Free Banking 

Larry Summers had op-eds in the Financial Times and the Washington Post this week with essentially the same message. (Well played, Larry: apparently the Post’s editors do not read the Financial Times. It would not hurt them to start.) In both, he used the line, “Government has no higher responsibility than ensuring that economies have an adequate level of demand.” So, that stuff about securing life, liberty, and the pursuit of happiness is all secondary to ensuring an adequate level of demand?

That brings me to another recent column, also in the Washington Post, by Robert Samuelson. Though not an economist by training, Samuelson’s curiosity, willingness to listen to different views, and frank admission of how much he (and we) do not know make him consistently interesting to read.  By combining those characteristics with diligence, he has become a better economist than most professional economists. He writes:

"There’s a paradox to economic policy. The more it succeeds at prolonging short-term prosperity, the more it inspires long-run destabilizing behavior by businesses, banks, consumers, investors and government. If they think basic stability is assured, they will assume greater risks — loosen credit standards, borrow more, engage in more speculation, relax wage and price behavior — that ultimately make the economy less stable. Long booms threaten deep busts."

Samuelson expresses a view that the Austrian school of economics is somewhat comfortable with but that most other schools are not. Cross Ludwig von Mises on the drawbacks of interventionism and Joseph Schumpeter on the “creative destruction” of capitalism, and you get the conclusion that an unhindered market economy may in fact seem quite unstable in some ways, but that it is in fact less so than an economy that government is continuously trying to stabilize. It’s a “pay me now or pay me later” view that a market economy contains an irreducible minimum volatility. If you want to stabilize it permanently you have to suppress its dynamism.

I said the Austrians are somewhat comfortable with this view because it is in partial conflict with the idea that absent government intervention, many problems of scarcity would be greatly reduced, improving and even saving lives. I think the key is to understand that, as one of my economics professors, the late Don Lavoie, used to stress, we must ask “Compared to what?” That is, what is the workable alternative to an economy that experiences a shallow bust now and then: an economy that experiences no busts, or an economy that experiences deep busts? This is a topic that requires further development by Austrian economists.

Finally, I note a poll of 40 economists in which they unanimously disagreed that a gold standard would result in better price stability and employment outcomes for the average American. The poll taker remarks that “The panel members are all senior faculty at the most elite research universities in the United States.” That must account for the deadening uniformity of opinion; normally it’s hard to get 40 economists even to agree that the sky is blue. The economists who offer short answers for their votes say something along the lines of “the price of gold would be too volatile.” Compared, for instance, to the dollar, which was $35 per troy ounce about 40 years ago and is now around $1700? What would it take to pry open a few minds among these elite economists? First, evidently, a calamity; the near-calamity of 2008-09 was not enough. Second, they would have to know to distinguish among different types of gold standard, a topic I have discussed before and which I will soon return because it is still not sufficiently appreciated.

ADDENDUM: If the Austrians are somewhat comfortable with the idea of minimum volatility, some economists who work on "real business cycle" theory are completely comfortable. I thought when I wrote the post that after waiting awhile I might have something to say about them later, but I don't. They seem content to stick to their classrooms and their academic papers, and haven't made as much noise in newspapers or in blogs as other tendencies of thought.

I address this range of issues in an editorial this week published in the Washington Times.

Scott Sumner and Paul Krugman have been going back and forth about fiscal multipliers, in a debate with many other participants. (Here are the first post and the latest post by Sumner on the issue.) For those of you who have not followed the debate, the fiscal multiplier is the change in output resulting from an additional dollar of government spending. If the multiplier is greater than one, $1 of additional government spending results in more than $1 of output.

What has been missing from the debate is the concept of the structure of production. Resources, including human abilities, are not just a homogeneous lump. They have a structure: some are less scarce than others, some are easier to switch to new purposes than others, some require less know-how to work with than others. The idea of a fiscal multiplier from spending makes me uneasy because it is basically a supposed case of something for nothing: the government, which almost everywhere in the world cannot even deliver the mail at a profit, steps in to fix a situation that the private sector cannot. How does it happen? The answer has to be that somehow the government is able to put resources to a higher-valued use than the private sector can. Given the specificity of resources and the knowledge that must be applied to use them efficiently, it is hard to imagine how such a thing can happen unless resources are so abundant that is little risk from wasting them.

An early critic of John Maynard Keynes, W.H. (William Harold) Hutt wrote a book on precisely this point in 1939, called The Theory of Idle Resources. Hutt carefully explained how many resources that seem idle to the unpracticed eye are in some kind of use — perhaps not the most active use we can imagine for them, but one that has considerable economic value. Considers cars. Most car owners use their cars for just an hour or two per day. Are the cars idle the rest of the day? True, they are parked, but they not idle in the economic sense. They are held in inventory, set aside by their owners for whatever need may arise to use them. People who don’t wish to hold a car in inventory can ride the bus or hail a taxi to get them where they want to go. (George Selgin or Steve Horwitz, both of whom have used Hutt’s ideas to help develop their own conceptions of the relationship between money and business cycles, may want to chime in with their own posts to say more about Hutt.)

If some resources are so abundant that there is little risk from wasting them, something is restraining the private sector from using them. Either millions of experienced businessmen can find no opportunities for converting something abundant into something more valuable, or government is somehow preventing the private sector from taking the initiative.

I lean to the latter explanation. Why should government, which eats profits (through taxes) rather than generating them, know how to turn resources to more profitable use than the people in the private sector who spend their whole careers trying to do just that?

As Scott Sumner has discussed on his blog, when monetary policy has gone so wrong that it is impeding trades that people would otherwise make, to their mutual benefit, there is a case for certain kinds of fiscal policy as a clumsy work-around. The simpler course, though, is to change monetary policy. And so I wind back up at free banking. Because free banking applies principles of competition that we observe at work in other markets, and that historically have worked in the issuance of money and credit as well, free banking is less likely than central banking to result in economy-wide failures to use resources efficiently. I do not think free banking would eliminate credit booms and busts, but I think they would be less severe than they are under central banking because the scale for making mistakes in monetary policy would be smaller. Then there would be even less reason to debate fiscal multipliers.

Discussion about the gold standard often has advocates and critics talking past one another. One of the reasons is that there are members of both groups who do not know or, during the heat of argument, do not acknowledge that there have been many varieties of the gold standard. A free banking gold standard differs in important respects from other varieties of the gold standard. Here are key questions about the details of a gold standard, and the answers as they apply to its free banking form.

What is the legal foundation for payment in gold? Ordinary contract law. Government may establish a definition of a currency unit in terms of gold, but if so, under free banking the unit (say, the dollar) is merely a convenient name for the weight of gold, rather than saying that “a dollar is a dollar” no matter how much the gold content changes.

Is gold the only legal form of payment? No; payment can occur in any commodity or currency that people wish to use. This contrasts with the practice in some countries under various other forms of the gold standard, in which certain payments were only legal if made in national currency.

Who offers payment in gold? Anybody may do so. This means lenders and borrowers may agree to "gold clauses" in contracts. In many countries, governments have nullified such clauses after abandoning the gold standard or after moving to a more restrictive form of the gold standard where people have less freedom to own and pay in gold.

What forms of money and credit are payable in gold? Any that the issuers of those forms wish to offer.

Is production of any of these forms a legal monopoly? No; in particular, under a pure free banking system there is no legal monopoly of notes or coins, so they are competitive in the same way that deposits are competitive. In most historical free banking systems, issuance of notes was competitive but issuance of coins was not.

Who can demand payment in gold? Anybody who holds a liability that an issuer has made payable in gold. This contrasts with the Bretton Woods gold standard as it existed in the United States, under which Americans were prohibited from owning gold bullion.

Are there restrictions on the purposes for which people can demand payment in gold? No, there are no exchange controls or like restrictions. Again, this contrasts with the Bretton Woods gold standard, under which most countries on the standard imposed exchange controls.

What legal penalties exist for people or organizations that break their promise to pay in gold? The standard penalties applying to breach of contract. Observe that this differs from a central banking gold standard, in which the central bank cannot be sued for breach of contract if it devalues.

Is fractional reserve banking permitted? Yes; so is 100% gold reserve banking, but as George Selgin commented in a post some time ago, there have been no historical cases in which 100% gold reserve banking has dominated in competition with fractional reserve banking. I would expect there to be some 100% gold reserve banks, appealing to people who did not trust regular banks and were willing to forego interest, but I would expect such banks to hold less than 1 percent of all banking assets. 

Are taxes only payable in gold? Perhaps. It should not make much of a difference if a free market in foreign exchange exists.

Is accounting in units other than gold permissible? Yes, but perhaps everything has to be converted into gold units for tax purposes. This is an area where I think more work is needed to explore whether there are important implications for monetary freedom.

In my initial post last May I mentioned I would discuss some of the economic environments that I have worked in as part of my consulting work. I have some very clear memories about inflation in the US from the late 1970s and early 1980s. I worked in a grocery store from 1979 to 1980 in suburban Chicago and one of my duties was to change prices on the full range of grocery products. This was before the time of electronic bar codes that allowed price changes to happen essentially automatically. Back then you had to either scrape the price tags off cans and put the new price tag on, or for products in boxes the old price tags had to be covered up with the new, higher price tag. Also as a business student in the early 1980s I remember that we took up quite a bit of time on inflation accounting, learning how to detail financial statement footnotes regarding the underlying cost basis. I don’t recall ever using that concept in practice once I started working full-time in the mid-1980s.

In one of my trips late last year, I spent some time working in Belarus in November.  One interesting characteristic that I found about the Belarusian economy is that inflation is currently hovering around 100 percent. The currency experienced two major devaluations during 2011. Last spring the USD/BYR exchange rate stood at about 3,000:1. One devaluation occurred in May that sent the rate to about 5,000:1 and another devaluation in September and October sent the rate to just under 9,000:1 which is about where it stood when I was there. It has recently drifted back to about 8,300:1. Usually when I travel to a country I immediately exchange a few hundred dollars into the local currency. I didn’t do that in Belarus. I exchanged about $40 of spending money every two or three days and I got a few thousand BYR more each time I went to exchange currency. Some cite loose credit in the form of “issuing cheap loans to cover state firms' budget gaps and propping up the ruble at what eventually became more than double its actual worth” as the cause of the problems with the economy. Most of the lending in Belarus is undertaken by large state-owned banks.

One final anecdote will close out my post. I have been to three countries where I have seen Lenin statues previously—Tajikistan, Ukraine and now Belarus. In Tajikistan and Ukraine, the statues were tucked away in parks. In Belarus, the statue is in front of the Government.

A couple of weeks ago, Scott Sumner pointed out that many conservative-leaning economists think that certain types of deflation can be good. The same economists, though, are typically reluctant to acknowledge that by a similar argument, certain types of inflation can be good.

As Sumner points out, there are economists who understand that the argument is symmetrical. He mentions George Selgin. Selgin’s 1997 monograph Less Than Zero: The Case for a Falling Price Level in a Growing Economy implies in its title that in a shrinking economy there may be a case for a rising price level. Selgin in fact discusses the case for such "good inflation" on page 39 of the monograph, although his main focus is on "good deflation" because at the time he wrote, it was a more unusual idea. Selgin, and fellow blogger on this site Steve Horwitz, make remarks in Sumner’s comment section.

Selgin stated his arguments in a way to give them textbook simplicity for ease of understanding. In an actual free banking system, the details of the system might add some wrinkles that would require changes to the  form is arguments while preserving their spirit. Expectations about the supply of the monetary base and thus the path of prices over time might differ considerably depending on whether the monetary standard was gold, silver, a frozen fiat monetary base, a commodity basket, or something else. Under some standards, inflation and deflation might be relative to average expectations for the price level rather than absolute. It remains an open question to me whether a standard in which the monetary base was shrinking and expected to continue shrinking (as was the case in some earlier eras with the supplies of gold, silver, and copper) would be compatible with the monetary system attaining the "full information" ideal of not being a disturbing factor to trade.

December 28, 2011

Editor
The New York Times

Sir,

As you claim that Ron Paul’s belief that the Federal Reserve should be abolished disqualifies him for the presidency (“Mr. Paul’s Discredited Campaign,” December 27), and thereby appear to be convinced that no alternative to the Fed could possibly do better, we wish to alert you to our recent research reaching the opposite conclusion (“Has the Fed Been a Failure?” Cato Institute Working Paper no. 2, forthcoming in the Journal of Macroeconomics). We wonder as well about the grounds, apart from mere a priori convictions, for your contrary opinion.

Sincerely,

George Selgin, professor of economics, the University of Georgia;
William Lastrapes, professor of economics, the University of Georgia;
Lawrence H. White, professor of economics, George Mason University.

Presented at the Cato Institute Annual Monetary Conference, 16 November 2011

Suppose for the sake of argument that we all agree to the following proposition: If we could change the monetary regime with zero switching cost, merely by snapping our fingers, we would prefer the US to be on a gold standard. In the most general terms a gold standard means a monetary system in which a standard mass (so many grams or ounces) of pure gold defines the unit of account, and standardized pieces of gold serve as the ultimate media of redemption. Currency notes, checks, and electronic funds transfers are all denominated in gold and are redeemable claims to gold.[1] The question then arises: What would be the least costly way for the United States to make the transition to a new gold standard? We need to choose a low-cost method to insure that the agreed benefits of being on the gold standard exceed the costs of switching over.

Two transitional paths suggest themselves. (1) One path is to let a parallel gold standard grow up alongside the current fiat dollar. (2) The more conventional path, as followed after the suspension of the gold standard during the US Civil War, is to set a date after which the US dollar is to be meaningfully defined as so many grams of pure gold. Or as it is more commonly put, an effective parity is established stipulating so many dollars per fine troy ounce of gold. In our present situation, where Federal Reserve liabilities (book entries and currency notes) and Treasury coins constitute the basic dollar media of redemption, that implies converting the Federal Reserve System’s liabilities and the Treasury’s coins into gold-redeemable claims at so many grams of gold per dollar (or equivalently so many dollars per ounce of gold).

We see analogs to these two transitional paths when we observe how peso-using countries have made the transition to using the US dollar. In Ecuador in 1998-2000, a parallel unofficial US dollar system emerged as the annual inflation rate in the local currency rose from low to high double-digits, then to triple-digits. The private sector of the economy was already heavily dollarized when the plug was finally pulled on the heavily depreciated local currency unit in 2000. In El Salvador in 2001, the government chose to permanently lock in the dollar value of the currency—by switching from a dollar-pegged exchange rate to outright adoption of the US dollar—while inflation was low and the local currency still dominant. In a nutshell, when the official switch to the harder currency came in Ecuador, it was an act of necessity in the midst of a hyperinflation crisis. In El Salvador it was an act of foresight, to rule out such a crisis.

Allowing a parallel gold standard

Clearing away the legal barriers to a parallel gold standard is fairly simple and can be done without immediately altering existing financial institutions. Rep. Ron Paul’s HR1098, the Free Competition in Currency Act of 2011, represents one straightforward approach. It would (1) ensure the enforceability of contracts denominated in units other than fiat dollars be removing legal tender status from Federal Reserve notes and Treasury coins, (2) remove taxes on gold and silver coins that FR notes do not face, and (3) remove sections of the US Code that have been used to criminalize the victimless activity of privately minting distinctive private pieces of metal intended to circulate as money.[2] If these steps seem unprecedented, note that Federal Reserve Notes did not become legal tender until 1933. Bank of England notes are not legal tender today in Scotland or Northern Ireland, where private banknotes (also not legal tender) predominate. Note also that in Switzerland “the purchase and sale of Gold is not subject to taxes (such as value-added tax or capital gains tax) under current Swiss law.” [3]

Further legal and regulatory changes are necessary to allow citizens who adopt the parallel gold standard to have access to gold-denominated banking services. Banking services, including the issue of gold-redeemable paper currency notes and token coins, are of special importance for the success of a gold standard given the awkwardness of making small transactions in physical gold coins. Either existing bank holding companies would have to be free to operate separate gold-denominated subsidiaries, or new gold-based institutions would have to be free to open.

The case for a level playing field between the fiat dollar and other monetary standards rests on the simple fact that the well-being of consumers is better served by competition than by monopoly. Keeping alternatives to fiat dollar at a legal disadvantage, like silver- and gold-backed bank-issued monies, or foreign currencies, limits the options of American consumers to their disadvantage. The option to use an alternative to the fiat dollar is naturally most valuable in an environment of high dollar inflation. Consumers who don’t like the ongoing shrinkage of the value of the currency in their pocketbooks and wallets are then not limited to complaining, or trying to lobby the Fed or Congress for better policy, but can “vote with their pocketbooks” to protect their assets by moving into less inflationary alternative currencies.

We should not expect a spontaneous mass switchover to gold, or to Swiss Francs, as long as dollar inflation remains low. The dollar has an incumbency advantage due to the network property of a monetary standard. The greater the number of people who are plugged into the dollar network, ready to buy or sell using dollars, the more useful accepting dollars is to you. Conversely, if you are the first on your block to go shopping with gold coins or a gold-denominated debit card, you will find few stores ready to accept payments in gold. But like the benefit from using dollars in a peso economy, the willingness to accept gold-denominated money in a fiat dollar economy increases with the incumbent currency’s inflation rate and its uncertainty. As Gabriele Camera, Ben Craig, and Christopher J. Waller express the general theoretical proposition, “the local currency sustains internal trade if the purchasing power risk is kept very low, but once that risk gets very high substantial currency substitution kicks in.” [4] Should the US inflation rate return to double digits, consumers would find it very helpful to have an alternative currency network available. Potential competition might even help incentivize the Fed to keep inflation low.

Who is likely to produce private gold coins once they are recognized as legal? Gold medallions and biscuits in various sizes, from private producers around the world, are already widely held. Investors in coined gold normally pay a premium over the value of uncoined gold, which covers the cost of coining. In a recent working paper Olivier Ledoit and Sébastien Lotz, two economists at the University of Zurich, raise an interesting possibility while discussing a proposal to allow private gold coinage in Switzerland. They envision that “Gold Francs would be minted by Commercial Banks, [and] the Banks would be allowed to put their brand name and/or logo on one side of the coin. The marketing benefits from having the bank logo in every citizen’s wallet would clearly cover any minting costs, so these coins could be sold at par value with the market value of their weight in Gold.”[5] It is actually not clear, but remains to be seen, that marketing benefits would cover minting costs. It is true that if the public prefers to use full-bodied coins, gold coins could circulate practically in larger denominations. Historically, however, the everyday circulation of gold coins became rare once people found banknotes more convenient and sufficiently trustworthy. At $1600 per ounce, full-bodied gold coins are completely impractical at perhaps $50 and below.

We can therefore expect most bank-issued coins to be tokens, essentially metallic banknotes, redeemable in gold (upon presentation of a minimum quantity) at the bank. Such tokens can carry the bank’s logo, but they will pay for themselves by sparing the issuer the expense of using precious metal in coin production, and will save the system the burdens of incidental wear- and-tear and deliberate shrinkage that accompany full-bodied precious-metal coinage. As with paper banknotes, the float revenue rather than only the advertising value will cover the production and circulation costs. Ledoit and Lotz appear to overlook the standard historical solution to the problem of keeping small currency at par—redeemable tokens and banknotes—because they assume that payment services would be provided only by money warehouses, and do not consider that money-users might be incentivized by banks to prefer the lower-cost alternative of fractional gold-reserve bank liabilities.

Re-establishing a gold definition of the US dollar

The network property of a monetary standard supports the case for not simply legalizing a parallel gold standard, but re-establishing a gold definition for the US dollar. If network effects mean that an uncoordinated piecemeal switchover to a superior standard would not occur except during a painful period of high and uncertain inflation in the incumbent standard, there is a strong case for avoiding that pain through a coordinated switchover before high inflation occurs. That is, we would do well to follow the Salvadoran model of transition rather than the Ecuadoran model.

In considering the re-establishment of a gold dollar now, more than forty years after President Nixon closed the gold window, the question of the appropriate new parity (how many dollars per gold ounce) naturally arises. It is widely recognized that it would be foolish to try to relink the dollar to gold at the pre-1933 parity of $20.67 per ounce, the 1934-71 parity of $35 per ounce, or the post-1972 accounting price of $42.22 per fine troy ounce. It would be foolish because the US price level has risen more than 5-fold since 1971, and the real price of gold has risen in addition, so that $42.22 per ounce or anything lower implies a massive deflation not anticipated in existing nominal contracts. Great Britain’s painful deflation during Churchill’s ill-considered attempt to return to gold at the pre-War parity, after its high inflation during the First World War, stands as a stern warning. The purchasing power of gold was greater in the rest of the world than in Britain at that old rate, gold accordingly fled Britain, and pound-sterling values faced inescapable downward pressure. Fortunately this point is widely appreciated today, and nobody advocates returning to such a low parity.

By similar logic, it would be foolish to declare a new parity of (say) $8000 per ounce, five times the current price. The result would be a sharp transitional inflation, and a very expensive importation of gold from around the world. Gold would rush in to take advantage of its higher purchasing power in the US, until the US price level rises approximately five-fold, to the point that $8000 no longer buys more than one ounce of gold.
The gold parity that would avoid any transitional inflation or deflation is something close to the current price dollar price of gold. “Close to” because there will be some change in the real demand for monetary gold following the stabilization of the gold value of the dollar. On the one hand, with lower expected inflation, the cost of holding non-interest-bearing money will be lower, and hence the real demand to hold money in the form of M1 dollars will rise. On the other hand, with dollar inflation risk dramatically reduced, the dollar-inflation-hedging demand for gold Krugerrands and Eagles and bullion will fall dramatically. The latter effect is likely to dominate, seeing that hedging demand is the main reason why the real price of gold is higher now than it was when the United States abandoned the last vestiges of gold redeemability in 1971.

Does the US Treasury own enough gold to return to a gold-redeemable dollar at the current price of gold? Yes, assuming that they have what they say they do. At a market price of $1600 per fine Troy oz. (to choose a recently realized round number) the US government’s 261.5m ounces of gold are worth $418.4b. Current required bank reserves are only $83b. Looked at another way, $418.4b is 19.9 percent of current M1 (the sum of currency and checking account balances), a more than healthy reserve ratio by historical standards.[6] Combined with the likelihood that US citizens’ hedging demand for gold will shrink by more than banks’ reserve demand will grow with larger real demand for M1 balances, I expect that the denationalization and remonetization of the US bullion stock at the current price would allow the US economy to export some excess gold. There will be a small transitional windfall for US citizens, getting imported goods and services in exchange for excess gold.

Expeditiously establishing a new gold definition for the US dollar thus requires the following two steps:
1) Withdraw most of the $1.6 trillion in non-required reserves that banks have accumulated since September 2009 by eliminating interest on reserves and selling the mortgage-backed securities that the Fed acquired in QE1, plus enough Treasuries to bring total bank reserves down to the current value of the US government gold stock.
2) Redeem Federal Reserve liabilities with the US government’s gold at the then-current market price.

Why not establish 100% reserves for M1?

$8000 is the approximate figure we get if we divide October 2011’s M1 ($2105b) by the stock of gold ounces held by the US government (261.5m oz.).[7] Some economists who favor 100 percent gold reserves for currency and checking accounts have offered this approach as the way to set a new parity. As noted above, however, such a high parity implies a large influx of gold from the rest of the world, a large loss of other US wealth in exchange, and a sharp transitional US inflation. The US cannot establish 100% gold backing for currency and checking accounts without great expense. (Even more expensive, because it implies an even higher dollar-per-ounce parity, would be to set the parity by dividing M2 or any broader aggregate by the existing stock of government gold.)

To be specific, at $1600 per ounce of gold, the difference between M1 (about $2.1 t) and the current stock of Ft. Knox gold (about $400b) is about $1.7t. American taxpayers would have to buy $1.7t worth of gold, a very expensive proposition. And that is only the one-time cost. In an economy with 3 percent per annum real GDP growth, assuming a flat trend in the ratio of gold to GDP, a constant purchasing power of gold implies the importation each year of 3% of the gold stock. For a gold stock of $2.1 trillion (100 percent of M1), that would mean an annual expense of $63 billion. With a 20 percent (or alternatively 2 percent) fractional reserve against M1, the annual expense would be one-fifth (or one-fiftieth) of that figure.

It should also be noted that with 100% reserves, the historically familiar sort of currency, circulating redeemable private banknotes and token coins, are infeasible. A money warehouse would be unable to assess storage fees on anonymous currency holders. Debit cards would still be feasible, but the warehouses issuing them would have to charge storage fees.[8]

What about the central bank?

Because the nation’s stock of money becomes endogenous under a gold standard, no monetary policy is needed.[9] Retaining a central bank committee to “manage” the gold standard undermines its automatic operation, creates uncertainty by opening the door to policies that lead to devaluation or suspension, and thus does more harm than good. A central bank inevitably faces political pressures to pursue monetary policies inconsistent with redemption for gold at a fixed rate. It can endanger or suspend redemption so with legal impunity, and it faces no competitive pressure to maintain its reputation. When the central bank runs a policy inconsistent with maintaining the gold standard, typically the gold standard gives. Competing private banks, which do face legal and competitive constraints, have a better historical track record than central banks for maintaining gold redemption.[10] The classical gold standard of 1879-1914 functioned quite well without a central bank in countries like Canada that did not weaken their commercial banks with legal restrictions. Even in the United States, despite several financial panics that (to judge from the Canadian example) could have been avoided by banking deregulation, the business cycle was not worse than it has been under the Fed’s watch since 1914. [11]

Nor does the gold standard require a central bank for other purposes. Many of the banks that issue checking accounts may also be relied upon to issue gold redeemable circulating currency notes, as they did before the Federal Reserve monopolized banknote issue, and token coins. The Fed’s other useful functions can be returned to private clearinghouse associations, namely the clearing and settlement of payments, the setting and enforcement of membership standards for solvency and liquidity, and the last-resort lending of temporary liquidity support to solvent member banks. Because their members’ own money is at stake and they cannot simply print fiat money, clearinghouse associations do not and cannot bail out insolvent banks at taxpayer expense, whether through direct capital injections, asset purchases at above-market prices, or loans at below-market rates.

The journalist Martin Wolf has written that “the obvious form of a contemporary gold standard would be a direct link between base money and gold. Base money — the note issue, plus reserves of commercial banks at the central bank (if any such institution survives) — would be 100 per cent gold-backed. The central bank would then become a currency board in gold, with the unit of account (the dollar, say) defined in terms of a given weight of gold.”[12] Actually, although irredeemable central bank notes are base money today, under a gold standard only coined gold and bullion reserves are base money. Notes in circulation are redeemable liabilities of the issuers and not part of actual or potential bank reserves. And although a currency board is less likely than a central bank to undermine the gold standard, there is no need for either. The most efficient form of a contemporary gold standard makes gold the base money, i.e. the medium of redemption and unit of account, while currency and other common media of exchange are the fractionally backed gold-redeemable liabilities of commercial banks. Wolf rightly recognizes that “It is wasteful to hold a 100 per cent reserve in a bank, if depositors do not need their money almost all of the time,” but does not draw the obvious conclusion that “a currency board in gold” is therefore less efficient than fractional-reserve banking under a gold standard. [13] Wolf expresses the common worry that “Such a system is unstable. In good times, credit, deposit money and the ratio of deposit money to the monetary base expands. In bad times, this pyramid collapses. The result is financial crises, as happened repeatedly in the 19th century.” But the banking system is more robust than he suspects, as seen in Scotland, Canada, Sweden, and other less-regulated systems without central banks under the gold standard. Repeated financial crises were a feature of the nineteenth-century banking systems in the United States and England, weakened as they were by legal restrictions, but not of the less restricted systems elsewhere.[14]

Barry Eichengreen’s recent critique of reinstating the gold standard

In a recent critique of proposals for reinstating a gold standard, the economic historian Barry Eichengreen has repeated the often-made but nonetheless absurd claim that a gold numeraire is equivalent to a commodity price support, writing: “Surely a believer in the free market would argue that if there is an increase in the demand for gold, whatever the reason, then the price should be allowed to rise, giving the gold-mining industry an incentive to produce more, eventually bringing that price back down. Thus, the notion that the U.S. government should peg the price, as in gold standards past, is curious at the least.”[15] Surely Professor Eichengreen understands that if there is an increase in the demand for gold under a gold standard, whatever the reason, then the relative price of gold (the purchasing power per unit of gold over other goods and services) will in fact rise, which will in fact give the gold-mining industry an incentive to produce more, which will in fact eventually bring the relative price back down. That one unit of gold continues be worth one unit of gold does not involve the pegging of any price.

“More curious still,” Eichengreen continues, “is the belief that putting the United States on a gold standard would somehow guarantee balanced budgets, low taxes, small government and a healthy economy.” Of course “guarantee” is too strong a term, and a budget balanced each and every fiscal year is not the right goal. But a gold standard does help to ensure budget balance in the desirable present-value or long-run sense, by requiring a government that wants to sell its bonds in the international market to stay on a fiscal path consistent with full repayment in gold.[16]

“Most curious of all” to Eichengreen “is the contention that under twenty-first-century circumstances going back to the gold standard is even possible.” This time is somehow different, apparently. But going back to the gold standard by re-establishing a dollar-gold parity requires today only what it has always required: (1) a sufficient real gold stock, which as shown above the US government already has on hand, and (2) the political will to do so. Developing a parallel gold standard, using present-day technologies for money transfer, would probably be easier today than it has ever been.

Notes
[1] For the generic definition and supply-demand analytics of a gold standard see Lawrence H. White, The Theory of Monetary Institutions (Oxford: Basil Blackwell, 1999), ch. 2.
[2] See Lawrence H. White, “Statement on HR 1098, The Free Competition in Currency Act of 2011,” http://financialservices.house.gov/UploadedFiles/091311white.pdf.
[3] Olivier Ledoit and Sébastien Lotz, “The Coexistence of Commodity Money and Fiat
Money, University of Zurich Department of Economics Working Paper No. 24 (August 2011), p. 2.
[4] Gabriele Camera, Ben Craig, and Christopher J. Waller, “Currency competition in a fundamental model of money,” Journal of International Economics 64 (Dec. 2004), pp. 535–36.
[5] Ledoit and Lotz, op. cit., p. 5.
[6] Note: In counting all the gold as bank reserves I’m assuming that coins in circulation would become redeemable tokens, not become full-bodied gold coins. The current numbers update Lawrence H. White, “Will the Gold in Fort Knox Be Enough?” in Prospects for a Resumption of the Gold Standard: Proceedings of the E. C. Harwood Memorial Conference [Economic Education Bulletin vol. 44, no. 9] (Great Barrington, MA: American Institute for Economic Research, 2004), 23-32.
[7] The Fed’s gold certificate entry as reported on its balance sheet (H.4.1, 6 October 2011) is $11,041 million, the product of the bookkeeping price of $42.22 times 261.511 million oz. Au. See also Federal Reserve Bank of New York, “The Key to the Gold Vault” (2008), p. 17, which notes: “A majority of these reserves are held in depositories of the Treasury Department at Fort Knox, Kentucky, and West Point, New York. Most of the remainder is at the Denver and Philadelphia Mints and the San Francisco Assay Office.” I ignore the US share of IMF gold.
[8] Lawrence H. White, “Accounting for Fractional-Reserve Banknotes and Deposits,” The Independent Review 8 (Winter 2003), pp. 423– 441.
[9]As Alan Greespan told Jon Stewart on the Daily Show, 19 Sept. 2007: “You didn’t need a central bank when we were on the gold standard, which was back in the nineteenth century. And all of the automatic things occurred because people would buy and sell gold, and the market would do what the Fed does now.”
[10] George Selgin and Lawrence H. White, “Credible Currency: A Constitutional Perspective,” Constitutional Political Economy 16 (March 2005), pp. 71-83.
[11] George A. Selgin, William D. Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?,” Cato Institute Working Paper no. 2 (November 2010), forthcoming in Journal of Macroeconomics.
[12] Martin Wolf, “Could the World Go Back to the Gold Standard?,” Martin Wolf’s Exchange blog (1 Nov. 2010), http://blogs.ft.com/martin-wolf-exchange/2010/11/01/could-the-world-go-back-to-the-gold-standard/#axzz1aPjGlRV6
Wolf incidentally remarks that “Economists of the Austrian school wish to abolish fractional reserve banking,” but this is true only of a fraction of Austrian-school economists.
[13] See Kevin Dowd, ed., The Experience of Free Banking (London: Routledge, 1992); also George Selgin, “Bank-lending ‘Manias’ in Theory and History,” in Selgin, Bank Deregulation and Monetary Order (London: Routledge, 1996).
[14] Barry Eichengreen, “A Critique of Pure Gold,” The National Interest (Sept. –Oct. 2011), http://nationalinterest.org/article/critique-pure-gold-5741.
[15] The recent Nobel laureate Thomas Sargent made this point in “An Interview with Thomas Sargent,” The Region (Federal Reserve Bank of Minneapolis), September 2010.

Since my last post was about Hayek, I will now say something about John Maynard Keynes. Keynes remains influential today for three reasons. One is that he led the kind of life every economist would like to lead. He was clever; became rich; knew most of the people worth knowing at the time in politics, finance, and the arts; and served Britain superbly during two world wars. The second is that he wrote some great stuff. The Economic Consequences of the Peace (1919), an international bestseller, is a prescient protest against the statesmen’s blunders in the aftermath of World War I that made another world war too likely. A Tract on Monetary Reform (1923) is that rare thing, a book on economics that is a masterpiece of writing style. If I recall correctly, Robert Skidelsky’s biography of Keynes reports that Virginia Woolf admired its style. Even the second volume of the Treatise on Money (1930) remains worth reading for economists interested in central banking.

The third reason Keynes remains influential is that his most important book, The General Theory of Employment, Interest and Money (1936), is a muddle. In a noble quest to explain the Great Depression, Keynes was struggling to express thoughts that were beyond his grasp, and in some areas beyond the grasp of other economists at the time also. Parts of the book contain flashes of insight expressed in Keynes’s vivid style, using metaphors from nature or Biblical parables. Other parts are head-scratchingly obscure, and have given rise to a cottage industry, persisting to this day, of trying to determine what Keynes really meant. The book is worth reading and even rereading for economists, but in the end it does not cohere and it should be read with that in mind.

In the same year as The General Theory was published in London, so was Vera Smith’s book The Rationale of Central Banking. Keynes’s book was the effort of mature scholar. Smith’s book was her Ph.D. dissertation, supervised by Hayek, published when she was just 24. Smith’s book, which is about how central banking came to replace free banking in a number of countries, attracted little notice when it was published, but it has had a long afterlife, and it is still read today, though by a far smaller continuing readership than The General Theory.

To my knowledge, Keynes never discussed free banking. He was willing to think about all sorts of other ideas that at the time were unusual, but despite its historical record, free banking seems to have been almost unthinkable for him as a live possibility for monetary reform. It was to remain so among economists generally for several decades. Keynes was, however, willing to think about other non-central banking systems. He was the guiding spirit behind the currency board that existed in North Russia from 1918-1919.

We are not done with Keynes yet. Even though his collected writings published by the Royal Economic Society run to 30 volumes, some important unpublished material remains scattered in archives and elsewhere. Perhaps one day we will turn up a letter, a memorandum, or a speech showing that he did at some point ponder free banking.

Alan Blinder in the Wall St. Journal today urges his readers to "remember the two fundamental determinants of exchange rates: (1) productivity in different countries—so, other things equal, faster productivity growth should lead to a rising exchange rate; and (2) prices and wages in different countries—so lower inflation should lead to a rising exchange rate. Thus, for a currency union to succeed, its member nations need to register approximately equal productivity growth and approximately equal wage and price inflation."

Really? There are at least two curiosities here, which I will label A and B.

(A) In standard usage, when an economist speaks of an exogenous shift that "should lead to a rising exchange rate," he is applying a theory of the market exchange rate in a regime of floating exchange rates. Here Blinder is talking about a currency union, within which there "should" be no changes in exchange rates because there is a common currency. If factor x would cause an appreciation of Germany's currency under floating rates but does not within the eurozone, that is not prima facie a failing of the currency union. Some other mechanism will provide the appropriate monetary adjustment, typically money flows into Germany from other countries.

(B) According to the standard Purchasing Power Parity theory of floating exchange rates, Blinder's (2) is the only fundamental determinant of exchange rates. If (1) matters, it matters only so far as it works though (2). There is in fact no need for currency union members to have approximately equal productivity growth. Example: Panama and the US have been in a successful currency union for 107 years. Likewise Maine and Florida.

Can any of my economist friends explain to me why on earth Blinder thinks that you can't have a currency union between countries with disparate productivity growth?