;
The long term interest rate should not be higher by 2 percentage points
than that of the average of the three best performing member states of the
EU in terms of price stability.
An exception to the rule was, as in many other areas, the United Kingdom (which, alongside
Denmark, is one of the two EU countries having an opt-out from the euro). In 1997, the then
Chancellor of the Exchequer, Gordon Brown, formulated five tests for assessing the
preparedness of the British economy for the adoption of the euro (see Box II).
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The two assessments from 1997 and, respectively, 2003 led to the conclusion that the British
economy was not ready – at least not yet – to make this step. In retrospect, one may safely
affirm that it was better for everybody that the United Kingdom did not join the euro area –
otherwise Brexit would imply leaving not only the EU, but the euro area as well, with
destabilizing consequences for the EMU.
Are business cycles and economic structures compatible so that we and
others could live comfortably with euro interest rates on a permanent
If problems emerge is there sufficient flexibility to deal with them?
Would joining EMU create better conditions for firms making long-term
decisions to invest in Britain?
What impact would entry into EMU have on the competitive position of
the UK's financial services industry, particularly the City's wholesale
In summary, will joining EMU promote higher growth, stability and a
lasting increase in jobs?
In 1998, the ECB and the EC adopted a rather benevolent stance when interpreting the
fulfilment of the nominal convergence criteria, so that 11 countries were able to form the euro
area in January 1999. The exchange rate criterion was interpreted in a generous manner for
Italy and Finland, as at the time of the assessment the domestic currencies of the two
countries had been taking part in the ERM for less than the minimum period of 24 months.
Moreover, Austria, Belgium, Italy and the Netherlands entered EMU with a public debt in
excess of 60 percent of GDP. Greece was admitted to the club only two years later with even
more open-handedness: in the assessment of its convergence, the fiscal position criterion was
deemed met although the government debt exceeded 100 percent of GDP and the fiscal deficit
stood below the reference value only due to its falsification by the Hellenic authorities.
The countries which joined the EU in 2004 and 2007 announced – even well before accession
– quite ambitious plans as regards the timing of euro adoption. The then governor of the
Polish central bank, Leszek Balcerowicz, had already pointed out in 2001 that an early entry
of the candidate countries into EMU would allow them to start reaping the related advantages – more price transparency, reduced transformation costs, stronger macroeconomic
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Wilhelm Salater
framework – at an earlier date. A fast and sound economic growth was rather seen as
achievable inside the euro area than outside it, before joining it. A quick – even forced –
nominal convergence process was deemed a price worth paying for arriving early in
In addition, many new member states experienced a kind of real convergence fatigue after
joining the EU, while there was some fresh enthusiasm for achieving nominal convergence
and entering the euro area. The Maastricht criteria were definitely fancier than the ones
concerning the real economy and the mirage of the Promised Land was still intact…
However, these admission criteria had an “original sin”: they were designed for countries
with relatively small gaps in terms of real convergence, as their adoption took place well
before the euro area came into existence. The Maastricht criteria were formulated having in
mind the goal of establishing the euro area rather than its future enlargement. The particular
economic conditions of the Central and Eastern European countries which joined the EU in
2004 or afterwards were not taken into account at all in the early 1990s. This is the main
reason why all the criteria regard the field of nominal convergence. As it is hard to imagine
that the Maastricht Treaty could be formally adjusted to include additional convergence
indicators for testing the level and the sustainability of convergence, the criteria are to remain
as they are. However, their interpretation by the EC and the ECB might suffer some changes.
An extreme case of the “shortcut to heaven” approach – one circumventing the obligation to
fulfil the nominal convergence criteria – is the unilateral euroisation. A small country outside
the EU did it in 2002: Montenegro unilaterally adopted the euro after the Deutsche Mark had
been its currency since November 1999. Even if Montenegro is not part of the euro area,
unilateral euroisation was advocated by some economists (Nuti, 2002; Buiter and Grafe, 2002;
Rostowski, 2002) as an adequate solution for the non-euro EU countries. In the context of
free capital movements, they saw it as a way to avoid the risk of speculative attacks against
the currencies of these countries in the period of at least two years inside ERM II imposed by
the Maastricht exchange rate stability criterion.
The EU authorities rejected this type of shortcut to euro, indicating that they regarded the
adoption of the euro by the EMU applicant countries as the final result of an orderly
adjustment process ensuring the progress of both nominal and real convergence. The
premature exposure of not sufficiently flexible emerging economies to the strong discipline of
the euro was seen as extremely risky. It was therefore evident that – beyond the fact that it
would breach the principle of equal treatment – allowing a country to take a shortcut to the
euro rather than following the official roadmap could be unwise as a sustainable convergence
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that is conducive to the maintenance of price stability and to the coherence of the euro area
may not have been achieved; moreover, unilateral euroisation would not ensure that the
authorities of the country in question pursue the right policies to thrive in the euro area.
Consequently, newcomers to the euro area are expected to enter through the front entrance
after meeting the Maastricht criteria (including spending at least two years inside ERM II),
not via the backdoor (Stark, 2008).
A different case of shortcut to euro – which, unlike unilateral euroisation, did not imply
taking on the single currency without satisfying the Maastricht criteria – was represented by
the countries having in place euro-based currency board arrangements. The currency boards
of Bulgaria, Estonia and Lithuania deviated from the textbook ones (examples of major
departures being the active use of minimum reserve requirements, the preservation of the
function of lender of last resort or the existence of government deposits with the central
bank), as their design reflected an effort to find adequate compromises between credibility
and flexibility and between rules and discretion (Salater, 2004). Even so, these countries
preserving their currency boards until euro area entry were confronted with the “impossible
trinity”, as they had a firmly pegged exchange rate, a fully open capital account and a strict
inflation target – represented by the reference value of the specific Maastricht criterion – the
attainment of which, in the absence of an independent monetary policy, was a major hazard
(Lithuania breached the criterion by just 0,1 percentage points in 2006, when its first
application to join the euro area was rejected). Moreover, the Balassa-Samuelson effect –
deemed by many economists at the time as a major obstacle to meeting the Maastricht
criterion regarding price stability – fully translates in the inflation differential against the
euro area, a nominal appreciation being not possible under a currency board arrangement.
It is questionable whether the Maastricht exchange rate criterion should be considered
fulfilled amid the preservation of these arrangements during the mandatory ERM II stay.
However, as the euro-based currency boards were eventually deemed by the EC and ECB as
compatible with the adherence to ERM II, a problematic double regime shift in these
countries – first from a hard peg to an exchange rate fluctuation band and then to the single
currency – was avoided.
Beyond the special cases of unilateral euroisation and currency boards, the “shortcut to
heaven” approach to euro area entry gave birth to a tendency to treat the set of nominal
convergence criteria as a “Procrustean bed” with negative effects on the economies having to
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Wilhelm Salater
meet them. Before or immediately after their EU accession, for many countries aiming at a
fast euro area entry, the fulfilment of the Maastricht criteria looked like a bridge too far
(Salater, 2005).
Against this background, it was argued that, as these economies were far from being similar
to the ones already integrated in the Economic and Monetary Union (EMU), an even more
flexible interpretation of the nominal convergence criteria would be advisable in their case,
although it would breach the principle of equal treatment. Jonas (2006) formulated some
difficult questions whose open debate was deemed necessary (see Box III).
Does the emphasis by the European institutions on upholding the rules
pose a problem?
What is the risk that excessive emphasis on rules relative to discretion
would force the Central and Eastern European countries to pursue
economic policies that would be damaging to their economic performance
and slow down their real convergence with the more advanced European
Is there a risk that a further relaxation of rules and application of more
discretion in managing the process of EMU enlargement would weaken
the credibility of legal and institutional framework in the monetary
In order to deliberate on these issues in a constructive manner, it is essential to identify and
assess the alleged imperfections of the Maastricht criteria perceived as making the strict
adherence to them dangerous to the economies of the euro-area candidate countries.
Some major arguments in favour of the claim that old rules are not necessarily adequate for
new members are related to the price stability criterion. The most prominent two of them
regard the terms of the formula used for determining the reference value for the inflation
Firstly, it is argued that, in order to preserve its relevance for the nominal convergence
process, this criterion needs to be adapted to the fact that the euro area exists. Gros (2004)
pointed out that the original formulation of this criterion, which linked the reference value to
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the inflation rates of the three best performing EU member countries, understandable when
EMU was first constituted, no longer makes sense at a time when the euro area is a reality.
The larger the number of EU countries, the higher the probability for the three best
performing member countries not to be inside the EMU. Even if they were part of the euro
area, their extremely low values might not be in line with the inflation rate prevalent in the
EMU. It is quite difficult to see the added value of converging to inflation rates much lower
than the one of the euro area...
A way out was offered by Schadler (2004): an interpretation of “the three best-performing
Member States in terms of price stability” as those nearest to the ECB’s inflation objective
(close to, but below 2 percent) would render a ceiling of about 3 - 3.5 percent, thus avoiding
imposing excessively low inflation rates in the euro-area applicant countries. Another
reasonable solution could be the use of the average inflation rate in the euro area – instead of
the ones of the three best-performing Member States – for determining the reference value
(Darvas and Szapáry, 2008).
Applying one of these suggestions would have prevented bizarre readings of the price stability
criterion like the one in the 2016 edition of the Convergence Report – as all the three bestperforming Member States recorded deflation, the reference value for April 2016 stood at no
more than 0,7 percent. Under these conditions, the price stability criterion is not fulfilled, for
example, by Sweden, with a low inflation rate of 0,9 percent (well below the Riksbank target
of 2 percent) and a negative policy rate. Not to mention that, in general, economies with
negative inflation rates should rather be seen as sinners than saints (or best performers) in
terms of price stability…
Secondly, the 1.5 percentage point spread vis-à-vis the average inflation rate of the three best
performers was viewed by some economists as insufficient enough to accommodate the
estimated magnitude of the Balassa-Samuelson effect in some euro-area candidate countries.
The fulfilment of this criterion by forcing a substantial nominal appreciation could lead to an
unsustainable level of the exchange rate, resulting in devastating effects on the external
competitiveness of the tradable sector, a collapse of the exchange rate before joining the EMU
or an overvalued final conversion parity against the euro (Kopits, 1999; Rostowski, 2002). As
Szapari (2001) stressed, there is no economic logic behind requiring similar levels of inflation
from countries at different stages of economic development. The Maastricht inflation
criterion can be met by resorting to very tight monetary and fiscal policies that reduce the
pace of the economic growth, partly via a nominal appreciation of the exchange rate. The
excessive strictness of the inflation target may lead to a “weighing-in” syndrome during the
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Wilhelm Salater
run-up to the EMU, consisting in an inter-temporal substitution of the economic growth. In
such a scenario, growth is temporarily repressed in order to meet the inflation criterion in the
period relevant for the nominal convergence assessment; once the euro area membership is
obtained, no constraints on the national inflation rates apply. The temptation to meet the
Maastricht criteria as soon as possible could also lead to the postponement of structural
reforms that are important for the real convergence, as national authorities may adopt a “low
inflation now, reforms later” approach (Bulíř and Hurník, 2006).
Buiter and Grafe (2002) went even further in criticizing the price stability criterion: as the
monetary union is the means par excellence for achieving inflation convergence (up to a
Balassa-Samuelson differential), their belief is that making inflation convergence a
precondition for entering a monetary union is putting the cart before the horse. Moreover,
the monetary policy credibility built in time with substantial efforts by the central bank of the
candidate country in order to be able to fulfil the severe inflation criterion becomes useless
once the single currency is adopted. As inside the euro area there is a single monetary policy
entrusted to the ECB, the accumulated reputational capital is scrapped.
The same authors argued against the mandatory stay in the ERM II, qualified as an
“unnecessary and uncomfortable purgatory” on the road to the “heaven” represented by the
euro area. They highlighted that the history of the pursuit of two nominal targets – or one
nominal target subject to a nominal constraint, as in the case of the inflation target associated
with the Maastricht price stability criterion having to be met in the context of operating an
exchange rate band – was not a happy one.
It would be pointless to request candidate countries to undergo such a risky experiment after
the full capital account liberalisation required for the EU accession. It could be wiser to
acknowledge that the ERM II may not be suitable under conditions of substantially increased
international capital mobility and for countries with more integrated economies and financial
systems (Rosati, 2001).
In order to limit the danger of speculative attacks during the two or more years spent in ERM
II, Wyplosz (2002) recommended an ex post application of the Maastricht exchange rate
criterion for the countries that run flexible exchange rate regimes. Avoiding formal ERM II
membership might be a way to allow inflation targeters to maintain a free or managed float
instead of introducing an exchange rate band which, at some point in time, might become
inconsistent with the inflation objective. Since trying to simultaneously reach the inflation
and exchange rate objectives under an inflation targeting regime might prove very
challenging for monetary policy, as one cannot rule out the case when either the exchange
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rate band or the inflation target would be sacrificed at the expense of the other, such a
solution could be appropriate.
In fact, a major source of perceived fragility of the ERM II was its standing among
intermediate exchange rate regimes. This was seen as problematic, especially at a time when
the move from soft pegs towards the corner solutions of hard pegs and floating (or, in terms
of monetary policy regimes, currency boards and inflation targeting) was widely seen as the
right response to the impossible trinity (Salater, 2002). If what Fischer (2001) called the
bipolar view is correct, ERM II is not a viable arrangement. However, it can be argued that its
multilateral nature and the existence of an exit strategy (to the euro) make the ERM II less
subjected to the weaknesses usually associated with intermediate regimes; in this sense, ERM
II could be classified as an intermediate regime only in that it is intermediate to the euro area
entry (Mihaljek, 2004).
Right or wrong, the “Procrustean bed” approach to the Maastricht criteria – in fact, to the
two of them concerning price and exchange rate stability – remained quite popular as long as
a rapid catching up occurred in the Central and Eastern European economies amid massive
capital inflows and as the euro area looked like the place to be, entailing ambitious accession
As the global crisis revealed that life inside the euro area is not easy, the enthusiasm of many
EU new member states for an early entry was replaced by a “wait and see” approach.
Numerous theorists and policymakers realized that euro area membership was rather a twoedged sword than a free lunch, as the drawbacks might outweigh the benefits.
It became increasingly clear that adopting the euro too soon would be much more dangerous
than entering the EU without being thoroughly prepared – the second option has at least a
few favourable implications for the process of real convergence. Mühlberger (2008) identified
five drivers of real convergence on which the EU entry exerted a substantial favourable
impact in the cases of several new member states. Three out of these five determinants are
directly observable: the depth of the financial sector, the real capital and the openness of
external trade. The power of the three above-mentioned drivers was considerably enhanced,
as the EU membership – or just its prospect – brought about higher involvement of Western
European banks, raising foreign direct investments and free exchange of goods and services.
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What is valid for the EU as a whole is, however, not manifest at the level of the euro area. In
spite of what was initially hoped for, euro adoption – unlike the EU entry – is not able to act
as a catalyst for real convergence. As the dispersion of per capita income levels has increased
overall for the euro area countries (in the EA 12 composition), it is obvious that there are no
automatic mechanisms to ensure that the process of nominal convergence which occurs
before the adoption of the single currency produces sustainable real convergence after the
euro area entry (ECB, 2015). Consequently, a too fast euro adoption might stop – or even
reverse – the catching up of a country. The example of Greece is highly relevant in this
With a view to avoiding such developments, each euro-area candidate country should strive
to put its house in order before taking on the single currency, being aware that the mere
fulfilment of the Maastricht criteria is not enough to warrant a robust economic performance
in the euro area. As Isărescu (2013) pointed out, in the absence of an independent monetary
policy, an ample real convergence gap might complicate the business cycle management. But
the Euroland should put its own house in order as well in order to be attractive to other EU
countries again, as it became obvious during the crisis that it had not become a hurricaneproof building yet. As what Issing had already noticed in 2006 – “we had to manoeuvre
through uncharted waters and we may not yet have arrived in the Promised Land” – is still
valid, the architecture of the EMU has to be strengthened in order to further improve its
resilience. While the enlargement of the euro area is a challenge, the consolidation of its
internal governance is a must. In this context, the evaluation of the preparedness for the euro
area entry is an exam – a very difficult and complex one! – for both the candidate and the
examiner. And the two parties involved should be aware that preparedness means being
ready for the worst...
The Maastricht criteria remain a handy formal and quantifiable measure of readiness for the
adoption of the euro (Lavrac, 2004) and an important part of the admission test. However, it
is clear that they are not able to tell the whole story. The relevant picture is certainly much
bigger: real convergence indicators or the scoreboard ones have to be carefully taken into
account when assessing the adequate timing to adopt the euro. Moreover, all these indicators
should not just be met in order to pass the exam – they must be fulfilled in a sustainable
manner. If not steered along these coordinates, the EMU enlargement will generate a much
more heterogeneous euro area, in which a one-size-fits-all ECB monetary policy will be just
wishful thinking.
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Half-jokingly, Belka (2014) proposed an original test for joining the euro area: if a country
does not have an economy as competitive as Switzerland’s, a labour market as flexible as
Denmark’s and public finances as disciplined as Estonia’s, it should think twice about
adopting the euro. These tough criteria give a sense of the scale along which countries should
measure their capacity to perform well inside the euro area. Ignoring the importance of
substantial progress in the above-mentioned areas and attempting an early euro adoption by
meeting the Maastricht criteria as soon as possible means accepting to endure too much pain
for too little gain, if any…
Nothing new, as a matter of fact: long before the outbreak of the global crisis, when many
economists approached the nominal convergence criteria as a shortcut to heaven or as a
Procrustean bed, Remsperger and Mersch – among other central bankers from the euro area
countries – stressed that EMU entry before sustainable convergence had been achieved could
prove to be a serious mistake. For example, by forgoing too early the possibility of using the
exchange rate as an adjustment instrument, the external competitiveness of a country could
be severely endangered. It is vital to fulfil both the Copenhagen and Maastricht criteria for
enlargement to actually be fulfilled, as nominal and real convergence are two sides of the
same coin. Before a country can join the euro area, it really needs to be a case of Maastricht
meeting Copenhagen (Remsperger, 2001). The second Copenhagen criterion clearly indicates
that, in order to enter the EU, a country has to demonstrate its capacity to cope with
competitive pressure and market forces. Even the Maastricht Treaty clearly spells out that the
criteria must be fulfilled in a sustainable way and there is no such way unless the catching up
in real terms is pursued in parallel (Mersch, 2002).
However, there is good news, which deserves to be pointed out: the steady shift in the general
attitude towards the convergence requirements from the “Maastricht criteria are too severe”
message of the “Procrustean bed” approach to the “Maastricht criteria are not enough” view
gaining ground in the post-crisis period. The fact that the Maastricht criteria are far from
being perfect is not a reason to reject the need to achieve durable economic convergence prior
to the euro area entry. The prevalence of a prudent approach to adopting the single currency
at a time when the nominal convergence criteria are attained or within reach in many noneuro EU countries suggests that this lesson has been learned.
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While there is enough empirical evidence that the EU accession supports real convergence, it
is equally obvious that the euro area is far from being the convergence club it once promised
to be. Against this background, euro adoption is not at all a cure for every economic disease
and the preparedness to successfully join the euro area implies much more than just
satisfying the Maastricht criteria at some point in time. These criteria remain useful tools to
assess nominal convergence, but their fulfilment is not enough for a country to be able to
perform well inside the euro area.
As it is very difficult to change the rules during the game (i.e. to formally adjust the euro area
admission criteria), it is more practical to look for additional tools – including real
convergence measures and scoreboard indicators – for a proper assessment of the level of
preparedness to enter the euro area, with the focus on finding the optimal trajectory toward a
high degree of sustainable convergence in both nominal and real terms. Otherwise, the EMU
enlargement process will lead to a much more heterogeneous economic area than it already
is, increasing the risk of a one-size-fits-none ECB monetary policy.
It is therefore in the best interest of the EU countries seeking to take on the single currency to
look more to what the economic convergence involves beyond the fulfilling of the Maastricht
criteria than to what stood behind them at the time of their adoption. Comparing investments
to baseball, Warren Buffet once said that to put runs on the scoreboard, one must watch the
playing field, not the scoreboard; likewise, in order to be able to take advantage of the euro
area membership, one should not watch the table with the Maastricht criteria, but the
economic convergence process as a whole.
The path to Euroland is not an against-the-clock race in which the fast one wins, but rather a
long-term endeavour at the end of which the prudent and coherent one can reap the benefits
and minimize the costs. Meeting the Maastricht criteria and joining the euro area should not
be built on untenable foundations. As steadiness counts much more than speed, the fast track
is not necessarily the right track.
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Balcerowicz, Leszek, “The optimal timing and path for Poland’s entry into EMU”, speech
at the 11th European Banking Congress in Frankfurt, 23 November 2001.
Belka, Marek, “Monetary policy challenges in a non-euro EU country”, speech at the
Euro50 Group Meeting “The Eurozone in the aftermath of the Euro Crisis”, Washington
DC, 12 October 2014.
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Accession Countries” Working Paper, No. 3184, CEPR, London, January 2002.
Bulíř, Aleš; Hurník, Jaromír, “The Maastricht Inflation Criterion; How Unpleasant Is
Purgatory?“, IMF Working Papers 06/154, 2006.
Darvas Zsolt; Szapáry, György, “Euro Area Enlargement and Euro Adoption
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12. Kopits, George, “Implications of EMU for Exchange Rate Policy in Central and Eastern
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of the Association des Cambistes d’Internationaux, Luxembourg, 25 May 2002.
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Europe?”, paper presented at the conference “Emerging markets and global risk
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Monetary Union: Maastricht meets Copenhagen”, speech at the annual meeting of
ELEC, Frankfurt, 7 December 2001.
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Questions”, paper presented at the conference “Management of Capital Inflows in
Transition Economies”, ICEG, Budapest, October 2001.
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Euroization” in “Financial Vulnerability and Exchange Rate Regimes. Emerging Markets
Experience” (eds. Blejer, Mario and Škreb, Marko), MIT Press, Cambridge, 2002.
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Inflation Targeting versus Currency Board”, paper presented at the conference “Exchange
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of modern currency boards” in Kovacevici, Dragan (editor): “Modern-Day European
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The Changing Faces of the Maastricht Criteria: from a Shortcut to Heaven to Just Another Exam via a Procrustean Bed
26. Szapáry, György, “Maastricht & The Choice of Exchange Rate Regime in Transition
Countries during the Run-up to EMU”, ENEPRI Working Paper No. 6, May 2001.
27. Wyplosz, Charles, “The Path to the Euro for Enlargement Countries”, Briefing Note to
the Committee for Economic Affairs of the European Parliament, May 2002.
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of
Quantitative Easing Policy and Market Turmoil
Andreea Oprea*
In times when financial markets around the world seem to be affected by unprecedented
levels of uncertainty, we wish to analyse the behaviour of gold price on a background of
unconventional monetary methods and market volatility. Since interest rates play a key
role for the Quantitative Easing policy, we will also observe the dynamics of gold and bond
markets in parallel. We will conduct an empirical analysis to check whether the expected
inflation (using break-even inflation rate as a proxy) is a significant predictor for bond and
gold returns, given the property of these assets to act as “safe havens” in times of market
bond market, gold market, quantitative easing, break-even inflation, volatility smile, gold
JEL Classification:
G10, G13
Graduated of the Doctoral School of Finance and Banking (DOFIN) MS programme (2016);
corporate and retail sales trader in the Treasury and Financial Market Division of Piraeus Bank
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
The reason we focused our attention on gold was the recognized feature of this asset to
behave as a hedge against most investment tools. What is even more important, considering a
situation of persistent market uncertainty, is that gold also proved to be a safe haven asset.
While both the hedge and safe haven are defined to go uncorrelated or negatively correlated
with other assets, the latter has the unique property of behaving in such a way in times of
market stress or turmoil1. Being a store of value, gold also represents a hedge under
inflationary pressures; however, given the current situation, when central banks across the
world make efforts to boost economic growth in episodes of liquidity injections, it would be
unrealistic to perform this analysis without taking into account the possibilities of a
deflationary environment as well.
Of all the main drivers of uncertainty we mention the unknown long term effects generated
by the unconventional methods of monetary policy. As a repercussion of the financial crisis
started in 2008, and after all the traditional measures had been exhausted, central banks
across the world adopted Zero Interest Rate Policies (ZIRP) and Large-scale asset purchases
(LSAP) or Quantitative Easing (QE), as it is better known, with the aim of price stabilization
and, in the case of the Federal Reserve, also for employment maximization purposes. Central
banks use Quantitative Easing measures in order to increase the money supply in an
economy; in contrast with the traditional tool of targeting the overnight interbank interest
rate2, under QE central banks purchase financial assets via open market operations.
Quantitative Easing became widely used with the start of the financial crisis (the alternative
monetary policy of banks such as the Federal Reserve, European Central Bank or Bank of
England), but the pioneer was Japan in the early 2000. Later on, between 2014 and early 2016,
central banks in the euro area, including central banks from Denmark, Sweden, Switzerland
and Japan implemented Negative Interest Rates Policy (NIRP), breaking this way the zero
lower bound3. Interest rates below zero imply that commercial banks must pay in order to
place deposits at the central banks. Although the main purpose of NIRP is to fight
deflationary pressures, until now its short- and long-term repercussions seem to be of
obscure nature. Given the eroded confidence of the markets in the effectiveness of
Quantitative Easing policy in stimulating economic growth, the demand for gold as a highreturn generated asset might start knowing a continuous, sustainable increase. Distributions
of historical returns show that gold returns are, in general, more than double than their longterm average, under low rates circumstances 4.
Apart from gold, government bonds are prone to be chosen by investors in times of market
turmoil because of their low risk nature. However, in a low-to-negative yields environment,
the bond market might perform poorly and other instruments, such as gold, might become
the preferred solution for mitigating risk and generating portfolio diversification.
Central Bank Journal of Law and Finance, No. 1/2016
Andreea Oprea
As previously mentioned, both gold and bonds represent good choices for investors in times
of high market stress. While gold tends to store its real value in the long run, short-term
factors might drive the price of the precious metal away from its long term equilibrium for
extended periods of time5. We considered the beginning of 2008 an important threshold in
separating the performance of gold and bond markets under conventional and nonconventional monetary policies respectively; and even though the pioneer of this policy was
Japan, in the early 2000, it was under the 2008 crisis when Quantitative Easing became a
measure of last resort for most central banks including the Federal Reserve, European
Central bank and Bank of England.
Quantitative Easing measures aim to sustain economic growth by increasing the money
supply in the system. When this is done via bond purchasing, yields on the fixed income
market face a downward pressure, enabling businesses to raise capital at a lower cost; and
this is a brief scheme on how unconventional monetary policies are intended to work.
However, before reaching the ultimate goal of the economic growth, easing monetary policies
might lead to additional ramifications upon which markets could speculate. For example,
since Quantitative Easing is expected to help maintain a healthy rate of inflation 6, then we
can judge in advance and expect Gold to be a good performer, considering its “inflation
hedge” property. At the same time, we would expect both gold and bonds to perform well
given the uncertain financial and economic environment, where agents might be more prone
to cover risks rather than maximizing returns. A question that, therefore, derives in the case
of bonds is to what extent the investors will be willing to allocate money for instruments that
- due to Quantitative Easing measures - only foresee lower and lower yields. In other words,
would there be a point in investors ceasing to invest in low-risk assets, even when market
turmoil is present? And, in that case, would the reduction in bonds automatically imply an
increase in Gold holdings in a portfolio optimization problem?
Looking at the graphic below, containing the price of Gold (XAUUSD), the 10-Year US
Treasury yield (US10Y) and the 10-Year US Inflation Break-even (ILBEUS10Y), we notice a
long period after the start of the crisis in 2008 when the price of Gold and the benchmark of
the US bond market went uncorrelated, in line with the assumptions made above: market
stress and rising inflationary expectations consistently sustained the price of the precious
metal, while bond yields followed a clear downward pattern.
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
Figure 1: Evolution of Gold Price, 10-Year US Treasuries and 10-Year US Inflation
Breakeven Rate before and after 2008
Source: Thomson Reuters, Bloomberg, own computation
The analysis we performed on the aforementioned data revealed a significant negative
correlation between 10-Year US Treasury yields and the price of gold both before and after
the crisis from 2008 (and implicitly before and after the unconventional monetary policies
became widely used). The difference lies in the degree of correlation: a coefficient of -0.36
before 2008 versus a correlation coefficient of -0.61 after 2008 (Appendix 1). A visual
representation (displayed as a scatter plot) of the correlation between 10-Year Treasuries and
the price of Gold before (BC) and after the crisis (AC) is exposed below:
Figure 2: Scatter Plots XAU vs. 10Y-US Treasuries before and after 2008
Source: Thomson Reuters and Bloomberg data, Eviews mining
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Andreea Oprea
When considering the Gold return distributions for the period before and after the beginning
of 2008, we notice that, following the crisis, returns unveiled a more left skewed tail and a
lower kurtosis; moreover, we can affirm that in comparison to the distribution of returns
prior to the 2008 crisis (which displayed a higher kurtosis, therefore a higher probability of
extreme events), the post-crisis period showed something resembling much more a normal
distribution. The Jarque-Berra tests for normality (Appendix 2) support our visual intuition
and prevent us from rejecting the null hypothesis of normality in the case of post-crisis Gold
Figure 3: Distributions for XAU Returns before and after 2008
Source: Thomson Reuters and Bloomberg data, Eviews mining
Going one step forward with the correlations between the price of gold and the elements from
the bond market, two well-known indicators of market turmoil and increased risk aversion
are worth mentioning: the first one is the so-called “Ted” spread –the spread between the US
3-month T-bill and the 3-month US interbank rate, while the second is the spread between
low and high-rated corporate bonds (e.g. the BBB-AAA spread). These stress measures
revealed high correlation with gold prices in times of market crashes (1987) and during the
financial crisis (2007-2009). Sharp spikes in the “Ted” spread are most often associated with
significant rises in the gold price7.
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
Figure 4: 4 Gold vs. Ted Spread and Gold vs. BBB-AAA Spread
Source: Oxford Economics, The Impact of Inflation and Deflation on the Case of Gold
But how should we judge, however, if we were to compare and choose between the two assets,
gold and bonds? Since we have concluded that bonds stop being appealing in a world of
negative interest rates, we should first try to find a reason why levels have gone so low and
the easing policy’s effects barely seem to come up.
An interesting explanation – according to which central banks adopting Negative Interest
Rates Policy are only chasing tails – can be found in the bond market, more precisely in the
Treasury Inflation Protected Securities (TIPS) market. These types of papers differ from
nominal bonds in the sense that coupons and principal payments for TIPS are adjusted with
the Consumer Price Index (CPI) inflation. Due to indexation, both coupon and principal
payments are fixed in real terms, namely on an inflation-adjusted basis8. In case the level of
future inflation was known, the price of an inflation-indexed bond, issued at time t, at par
value, with maturity N and coupon c, would be:
represents the zero-coupon nominal interest for n-periods, at time t,
represents the average annualized rate of inflation.
Central Bank Journal of Law and Finance, No. 1/2016
Andreea Oprea
More specifically, the price of Treasury Inflation Protected Securities represents the
discounted sum of future nominal payments, adjusted with the Consumer Price Index. What
we observe from the above formula is that an inflation-indexed security is actually valued as a
regular bond, but discounted by using real interest rates instead of nominal ones.
The spread between a nominal bond and Treasury Inflation Protected Securities – also
referred to as inflation breakeven – is influenced by the investors’ expectations regarding the
future inflation.
In case investors were neutral to risk, the breakeven inflation would have to equal (or be very
close to) the annualized cumulative inflation rate that agents assume over the maturity of a
security. The explanation lies in the fact that risk-neutral investors would demand the same
expected real return for both types of securities. However, complications arise because of the
uncertainty related to future inflation:
can be rewritten as:
From equation (3), the uncertainty regarding inflation will cause the inflation compensation
to be lower than the expected inflation. This relationship arises because higher inflation
deteriorates real returns at a slower pace than lower inflation boosts it. However, not only
convexity tends to have an influence on inflation break-even, by pulling it down in relation to
the expected inflation. Risk-averse investors might demand an inflation risk premium which
moves in the opposite direction. This premium would therefore increase the cost of Treasury
Inflation Protected Securities over nominal securities.
Coming back to the actual economic environment, where central banks around the world are
struggling to boost economic growth via easing monetary methods, what would be the benefit
of holding inflation-indexed bonds? Indeed, there seems to be no rational explanation for
carrying out such instruments, especially if we also consider that some banks adopted the
Negative Interest Rates Policy. Still, the inflation-indexed bond market does have a valuable
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
purpose: it provides important information regarding the market’s expectations of future
Negative Interest Rate Policy might have just the opposite result of what policy makers
expect, since a shock in the bank’s profitability, and hence in their balance sheets, would
most probably lead to the financial markets losing trust in the negative interest rates policy.
In addition, as interest rates and bond yields turn negative, they will also start dragging down
inflation expectations. Scott Mather, a chief investment officer at the global bond fund
PIMCO (Pacific Investment Management Company) believes that a continuous downward
pressure on nominal yields would not only put pressure on the real component as it should
be, but also on the inflation component9.
Expectations of further low inflation would just cause agents to postpone consumption and
therefore maintain a low level for prices. This way, negative interest rates policies simply end
up chasing their tail, as we previously stated. An aspect from market psychology best explains
this behaviour, since the demand for inflation-protected instruments increases the most not
when high inflation is expected, but when the realized inflation actually prints high, which is
a backward looking approach.
In comparison with inflation-protected securities, gold investment is not only an investment
product aimed at hedging inflation risk, but it is also an alternative in times of deflation10. To
support this idea, the World Gold Council’s report from 2011 showed that even though assets,
such as equity and bonds, outperformed gold in times of moderate inflation, the return on the
precious metal proved to be superior in periods of both high inflation and deflation.
More recently, in 2016, the same World Gold Council has performed an analysis showing that
current bond yields are a good predictor for future returns, so bond holders should expect
further low, even negative returns on a background of negative interest rates policy. The
study has empirically proved that, in periods of negative real interest rates, returns on gold
investments were more than double than their long-term average and that investment in
bonds might be less effective than gold in diversifying portfolio risk under negative or zero
interest rates policy. Not only investors have used gold as means of diversification, but also
central banks; in the second half of 2015 alone, central banks increased their reserves by over
336 tonnes of gold.
Central Bank Journal of Law and Finance, No. 1/2016
Andreea Oprea
In order to check the impact of inflation expectations on gold and bond returns, we
performed an empirical analysis, using gold prices (in XAUUSD - USD per ounce), 10-Year
US Treasuries since they represent a benchmark markets always look at, and the 10-Year
breakeven inflation for US Treasuries. We therefore wanted to test whether the breakeven
inflation rate, used as a proxy for inflation expectations, was a significant predictor for gold
and bond returns. The intuition behind this relationship is that once an agent has knowledge
about future inflation, he would speculate upon gold prices and therefore increase his return.
Analysis was performed with monthly data from 1998 to June 2016 and split in two periods,
before and after the crisis from 2008, when unconventional monetary policy tools started to
be used. While gold returns and breakeven inflation proved to be stationary when applying
the Unit Root test Augmented Dickey Fuller (ADF), for the bond yields we had to take the
first difference to make the series stationary (Appendix 3). After solving the stationarity
aspect, six regressions based on ordinary least squares method were performed: we regressed
gold and bond returns on inflation breakeven rates 3 times, for the whole range of data, and
separately for pre- and post-2008 crisis.
A visual inspection of the residuals guided us to search for ARCH (autoregressive
conditionally heteroscedastic) terms in the case of gold returns over inflation breakeven for
the whole set of data. Regarding the case of bond returns over inflation breakeven, we
observed the clustered volatility for the whole range of data and for the after-crisis data taken
separately. By observing the clustered volatility we defined periods of low volatility followed
by periods of low volatility, and periods of high volatility followed by periods of high volatility
as well.
Figure 5: Clustered Volatility for Gold (left) and Bonds (right) Returns Regressed
over Inflation Breakeven (1998-2016)
Source: Thomson Reuters and Bloomberg data, Eviews mining
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
However, when applying the LM (Lagrange Multiplier) Arch Test, under the null hypothesis
of no ARCH (autoregressive conditionally heteroscedastic) effect, we found proofs of ARCH
effects in the case of Gold return regression (for all data implied) and for Bond returns (all
data and after-crisis data). Following the methodology used by Sadaf Zafar and Yasmin
Javid11, we further analysed the impact of the expected inflation (using the 10-Year US
breakeven inflation as proxy) on gold and bond returns adding ARCH and GARCH
(Generalized AutoRegressive Conditional Heteroscedasticity) specifications, but not ARMA
(Autoregressive-moving-average) terms, since the correlograms for gold and bond returns
revealed no autocorrelation (Appendix 4):
The gold and bond returns in our regressions are represented by the dependent variable ,
while the explanatory variable is the breakeven inflation. The error term is normally and
independently distributed with the mean zero and conditional variance . As previously
mentioned, since we found proofs of clustered volatility, we also allowed residuals to be
explained by the squared error terms of past moments (ARCH (autoregressive conditionally
heteroscedastic) term, first summation term from equation (5)) and by their own historical
lags (GARCH (Generalized AutoRegressive Conditional Heteroscedasticity) term, second
summation term from equation (5)).
In none of the cases discussed, inflation expectations represented by the 10-Year breakeven
inflation rate proved to significantly predict the returns for gold and bonds respectively,
under a significance level of 5%. This result could be interpreted in more than one way: on
the one hand, the 10-Year breakeven inflation might not represent a good proxy for the
expected inflation. In this case, we suggest, as further direction, the use of different proxies,
such as the breakeven inflation for tenors other than 10 years.
The problem with using breakeven inflation as a proxy for the expected inflation is that it
might not rely on the choice of tenor though. Some studies show that in times of market
turmoil the poor liquidity of TIPS lead to distorted information contained in their price 12. A
very intuitive explanation for this phenomenon is that treasury inflation-indexed investors
request extra compensation for holding these less liquid assets, generating an upward
pressure on the Treasury Inflation Protected Securities yields. This way, the breakeven
inflation level is pushed down below its fundamentals.
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Andreea Oprea
On the other hand, there is the backward looking approach that we have mentioned earlier; if
we assume markets distrust the future effects that Quantitative Easing policies are supposed
to have and rely on realized inflation rather than expected inflation, then we can understand
why treating breakeven inflation as a clean proxy for future inflation might result
Both the expectations regarding inflation and the gold market’s expectations themselves
could be suspected to have an influence on gold returns. Believing an asset is going to move
in a certain direction will determine a certain present action and that action will have a direct
impact on the asset’s price. This is how expectations indirectly affect the price of an asset:
they offer information regarding probable future actions of market’s players and it is the
concretization of those actions that will actually drive the evolution of a specific asset. Betting
on market’s expectations is actually making assumptions on the agent’s future actions.
From this point of view, current option primes with the underlying price of gold (XAU) could
offer a view on how the market is positioned. In addition, options might also provide
information regarding the moment a certain movement, of significant amplitude, is most
probable to take place. A graphic representation of the way in which investors perceive future
volatility is called volatility smile; the name is extremely suggestive, since it appears to be
similar to a smile.
In essence, in the case of a perfect volatility smile, at-the-money options display the lowest
implicit volatility, and it increases symmetrically as options become more in-the-money or
out-of-the-money (Call options are ITM when the strike price is lower than the spot price of
the underlying asset; on reverse, Put options are ITM when the strike is higher).
First volatility smiles were observed in 1987. Before this year, the smile had actually been a
horizontal line, suggesting that the function between implicit volatility and strike price had
rather been a constant. The market collapse from 1987 brought significant changes in the
pricing of options, since traders have been forced to accept that one single trading day can
generate huge losses.
The implied volatility of an asset is calculated through an evaluation model that gives the
prices of the primes; the name implied is given because even though the volatility represents
an explanatory variable, it is deduced subsequent to the calculation of the prime. A high
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An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
implied volatility suggests the market is unsure regarding the price evolution, therefore the
option prices (primes) will be higher.
Figure 6: Gold Price (USD/ounce) vs. Gold Implicit Volatility (%) for 2M, 3M, 12M
Source: Thomson Reuters data, own computation
From the graphic above, we can observe that, until 2013, the 1-year implied volatility for Gold
derivatives had been higher than the volatilities of shorter tenors; this effect was ultimately
reversed, as the market started to perceive investments of longer tenors as more secure than
the ones of short maturities. We consider that a possible explanation for this phenomenon
lies in the decision taken at that point by most central banks to increase their Gold reserves,
on a background of increasing global debt and uncertainty regarding the economic stability.
The fourth Central Bank Gold Agreement signed by the European Central Bank and 20 other
central banks from Europe in May 2014 was explicitly limiting the gold sales to a maximum of
near 400 tonnes per year and 2,000 tonnes in the next five years. Moreover, with this signed
agreement, markets stopped fearing that a high amount of official gold would come onto the
market13 (a feeling which was among the heaviest contributors to the drop in price of the
precious metal after 2012).
A more recent event that marked the importance of Gold as a reserve asset was the
announcement made by the People’s Bank of China (PBOC) in July 2015 regarding the 57%
increase in gold reserves, namely up 604 tonnes from 1,054 tonnes in 2009. Suki Cooper,
Central Bank Journal of Law and Finance, No. 1/2016
Andreea Oprea
director of commodities at Barclays, NY, thought this action would give support to the price
of the precious metal. Indeed, we can observe from the graphic below that, subsequent to the
People’s Bank of China announcement, the price of Gold started to regain significant ground.
Figure 7: Evolution of Gold price, 10-Year US Treasuries and 10-Year US Inflation
Breakeven Rate after the 2008 Crisis
Source: Thomson Reuters data, own computation
Apart from the news and announcements referring to the Gold demand and official reserves,
the graphic above illustrates the evolution of the 3 elements introduced in Part 2 (Gold price,
10-Year US Treasury yields and 10-Year US Inflation Breakeven rates) exclusively after the
crisis, when the use of non-conventional monetary policies became the preferred measure of
most central banks.
In a study conducted at the European Central Bank14, the author Roberto A. De Santis proves
empirically that the Asset Purchase program does have an impact upon financing conditions
and, moreover, that it is time-persistent. Also, he adds-in a remark according to which the
analysis based on event studies might not be accurate due to the unrealistic hypotheses that
Quantitative Easing announcements are unanticipated, so they represent news for the
financial markets. Actually, Quantitative Easing purchases are not only anticipated by market
players, but also priced-in, which may diminish the effect of the QE policy based on a calmer
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An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
market background. Considering it would be naive to neglect the fact that market’s
expectations play a key role in the state contingency of Quantitative Easing effects, we find
that a proper interpretation of how markets are positioned is critical.
In general, in the case of Gold, the aforementioned volatility smile is not symmetric, but
skewed to the right (forward skew). This effect is based on the following argument: in the
case of commodities, the actions of the market would rather position towards assuring there
will be no sudden disruptions in the supply; this way, the implied volatility will increase in
the case of those options with higher strike. In order to explain this phenomenon as
practically as possible, we will make an analogy with a different commodity from Gold, one
more prone to undergo supply disruptions in the supply for certain agriculture products, the
market will put pressure on in the demand for Out-The-Money Call options.
The intuition behind is very simple: a frozen supply would lead to an increase in price, so the
market will buy Calls for protection; on the other side, given a high volatility environment
(translated in high probabilities of trend reversal), Out-of-the-Money options become the
most rewarding. Out-of-the-money options are significantly cheaper than the ones which are
in-the-money or at-the-money and offer the highest leverage in case the view of the trader
Figure 8: Three-Month Volatility Smile (%) for Gold (Mid Prices) (end of March 2016)
Source: Thomson Reuters data, own computation
The curvature or smile previously mentioned – that exists at any point in time- can turn
steeper in times of market turmoil. Also, a forward skew type of graphic appears as a
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Andreea Oprea
response to the probability of a market crush (even it is a very remote one); therefore, this
aspect illustrates that the option prices also include the risk of some severe market events.
Most often, in periods when the trend is bullish15, investors pay approximately the same
implied volatility for both out-the money Puts and Calls. There are, however, situations when,
on a bullish pattern, the prices for out-the-money Put options start to increase (due to a surge
in demand for this type of options). This phenomenon could be interpreted as a signal that
the market is expecting a decrease in price.
Figure 9: Gold Price vs. Implied Volatility for OTM PUT options at 12 M
Source: Thomson Reuters data, own computation
For example, we can observe that, when the precious metal knew an exponential increase more precisely 3 months before reaching its maximum of 1,883.7 USD per ounce in
September 2011 - the implied volatility for Out-The-Money Put options boosted from 33.09%
to 99.85%; this was a very strong signal that the markets were beginning to expect a crush for
the precious metal (despite the fact that the trend was still very bullish) and were initializing
transactions to hedge this risk; 3 months later, the investors’ expectations were confirmed:
within less than 2 years Gold lost 35.06% value, reaching 1,233.14 USD per ounce. The implied
volatility reached 2 more important spikes in 2013 and 2014, confirming that the markets
were still not expecting a recovery.
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An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
The aim of this article was to provide some in-depth approaches regarding the implications of
the most prominent conditions dominating the financial world nowadays – the use of easing
monetary policies and the persistence of uncertainty and market turmoil – on the evolution
of gold and bond prices. These two markets are analysed together for several reasons: first of
all, both types of assets are considered to be opportune hedging tools in times of market
uncertainty, when investors rather revert to the risk-off mood. However, during periods of
extreme turmoil (associated with dangers of financial crashes), gold goes beyond its hedging
property and becomes a safe haven.
Among the main reasons for which demand for gold rises in times of crisis, we mention the
pronounced declines and high volatility in other markets, such as the equity market.
Moreover, fears related to the lack of liquidity and the security of fixed income papers
(because of the probability of default) are heavy drivers of gold demand, since the precious
metal goes uncorrelated with the aforementioned assets in such periods.
Another aspect for which we have conducted an analysis of the relationship between gold and
bonds lies in the effects that expected inflation has upon both assets; in our opinion, the bond
market (in particular, the Treasury Inflation Protected Securities market) provides valuable
information not only in terms of expected inflation (through the break-even inflation
channel), but also as an explanation to why the desired effects of Quantitative Easing policies
barely seem to show up. The answer can be briefly explained through the following scheme:
at a theoretical level, the purchase of assets by central banks drags the yields down, which, in
turn, implies low capital costs for businesses and, therefore, creates the prerequisites for
economic growth.
In reality, the trajectory that Quantitative Easing effects follow is far more complex and this
is due to the way markets expect inflation: when nominal yields for classic bonds go down as
a result of easing policies, so do real yields for Treasury Inflation Protected Securities, but at
a faster pace. We explain, at Section 2, that this happens because higher inflation deteriorates
real returns at a slower pace than lower inflation boosts it. While market agents distrust or do
not trust enough the Quantitative Easing measures, they will keep expecting low rates of
inflation (something which can be quantified via the real yields for Treasury Inflation
Protected Securities). Expectations of low inflation will determine agents to postpone
consumption, which will further lead to a downward pressure on prices (so just the opposite
effect that Quantitative Easing is supposed to have).
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Andreea Oprea
When returning to Gold, we find that there are actually two main forces that might impact
the price of the precious metal: the uncertainty dominating the financial markets and the
Quantitative Easing measures that are intended to increase inflation, and therefore to boost
gold demand since it represents an inflation hedge. Moreover, in case our assumption
regarding the expected inflation holds (which would translate into a sluggish effect of the
Quantitative Easing monetary measures), gold might still perform well on a background of
negative interest rates. Therefore, both uncertainty and easing monetary measures should
give strong support to the price of Gold.
In the last part of the article we explain the concept of volatility smile for gold derivatives and
try to observe how markets are actually positioned via the option prices. We observe that the
market’s expectations related to the price of gold may provide valuable information regarding
the future direction of the asset. For example, in September 2011, while the trend of gold was
highly bullish and apparently sustained, the implied volatility for Out-of-the-money options
spiked from 33.09% to 99.85%, signalling that markets were starting to expect a gold crush.
Within only 3 months, the expectations concretized as gold price started to drop significantly,
such that in less than 2 years the precious metal lost 35% value.
Therefore, we conclude that in a financial market driven by uncertainty, it is of vital
importance to search for correlations and hidden meanings not only by judging based on
historical events and trends, but especially by trying to interpret the agent’s expectations.
After all, it is within the actions driven by those expectations where future movements of any
amplitude take shape.
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An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
Dirk G. Baur and Brian M. Lucey, Is Gold a Hedge or a Safe Haven? An Analysis of Stocks,
Bonds and Gold, p. 5, February 2009.
Arvind Krishnamurthy and Annette Vissing-Jorgensen, The Ins and Outs of LSAPs, p. 57.
3 Assumption widely spread
across the market according to which interest rates could not fall
below 0.
World Gold Council, Market Update: Gold in a world of negative interest rates, p. 1, March
Oxford Economics, The impact of inflation and deflation on the Case for Gold, p. 2.
A low inflation rate of 2% is considered by policy makers the optimal inflation rate for a
stable economy.
Oxford Economics, The impact of inflation and deflation on the Case for Gold, p. 9.
8 Details on TIPS pricing are
provided in Sack & Elsasser: Treasury Inflation-Indexed Debt: A
Review of the U.S. Experience
10 Oxford Economics, The Impact of Inflation and Deflation on the Case of Gold, 2011, pp. 9-10.
Sadaf Zafar and Attiya Yasmin Javid, Pakistan Institute of Development Economics,
Evaluation of Gold Investment as an Inflationary Hedge in Case of Pakistan, January 2015,
p. 15.
12 Stefania D’Amico, Don H. Kim, and Min Wei, Tips from TIPS: the Informational Content of
Treasury Inflation-Protected Security Prices, 2014, p. 4.
13 Archived World
Gold Council Document, World Gold Council Review of: The Washington
Central Banks Agreement on Gold, 26 September 1999, pp. 1-3.
Roberto A. De Santis: Impact of the asset purchase programme on euro area government
bond yields using market news, Working Paper Series, European Central Bank, No. 1939,
July 2016, pp. 5-8.
Bullish = upward trend; bearish = downward trend.
Central Bank Journal of Law and Finance, No. 1/2016
Andreea Oprea
Appendix 1. Correlation analysis
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
Appendix 2. Jarque-Berra Tests
Central Bank Journal of Law and Finance, No. 1/2016
Andreea Oprea
Appendix 3. Unit Root Tests
Augmented Dickey-Fueller Test Statistic
ADF Test Equation
Null Hypothesis: Variable has a root unit
Method: Least Squares
ASF test
Central Bank Journal of Law and Finance, No. 1/2016
An Analysis of Gold and Bond Market in the Context of Quantitative Easing Policy and Market Turmoil
Appendix 4.1 Correlogram for Gold returns
Appendix 4.2 Correlogram for Bond returns
Central Bank Journal of Law and Finance, No. 1/2016
Andreea Oprea
1. Adibe, Kelechi, Fei Fan, “Theories of Gold Price Movements: Common Wisdom or
Myths?”, Department of Economics, University of Michigan, May 2014, pp. 10-16.
2. Baur, Dirk, Lucey, Brian, “Is Gold a Hedge or a Safe Haven? An Analysis of Stocks, Bonds
and Gold”, February 2009, p. 5.
3. D’Amico, Stefania, Kim, Don H., and Wei Min, “Tips from TIPS: the Informational
Content of Treasury Inflation-Protected Security Prices”, 2014, p. 4.
4. De Santis, Roberto A., “Impact of the asset purchase programme on euro area government
bond yields using market news”, Working Paper Series European Central Bank, July 2016,
pp. 4-5.
5. Krishnamurthy, Arvind, Vissing-Jorgensen, Annette, “The Ins and Outs of LSAPs”, 2013,
p. 57.
6. Oprea, Andreea, “Rolul zambetului de volatilitate al aurului in determinarea pozitiei
pietei”(The role of Gold volatility smile in determining market’s position), Gold Magazine
33rd edition, Piraeus Bank Romania, Q1 2016, pp. 1-5.
7. Sack, Brian, Elsasser, Robert,“Treasury Inflation-Indexed Debt: A Review of the U.S.
Experience”, FRBNY Economic Policy Review, May 2005, pp. 49-60.
8. Shafiee, Shahriar, Topal, Erkan, “An overview of global gold market and gold price
forecasting”, Elsevier, Resources Policy 35, 178–189, 2010, pp. 180-185.
9. Stoeferle, Ronald-Peter, Valek, Mark J., “In GOLD we TRUST”, Incrementum Chartbook,
2015, p. 14.
10. Zafar, Sadaf, Javid, Attiya, Yasmin, “Evaluation of Gold Investment as an Inflationary
Hedge in Case of Pakistan”, Pakistan Institute of Development Economics, January 2015,
p. 15.
11. Oxford Economics, “The Impact of Inflation and Deflation on the Case of Gold”, 2011, pp.
12. World Gold Council, “Market Update: Gold in a world of negative interest rates”, March
2016, p. 1.
13. World Gold Council Review of: The Washington Central Banks Agreement on Gold,
Archived World Gold Council Document, 26 September 1999, pp. 1-3.
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