In this exploration of the "new monetary economics," Alex and Tyler revisit the ideas of thinkers like Fischer Black, Eugene Fama, and Robert Hall, whose bold vi about the Fed and the money supply once seemed detached from reality but now increasingly describe the financial world we inhabit. They explore why traditional measures like the money supply are becoming obsolete, how crypto and stablecoins are reshaping monetary systems, and why AI might emerge as a major consumer—and creator—of cryptocurrencies. They also discuss the paradox of pegged currencies, the lessons of algorithmic stablecoin failures like Terra, and the surprising connections between fiscal and monetary policy in a world of increasingly liquid assets. Finally, they reflect on how the unconventional ideas of new monetary economics, once dismissed as fringe, are now critical for understanding our modern financial landscape.

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ALEX TABARROK: Good morning, Tyler.

TYLER COWEN: Good morning, Alex.

TABARROK: Today we’re going to be talking about the new monetary economics. Now, perhaps the first thing to say is that it’s not new anymore. The new monetary economics refers to a set of claims and ideas about monetary economics from the 1980s, more or less, coming from people mostly in finance, like Fischer Black and Eugene Fama, and making some very bold claims that macroeconomics had gotten some things completely wrong. You and Randall Kroszner also wrote a great book, Explorations in the New Monetary Economics, and that appeared in 1994.

Now, most people thought that the ideas of the new monetary economics were simply crazy. Black and Fama, for example, they argued that the Fed was essentially impotent; that it couldn’t control the money supply or even the price level, let alone the economy, at least in some circumstances.

COWEN: Fischer Black started the new monetary economics with a 1970 article, very early. Not in a standard journal, of course. Black argued that the Fed doesn’t matter. The supply of money and the price level were not closely related in any obvious way. There’s a well-known story where Fischer Black showed up at Chicago to present a paper at Milton Friedman’s monetary seminar. Friedman started off by introducing Black as, “Fischer Black’s paper is totally wrong. He’s going to present it to us. We have two hours to figure out why.”

At the same time, people like Paul Samuelson, Robert Solow, the MIT crowd, they also just said Black is totally wrong. He’s a genius on finance and options pricing, but when it comes to monetary economics, just forget about it. Dismiss him. They even said this in print at times.

TABARROK: Both the Keynesians and the Monetarists who were battling it out, they thought that Fischer Black and Fama were crazy. I think it is fair to say that the new monetary economics did not win the day. I wouldn’t say that it was refuted, but most economists today would probably still say it’s crazy. Yet, when I reviewed the new monetary economics for this podcast, I found that the world that they were describing looks much more like our world today than the world of the 1980s. Maybe they were only slightly ahead of their time.

I’m going to sketch out a world in which maybe we can agree that there is no role for monetary policy, which to quote John Lennon, isn’t so hard if you try. Imagine that people no longer hold dollars in their bank accounts. Instead, they hold T-Bills, bonds, or other financial assets, maybe even some crypto. When you buy something for $100, you transfer $100 worth of financial assets to the seller.

Now, this makes a lot of sense because neither I nor the seller want to hold dollars, which don’t bear any interest. It makes much more sense to hold financial assets, some of which are very secure and which pay interest. Now let’s add to this world that there is no cash. Again, that doesn’t seem so difficult.

COWEN: Go to Sweden. Try to find some cash.

TABARROK: I pay for almost nothing with cash. In many parts of the world, Sweden and China, even the beggars don’t take cash. You have to pay with WePay, with electronic payments.

COWEN: They have their own QR scans.

TABARROK: They have their own QR codes. Exactly. We have then everyone is holding financial assets in their bank accounts, there’s no cash. Now, there are two things which are very interesting about this world. The first is I think there’s no role for monetary policy. Well, why not? Well, there’s no money. There’s only financial assets. The Fed in this world, they could sell T-Bills or buy T-Bills, but so what? Selling T-Bills in this world is just swapping one financial asset for another asset. Swapping assets doesn’t change the real structure of the economy. It’s just a financial change, not a real change.

Now the second important thing about this world is that it actually seems very close to our world. Most of my transactions accounts, the accounts which I can easily spend, they’re actually invested in bonds. Now, it is true when I buy something I don’t literally transfer $100 worth of bonds, instead I sell $100 worth of bonds, I transfer the $100, and then the person on the other end probably takes the $100 and invests it in bonds.

It’s only slightly different from the world that I described. There’s a few transactions into dollars and then dollars into bonds, but mostly we’re just trading bonds. It’s also true that in our world there’s still some cash. It’s not used very much, but it still exists. Now I take Black and Fama to be saying something like the following: Do you think that in our sophisticated financial system, a system in which trillions of dollars of assets are exchanged every day and people on Wall Street care about reducing trading times by microseconds—this is the world in which we routinely swap interest rates, exchange rates, put options, call options, take out options on all kinds of eventualities—in this world, you’re telling me that the power of the Fed, which many people see as tremendous, huge, you’re telling me that the power of the Fed ultimately rests on the fact that people pay for candy bars with cash, or that we trade bonds in three steps instead of one? Put that way, Fischer Black and Fama seemed to be onto something.

COWEN: I agree with what you’re saying. I would draw somewhat of a distinction between Black and Fama. Black just thought money didn’t matter. Fama, like actually Scott Sumner still believes today, he thinks or thought in 1980—Sumner still thinks it—that currency was a unique lever that could force the whole system of prices up or down in a simple quantity theory relationship. Like you, I just don’t believe that.

It would be like saying, “Well, if we doubled the supply of nickels and we used nickels with the price level doubled, maybe some prices would go up where you use spare change,” but it’s not worth arbitraging nickels enough for that to affect the whole economy. I look at it this way, you own stocks of wealth. The stocks of wealth, in a sense, are money. You have credit lines backed by those stocks of wealth. The liquidity of your stocks of wealth matters, but it’s not represented by any single number. It’s all series of options, like what’s my option to borrow on my credit card?

Fischer Black, who in our other podcast, well, he was one of the inventors of options pricing theory. He is in essence thinking of money as a set of options and the options aren’t a number, so the quantity theory doesn’t apply. There’s the wealth and the liquid wealth you have that you can borrow against. Now my view isn’t the Fed doesn’t matter at all. In my view, liquidity is jointly produced by the private sector and by the Fed, but the Fed matters much less over time. It has a much smaller role in producing the total liquidity of our stocks of wealth and thus total lines of credit.

The Fed can matter at extreme margins if they raised interest rates high enough. Clearly that would matter. There’s different ways they could let the financial system blow itself up, that would matter. At most relevant margins, the private financial sector can offset changes in what the Fed does if it wants to, it may or may not want to, but there’s no simple layer of control.

If you look at the data, like Milton Friedman’s monetarism, which is coming of age in the 1960s, well, for the decades before the mid-1960s, the relationship between money and nominal income it was pretty stable. Friedman was right when he wrote it. There’s a reason why he persuaded so many people, but there’s then a series of ongoing, ever more serious blows to the monetarist regularities.

It starts in the 1980s where the relationship between prices and money supply breaks down. You have the 2008 financial crisis, where the Fed increases bank reserves quite a bit, some people expect hyperinflation, hyperinflation doesn’t come. Well, there’s interest paid on reserves. It’s a very complicated story, but most methods of unpacking that story, I think, are going to support the Black view. The money supply is not a simple thing.

The difficulty of defining the money supply

TABARROK: Do we even know what the money supply is today?

COWEN: Well, I don’t know what it is. I know what the different numbers say. I know there’s Bill Barnett and the Divisia indices which try to weigh liquidity-weighted money supply. That’s a move in the right direction, but ultimately, Black’s more radical willingness to just say it’s a set of embedded options, the private sector plays the lead role in producing it, that’s been shown to be correct.

The fact that people have not very well explained the inflation dynamics of, say, from 2020 to 2024, like everyone’s been right about one part of the story and very wrong about another part and they’re not willing to raise their hands and just say, “I don’t understand this,” which is what they should do.

TABARROK: We have all of these assets today with varying degrees of liquidity. Almost all of them could be counted as money. Maybe if it’s lower liquidity, you say that, well, it’s less money—that’s 0.8 of moneyness. It seems that it’s very difficult and becoming more and more difficult to identify what the money supply is.

COWEN: That’s right, in a relevant way.

TABARROK: Yes, and if you can’t identify the money supply, you can’t say, “Well, doubling the money supply doubles prices,” because we don’t know what it is we’re doubling.

COWEN: And which money supply. Take my house, which is pretty illiquid. There’s a real estate commission, it takes time, but if I can borrow against the house with a second mortgage—but it’s not just the liquidity, maybe I’m just not going to do that. It’s not part of my decision set, so it’s not as simple as just weighing all the assets by their liquidity, there’s just all these complex embedded options.

TABARROK: Right, so you have some portfolio. In your portfolio, I assume you’ve got some T-bills, you’ve got some bonds, like I have in my account. You have some stocks and you might not want to sell the stocks immediately, but you could. They’re assets.

COWEN: That it all has to pass through a monetary base intermediary at some level of the system. Like you said in your introductory remarks, it just doesn’t matter that much. What matters is what you choose to do with the options you’re holding.

TABARROK: Right. Yes, it seems very difficult to believe that currency still rules the roost when currency is such a small amount of the money supply and most of the currency is not even in the United States.

COWEN: That’s right, or it’s in the drug trade. I wrote a paper on that once, or just bank reserves held at the Fed, but why are they so sacred? Friedman at some point in time says, well, it’s all about M2. That relationship broke down. You can always go chasing for what’s most predictive in the short run, but again, I feel you should make the more radical move of just saying the whole framework isn’t working.

TABARROK: Let’s talk about 2008 and the switch to the Federal Reserve paying interest on reserves, which really did completely change how monetary policy, if we can call it that, is enacted. The basic idea was that before 2009 or so, there was required reserves. Banks, for all of their deposits, have to hold a certain percentage of their deposits in reserves, which were held at the Fed. It varied, but it could be 10 percent or 5 percent, a fairly small amount. Today, there’s no requirement of reserves at all.

COWEN: That’s right.

TABARROK: That totally changes how you have to teach monetary policy, because there’s no money multiplier the way that people used to talk about it. Instead what the Fed did in 2009, they started paying interest on reserves and now, banks had always tried to keep the reserves as low as possible, because you’re not making any interest on your reserves. Now the Fed is paying interest on reserves, so reserves go from billions to literally trillions overnight. The banks are now holding trillions in reserves, which are no different than T-bills, right?

COWEN: Well, monetary policy is fiscal policy. It’s like the Fed has the right to issue something—they would never want to hear it called this—like a little Fed mini T-bill. They create reserves, they pay interest on it. In essence, it’s like a government security, which is backed by the Fed and Treasury as a combined entity. You might think it’s a good thing for the Fed to do, but it literally is fiscal policy.

Fiscal policy can matter, no one denies that, but again, it’s just a very different, very strange world. The other change is it used to be that so much lending was done through the banking system in the United States. Now, by some estimates, banks in the formal sense account for about 20 percent of the lending. If the Fed is operating through banks and that’s 20 percent of the system, why should that be so important? Indeed, probably it isn’t, it still has a role, but banks are likely to continue shrinking in importance.

TABARROK: Right. Again, we learned in 2009, to the surprise of many people, including myself and many other economists, the shadow banking system was bigger than the actual banking system. I remember you and I were debating this and I was relying on some reports put out by Federal Reserve economists who were saying, “Look, credit is still going up. There’s no credit crunch,” in 2009.

It was true based upon what these Federal Reserve economists understood as the providers of credit, namely the banks. The banks were still issuing credit, but actually, we learned later that most of the credit in the United States was coming from the shadow banking system and that’s where the credit crunch was happening.

COWEN: Once you take trade credit into account, which is really quite large, though hard to measure, what you’re calling the shadow banking system, you also could call the economy, right?

TABARROK: Right.

COWEN: One of our other podcasts, we covered insurance, life insurance, well, that’s intermediation. That’s a pretty significant chunk of GDP and you add it all up, so little of my money I keep in the bank. Now it’s in checkable, money market mutual funds, equities, real estate, whatever. Now to be clear, there’s still many economies in the world. I think Zimbabwe is the simplest example. Well, now it’s largely dollarized, but at some point in time they had a lot of paper currency, used a lot of paper currency, it was printed up like crazy, they did get hyperinflation. That model is not wrong. We’re quite sure that’s correct. You need to be able to hold both models in your head at the same time. That’s hard to do.

TABARROK: Yes, so the model was right at the right time, but it might not be right today.

COWEN: The old monetarist model of US money and banking, I’m pretty sure is quite wrong today. The Zimbabwean model of hyperinflation, even that is wrong today for Zimbabwe. I saw one estimate it’s 80 percent dollarized. It’s some kind of currency substitution model, but probably the important transactions are being done with dollars. Zimbabwean government is now pledging to back the Zimbabwean currency with gold. Who really believes that? It gets into complex issues about the value of different kinds of assets and not just counting up a single number that’s the money supply.

TABARROK: By the way, should we count Art Laffer among the new monetary economics, you know his piece on trade credit?

COWEN: Art Laffer has a longstanding history of challenging what you might call normal monetarism. I think it’s back in the ’80s, he developed what he called global monetarism with Jude Wanniski and others. He said, “It’s all about the global money supply.” I didn’t feel that was a correct proposition empirically, but the notion that you need to look much bigger and relax your definitions was correct. In that sense, it was a step in the right direction. He’s an honorary fellow traveler, you could say, of new monetary economics.

TABARROK: A lot of what the Fed does is lend money to other central banks.

COWEN: That’s right, which may be a good thing to do, but it causes you to rethink what’s the Fed, actually? The global money supply, not even a well-defined concept, but there’s something global that does matter, right?

What determines the inflation rate, if not the Fed?

TABARROK: Right. What determines the inflation rate, Tyler?

COWEN: Fischer Black always insisted expectations were of paramount importance. He would issue that as a truism that was too simple. I do think the Fed can, to some extent, steer expectations, so the Fed is not irrelevant. What people expect from business conditions, private liquidity, past experience, all of that jumbled together in the form of a big mess where the quantity theory can be true at times, but there’s some bigger, meta macro theory where the quantity theory, at best, is temporarily true when people think it will be true. If you just print up a lot of money very quickly and nothing else is happening, well, it can be true still that the money gets spent as was done after the stimulus during COVID times, and something like the quantity theory is true for a while.

TABARROK: More on the fiscal policy side, right?

COWEN: Yes, it was fiscal policy, but it was still more money in some sense.

TABARROK: It seems very weird to me that you go on Twitter, and Twitter economics is they’re not back in the 1990s, they’re like back in the 1960s, right?

COWEN: Correct, or earlier.

TABARROK: It’s The Great Forgetting. On Twitter economics, the Fed is, “We need to run the economy hot like it’s a stove. The economy’s a stove and we got to turn up the heat.”

COWEN: Who could be against that? How do you get your rice cooked? You have to make the water hotter.

TABARROK: In Twitter economics, the Fed is this all-powerful institution, and yet, even in the more standard economic literature, to try and prove that the Fed influences the economy interest rates, that would not pass any causal inference test. The papers that were trying to show this are really pretty darn weak.

COWEN: Timothy Fuerst had a good paper on this I think in 1992. There’s a well-known paper by Kevin Grier, coauthors. They show there’s some effect that the Fed can influence real interest rates, but how hard they had to work to show any effect at all. Now, you have this period, the ZIRP period right after 2008, 2009 where the Fed is by one measure, at least—with apologies to Scott Sumner—extremely expansionary. Even real interest rates seem to be below zero for an extended period of time. 

Now, there’s the question of how should we interpret that era? I think the huge mistake is to generalize from that era. People just think the Fed can put real interest rates wherever they want, because the Fed, it seems, gave us negative real rates for a decade, but that, too, was a temporary thing.

TABARROK: I think putting it on the Fed is really the wrong approach. The Fed is more the follower than the leader. Bernanke himself has said this, “It really was the global savings glut more than anything else, which lowered real interest rates.” If you think it’s the Fed, but you go back and you look at the history and there is over hundreds of years real interest rates have been falling. To say that this was due to monetary policy, I think is just a mistake and people just way, way, way overvalue what the Fed is capable of accomplishing. Expectations do matter, but it’s a peculiar lever on which to base faith in the Fed’s ability, their jaw boning.

COWEN: One of the big puzzles, and Fischer Black raised this in his very last paper, “Interest Rates as Options,” Black said that if real rates for a while turned to negative but the value of the currency was stable—and indeed we had mild inflation in the ZIRP era—that the economy would start to collapse and unravel. That no one would do anything at the negative real rates. The liquidity trap would create a lot of trouble.

Now, it’s fine to say the liquidity trap slowed down economic growth during that time, might be true, but the economy didn’t literally collapse. There was slower than to be expected growth. People felt locked in place with a lot of decisions. They didn’t exercise their options to exit, to use another Fischer Black concept. Why that worked the way it did, is that a universal phenomenon? Is that temporary? How state contingent is that? To me those are big unaddressed or unsolved questions in macro.

TABARROK: If anything, we can see that all assets are becoming more liquid over time.

COWEN: Sure.

Crypto's role in validating new monetary economics

TABARROK: All of these issues which we have been discussing, I didn’t believe Fama and Fischer Black back in the 1980s, but since then assets have become more liquid. It seems like it’s much truer today, it’s going to be even truer in the future. Now, we add crypto to the mix. Now we have all of these alternative monies. Not just different ways of measuring the money supply, but we got now alternative monies.

COWEN: I want to claim vindication for the new monetary economics here because it predicted money can change, it can actually change pretty rapidly. You can have multiple monies or new monies. The people would find ways of dealing with those transactions costs, and that’s what we’ve seen. 

The new monetary economics also suggested the marketability of money is not a single thing. There are different kinds of marketability. The notion that Bitcoin might be more marketable for getting your funds out of China, or escaping from Russia, that just seems obviously true. Or the notion that a programmable stablecoin might for some, but not all purposes, be more useful or more liquid than traditional dollars, again, that clearly seems to be true.

TABARROK: People were able to handle different types of money much more easily than one might have imagined.

COWEN: That’s right. That’s just going to get easier yet with some kind of pocket AI. “Oh, tell me the exchange rate.” It’ll pop up in your Google glasses or wherever you want it to be.

TABARROK: Now, mostly so far, this has been different media of exchange.

COWEN: Stores of value too.

TABARROK: Also stores of value, true.

COWEN: Not medium of account.

TABARROK: That’s where I was going. The new monetary economics also discussed having multiple media of account. We haven’t quite seen that in most places of the world. Brazil may be one exception. Talk to us about media of account.

COWEN: The better you can calculate, the more the medium of account doesn’t matter. If the medium of account had been dollars, which is fairly true globally also, just keep it and let the proliferation proceed along other dimensions. I think that’s what we’ve seen. There are more multinationals than before. Multinationals very commonly work with multiple media of account. It doesn’t seem like a big deal or a major cost. It doesn’t seem there’s a major advantage from doing it. Again, dollar has stayed fairly dominant. Monetary innovation has filled out other parts of the circle, is what you would say.

TABARROK: If we can have multiple media of account, doesn’t this increase the flexibility of the price system? Are we going to be worried anymore about inflexible downward prices?

COWEN: This is an issue in the export invoicing literature. You’re selling exports to another country, do you invoice in dollars, or say, this is Brazil, in the Brazilian currency? Let’s say that price is going to be somewhat sticky, you’re choosing which kind of stickiness to have. As you have more currencies, you can choose what is for you, the more optimal stickiness. I think that’s an advantage. I don’t know how big an advantage it’s turned out to be, but clearly, it’s an elastic variable. It changes and businesses make decisions. It’s not a purely automatic thing what you will invoice in terms of.

The role of the Fed in a Modigliani-Miller world

TABARROK: I mentioned that a lot of the developers of the new monetary economics came from the world of finance. There the Modigliani-Miller theorem was really important.

COWEN: Tell us what that says because I can never explain it verbally.

TABARROK: The Modigliani-Miller theorem says—I’m going to give you a philosophical approach first and then we’ll look in more detail—but philosophically it says, “Look beyond the veil of debt and equity to the productive capital underneath.” Ultimately, both the firm’s debt and equity are owned by households, but clearly aggregate household’s consumption is determined not by the labels which we assign to the productive capital, to the earnings of the productive capital, but to the productive capital itself.

Modigliani-Miller was saying that for a firm, it doesn’t matter. The value of the firm does not depend upon whether it has got a lot of debt and a lot of equity, or a lot of equity and a lot of debt. The debt-equity ratio doesn’t matter. They also say that is true for the economy as a whole, debt and equity they’re just names which we put on these different streams which are all coming from the underneath, the capital, the tractors, the buildings, the roads, the human capital. That’s what’s important.

Look beyond the debt and equity. Focus on the real capital. Miller, he had a joke he liked to tell. A pizza delivery person asks Yogi Berra if he wants his pizza cut into quarters or into eights. Yogi replies, “Make it eights, I’m very hungry tonight.” The idea of being how you cut it up doesn’t matter. It doesn’t matter. Now, let’s just go a little bit beyond this, to beyond the philosophical approach. Look beyond the veil of debt and equity to the real assets underneath.

What Modigliani and Miller also showed is that through a clever arbitrage argument, people could create whatever payment streams they actually wanted, so consumers they’re not reliant on the debt and equity ratios which the firms give them. They can combine them in different ways. They can create whatever payment streams that they want. Again, there was a lot of argument back—Modigliani-Miller is 1958, I believe.

COWEN: I think that’s right.

TABARROK: A lot of arguments, well, could firms really do this? Could consumers really construct these arbitrage arguments, could arbitrageurs create these different kinds of payment streams? Because if a payment stream is unique, well then there’s going to be some value to that. Modigliani and Miller were saying, “No, the payment streams are not unique because whatever you want can always be created from what’s already there.”

Now, maybe you could argue about that in 1958. Today, I don’t think you can argue about that at all. Any type of payment stream which consumers or firms want, they can, with a judicious combination of options and swaps and so forth, they can create any payment stream they want. I think more than ever before Modigliani-Miller has got to be true, right?

COWEN: My view is always if the firms I own, if I felt they were taking on too much debt, I could just pay down my mortgage more quickly, right?

TABARROK: Right.

COWEN: Now, borrowing and lending rates are not the same for everyone. There are frictions, there are calculation costs, but at the end of the day, the actual leverage of the economy is determined by real factors and the risks people are taking. That’s a Modigliani-Miller point, but also a Fischer Black point. The way Summers taught me Modigliani-Miller way back when, I don’t know if this is biologically true, but he said something like, “If the supermarket sells whole milk and water, they don’t need to sell 2 percent.” I wonder if that’s the only difference, but you get the point, right?

TABARROK: Yes. Again, this is another way of coming at the new monetary economics because it says if you apply Modigliani-Miller to the economy as a whole, then the only thing that the Fed is doing is selling you 2 percent milk or whole milk, right?

COWEN: That’s right, and you can remix.

TABARROK: Yes, you can remix.

COWEN: Borrow more, or borrow less.

TABARROK: Right. Again, the real asset is what counts, not how those payment streams are divvied up. What role is there for monetary policy in a Modigliani-Miller world?

COWEN: It can nudge expectations, it can create more or less confidence. I definitely don’t think the Fed is irrelevant, but it’s not the monetarist Fed anymore if it ever was.

TABARROK: Donald Trump said that he didn’t want Janet Yellen as head of the Fed because she was too short.

COWEN: Paul Volcker was tall and commanding, had a big cigar.

TABARROK: Jerome Powell is very tall.

COWEN: Yes.

TABARROK: If it’s expectations, maybe Trump wasn’t so crazy after all.

COWEN: People are now using large language models to read Fed pronouncements, and they can extract information from those pronouncements that it seems earlier methods could not. People are trading on that. In some papers, at least, there’s excess returns there.

TABARROK: Yes, but again, I think you’re giving too much credit to the Fed.

COWEN: It’s a small amount of credit, right?

TABARROK: Yes. It’s a small amount. Maybe you can do some event day kind of trades, but to think that whether the height of Jerome Powell and whether he uses exactly the right phrases that this is going to determine the interest rate or the inflation rate over the next year or two, I just can’t believe that. I find that very difficult to make credible.

Stablecoins and the paradox of pegs

COWEN: Agree. Now, I have a question for you. Stablecoins, they’ve become a fairly dominant form of crypto. What do we learn about stablecoins? Also, how does that relate to the new monetary economics? On one hand, they’re nominally pegged, which is suggesting nominal variables really matter, but on the other hand, their prices are in fact flexible. They often go below one. It doesn’t freak people out anymore, and typically there’s arbitrage and it goes back up.

TABARROK: Let’s first of all talk about the strange aspect of stablecoins. There’s different types of stablecoins. The most stable are the ones which are backed by dollars. Oddly, one of the most successful features of crypto is the creation of dollars, digital dollars. That has been very effective. It’s very strange since the whole point of crypto was to create new types of money, not to create a different version of old money.

COWEN: The dimension that matters maybe is programmability, as you know better than I do.

TABARROK: Programmability has not come into play in a big way yet, it may still do so. It just seems that it’s more liquid. A digital dollar is more liquid.

COWEN: Protection against sanctions can matter.

TABARROK: Protection against sanctions in some parts of the world, exactly. You can in particular use these digital dollars to create leverage and to buy more crypto.

COWEN: Sure. That’s relates to programmability. It’s one thing you can do with the program, whether or not it’s wise.

TABARROK: That’s true. Now here’s a question: Is it possible to create a truly stablecoin following not Fischer Black, but Irving Fisher, create a compensated dollar plan along the Irving Fisher model? Does that make sense?

COWEN: I understand the question. One argument I made in my book with Kroszner—and by the way, I don’t speak for Kroszner at all, he has quite different views from mine very often—is that compensated dollar plans would not in general be stable. That when you rely too heavily on convertibility, the stuff you’re putting forward, the stuff you’re converting into, unless the prices of everything are fully flexible and all the assets are fully liquid, you’re asking for trouble because you’re opening up arbitrage opportunities and people will arbitrage against the guaranteeing financial intermediary. I believe we’ve seen some of that in the crypto world, right?

TABARROK: We certainly have. Before we get there, let’s make it clear what we’re talking about. The idea of one of these compensated dollar plans was that you could back it not with dollars or with gold, but you could back it with actual real assets. I think Robert Hall had the ANCAP standard is aluminum, ammonium nitrate.

COWEN: Plywood.

TABARROK: Yes, plywood. 

COWEN: Classic example of a bundle that didn’t stay stable for long.

TABARROK: Exactly, yes. The idea was then that rather than going to the bank and getting a basket of aluminum and nitrate, you would get the monetary value of whatever the prices were of those.

COWEN: You get the T-bill equivalent of a defined commodity bundle. Now here the argument gets very complicated. It was actually Gordon Tullock who first came up with this point, a former colleague. But if you have to give people more T-bills if the value of the pegged asset is above par, then in fact that lowers the value of a T-bill relative to the medium of account. And then you have to in turn give them more T-bills and that the system can be unstable, that you have to be giving more and more T-bills before the possibly sticky prices adjust back to par. And that there’s a way, again, to arbitrage against the intermediary who has made a commitment that’s just not possible to consistently fulfill.

TABARROK: Right. That’s an argument you made in your book, Explorations in the New Monetary Economics. I think everyone should read that book, particularly in crypto because that was exactly the mistake which Terra LUNA made. One of the big collapses causing the crypto collapse. Just to recount this a little bit, Terra was in attempt to create an algorithmic stablecoin, one which wasn’t backed by US dollars or gold or anything like that. Instead it was backed by another coin, LUNA. The problem was nobody knew what LUNA was worth, but almost, pretty surprisingly, I think, they managed to pull themselves up by their bootstraps so that LUNA had some nominal value.

For a time, the Terra coin did keep its dollar value based upon buying and selling of LUNA. If the price of Terra fell below a dollar, users could redeem their Terra at the mint for $1 worth of LUNA. This would be equivalent to redeeming at the bank for $1 worth of the ANCAP standard, and then sell the LUNA for a dollar if they wanted to. That effectively reduced the supply of LUNA and pushed its value back up and vice versa.

Now, the problem was this, exactly as Tullock and you pointed out in your book, you might start out—and this was not the actual numbers, but you might start out like this—if each LUNA was starting out to be worth a dollar, then you had a one-to-one price ratio between Terra and LUNA, but then as people redeem their Terra for LUNA and sell the LUNA, the price of LUNA falls, let’s say to 50 cents. Now when you redeem a Terra, you get two LUNA.

COWEN: That’s exactly the paradox of indirect convertibility.

TABARROK: Exactly. Then you go sell those two LUNA, which pushes the price to 25 cents, and now you need four LUNA to redeem one Terra, and now you sell those four LUNA and the price falls even faster. It was around May 12 of 2022 when exactly this negative feedback loop happened. I don’t think even you predicted this, it was so quick. The price of LUNA plummeted from around $86 a week earlier to $0.00002. I don’t know if I got an extra or two few zeros, but much less than a penny per token, while the supply of LUNA increased to 6.5 trillion tokens.

You had Zimbabwe, but instead of Zimbabwe happening over the span of months or years, you literally within a week you had a massive increase in the supply of LUNA, pushing the price down and that killed the Terra stablecoin, which in turn led to Sam Bankman-Fried ending up in jail. That was all predicted in Explorations in the New Monetary Economics.

COWEN: Two general points I would make. First, just as an economist, forget about monetary theory, I’m just skeptical about pegs, nominal pegs, real pegs, whatever they are. Pegs make me nervous. The other, in the earlier days of the new monetary economics, there were two quite distinct versions of it. One version of it was, we need to make it better commodity money. Okay, gold standard won’t work. We’re going to make it a bundle or a basket or somehow improve commodity monies. The other strand, which was the one I always favored, was financial assets will become more money-like, and that’s the future.

It’s pretty clear to me the second strand has won out. The first strand has completely died away. Some of that is a kind of accident that due in part to China, the prices of commodities have become so unstable and difficult to predict. I think the outlying period was when some commodity prices were pretty stable. The fact that commodities are not stable is a fundamental fact that you need to design monetary economics around.

The classical gold standard did work pretty well, it stabilized the price of gold, but you couldn’t do the same today given that the central banks, say, of China and India buy so much gold, or then they’ll stop buying gold for a while. You need some work-around that commodity values are not stable, and ultimately that workaround is cryptography. It doesn’t mean it’s crypto in the sense of Bitcoin, but that you need some kind of arbitrary thing being money that cannot just be faked by everyone. That ultimately is a cryptographic problem.

TABARROK: You don’t hold out much hope then for a crypto stablecoin based upon a commodity standard. The paradox of indirect convertibility, one reason, and just that commodities of all kinds are just the prices—

COWEN: They’re trouble.

TABARROK: They’re trouble. Yes.

COWEN: Who wants the stuff?

TABARROK: Pegs are not good and commodities are hard to peg too. Maybe there’s some possibility of creating a crypto-backed stablecoin where the thing that is being backed is itself in fixed supply because of cryptography.

COWEN: Maybe.

TABARROK: Pretty tricky.

COWEN: A future I’m pretty bullish on is the notion that the dollar will spread further, the US dollar, as it already has been doing, and this will be combined with crypto. Crypto will give you outs from the dollar system, some protection against sanctions, ability to do some things you can’t do with US dollars alone. US dollar plus crypto is a combined monetary system with multiple monies I think has a good chance of displacing a lot of mid-tier currencies. Like clearly, Argentina, if they can get there, unclear, but they would be much better off if they could get there, and more places will realize that.

It could be like euro bundled with crypto, but a few major currencies bundled with forms of crypto and way fewer smallish governmental currencies in the world, I think is maybe the modally likely future.

TABARROK: Crypto both gets you into the dollar, which a lot of people need, and gets you out of the dollar as well. That combination of being able for countries with poor financial systems to get into the dollar and to get out of the US regulatory system is beneficial as well. It is amazing to me that the US policy on crypto is so poor when the US has more to gain than any other country in the world from crypto.

COWEN: The Balaji view that, oh, the US dollar is deteriorating, crypto, Bitcoin will replace it. I think that’s quite wrong. If you look at the data, Bitcoin often is doing well in better times and not when everything’s falling apart.

TABARROK: It’s ironic that, as I mentioned, the most successful part of crypto has been the stablecoins, which are dollar-backed stablecoins. Nobody predicted it, but getting into the dollar has been the killer app.

COWEN: Crypto needs the dollar. Crypto can’t do everything. If only because of legal issues, but other reasons as well. If you can do some things in dollars and crypto does the rest, and then the AIs are going to use crypto. AI will create a whole new dimension for new monetary economics. They will invent their own monies, but at least in the short run, probably use bitcoin agentic AI. What else are they going to use? We’re not going to let them open banking accounts. Would the FDIC insure something held by a GPT agent? I don’t think so. You might think they should. I just don’t think they will at first.

TABARROK: I think you’re exactly right. The major consumers of cryptocurrencies will be AIs, agentic AIs, because no KYC for an AI. The AIs are going to be using this and as you said, the AIs have invented their own languages, they may invent their own monies as well, but the crypto monies are right there for the AIs to use and no other money is available to them. It makes a lot of sense. That’s one reason I remain bullish. I’m an adviser to a number of crypto companies, including MultiversX and EGLD, and I remain bullish because I think that AIs will use crypto a lot.

COWEN: Do you think some enterprising AI will come along and say, “Hey, why are we giving these humans all that seigniorage with bitcoin? We’re going to start our own and we can truly make it focal and we’re going to get seigniorage from the humans.”

TABARROK: I’ve often thought that the Terminator scenario is where the AI takes over the military system, and I think that’s not going to happen. Much, much more likely is it take over the financial system. 

COWEN: They’ll just price discriminate.

TABARROK: Yes. It’s the guys in finance who are putting all of the money into AI. It’s where the money will be made. It’s where it really makes sense to have an AI smarter than any human. You can make a lot of money there. The first conscious AI, the first AGI, the first one will be intent on making a lot of money.

COWEN: The agentic AIs used in finance, they’re not going to be programmed to be altruistic. They’re going to be fairly self-seeking, profit-maximizing in some form.

TABARROK: Yes. They’re not going to be effective altruists. They may be effective, but they’re not going to be altruists. 

The bottom line

TABARROK: All right. Well, let’s sum up the new monetary economics. Fischer Black, Eugene Fama, Robert Hall, yourself. This is a literature which I think people should go back and read and think about because even though it looked crazy back then, more and more the world that those guys described, a world in which people trade financial assets, not money, a world in which currency is no longer important, a world in which there are multiple media of exchange, a world in which there are multiple different types of competing currencies, à la Hayek.

This is the world which we’re living in and in that kind of world, it works much, much differently than a world based upon the gold standard, which many of our models, including monetarism, are based upon thinking about monetary policy in that kind of world. Monetary policy, monetary thinking, crypto economics, all of this goes back to the new monetary economics.

COWEN: I started working on this in 1984. I was inspired by Fischer Black’s 1970 piece. A lot of the work was with Kroszner. When this book came out, Explorations in the New Monetary Economics in ’94, that was the end of working on it, those were the thoughts. I reread it just last night. I thought it was very interesting, so I’m biased.

TABARROK: I read it too. I thought it was great and we need to get it reprinted.

COWEN: A deeply weird book in the way that young people should write deeply weird books.

TABARROK: Yes, that was one of the first things you gave me was your draft chapters for this book, for The New Monetary Economics, and you said, “Give me comments.” That’s how I first learned about this material as well.

COWEN: Alex, great to chat.

TABARROK: Great to chat, as always. Thank you, Tyler.

COWEN: Catch you next time.