Up for grabs again

by Kurt Schuler October 28th, 2011 11:44 pm

Central banking has undergone drastic changes during the last 100 years that are often unappreciated today. Before World War I, most central banks were partly or entirely privately owned. They were not expected to spur economic growth or smooth business cycles. Rather, they defined their goals more narrowly as adhering to the gold standard and earning modest profits for their shareholders in normal times. True, during wars they were expected to lend heavily to the government, temporarily suspending the gold standard if need be, and during financial crises they were expected to act as lenders of last resort to solvent but illiquid financial institutions. War between the major powers was viewed as improbable, though.

World War I struck like a thunderclap. Browse through old issues of the Commercial and Financial Chronicle, which in 1914 was the leading U.S. business publication, and you will see that in the month leading up to the war, European politics received little ink, as if the assassination of Archduke Franz Ferdinand were of no more world importance than the man who fired shots at the U.S. embassy in Sarajevo today. Then war came and within a week, more than half the world was embroiled in it, because Europe’s colonies were involved also.

By the war’s end, the central banks of the belligerent countries had created so much inflation to finance the war that returning to prewar exchange rates was either painful or impossible. Although the gold standard in principle remained the goal, the war had planted the idea that monetary policy could be “mobilized” in peacetime somewhat as it had been in wartime. The brief return of many countries to the gold standard in the late 1920s occurred in an intellectual climate where the standard no longer enjoyed its former unquestioned, and largely unquestioning, support. The Great Depression and World War II finished the job. By 1945, almost all central banks were government owned institutions whose primary goal was macroeconomic management, not profit seeking. There was a kind of gold standard — the Bretton Woods agreement had been signed and the signatories were working towards implementing it — but it was a gold standard in most cases hedged about by exchange controls, and without the depth of commitment of the pre-World War I gold standard. In the early 1970s that, too, ended.

As all readers who are at least middle-aged will remember, a generation of turbulence followed. Inflation in the rich countries in the 1970s, the Third World debt crisis of the 1980s, inflation in postcommunist countries and the emerging market financial crises of the 1990s. Finally, in the last decade, there were some quiet years, when it was plausible to think that the main practical problems of central banking been largely solved. Now it’s all up for grabs again.


Once more: central banking is a form of central planning

by Kurt Schuler October 22nd, 2011 11:57 pm

I have been busy writing a paper that I will summarize in a later post, so I am only now making a belated reply to comments by David Glasner at his worthwhile blog, Uneasy Money, disputing my claim that central banking is a form of central planning. I will take one last shot at the subject for now because the idea that central banking is a form of central planning is a crucial part of free banking thought, and because I am amazed by Glasner’s view given that he once wrote a book on free banking,

Central planning need not extend to every economic activity. It is enough for the government to control key institutions, which Vladimir Lenin called “the commanding heights” of the economy. The monetary system is obviously one such institution. A monetary system that is not under government control is incompatible with central planning because it gives people a powerful and easy means of making decentralized exchanges that circumvent the plan.

As I wrote in a previous post, centrally planned economies have monobank systems, in which commercial banking is a government monopoly, whereas in more market-oriented economies, commercial banking is competitive. Even if a monetary system has competitive commercial banking, it remains true that central banking injects substantial elements of central planning. The whole point of central banking in the form in which it has existed since about World War I is to monopolize the monetary base; consciously use the monopoly to affect conditions throughout the economy; do so through a centralized, government institution; and prevent challenges to the monopoly that might end its power. None of these elements are present in a free banking system.

Glasner claims that in Hayek’s monograph Denationalisation of Money, “Hayek’s dismissal of central banking was crucially and explicitly dependent on an argument that private competitive banks would issue their own currencies defined in terms of units of their choosing not redeemable in terms of any outside asset not under the control of the issuing bank.” The monetary system Hayek discussed Denationalisation of Money was one of competing, bank-issued fiat currencies, but Hayek was also aware of the existence of competitive banking systems based on gold. Much earlier in his career he supervised Vera Smith’s dissertation, The Rationale of Central Banking, which discussed some historical episodes fitting that description. Hayek, like his teacher Ludwig von Mises, had an extraordinarily wide range of intellectual interests, of which monetary theory was only one. They did much, but left much still to be done by successors who were willing to focus on monetary theory alone. That helps explain why the building blocks of the idea that central banking is a form of central planning are present in Mises and Hayek, but not until Lawrence H. White and George Selgin in the 1980s did Austrian economists use the building blocks to construct a detailed argument.

We can agree that central banks are run by intelligent people who have good intentions. We can debate whether there is some element of natural monopoly in money that means certain tasks are better done by a central planner than by competitive markets. (If it really is a natural monopoly, why does the law need to forbid competitors?) It should be evident, though, that central banking is indeed a kind of central planning.


Tom Sargent, 2011 Nobel Laureate

by Larry White October 10th, 2011 11:17 pm

In honor of Tom Sargent's prize, I extract the last section of (forgive the self-promotion) my forthcoming book The Clash of Economic Ideas (due out in April from Cambridge University Press).

Unpleasant monetarist arithmetic

During the early 1980s a group of economists then at the University of Minnesota and the Federal Reserve Bank of Minneapolis, Thomas J. Sargent, Neil Wallace, and Preston Miller, spelled out a worrisome potential connection between the growth of government debt and the resort to inflationary finance. Their basic message was that the ability to finance government spending with borrowing will eventually hit a ceiling, leaving money-creation the only method left for covering continued budget deficits. The resulting inflation cannot then be stopped, because money-creation cannot be stopped, unless there is a fiscal reform: “the monetary authority is forced to create money” to satisfy a need for seigniorage revenue.

In a much-discussed 1981 article entitled “Some Unpleasant Monetarist Arithmetic,” Sargent and Wallace asked their readers to consider a fiscal and monetary regime in which the fiscal authority (say, the Congress) first announces the path of future budget deficits. By rearranging the budget constraint, we see that the size of a budget deficit (G – T) must be matched by the sum of new borrowing and monetary expansion:

G - T = ΔD + ΔM.

In other words, a budget deficit implies some combination of bond finance and inflationary finance.

To explain the limit on bond finance, Miller and Sargent defined G as spending on things other than debt service, and defined ΔD as the proceeds from borrowing net of debt service (i.e. net of interest and principal payments on the public debt). From an ordinary upward-sloping supply curve for loanable funds it follows that the real interest yield required by bond-buyers (lenders) rises with the volume of a government’s debt, other things equal. The size of ΔD then eventually hits a ceiling for “Laffer Curve”-type reasons. At some high ratio of debt to GDP, issuing new debt is a wash (nothing is gained for government spending) because the rising bond yield demanded by the market raises the cost of debt service on the entire debt (as it is rolled over) by as much as the new amount borrowed. Only inflationary finance then remains to meet ongoing deficits.

To avoid this “unpleasant” fate, Sargent and Wallace advised, the path of deficits must be kept in check. They suggested that the monetary authority should announce its plans for future money growth first, thus limiting the feasible path of deficits. Alternatively, a switch from fiat money regime to a commodity money regime could effectively restrict the path of M. As Sargent commented elsewhere:

Remember that under the gold standard, there was no law that restricted your debt-GDP ratio or deficit-GDP ratio. Feasibility and credit markets did the job. If a country wanted to be on the gold standard, it had to balance its budget in a present-value sense. If you didn’t run a balanced budget in the present value sense, you were going to have a run on your currency sooner or later, and probably sooner. So, what induced one major Western country after another to run a more-or-less balanced budget in the 19th century and early 20th century before World War I was their decision to adhere to the gold standard.

Sargent here seemed to assume that a government central bank issues the country’s gold-redeemable currency, and bears the brunt of a speculative attack. Many countries under the classical gold standard before World War I, like the United States, Canada, and Australia, had in fact no central bank, but instead decentralized private note-issue. A more general statement of the disciplinary mechanism would be: If a country didn’t run a balanced budget in the present value sense (spending balanced by present taxes or a credible commitment to future taxes), the international bond market would put a high default premium on its bonds, eventually making further bond finance impossible.

Some critics regarded Sargent and Wallace’s scenario as far-fetched. In a 1984 comment, Michael Darby argued that their model was “seriously wrong as a guide to understanding monetary policy in the United States.” An economy reaches the “unpleasant” zone in their model when the real yield on government bonds exceeds the economy’s growth rate. The real yields on US Treasury bonds and bills from 1926-81, Darby pointed out, had averaged close to 1 percent per annum, while the economy grew at around 3 percent per annum. Deficits were financed by new debt without the real yield appreciably rising or the revenue from bond finance coming close to a ceiling. The monetary authority’s hands were therefore never tied by fiscal policy, and it could choose the rate of money creation independent of the size of the deficit. The United States, one might say, remained in Pleasantville.

In a reply, Miller and Sargent emphasized that the real yield on government bonds isn’t given, but rises with the real debt or debt-to-GDP ratio. Darby’s evidence about United States’ past does not rule out the real yield on US government bonds someday rising above the economy’s growth rate if the debt-to-GDP continues to rise (a point Darby had already conceded in theory, but thought far from currently relevant). They noted two other effects working toward unpleasantness as the debt-to-GDP ratio rises: (1) Private capital and real income decline as government debt crowds out capital formation, therefore T falls and the deficit grows relative to GDP; and (2) The real demand to hold money falls as bond yields rise, therefore the tax base for real seigniorage falls. As if anticipating the events in Greece and Ireland twenty-five years later, they warned that a large jump in the size of government budget deficits can push a previously pleasant economy it into the unpleasant zone where real government bond yields rise above the economy’s growth rate and the debt-to-GDP ratio begins to grow without limit.

Sargent would go on to explain the Greek and Irish fiscal crises by applying the unpleasant-arithmetic argument. Despite the European Central Bank’s rules against any member country running a large deficit or accumulating a high debt-to-GDP ratio, a number of countries at the European Union economic periphery—Greece, in particular—violated the rules convincingly enough to unleash the threat of unpleasant arithmetic in those countries. The telltale signs were persistently rising debt-GDP ratios in those countries. Of course, the unpleasant arithmetic allows them to go up for a while, but if that goes on too long, eventually you’re going to get a sovereign debt crisis.

Time will tell whether—or how soon—the governments of Japan, the United States, the United Kingdom, or other countries will get a debt crisis. But seeing government debt sharply rising in those countries, and having observed events in Greece and Ireland, one can no longer dismiss the unpleasant scenario of a sovereign debt crisis as far-fetched.


Dexia: Nothing New Under the Sun and Financing Failure

by Vern McKinley October 9th, 2011 6:41 am

Took some time away from blogging recently distracted by a number of issues, including moving back to the US from Kyiv where I had been living for 18 months, transitioning to different clients work-wise and also finalizing a book I have been working on the past two plus years.

It is interesting to see that not much has changed world-wide as far as how central banks and governments around the world continue to panic at the least sign of a potential large bank failure. This week governments were aflutter about Dexia Bank of Belgium as its central bank, as well as the French central bank, are coming to the rescue (http://www.reuters.com/article/2011/10/04/dexia-belgium-cenbank-idUSB5E7KS06420111004).

Dexia Bank is an interesting case for a number of reasons.  First of all, it just received a bailout package three years ago from its government and I guess that went so well that another bailout may be in order. This parallels the well-publicized troubles of Bank of America in recent weeks which had a relapse with its stock back down near 2009 lows. This is after it was bailed out in early 2009 when the Merrill Lynch purchase threatened its long-term viability. I also recall during the 1980s that two of the largest banks in Texas during that period were bailed out and then they ultimately failed a few years later when the bank groups did not bounce back as expected: BancTexas and First City. So the history of bailouts reveals that many times the cure just does not take.  The way the bailout crowd explains it though is that bailouts are an elixir that cures all ills for a bank under stress.

Another interesting issue about Dexia is that just this past summer it went through the so-called “stress tests” by the European Banking Authority. Dexia passed with flying colors with an 11% capital ratio intact, well above the 10% ratio that its regulators had hoped for. This was the procedure that 91 of Europe’s largest banks went through to see how they could withstand the stress of a downturn. Seems the stress test was not so stressful, as it just assumed that sovereign debt would not cause any problems for Dexia. So the post-crisis panacea for addressing future stress of having banking agencies worldwide demand higher capital ratios and then intervene early to avoid bailouts seems to be coming apart before it was even fully implemented.

To loop back to a few of the issues I started with at the beginning of the post, have a look at a recent interview I had with the Wall Street Journal about my forthcoming book Financing Failure: A Century of Bailouts and the Independent Institute’s promotional page that provides a summary and some initial comments on the book itself.


Achieving a Stable Dollar

by Larry White October 6th, 2011 10:20 pm

I gave the following talk this morning at the Heritage Foundation Conference on a Stable Dollar, held at the Ritz-Carlton Hotel in Arlington, VA.

I’m going to talk about some of the choices we face among monetary regimes, including choices among various types of gold standards. But let me begin with a story.

One day I saw this guy about to jump off a bridge. I said to him, "Don't do it!" He said, "Why not? Nobody loves me." I said, "God loves you. Do you believe in God?" He said, "Yes." I said, Me, too!”

"Are you a Christian or a Jew?," I asked. He said, "A Christian." I said, "Me, too! Protestant or Catholic?" He said, "Protestant." I said, "Me, too! What franchise?" He said, "Baptist." I said, "Me, too! Northern Baptist or Southern Baptist?" He said, "Northern Baptist." I said, "Me, too! Northern Conservative Baptist or Northern Liberal Baptist?"

He said, "Northern Conservative Baptist." I said, "Me, too! Northern Conservative Baptist Council of 1879, or Northern Conservative Baptist Council of 1912?" He said, "Northern Conservative Baptist Great Lakes Region Council of 1912." I said, "Die, heretic!" And I pushed him off the bridge.

I tell this story – borrowed from the comedian Emo Phillips—in order to emphasize that in discussing the choices among types of gold standars I don’t intend to declare anyone a heretic. If you think that the questions of whether and how to completely privatize money can wait until after we re-establish a gold dollar, I don't propose to push you off the bridge.

What should Congress do?

1) Immediately allow private individuals to put themselves on a parallel gold standard if they so choose. Ron Paul’s HR1098, the Free Competition in Currency Act of 2011, is one approach: ensure the enforceability of contracts denominated in units other than fiat dollars, remove taxes on gold and silver coins that FR notes do not face, and remove federal statutes that criminalize the victimless activity of minting distinctive private pieces of metal intended to circulate as money. (See my testimony on the Act at freebanking.org.)

2) Re-establish a gold definition for the US dollar. Why isn’t free competition in standards enough? Incumbency advantage / network properties. People don’t abandon pesos until inflation is very high, measured per month rather than per year.

3) Direct the Fed to withdraw most or all of the $1.6 trillion in excess reserves that the Fed is currently paying banks to hold (eliminate interest on reserves and sell the MBSs that the Fed acquired in QE1), then redeem FR liabilities in gold at the current market price.

4) There is more than enough gold in Fort Knox, at current prices, to provide banks with sufficient reserves for backing the current money supply. Redeeming FR liabilities at the current price of gold is necessary to avoid both painful transitional deflation (as experienced in Britain in the 1920s, after it returned to gold at a parity too high for the price level) or transitional inflation (from returning at a parity too low). Here are the relevant numbers: Fort Knox contains 245.2m fine Troy ounces of gold. At $1615 / oz., that gold is worth $396b. This well exceeds currently required US bank reserves, which are only $83b. Current M1 is $2105b. Dividing the gold stock value by the M1 value, we find the available reserve ratio: $396b / $2105b = 18.8%, a gold reserve ratio more than sufficient for a stable monetary system, based on historical evidence.

5) Why not establish 100% reserves for M1, as some advocate?

a. At today’s price of gold, the difference between M1 (~$2.1 t) and the current stock of Ft. Knox gold (~$400b) is ~$1.7t. The US taxpayers would have to buy $1.7t worth of gold, a very expensive proposition.

b. Or, to back M1 100% with Fort Knox gold, the US dollar would have to be defined such that 1 oz. Au = $8479. This is not a costless fix. At that gold/dollar rate, with our current level of goods prices, gold would come flooding into the US. The purchasing power of $8479 available in the US for one ounce of gold, would greatly exceed the purchasing power of one ounce of gold elsewhere in the world. US citizens would again end up paying about $1.7 trillion in exports of goods in exchange for the incoming gold. On top of that the US would suffer massive price inflation in the transition as M and P rose to support the high dollar price of gold.

c. Plus, with 100% reserves, circulating banknotes are infeasible without an ongoing taxpayer subsidy to cover storage costs. Warehouse owners couldn’t collect storage fees on bearer notes given that the holders are anonymous, because they would know whom to assess for storage costs.

6) Once the Fed’s liabilities are converted into gold, my own preference is to decommission the Fed.

a. We already rely on commercial banks to issue most of M1, which consists of dollar-redeemable checking deposits. Let them issue gold-dollar redeemable circulating currency notes as well.

b. Privatize the Fed’s other useful functions by returning them to private CHAs: payments clearing and settlement, membership rules for solvency and liquidity, lender of last resort (not bailouts, but in the true sense of temporary liquidity support to solvent banks).

c. No monetary policy needed once we’re on a gold standard. Retaining the FOMC to “manage” the gold standard would do more harm than good. The classical gold standard of 1879-1914 functioned quite well without a central bank in the US, thank you very much. Despite the financial panics, which could have been avoided with banking deregulation, the business cycle wasn’t worse than under the Fed’s watch. For the evidence see George Selgin, William Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?,” available at cato.org in the Cato Working Papers series.

d. Why end the Fed? Wouldn’t a gold standard constrain it strictly enough to render it harmless? It would if the Fed would play by the “rules of the game.” But it wouldn’t. Note that the ECB had a constitution that was supposed to constrain it to the single goal of 2% inflation. That constraint lies in tatters—Eurozone inflation is running close to 4%--as the ECB loads up on junk sovereign bonds to help Greece, Ireland, Portugal, Spain and Italy.

e. In general, central banks face temptations to pursue monetary policies that are inconsistent with redemption for gold at a fixed rate. They can alter the redemption rate at will, and can do so with legal impunity. Private banks historically have a better track record for maintaining the gold standard.

Closing remark: Now that fiat money and central banking have failed, let’s try letting the monetary system regulate itself.


Steve Jobs and free banking

by Kurt Schuler October 6th, 2011 9:34 pm

As a child, I watched The Jetsons, a 1960s cartoon comedy series that followed the lives of an American family in a high-tech future. Nearly 50 years later, when I thought that future would have arrived, robot maids do not do our cooking and housecleaning, we do not work three-day weeks, and our cars do not fly through the air. There are ways in which our world closely resembles the world of The Jetsons, though: we can communicate easily all over the world, by text, voice, or video; and we can retrieve information and music almost instantly from vast storehouses.

Steve Jobs helped to make those futuristic dreams a reality, not just for a few people, but increasingly for everybody. Asian peasants and African cattle herders have cell phones; in a decade they will have knockoffs of the iPad as well. I am writing these words on an Apple Power Mac G5. It is both the most powerful and the cheapest computer I have ever owned. I paid $50 to buy it as surplus from a company that was upgrading its computers last year. The G5 was a technological marvel when Steve Jobs introduced it in 2003, but it is worth little more than scrap metal today. That is a breathtaking pace of progress.

The future of free banking is inextricably linked to the computers, cell phones, and other personal electronic devices that Steve Jobs did so much to envision, develop, and popularize. If there is a way to bypass central banking, it will use the networks of these devices, as some people are already trying to do. Rest in peace, Steve Jobs.