More on free banking and the historical gold standard

by Kurt Schuler July 31st, 2011 3:41 pm

Jon Catalan and David Glasner made comments about my post on free banking and the historical gold standard that are worth responding to, so here are some further thoughts on the subject.

Jon asked what influence Britain had on the world gold standard before World War I. Britain was the dominant financial power, because it was the leading country of the Industrial Revolution; market participants trusted the pound sterling to be as good as gold because of its comparatively good historical performance; and Britain’s huge empire led to many commercial and government financial transactions that were most easily settled in London, which then as now was the world’s largest financial center. All these factors gave Britain, the pound sterling and the Bank of England an importance that were not rivaled by China, the United States, or Germany, even though by the end of the period all had larger economies than Britain.

As I remarked, I do not consider that the Bank of England was the "conductor of the international orchestra" during the period. Its power was greater than that of any other bank, but limited by its avoidance of modern-style macroeconomic management and by the operation of the international gold standard as a system with few exchange controls. For instance, a period of falling prices affected Britain along with other countries on the gold standard from about 1873 to 1896. Falling prices resulted from increased demand for gold as Germany, followed by other countries, switched from silver or bimetallic systems (where both gold and silver were used as money, at a ratio set by the government) to gold. Government regulations regarding currency aggravated matters somewhat by erecting barriers to private coinage or issuance of notes that people might well have accepted as substitutes for gold coins in some countries. Countries that were on the silver standard or that were experiencing paper-money-based inflations did not have the same experience. It is currently hard to marshal the data, though. One of the goals of the Historical Financial Statistics data set, a spare-time project of mine, is to gather such data and make them readily available for public use. In many cases the data have been collected but not digitized, or digitized but not gathered conveniently together.

David Glasner said that “The adjustments at the margin that were sufficient to keep the prewar gold standard operating relatively smoothly most of the time were not sufficient in the interwar period after the enormous dislocations and inflations created by World War I and its aftermath.” The biggest dislocations were created by Britain and other countries trying to return to their prewar parities despite a large accumulation of inflation during the war. I think a second key factor in the instability of the interwar period was that central banks engaged in much more activist monetary policy than before the war. Moreover, an increasing share of the world’s countries had central banks. Glasner mentions that many observers think that if Benjamin Strong, president of the Federal Reserve Bank of New York, had not died prematurely in 1928, the Federal Reserve Board of Governors would have avoided many of the blunders it made that helped cause the Great Depression. I am inclined to agree, but the deeper question is why the financial fate of the world was so dependent on one man. The answer is that central banking by design had concentrated power to a degree that would not have occurred under free banking.


Ye Shall Know Them by Their Fruits

by George Selgin July 30th, 2011 10:36 am

Every once in a while I get this sudden urge to smash my fist into a nestfull of Rothbardian hornets, as I did with my last blog, causing a cloud of them from the EconPolicyJournal.com hive to rush to the defense of the Queen Wasp. As the venom of vespa rothbardbro has a curious molecular struture that may interest students of economic entomology, I here offer some samples from among those I garnered by means of my brave sacrifice to the cause of science:

"George Selgin has the mind of a child. I am almost embarrassed for him. It comes from hiding in a University environment where you don't ever have to grow up and be an adult in the real world so you can spend your life as a freakish governemnt (aka, mommy-n-daddy) worshiper. It sometimes is appealing...Especially with the young coeds."

"Rothbard's writings are as popular as ever, and we can all learn from them. Friedman's book sales are pretty much limited to required readings that appear on reading lists of Keynesian [!] economics professors."

"Selgin is dealing in the never, never land where accurate price indexes and productivity levels can apparently be determined with the snap of a finger. In other words, Selgin's monetary policy prescription can't be executed in the real world. It is fairy tale stuff."

"Check out that blog of Selgin's. Fractional Banking. IP-socialism. Attacks on LRC "cult". Attacks on Rothbard and Rockwell. Koch economists."

"Here is Selgins's "sophisticated" and "non-naive" version of the "Austrian" credit cycle theory: 'many Keynesians might accept the framework of monetary equilibrium offered by me. Those who do not regard liquidity trap as important factual possibility would probably accept it as entirely adequate' (Theory of Free Banking, p. 59)."

"There are no "policies" in a free market. Readjust your premises."

"Your criticism of Rothbard is desperate and reeks of nothing but mindless antagonism."

"Did you know that your name is constantly used as a straw man by anti-Austrian Keynesians and other statists who say things like "Even George Selgin agrees with me."? It's people like you who are hampering change for the better. You compromising fools perpetuate the very systems you claim to be against, and you don't even know it, because you're too busy worrying about tenure and being accepted by the establishment."

"Someone who manages to tell you in line one that he was debating "Lord xyz..." and in his concluding lines disses you and the blog with the condescension befitting one who banters with the British upper-crust, should maybe know the difference between elicit and illicit?" (NB: I did indeed type "illicited" in my original post. You can't be too careful.)

Being only a field researcher I must leave it to others to determine the precise damage done to me by all this poison. But for whatever the amateur observation may be worth, I'm feeling perfectly chipper.

Addendum. I somehow overlooked the following barb, which deserves a place of honor among the others:

"I knew Selgin was a fruit loop when he denied Austrian methodology and epistemology by ignoring inevitable unintended consequences and the violation of subjective value theory with his central bank efficiency policy recommendations."

I'm not sure just how I violated subjective value theory, but if I did I hope that the right sort of counseling will help it to recover from the trauma.


Me, Murray, and Milton

by George Selgin July 28th, 2011 12:00 pm

While I was debating Lord Skidelsky in London yesterday, Milton Friedman's son David posted this response to Lew Rockwell's assertion that his father "is almost nobody outside of mainstream economics."

David's reply has elicited many responses, including a few referring to yours truly not, thank goodness, as a Rothbardian, but as a self-styled "Austrian" economist. As David seemed to be under the impression that that characterization was correct, I added my own comment, which I reproduce here for the sake of further distancing myself from Austrian disparagers of the late, great Uncle Milty:

David, for the record, I don't "describe myself as an Austrian," and haven't done so since graduate school. Indeed, I consider myself no less a fan of your dad's work than I am of work by Hayek and Mises. I think a good economists [sic] cannot concern himself or herself with belonging to any school, or being loyal to one. I'm pretty sure your dad would have said the same. It was others who labelled him a "Chicago" economist, while the only label he sought was "good" economist.

Rothbard, on the other hand, was only too determined to identify himself with the Austrian School and, more than that, to both take part in a personality cult, built around von Mises, and attract such a cult himself. One sign of the presence of such a cult is precisely the scorn its members heap on potential rivals to the cult figure.

As a monetary economist (I don't pretend to judge Rothbard's other economic contributions) Rothbard was mediocre to bad. His version of the Austrian business cycle theory was naive--in essence it equated behavior of M consistent with keeping interest rates at their "natural" levels with the elimination of fractional-reserve banking, an equation that holds only with the help of about a dozen auxilliary assumptions, all of which are patently false. He then went on to conjure up an equally false history of banking and of bank contracts designed to square his theory of the cycle, with its implied condemnation of fractional reserve banking, with his libertarian ethics.

Thanks to all this nonsense people like myself and Larry White (who does still call himself an Austrian) have to waste oodles of time debunking his ideas--we most certainly haven't simply "ignored" them--that we'd rather spend attacking central bankers' shenanigans.

To add to the record, I had the privilege of getting to know both Murray and Milton. Like most people who encountered him while in their "Austrian" phase, I found Murray a blast, not the least because of his contempt for non-Misesians of all kinds. Milton, though, was exceedingly gracious and generous to me even back when I really was a self-styled Austrian. For that reason Milton will always seem to me the bigger man, as well as the better monetary economist.

Follow-Up: A blog styling itself the EconomicPolicyJournal insists that my blog and comments together amount to a logical muddle. For the record (and in case the "EPJ" (sounds even better, doesn't it!) finds it unworthy of...er...publication, I replied by noting that if there was an error of logic the esteemed journal itself was gulty of it, since, far from being the same as Rothbard's ideal, Friedman's frozen base proposal did not (1) call for a gold standard, (2) call for abolishing fractional-reserve banking, or (3) call for a constant stock of money in the usual sense meaning a constant stock of public money holdings.


Free banking and the historical gold standard

by Kurt Schuler July 19th, 2011 10:06 pm

Over at his recently established blog “Uneasy Money,” David Glasner has a post on “Gold and Ideology.” (He has started fast out of the gate, writing prolifically; I hope he doesn’t burn out, but there’s a lot to write about when the subject is money.)  He claims that  “the gold standard never managed itself; in its classical period from 1870 till World War I it was under the constant management of the Bank of England with the occasional assistance of the Bank of France and other major banking institutions.”

I disagree. First, it is a mistake to begin in 1870. The gold standard is centuries older, and countries that were not on the gold standard before the late 1800s, such as Germany and India, were generally on the silver standard, which works on just the same principles. So when we discuss the gold standard, we are discussing a system whose roots stretch into antiquity, not one that lasted less than half a century.

Second, every study I have read about the gold standard acknowledges that the pre-World War I version worked much better than the interwar version, and at least in some respects better than the post-World War II Bretton Woods version. But hardly anybody has expressed clearly what I think is the reason for the differences in performance: the pre-World War I standard was much less heavily managed than the subsequent versions. Many countries did not have central banks. Instead, they had free banking or highly rule-bound government issuance of currency. These cases included three of the world’s largest economies: the United States, China, and India. The central banks of the era were typically fully or partly privately owned, and aimed at making profits rather than at managing the economy, although at times, especially during crises, they did act in what they perceived to be a broader interest. The spread of central banking was the other side of the coin of the decline of free banking: by the end of 1935, free banking had shrunk to such a point that the most important place where it still existed was Venezuela.

John Maynard Keynes called the Bank of England the “conductor of the international orchestra” of the pre-World War I gold standard. I prefer a different metaphor, from a kind of music that I suspect Keynes had little use for. The pre-World War I gold standard was more like a jazz jam session, where the players were riffing variations on a standard tune. The Bank of England was the piano player, who had a major role but did not conduct the session. The piano player was sometimes off key, making the music sound discordant. A number of major financial crises in the 19th century originated in England. Before 1845, when Scotland had free banking while England had central banking, the crises were more severe in England. Central banking, even though less oriented at overall economic management than it later became, seems to have been a destabilizing rather than a stabilizing force.

Since this is a post, not an essay, that’s all for now. I will return to the subject later.


What we still need to know

by Kurt Schuler July 15th, 2011 10:26 pm

Here are what I consider the most important gaps in our current knowledge of free banking.

Free banking and monetary equilibrium. George Selgin has provided the base on which future inquiry will be built. More remains to be said about the way that bank clearings signal banks to expand, hold constant, or contract credit.

Free banking in comparison to other monetary systems. More work is needed using balance sheets, models, or other tools of systematic description for comparing in depth the operational details of various monetary systems, especially in terms of how well they discover and respond to changes in the supply of and demand for savings.

The history of free banking. Much has been done, but much remains to do. As far as I know, nobody has published a book describing in detail a single episode of free banking. (Lawrence H. White’s Free Banking in Britain was a combination of theory, economic history, and history of thought, appropriate to the time because of its pioneering nature, but it was not simply a study of how the Scottish free banking system worked and how it evolved.) Ignacio Briones, a Chilean economist, wrote a good dissertation on Chile’s free banking period of the late 1800s, but he has not published it because he is busy in his current job as coordinator of international financial affairs in the Chilean Ministry of Economy. Moreover, he wrote it while studying in France and it is in French, a language that far fewer economists today read than read English or Spanish. Anders Ögren, a Swedish economist, has written a dissertation, published as a book, on the Swedish monetary system of the 1800s, but if he is to be believed, it was not a free banking system.

Returning to free banking. What are the steps, particularly with respect to financial regulation, that would re-establish free banking with the smoothest transition? Once re-established, are there any measures that would make free banking more politically durable than it proved to be the last time around? I understand that a student at George Mason University is working on issues such as these, advised by Larry White.

Rival monetary standards and free banking. Historically, free banking has been associated with the gold or silver standard. Other standards are conceivable, and have been proposed, such as Milton Friedman’s idea to freeze the existing monetary base or the late Earl Thompson’s idea for a labor standard of value. How do different possible standards compare with respect to their theoretical properties? In the end, consumer choice would determine which was superior. People might choose gold again, in which case we would have to investigate what it is about gold that people find to be so appealing. Or competing standards might coexist without one ever gaining a decisive advantage.


The Folly that is “Local” Currency

by George Selgin July 14th, 2011 5:16 pm

How’s this for a great idea: we build a small fleet of cars, and market them to people in the local community. How do we compete with Ford, G.M., Toyota, and all those other huge car companies? Easy. You see, our cars will have special octane requirements that will prevent them from refilling at ordinary gas stations. Instead, we’ll set up a few local stations that will be the only ones equipped with the right fuel. To top it off (so to speak), our cars will also have small gas tanks to prevent them from reaching the next town on a single tank. (Should we decide to go electric, we can instead equip them with special plugs and voltage requirements to accomplish the same result.) What all this means is that unlike other cars ours—call them “LETS” for “Local Energy Transportation Systems”—can only be used around town. That way, people who go shopping with them have no choice but to shop locally, and so contribute to boosting the local economy. Who wouldn’t want to do that?

The answer, to get serious, is plenty of people wouldn’t. Even people who like to buy local don’t like having to do so; and the option of driving out of town, whether to shop or for some other reason, is valuable. So a car that can go anywhere is worth more—for many a lot more—than one that can’t, which means that so long as Ford or Toyota or any other manufacturer can make a decent “national” car for no less than what the local alternative would cost, we’d better leave making cars to them.

Such reasoning presumably explains why there’s no such thing as a Local Energy Transportation System aimed at challenging existing car makers. Yet there is such a thing as LETS: it stands for “Local Exchange Trading System,” and there are now several hundred such systems in operation around the world. LETS are part of a still larger “local currency” movement. Like the fictional LETS we were just toying with, actual LETS and other local currency arrangements are designed to encourage people to shop locally. The UK LETS website, for example, boasts that, unlike ordinary money which “is quickly sucked out of the area where it has been created,” LETS “stays local, benefiting the community, rather than outside-interests.” The schemes’ promoters see to it that their currency won’t “leak out” of the local economy by encouraging local merchants and banks to accept it, while scrupulously refraining from encouraging “outsiders” from doing so. In short, they make a virtue of their currencies’ limited usefulness—of the fact that, unlike most exchange media, they are not generally accepted.

This strategy ought to make local currencies about as desirable as cars that can only run on local gas. Yet (if Wikipedia’s experts can be trusted) there are some 2500 such local currency schemes afloat, with new ones popping up all the time. So are monetary economists wrong in supposing that to be any good money has to be generally acceptable? They aren’t, and the proof is that the 2500 local currency systems collectively represent an insignificant part of the world money stock, and that the vast majority of such schemes that manage to get off the ground collapse after a few years, if not sooner. As for the few that have lasted longer, almost all are, by no coincidence, located in (mostly “liberal”) communities where strong “buy local” sentiments prevail. This means that there are relatively large numbers of people who feel good about shopping locally, for whom the opportunity cost of employing a strictly local currency is relatively small. For such consumers using local currency is like clipping coupons for stuff one plans to buy anyway. As for the banks that agree to accept local currency, most do so solely for public relations reasons, and despite the fact that local currency dealings eat into their profits, as is evident from the general reluctance of banks with large out-of-town networks to participate.

More importantly, the object that the local currency movement would achieve if it could—that of of “keeping trade within the community”--is, like all forms of protectionism, a highly dubious one: As Tim Harford succinctly puts it, “the gains from more trade with locals are more than offset by the losses from less trade with strangers. Otherwise economic sanctions would be a blessing.” (Try telling a Palestinian or Cuban about the virtues of “buying local”!)

Besides constraining people to buy locally, many local currencies are designed to yield “negative” interest, by losing value relative to national money according to a fixed schedule, or by expiring entirely after a certain period, or both. The idea here—one first popularized in the 30s by Silvio Gesell—is to discourage people from holding on to local money, thereby increasing its velocity, so that a given quantity results in that much greater a boost to local spending. Here again the aim of boosting local spending is at loggerheads with that of making local currency an attractive substitute for national currency. To return to the “local car” analogy, it would be like saying to a prospective car buyer, “Look, our cars’ bodies rot fast, so you’ll have to go shopping more often to get your money’s worth!”

This isn’t to say that local currency can never serve any purpose apart from that of allowing some people to better display their kind disposition toward local merchants and producers (or, perhaps, their poor understanding of basic economics). Historically, local currencies have played a crucial role in sustaining exchange when national alternatives were in short supply, as happened during the Great Depression (when in many communities “scrip” made up for vanished or inaccessible bank deposits), and as happened in late 18th-century England (when private mints and coin issuers made up for a dearth of official small change). Despite its inconvenience local money is of course better than no money at all; besides, the further back one goes the less onerous local currency becomes, since people traveled less anyway.

Though the shortcomings of local currency are serious ones, they are far from being inherent shortcomings of all substitutes for official (national) currencies. On the contrary: far from being inherent to such substitutes the shortcomings of local currencies are ones which, as I’ve indicated, have been purposely built into those currencies by persons seeking to make them serve an end quite at odds with that of making it as easy as possible for people to exploit potential gains from exchange. There is, in fact, nothing to prevent other kinds of unofficial currency from commanding a national market. The key to having them do so is that, like modern bank deposits, they must be fully compatible with the existing monetary standard, and readily useful throughout the national economy, if not beyond it. Historically, private banknotes have possessed these qualities wherever legal restrictions haven’t prevented banks from establishing branch networks or taking other measures to make their notes current beyond the banks’ headquarters; and it is conceivable that other forms of private currency, including privately-issued token coins, could also take the place of government-supplied alternatives, if only the government would let them.

So, while I applaud the effort of local currency proponents to break the Federal Reserve’s currency monopoly, I regret that they’ve chosen to sabotage this merit-worthy mission by linking it to the much less worthy one of keeping people from trading with “outsiders.” As the ever-sensible Bastiat once observed, “The worst fate that can befall a good cause is not to be skillfully attacked, but to be ineptly defended.”


Cross of Gold Speech Anniversary Today

by Bradley Jansen July 9th, 2011 10:45 am

Says the NYTs today, "On July 9, 1896, William Jennings Bryan caused a sensation at the Democratic National Convention in Chicago with his "cross of gold" speech denouncing supporters of the gold standard. Bryan went on to win the party's nomination."  We should add that he lost the general election, of course.  In fact, his was a politically losing argument not only in 1896, but 1900 and 1908 for him as well.

I wonder if there are any Gold Democrats left.  They had a great platform at the Convention of the National Democratic Party at Indianapolis, Ind., September 3, 1896.

'This convention was assembled to uphold the principles upon which depends the honor and welfare of the American people in order that Democrats throughout the Union may unite their patriotic efforts to avert disaster from their country and ruin from their party. The Democratic party is pledged to equal justice and exact justice in all men of every creed and condition; to the largest freedom of individual consistent with good government; to the preservation of the Federal Government in its constitutional vigor and support of the maintenance of the public faith and sound money; and it is opposed to paternalism and all class legislation. The declarations of the Chicago Convention attack individual freedom, the right of private contract, the independence of the judiciary, and the authority of the President to enforce Federal laws. They advocate a reckless attempt to increase the price of silver by legislation to the debasement of our monetary standard, and threaten unlimited issues of paper money by Government. They abandon for Republican allies the Democratic cause of tariff reform to court the favor of protectionists to the fiscal heresy. In view of these and other grave departures from Democratic principles, we cannot support the candidates of that convention, nor be bound by its acts. The Democratic party has survived a victory won in behalf of the doctrine and the policy proclaimed in its name at Chicago. The conditions, however, which make possible such utterances from a national convention are a result of class legislation by the Republican party. Is still proclaims, as it has for many years, the power and duty of the Government to raise and maintain prices by law; and it proposes no remedy for existing evils except oppressive and unjust taxation.'

The Independent had a write up of the Gold Democrats not so long ago.

History reminds us that Bryan campaigned not only for monetary debasement but prohibition of alcohol and the teaching of evolution (he wanted it banned in church-related as well as public schools).  In fact, the chief proponent of monetary debasement was also the leading light against the teaching of evolution at the Skopes trial in 1925.

Getting back on point, our friend Dan Mitchell posted this video of the speech of an NPR episode with a clip from Jennings repeating the cross of gold speech in 1923:


Is the Euro Flawed?

by Larry White July 8th, 2011 7:36 pm

What follows is the slightly revised first part of remarks I gave at the Estoril Political Forum, in Estoril, Portugal, on 28 June 2011.

Of course the euro is flawed. It is not, after all, a monetary standard evolved by the invisible hand of the marketplace from the decentralized choices of millions of users. Nor is it the next-best thing, divinely ordained. Instead, it is the brainchild of politicians and economic technocrats, assembled in committees.

Google the two terms “euro” and “flawed” together, and you receive back more than 2 million results. And that is only for the commentary in English.

Nearly all commentators agree that the euro is flawed in some way. I say “nearly all” but not “absolutely all” because officials of the European Central Bank sometimes join the discussion. They have yet to identify a flaw in the euro or in the European Central Bank that issues it.

There is much less agreement about how the euro is flawed, or about what a more ideal currency system would look like.

When the currency speculator George Soros says that “the euro is a flawed construct,” as he did in a widely reported speech in Berlin last year, he means that in his view it needs a stronger political union behind it, a single pan-European-Union welfare state, so that one fiscal policy (one set of taxing and spending decisions) could be made for all of Europe together with one monetary policy. The ECB’s head, Jean-Claude Trichet, has similarly begun to complain in recent weeks about the ECB’s lack of a companion Eurozone finance ministry to centralize member countries’ fiscal policies. Europe should resist the siren call that greater centralization of power will solve its problems. As a matter of fact, two or more countries can readily have a common money while keeping fiscal independence. They did so under the classical gold standard, a system to which I will return. Soros hopes that with one pan-European government, financially conservative Germany would no longer rule the roost. The ECB could then pursue looser monetary policy, which he supposes would cure the ills of the countries with weak economies and mounting public sector debts. This view, I fear, is widely shared.

When retired Dutch central banker André Szász says that the euro was flawed from the start, as he did earlier this year, he means almost the opposite, that it is a mistake to have “a monetary policy of one-size-fits-all” because such a monetary policy will be too loose for some countries and too tight for others, or as he puts it, interest rates will be “too low” for some countries and “too high” for others. Paul Krugman has registered the same complaint, as has Marine Le Pen of France’s National Front. This criticism is linked to the so-called “optimum currency area” analysis, which holds that to share a single currency, two or more economies should have “harmonized” business cycles so that a single monetary policy (interest rate) fits them all. Otherwise devaluation or exchange rate depreciation is supposed to help a weak economy dampen unemployment by lowering real wages or by stimulating real growth through greater real exports.

I think that both of these diagnoses begin from false premises. They both rest on the wishful thinking of Keynesian economics, in particular on the fond hope that an artfully timed discretionary monetary policy will improve or stabilize an economy’s real performance by improving or stabilizing real variables. That is to say, these arguments take for granted the ability to exploit the Phillips Curve (to lower unemployment by cheapening the monetary unit), alternatively known as exploiting the “money illusion” of the workforce. I think it is the supposed ability to exploit “money illusion” that is the real illusion. A policy regime of printing more money and devaluing does not in fact improve real economic performance, or dampen business cycles, but the does the reverse. The historical evidence on that question is clear.

A better start to understanding the fundamental shortcoming of the euro is to begin with the simple fact that the euro is a fiat currency, a paper money standard. A former business partner of George Soros, but of very different political persuasion, the investor Jim Rogers, has it right when he notes that “generally … paper money is flawed.”

The time-inconsistency problem

Economists have a technical term for the fundamental flaw in fiat money.  They call it “the time-inconsistency problem” or “the credible commitment problem.”

The classical allegory for the time-inconsistency problem is the episode in the Odyssey in which Odysseus wants to hear the beautiful singing of Sirens, but knows that without some binding constraint to keep him from the ship’s tiller, he would give into the temptation to steer the ship in the direction of the Sirens and end up smashed on the rocks.  Solution?  He has his shipmates tie him to the ship’s mast, and plug all of their own ears with wax. By constraining himself against temptation, Odysseus achieves a better outcome than if he had left himself with moment-by-moment discretion.  In light of today’s news, how ironic that this man who know to bind himself against short-sighted behavior was Greek.

When central bankers who issue fiat money have the discretion to alter monetary policy from month to month, to do whatever seems desirable at the moment, they also have a problem of the same sort.  (Kydland and Prescott brought this problem to the economics profession’s attention, and received a Nobel Prize in large part for doing so.)  Central bankers will find themselves pressured to promise low inflation and then to deliver something else that is inconsistent with low inflation, namely rapid money growth to lower unemployment or to buy up bad debts.  They face no penalty for breaking their promises.  As a result, the private citizens who use euros (for example) don’t know what the euro will be worth 5 or 10 years out, unless there is some binding commitment to a steady policy path.  Without a binding commitment, inflation is unnecessarily high and variable.

The European Central Bank has a commitment on paper, of course, to keep inflation below 2 percent.  But in the face of
pressure to buy the bonds of heavily indebted governments, to delay the day of reckoning for the sovereign debt crises of Greece, Ireland, and Portugal, the ECB’s commitment to low inflation is crumbling.

Contrast a free-market silver or gold standard.  Under such a monetary standard, the private mining firms that dig up the precious metals, the mints that produce coins, and the banks issue redeemable notes and transferable account balances are all constrained by contract and by competition.  There is no time-inconsistency problem in monetary policy because there
is no monetary policy.  Nobody has discretion over the quantity of money.

The challenge, for those who believe in the rule of law, is to reintroduce such constraints on money creation.   If not a gold standard, a serious and enforceable limit on fiat money.  You can’t believe in the rule of law and also believe in discretionary rule by central bankers.

The time-inconsistency problem was known to the designers of the ECB constitution and to some of the bank’s early officials, in particular the German economist and ECB board member Otmar Issing and the ECB’s first president, the Dutchman Wim Duisenburg.  To their credit, they tried to tie the ECB to the mast, to institute a quasi rule of law, to give to give the euro a binding pre-commitment to a steady policy path.  The ECB constitution specified that the ECB is to have an exclusive commitment to “price stability,” and a board statute early on that “price stability” means inflation no higher than 2%. The ECB website continues to declare:  “The ECB aims to maintain annual inflation rates as measured by the HICP [Harmonized Index of Consumer Prices] below, but close to, 2% over the medium term.”

In 2000, I participated in a published exchange with Prof. Issing, then a member of the ECB board.  In a lecture to the Institute of Economic Affairs (London), Issing emphasized that the ECB constitution had solved the time-inconsistency problem by tying the ECB irrevocably to the single goal of price stability.  In my commentary I said it was too soon to tell whether the constitution’s commitment on paper would actually bind the ECB in practice when pressure arose to pursue some other goal.  For a commitment to be a binding commitment, there must be some penalty for going astray.  The ECB constitution unfortunately does not specify any penalty for ECB officials who deviate from an exclusive focus on price stability.  They do not lose their jobs.  This is a fundamental design flaw.  The euro performed well for a decade, but now the sirens are singing.

Today the leadership of the ECB, under pressure from the EU and the national fiscal authorities, is violating its constitutional duty by filling the ECB portfolio with junk bonds from Greece, Ireland, and Portugal, in order to keep prices on those bonds high and yields low.  It is trying to support government bond prices generally, to make debt rollovers cheaper, by holding interest rates at a record low level, a level that is inconsistent with keeping inflation at or below 2 percent.

The result of the new monetary policy is becoming evident.  In 2011, the euro inflation rate has been persistently above the promised 2 percent ceiling.  The HICP has risen from 110.6 in November 2010 to 113.1 May 2011, six months of inflation at an annual rate of 4.5 percent, more than double the constitutional rate.  How much higher will the ECB let it go?


David Glasner is now blogging

by Kurt Schuler July 6th, 2011 11:16 pm

David Glasner has just begun his own blog, Uneasy Money. Glasner wrote the worthwhile book Free Banking and Monetary Reform (1989). The publisher, Cambridge University Press, wants £72 for it. Amazon sells it at about half as much new, $58, and AbeBoooks.com has used copies starting at $15. Readers who want to acquire the book will presumably minimize their costs.

In his first post, Glasner speaks of "the groundlessness of right-wing opposition to monetary easing." Whoa, fella. You accept Scott Sumner's argument that the Federal Reserve didn't respond fast enough to a large, sudden rise in demand for the monetary base in 2008. Eventually it did respond, and now the monetary base is about three times what it was just before the recession. Isn't it equally conceivable that the Fed won't respond fast enough if there is a large, sudden fall in demand for the monetary base? If so, the right-wing critics have a concern that may  become valid sooner than you expect. That being said, I look forward to reading further installments of the blog.



Four thoughts for July 4

by Kurt Schuler July 1st, 2011 9:55 pm

1. Why you should read this blog:

If the voters or the members of a parliament are faced with the problems raised by a bill concerning the prevention of cattle diseases or the construction of an office building, they may leave the discussion of the details to the experts. Such veterinarian and engineering problems do not interfere with the fundamentals of social and political life. They are important but not primary and vital. But if not only the masses but even the greater part of their elected representatives declare: “These monetary problems can only be comprehended by specialists; we do not have the inclination to study them; in this matter we must trust the experts,” they are virtually renouncing their sovereignty to the professionals. -- Ludwig von Mises, Bureaucracy, page 120

2. Much as the effectiveness of central planning was the overarching economic policy issue of the 20th century (and a focus of Ludwig von Mises's thought for most of his life), the financial sustainability of the welfare state will be the overarching economic policy issue of the 21st century, at least of its first several decades. Some weeks from now, after I have thought about the issue more, I will have something to say about where free banking fits into the picture.

3. The term "rent seeking" describes a pervasive problem that affects banking and many other economic sectors. It is such an awkward piece of jargon, though, that economists have long sought a snappy alternative. How about "the steal industry"? (Hat tip to a commentator at Coordination Problem.)

4. In the Declaration of Independence, about the only thing the Founding Fathers did not accuse George III of was debasing the currency. That was because most of the 13 colonies had already done it to themselves, over the objections of British officials.