In Depth

I believe that fiat money played an underappreciated role in the run-up to the 2008 financial crisis. In short, short-term private-sector liabilities can function as close substitutes for fiat money, resulting in inflation that only lowers the opportunity costs associated with holding short-term debt. The result is an ever more fragile system in which private sector zero-maturity money dwarfs the monetary base, inevitably culminating in collapse.

While this theory is a somewhat uncommon and undoubtedly incomplete explanation for the financial crisis, the Federal Reserve seems to agree with my thinking at least in part, as demonstrated by its decision to begin paying interest on reserves. This interest makes reserves more appealing relative to risky private-sector alternatives, reducing the danger posed by depreciating fiat money. I believe that by tinkering with the nature of the reserve asset, we can structure a framework which eliminates the uncertainties associated with discretion while simultaneously allowing for the safe injection of unlimited liquidity by the Fed, if necessary.

Reserves should be considered perpetual GDP-linked bonds with a coupon representing a share of  economic output. This coupon could be paid as interest on reserves after indexing against the price level: In other words, we pay interest on reserves equal to the rate of NGDP growth. Following this rule should prevent inflation in the long run, because on currency r < g.