Lars Christensen observes that in Zimbabwe a company called EcoCash, which allows customers to bank through their cell phones, is helping to solve the country's shortage of coins. During Zimbabwe's hyperinflation of the previous decade, local-currency coins disappeared because they were worth more as metal than as money, and as inflation accelerated it made no sense for the government to mint more. Zimbabweans used quickly depreciating notes for small change. Eventually, as the country became de facto dollarized, local currency became worthless. Zimbabwe then officially allowed people to use foreign currencies. The U.S. dollar is popular, but there are few U.S. coins in circulation because the cost of transporting them from the United States to Zimbabwe is high. The government has apparently not thought to let local private mints step in, as George Selgin has documented that they did in England about two centuries ago. Electronic transactions through cell phones provide an alternative private-sector solution. By the way, Steve Hanke clearly laid out the dollarization option for Zimbabwe in a paper more than half a year before it actually happened, and in the same paper he mentioned free banking as another option for monetary reform.
In reply to Larry White's recent post, my former student David Beckworth has rushed to the defense of QE3, prompting me to offer the following remarks, originally posted to his site, on some of the points he makes:
"there have been a series of negative money demand shocks."
I find this language unhelpful: a "negative" demand shock ought, strictly speaking, to mean that demand for the affected thing goes down, not up. So, the "shocks" must have called for less rather than more easing. But that evidently isn't what is meant here. "Negative" apparently has not its usual sense but that of "unwanted" or "undesirable."
"Institutional investors also need assets that facilitate transactions, but the assets in M2 are inadequate for them given the size and scope of their transactions. Consequently institutional investors have found ways to make assets like treasuries, commercial paper, repos, GSEs and other safe assets serve as their money"
This begs the question, for if it is these assets, rather than those found in narrower aggregates, for which there is excess demand, it is not in the Fed's power to increase their abundance. On the contrary: when it swaps FR liabilities for any of these very assets, it presumably reduces the supply of precisely those things that institutional investors supposedly have to have for their transacting! To help them, the Fed should have been doing "reverse" QE!
"household portfolios are still inordinately weighted toward liquid assets. Take a look at the figure below. It comes from the flow of funds data and show households' total deposit assets and treasuries as a percent of total household assets. There is a sudden jump in this series in 2008 that has yet to return to pre-crisis levels, a sure sign of elevated money demand."
An awkward claim, since the date [sic] suggest a slowdown in demand for time deposits during precisely the period--2007-209--when the "shortage" of money was presumably most acute, as evidenced by shrinking NGDP.
"interest rates are low because of ongoing economic weakness that has decreased the demand for credit. Excess money demand is at the heart of this slump. If money demand were not elevated and the public expected higher nominal incomes these interest rate would be rising. The fact they haven't speaks volumes to the ongoing demand for safe assets or money."
The argument here begs the question. Yes, credit demand is low; and that's because the economy is in a slump. But it doesn't follow that the slump is due to a lack of spending, as opposed to having structural or "real" causes. There is no guarantee that higher spending will lead to higher real rates, rather than simply raising nominal rates by boosting inflation expectations.
"It is hard to believe we have been in this slump since mid-2008. That is a long stretch and one would think enough time for money demand shocks to work themselves out. But the U.S. economy has been subject to a spate of money demand shocks and the Fed has consistently failed to fully respond to them."
The shock of 2008-9 is evident enough in the NGDP and other spending series. But the "shocks" after that do not show up in the one place that should matter most, especially to proponents of NGDP targeting. Instead all concede that NGDP has recovered its pre-2008 level and approximate growth rate; the question is whether it needs to grow faster to "catch up" to its former trend. That claim, in turn, depends heavily in how one constructs the "correct" trend, and especially on the extent to which one is prepared to allow "boom" period NGDP growth (e.g. from the dot.com and subprime bubbles) to inform estimates of "normal" trend growth. Draw the trend at 5% or more, as you and Scott prefer to do, and NGDP is "behind" where it "ought" to be. Draw it for 4.5% or less, and "catching up" looks like just the thing for blowing yet another bubble.
Ah, just like the good old days, David! And, no less than back then, I expect you will not be short of rejoinders and retorts!
Postscript (added 9/24 at 5:41): All these appeals to different measures of the money stock as offering evidence as to the extent to which money is in short supply or has been exposed to demand shocks really are, or should be, considered quite beside the point in the MM and other nominal spending targeting frameworks. After all, nominal spending targeting makes sense precisely to the extent that fluctuations in nominal spending serve as a good indicator of money shortages or surpluses. So who cares what M2 or M3 or m$ or other still fancier M measures are of have been up to? If spending has remained stable, the presumption is that the economy has been getting all the liquidity or exchange media it needs, and that it is therefore not tending to ride up or down a short-run Philips curve. It is precisely because NGDP targeting and similar schemes dispense with the need to track particular monetary aggregates, or worry about the stability of demand for them, while still sticking to a nominal target, that they constitute an alternative and appealing alternative to conventional "monetarist" rules.
So, when it comes to demonstrating that money is or has been in short supply, a consistent Market Monetarist has no reason to appeal to the behavior of any measure of M. What matters is whether a plausible case can be made that spending is too low, or has been growing too slowly. That of course leads to thorny questions concerning the choice of an ideal growth rate and, what amounts in the short run to the same question, the fitting of a trend to past data with the aim of finding the once that would have been most conducive to the avoidance of booth booms and busts. This latter task, it seems to me, is not quite as simple a matter as some MM's have made it out to be.
Scott Sumner told us in September 2009 that "the real problem was nominal," that is, the recession and its high unemployment were primarily due to an unsatisfied excess demand for money (combined with real effects on debt burdens of nominal income being below its previous path). In AS-AD terms, the AD curve (representing combinations of M times V equal to a given level of nominal income Py) had shifted inward, and the economy was sliding down the SR aggregate supply curve. The price level had not yet adjusted enough to clear the market of unsold goods corresponding to deficient money balances. This was a reasonable – almost inescapable – diagnosis in 2009, when the price level and real income were both falling.
Market Monetarists who have been celebrating the Fed’s recent announcement of open-ended monetary expansion ("QE3') seem to believe that Sumner’s 2009 diagnosis still applies. But what is the evidence for believing that there is still, three years later, an unsatisfied excess demand for money? Today (September 2012 over September 2011) real income is growing at around 2% per year, and the price index (GDP deflator) is rising at around 2%. If the evidence for thinking that there is still an unsatisfied excess demand for money is simply that we’re having a weak recovery, then as Eli Dourado has pointed out, this is assuming what needs to be proved. Dourado writes (I take his “in the short run” to mean “in a situation of unsatisfied excess demand for money”):
So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment, but even if unemployment is cyclical, it doesn’t mean that monetary adjustment has failed to occur—real sector recalculation may just take longer than monetary recalculation.
… If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.
While saluting Sumner 2009, like Dourado I favor an alternative view of 2012: the weak recovery today has more to do with difficulties of real adjustment. The nominal-problems-only diagnosis ignores real malinvestments during the housing boom that have permanently lowered our potential real GDP path. It also ignores the possibility that the “natural” rate of unemployment has been hiked by the extension of unemployment benefits. And it ignores the depressing effect of increased regime uncertainty.
To prefer 5% to the current 4% nominal GDP growth going forward, and a fortiori to ask for a burst of money creation to get us back to the previous 5% bubble path, is to ask for chronically higher monetary expansion and inflation that will do more harm than good.
In my Saturday post warning of the dangers of QE3, I wrote, among other things,
Having kept the federal funds rate at 1.75 percent for a year after the economy began to recover in November 2001, the Fed lowered it to 1.25 percent in November 2002, and to 1 percent in June 2003. Then, in August 2003, the FOMC, still unhappy with the sluggish pace of the recovery, and especially with the high unemployment rate, announced that the f.f.r. was “likely” to remain low for an “extended” period of time. Not for the first time, the Fed in its zeal to assist recovery was in fact setting the next boom in motion. And how!
To which Scott Sumner replies,
I’m tempted to respond; and how? Most people, including George Selgin and market monetarists like David Beckworth, believe that an easy money policy during the early 2000s led to an overheated economy in the middle of the decade, and that this was one factor in the crash during the latter part of the decade. I’m not convinced, or perhaps I should say I doubt the effect was as strong as most people believe. First of all, I see little evidence that monetary policy was particularly expansionary during the early 2000s. Some people cite the low rates, but we all know what Milton Friedman said about that. I agree with Ben Bernanke that NGDP growth is a good indicator of whether money is easy or tight. Here are the facts about NGDP growth during the previous expansion:
1. NGDP grew at a slower rate during the 2001-07 expansion than during any other expansion during my lifetime.
2. NGDP growth modestly exceeded 5% during the peak of the housing boom.
Scott's reply in turn provokes me to recall an important issue which, though occasionally raised in what I'm going to start calling simply the M-M-osphere for short, deserves a lot more attention. It concerns the question, "Which spending measure ought the Fed to keep stable?"
Although the focus on NGDP has been such as to allow "NGDP targeting" to become the favored way of referring to what Scott and other Market Monetarists have been plugging for, in fact NGDP is but one of many measures of spending or aggregate demand stabilization of which might be broadly consistent with the underlying economics of Market Monetarism. What's more, there are compelling arguments for regarding some alternative measures of spending as superior. And yes, it does make a non-trivial difference which measure one chooses to look at in assessing the degree to which instability of spending may contribute to booms as well as busts, as I hope to show.
Among the alternatives to NGDP one in particular, the Dept. of Commerce's measure of (nominal) "final sales to domestic consumers" deserves particular attention. It is the measure that was favored by the late Bill Niskanen--yet another largely unrecognized but long-standing proponent of nominal income targeting--who offered several good reasons for preferring it to NGDP targeting, the most fundamental of which was that "demand for money in the United States appears to be more closely related to final purchases by Americans than to the dollar level of total output by Americans."
In an article published just after the dot.com crash, from which I just quoted, Niskanen looked at the behavior of final sales from early 1992 until 2001. He found that until early 1998 the annual growth rate of domestic final sales was remarkably steady at 5.5 percent. But as Niskanen's chart, reproduced below, shows clearly, from early 1998 to the second quarter of 2000, coinciding with the dot.com boom, it shot up to almost 8 percent. The end of the boom brought, per usual, a collapse in spending. Niskanen argued, reasonably, that the Fed should strive next time to maintain the steady 5.5 percent growth rate it had managed to maintain, intentionally or not, throughout the early nineties.
Now, none of this is particularly earth-shattering. But the course of domestic final sales during the longer sample period including that since Niskanen wrote, yields a more striking picture, and especially so if one includes along with the plot for domestic sales those for both NGDP growth and core CPI inflation:
Among things worth noting here are, first, that the coincidence--to settle at calling it that--between periods of exceptionally rapid growth in final sales and "booms" is hardly less evident than that between periods in which domestic sales collapse and "busts"; second, that the coincidence is more evident in considering the behavior of final sales than it is w.r.t. NGDP, because of the more pronounced cyclical amplitude of the former series; third, that the "core" CPI tells us nothing at all about about either booms or busts; and, finally, that, yes, as of the last data record spending remains below Scott's preferred 5 percent target, and still further below the "Niskanen" growth target--but not by much.
The plain-old CPI is better than the core in reflecting both booms and busts, of course. But even with regard to it it seems entirely mistaken to assume that mere avoidance of >3 percent inflation (or something like that) should itself suffice to guard against the risk of another boom and bust cycle.
None of this, of course, amounts to a proof that excessive spending growth played a major part in either the last boom or any boom before it. But it certainly should suggest the presence of such a correlation as ought to rule out any temptation to reject a causal connection out of hand, and especially so in light of the many theorists, including both monetarists and Austrians (whose agreement concerning this matter is itself striking) who have offered independent evidence of the existence of such a link. Perhaps it's true that, had the Fed heeded Niskanen's advice, we would still have gone through the same subprime boom and financial meltdown. But I, for one, wouldn't bet on it.
P.S. (added at 3:50 EST): I fear that, in failing to say anything regarding the Fed's decision to direct its latest round of easing toward the purchasing of mortgage-backed securities, I may be thought to have no objection to that aspect of its new initiative. Nothing could be further from the truth. For the record, if the Fed is going to expand the stock of high-powered money, it should do so either the old-fashioned way, that is, by sticking to "Treasuries only," or it should offer to buy a wide range of investment grade securities, of the sort it might routinely accept as discount-window collateral (as I've suggested in my "L Street" paper), or it should scatter the new dollars from helicopters. Anything else is encroaching unnecessarily on fiscal policy, that is, is making decisions about who gets what that should be left to Congress, or to the states, or (lest we forget them) to the people, rather than sticking to the Fed's assigned function of tending to the economy's overall state of liquidity.
In the title of a recent post Scott Sumner jokingly wonders whether, having been credited by the press for badgering Ben Bernanke's Fed until it at last cried "uncle!" by announcing QE3, he now needs to worry about going down in history as the guy who gave the U.S. its first episode of hyperinflation.
Well, probably not. But if Scott and the rest of the Market Monetarist gang don't start changing their tune, they may well go down in history as the folks responsible for our next boom-bust cycle.
I'm saying that, not because, like some monetary hawks, I'm dead certain that no substantial part of today's unemployment is truly cyclical in the crucial sense of being attributable to slack demand. I have my doubts about the matter, to be sure: I think it's foolish, first of all, to assume that 8.1% must include at least a couple percentage points of cyclical unemployment just because it's more than that much higher than the postwar average; and (as I noted in a previous post), I'm far from convinced that NGDP is still substantially below where it should be given both the extent of the actual increase in spending since 2009 and the fact that there has surely been at least some downward adjustment in demand expectations since that time. Still, for for the sake of what I wish to say here, I'm happy to concede that some more QE, aimed at further elevating the level of nominal GDP to restore it to some higher long-run trend value to which the recession itself and overly tight monetary policy have so far prevented it from returning, might do some good.
But although QE3 is in that case something that might do some real good up to a point, it hardly follows that Market Monetarists should treat it as a vindication of their beliefs. On the contrary: if they aim to be truly faithful to those beliefs, they ought to find at least as much to condemn as to praise in the FOMC's recent policy announcement. And yes, they should be worried--very worried--that if they don't start condemning the bad parts people will blame them for the consequences. What's more, they will be justified in doing so.
So what are the bad parts? Two of them in particular stand out. First, the announcement represents a clear move by the Fed toward a more heavy emphasis on employment or "jobs" targeting:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
Yes, there's that bit about fighting unemployment "in a context of price stability," and yes, it's all perfectly in accord with the Fed's "dual mandate." But monetarists have long condemned that mandate, and have done so for several good reasons, chief among which is the fact that it may simply be beyond the Fed's power to achieve what some may regard as "full employment" if the causes of less-than-full employment are structural rather than monetary. The Fed should, according to this view, focus on targeting nominal values only, which can serve as direct indicators of whether money is or is not in short supply. Many old-fashioned monetarists favor a strict inflation target because they view inflation as such an indicator. Market Monetarists are I think quite right in favoring treating the level and growth rate of NGDP as better indicators. But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don't start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.
The second, even more troublesome part of QE3 consists of the FOMC's implicit promise to keep the federal funds rate near to its present, unprecedentedly low level for a very long period of time:
the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
What's wrong with that? It is well to remember the Fed's response to the last slow recovery--the one that followed the dot.com bust. Having kept the federal funds rate at 1.75 percent for a year after the economy began to recover in November 2001, the Fed lowered it to 1.25 percent in November 2002, and to 1 percent in June 2003. Then, in August 2003, the FOMC, still unhappy with the sluggish pace of the recovery, and especially with the high unemployment rate, announced that the f.f.r. was "likely" to remain low for an "extended" period of time. Not for the first time, the Fed in its zeal to assist recovery was in fact setting the next boom in motion. And how! And it did so, by the way, without having ever substantially exceeded its inflation target. Of course, so long as the boom lasted, the FOMC was confident that everything was just dandy.
The two aspects of QE3 that I think Market Monetarists had better start complaining about have nothing to do with targeting either the level or the growth rate of nominal income. On the contrary: both imply a risk, and perhaps a very substantial risk, that QE3 will devolve into a policy that leads to excessive nominal income growth instead of being terminated before that can happen. And though the excessive growth is hardly likely to be such as might lead to hyperinflation, and may not even be such as might lead to any considerable overshooting of the Fed's favorite (2 percent) inflation rate, that doesn't mean that it won't be capable of generating another serious asset price bubble, whether in the real estate market or elsewhere.
So, Market Monetarists: quit gloating and start complaining, loudly, about the dangerous aspects of the Fed's latest move--aspects that, far from reflecting your beliefs, are quite contrary to those beliefs. If you fail to do so now (and especially if you appear to endorse those aspects of the Fed's new policy), you may not have much to gloat about (though you may well end up getting lots more press coverage!) following the "long and variable lag" that started a few days ago and that may end, for all we know, sometime after 2015.
P.S.: To be fair, Scott in particular, and other MM's as well, haven't really been doing all that much gloating--they are in truth a remarkably modest bunch. But quite a few others have been doing plenty of gloating on their behalf.
The advice is for self-styled Austrian economists, and younger ones especially, who want to do good economics, and not just to "belong" to a school of thought. It is simple, and it applies to any research that's not intended to be a contribution to the history of economic thought.
Here it is: search for the word "Austrian" in your research papers, delete it, and rewrite where necessary. Next ask yourself whether what's left can stand on its own merits. Would your fellow Austrians find it interesting and persuasive without the help of all the winking, nodding, and fraternal handshaking aimed at declaring yourself one of the team, and at thereby evading friendly fire? Would they find the conclusions firmly attached by a series of solid links to some indisputable premises, as they should if you are really a competent praxeologist? Are they likely to find the evidence you supply persuasive, should you be so bold as to offer such? Would they, in short, find merit in what you've written even if they had no reason to suspect that you are one of the gang, or even a fellow traveler? If not, then your paper is good for nothing but joining a club that is, face it, all too willing to have you as a member.
But being able to win over Austrians without declaring yourself one of them is the least of it. The more important question you need to ask is, "Can my stealth-Austrian paper not only sneak past mainstream radars, but do some persuading once across enemy lines?" It surely will not be less persuasive than it would be with all that Austrian flag-waving, since the flags might as well be bright red so far as the rest of the profession is concerned. But if it still can't persuade at least some persons who aren't pals of yours at the Mises Institute or at GMU or at some other Austrian hang-out, what good is it?
Persuading non-Austrian economists with what are, in substance, "Austrian"-style arguments is, admittedly, rough going: all too many so-called economists today are mere technicians who care only for the latest mathematical and statistical gimmicks, and give not a jot for genuine economics. But there are thank goodness also plenty of real economists who aren't Austrians and who don't want to hear about Austrian economics, but are willing to hear any good argument and to be persuaded by it and by evidence that seems to support it. Persuading them is hard too. It's also every economist's job.
Except for omitted section headings what follows is the full text of the paper I presented last week at the Mont Pelerin Society General Meeting in Prague. As the paper had to be completed on time for a May deadline, it could not take into account subsequent developments. Fortunately those developments have mainly been entirely consistent with the paper's general thrust.
Otmar Issing, a former ECB chief economist and Executive Board member, also took part in my session. Although Mr. Issing's paper and public remarks put a much more favorable spin on the Euro's prospects for survival than my own, I believe--as I remarked during the session--that the only substantial disagreement between us concerned the conditions in which it would be appropriate to pronounce the Euro "dead." In brief, while Mr. Issing for his part appears to regard the merest heartbeat from Frankfurt as a sign of vitality, I say that, heartbeat or no heartbeat, the Euro is for all intents and purposes already brain-dead.
When the merits of a European Monetary Union were first being debated, many skeptics fell into one of two camps. The first camp consisted of “Keynesians” (for example, Eichengreen and Bayoumi 1997; Salvatore 1997) who, referring to the theory of optimal currencies areas, doubted that Europe constituted such an area, and believed that the proposed monetary union would eventually fall victim to country-specific (“idiosyncratic”) shocks: unemployment and other burdens stemming from such shocks would, these critics argued, eventually force the monetary authority to either abandon its commitment to price-level stability in order to offer relief to adversely-affected members, or cause the members to abandon the union so as to be able to re-align their exchange rates.
The other camp was comprised of “Hayekians” who, drawing upon theories of international currency competition, claimed that monetary unification, by reducing the extent of such competition, would give rise to a relatively high seignorage-maximizing Eurozone inflation rate, and thereby result in a level of actual Eurozone inflation that was bound to disappoint the monetary union’s more inflation-phobic members. It was in light of such reasoning that British Prime Minister John Major made his alternative proposal for a parallel European currency—the so-called “hard ecu”— to supplement rather than supplant the British Pound and other established European currencies.
Today the euro is indeed failing. But its failure has in large part been the result of fundamental shortcomings other than those pointed out by either of these prominent camps of early euroskeptics. Rather than merely being wrenched apart by pressure from idiosyncratic shocks, or by disappointments stemming from the ECB’s temptation to profit from its monopoly status, the euro is unraveling because commitments upon which its ultimate success depended—commitments that had to be credible if it was to work as intended—have instead proven to be perfectly or almost perfectly incredible. The euro, in other words, was built upon a set of promises that the authorities concerned were unable to keep. Orthodox theory—theory that is neither particularly “Keynesian” nor particularly “Hayekian” in flavor, suffices to explain—admittedly, with the help of hindsight—why the promises in question could not possibly have been kept so long as the EMU’s members enjoyed substantial fiscal sovereignty. The combination of effectively unconstrained fiscal sovereignty and a lack of credible commitments to avoid both centralized debt monetization and outright member-state bailouts created a perfect storm of perverse incentives.
The theory in question builds upon Kydland and Prescott’s (1977) well-known treatment of the time-inconsistency problem that confronts ordinary central banks. That analysis, it bears observing, takes for its starting point a benevolent (social-welfare maximizing) though discretionary central bank, while making no reference to region-specific shocks or imperfect factor mobility. Greg Mankiw (2006) offers the following summary of the standard time-inconsistency problem:
Consider the dilemma of a Federal Reserve that cares about both inflation and unemployment. According to the Phillips curve, the tradeoff between inflation and unemployment depends on expected inflation. The Fed would prefer everyone to expect low inflation so that it will face a favorable tradeoff. To reduce expected inflation, the Fed might announce that low inflation is the paramount goal of monetary policy.
But an announcement of a policy of low inflation is by itself not credible. Once households and firms have formed their expectations of inflation and set wages and prices accordingly, the Fed has an incentive to renege on its announcement and implement expansionary monetary policy to reduce unemployment. People understand the Fed's incentive to renege and therefore do not believe the announcement in the first place.
Monetary policy will also tend to be time-inconsistent when unanticipated inflation is capable of lowering the real value of outstanding nominal debts, thereby reducing the government’s fiscal burden. In this case the central bank has an incentive to announce a low inflation target so as to achieve a favorable inflation-taxation trade-off. Once again, were the central bank able to establish low inflation expectations, it would have an incentive to exploit those expectations so as to reduce the debt burden. Consequently the announced, low inflation target is not credible.
In the context of a monetary union whose members enjoy unlimited fiscal sovereignty, the usual time-inconsistency problem is compounded by a free-rider problem, with far more serious consequences. Here, as Chari and Kehoe (2007, 2008) have shown, a discretionary monetary authority’s optimal (benevolent) policy consists of setting “high inflation rates when the inherited debt levels of the member states are high and low inflation rates when they are low” (Chari and Kehoe 2007, p. 2400). Assuming that costs of inflation are borne equally by the member states, the ability to free ride off of other members of the union causes member states to be become more indebted than they would in a cooperative equilibrium, thereby bringing about an excessively high rate of inflation. Moreover, the free-rider problem gets worse as the number of countries gets larger, with the non-cooperative inflation rate rising, other things equal, as union membership increases (Chari and Kehoe 2008). The incentive to free ride will, finally, be especially great for relatively small participants, and for participants with relatively high debts ratios, other things being equal, for these participants will be capable of externalizing a relatively large share of the cost of any deficits they incur.
Observe that, although the suboptimal outcomes predicted here—excessive government deficits and higher inflation—resemble those predicted by Hayek and his followers, the causal mechanism is much different. For here a benevolent authority, concerned only with maximizing social welfare, is led inadvertently to engage in undesirable levels of debt monetization. Were there no externalities, or were the authority capable of committing to policy invariant to the extent of union indebtedness, the problem would not arise.
Chari and Kehoe first establish the presence of a “free rider” problem for the case in which national fiscal authorities issue nominal debt only to lenders who live outside the monetary union to which they belong (2007, p. 2400); they then go on to show that the problem holds as well in the case where governments borrow from within the union. The latter case, however, raises the additional possibility that union members can hold the union hostage, and thereby ultimately undermine it, by threatening either to default on their debt or to quit the union if it does not ease their debt burden by means of higher inflation or outright transfers (bailouts) or both. In the words of Thomas Mayer (2010, p. 51), if heavily-indebted member countries “pose a threat to Eurozone financial stability, they can blackmail their partners into open-ended transfers to cover both fiscal and external deficits. Or they can press the ECB to buy up and monetize their debts so as to avoid default.”
The “threat” to monetary stability can develop in several ways. First, foreign commercial banks may hold substantial quantities of the debt of the hostage-taking country, so that its decision to default would threaten the rest of the zone with a financial crisis. Second, the central monetary authority may itself hold substantial amounts of the troubled member’s debt, and so may also need to be recapitalized, at other participant countries’ expense, in the event of a default. Alternatively, the bad debts would have to be reduced by means of more aggressive monetization and consequent, higher inflation (ibid., p. 52). In either case, the decision to avoid the danger in question by instead supporting member governments in fiscal difficulties will tend to undermine public support for the monetary union while increasing the likelihood of further ransom demands.
Philip Bagus (2012) explains the particular course by which Greece was able to take the European Monetary Union hostage. Banks throughout the Eurozone, he says, bought Greek bonds in part because they knew that either the ECB or other Eurozone central banks would accept the collateral for loans. Thus a Greek default threatened, first, to do severe damage to Europe’s commercial banks, and then to damage the ECB insofar as it found itself holding Greek bonds taken as collateral for loans to troubled European banks.
In short, in a monetary union sovereign governments, like certain banks in single-nation central banking arrangements, can make themselves “too big to fail,” or rather “too big to default.” As Pedro Schwartz (2004, p. 136-9) noted some years before the Greek crisis: “[I]t is clear that the EU will not let any member state go bankrupt. The market therefore is sure that rogue states will be baled [sic] out, and so are the rogue states themselves. This moral hazard would increase the risk margin on a member state’s public debt and if pushed too could lead to an Argentinian sort of disaster.”
Indeed, the moral hazard problem as it confronts a monetary union is all the worse precisely because sovereign governments, unlike commercial banks, can default without failing, that is, without ceasing to be going concerns. This ability makes their ransom demands all the more effective, by making the implied threats more credible. A commercial bank that tries to threaten a national central bank using the prospect of its own failure is like a suicide bomber, whereas a nation that tries to threaten a monetary union is more like a conventional kidnapper, who threatens to harm his innocent victim rather than himself.
The free-rider and hostage-taking problems present in a monetary union that combines discretionary monetary policy with unrestricted national fiscal sovereignty has led some experts to speak of a new “Impossible Trinity” or “Trilemma," complementing the “classical” Trilemma long recognized in discussions of alternative international monetary regimes. The original Trilemma refers to the fact that, a country cannot pursue an independent monetary policy while both adhering to a fixed exchange rate and dispensing with capital controls. According to Hanno Beck and Aloys Prinz (2012), in the context of a monetary union it is impossible for authorities to adhere to all three of the following commitments: 1) Monetary Independence, including a commitment on the part of the monetary authority to avoid either excessive inflation or the monetization of sovereign debts; 2) No bailouts, meaning no outright loans or grants to national governments in danger of defaulting; and 3) Fiscal Sovereignty, meaning a commitment to refrain from interfering with member nations’ freedom to resort to debt financing.
As we’ve seen, so long as unlimited fiscal sovereignty prevails, member states can find themselves in a position to take the monetary union hostage, forcing the central authorities to renege on one or both of heir other commitments. It follows that either the principle of fiscal sovereignty must be abandoned in favor of something like an outright fiscal union, or that the union must abandon its commitment to either independent monetary policy or the no-bailout clause, exposing the union to the consequences of unconstrained fiscal free riding, with all the regrettable consequences that must entail.
Nor is the EMU’s experience the first to bear out these claims. Having reviewed the lessons taught by previous monetary unions, in a work published between the signing of the Masstricht Treaty and the actual launching of the euro, Vanthoor (1996, p. 133) concluded that
monetary union is only sustainable and irreversible if it is embodied in a political union, in which competences beyond the monetary sphere are also transferred to a supranational body. In this respect, the Maastricht Treaty provides insufficient guarantees, as budgetary policy as well as other kinds of policy…remain the province of national governments.
The euro’s flawed design, and the poor incentives created by it, have not merely caused the scheme itself to fail, but have done extensive damage to the European economy. Philip Bagus (2012) supplies an excellent summary of its more regrettable consequences. “To make an understatement,” he writes,
the costs of the Eurosystem are high. They include an inflationary, self-destructing monetary system, a shot in the arm for governments, growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty.
The euro, Bagus adds, has allowed European governments generally, and those of the peripheral nations in particular,
to maintain uncompetitive economic structures such as inflexible labor markets, huge welfare systems, and huge public sectors … Multiple sovereign-debt crises have in turn triggered a tendency toward centralization of power in Brussels [bringing us] ever closer to a more explicit transfer union.
The Greek government used the lower interest rate to build a public adventure park. Italy delayed necessary privatizations. Spain expanded the public sector and built a housing bubble. Ireland added to their housing bubble a financial bubble. These distortions were partially caused by the EMU interest-rate convergence and the expansionary policies of the ECB.
In light of all of these ill consequences, Bagus concludes, “the project of the euro is not worth saving. The sooner it ends, the better.” In other words, given the other consequences stemming from the euro’s poor design, it is just as well that that design is also causing the euro to self-destruct.
But perhaps the gravest of all consequences of the euro’s demise is also the most ironic, to wit: the harm done to inter-European relations. Instead of cementing European unity, as its proponents claimed it would do, the euro is bearing-out Martin Feldstein’s (1997) prediction that it would ultimately supply grounds for new inter-European squabbles, culminating in the emergence of a new and vehement nationalism, all too reminiscent of the nationalism that twice set Europe aflame during the previous century. As John Kornblum (2011), the U.S. Ambassador to Germany from 1997-2001, wrote last September, with the outbreak of the Greek crisis, “[t]he polite tone cultivated for decades by E.U. partners” has given way to “a tirade of insults”:
Germans have called the Greeks lazy, corrupt and just plain stupid. The news media in Germany gleefully point out Greek billionaires who pay no taxes, workers who retire at 50 and harbors filled with the yachts of the idle rich. German politicians have suggested that Greece sell some islands to repay its debt. In return, Greeks have pulled out the Nazi card, claiming that the Germans owe them billions in wartime reparations.
Rather than being specifically related to conditions in Greece this outcome, Kornblum observes, has its roots in the euro’s basic design:
Rather than being kept free of politics, as was originally intended, management of the currency has become a political football knocked back and forth by the growing resentments between richer and poorer Europeans. The poorer countries reject the austerity measures necessary to meet German standards. The Germans refuse to take the steps necessary to build a true economic community. The result is a standoff…. [I]f the euro hadn’t been implemented as a political project in a Europe not ready for a common currency, experts could probably clean up such a situation fairly fast. But now, they can’t. Because in the end, such decisions are still about the war.
In examining the cause of the euro’s failure, it may seem that I’ve only succeeded in raising a different question, namely, how, did the euro manage to survive for so long?
The answer hinges on the fact that the credibility of various commitments made at the time of the euro’s launching was not something that could be ascertained in advance. Instead, it had to be discovered. In particular, the public had to discover whether European authorities had avoided the “Impossible Trilemma” discussed above, by strictly limiting participants’ fiscal independence.
That such limits were necessary if the common currency was not to fall victim to the “free rider” problem was recognized by several authorities before the euro’s actual establishment (e.g. Goodhart 1995, p. 467). Indeed, it was generally understood that the EU would not allow any of its member states to go bankrupt, and that special steps would therefore have to be taken to guard against members’ tendency to free-ride on the union.
In principle, the time-inconsistency problem that sets the stage for free riding in a monetary union could itself have been avoided by means of a credible commitment to an independent ECB, unresponsive to European fiscal crises. Such credibility might have been achieved by means of explicit rules, with corresponding incentive-compatible sanctions, or it might have been the result of a reputation for independence established over time. But neither solutions was actually realized. As Chari and Kehoe (2007, p. 2401) observe, “notwithstanding the solemnly expressed intend to make price stability the monetary authority’s primary goal, in practice, monetary policy is set sequentially by majority rule. In such a situation, the time inconsistency problem in monetary policy is potentially severe, and as our analysis shows, debt constraints are desirable.”
The euro’s capacity for escaping the Trilemma, and hence for long-run survival, therefore had to depend entirely on meaningful constraints placed upon member states indebtedness. For a time the 1997 Stability and Growth Pact appeared to impose such constraints: the Pact appeared to provide for either the prevention or the timely correction of “excessive” government deficits (that is, deficits exceeding 3% of national GNP) or their rapid correction, thereby ruling-out “even the slightest possibility that a fiscal crisis in one country affect the entire Eurozone” (Mayer 2010, p. 49). But it was not long before the Pact began crumbling. The first fissures appeared in 2003, when France and Germany both exceeded the 3% target, and ECOFIN failed to impose sanctions on either. By the outbreak of the current crisis, the Pact had ceased to be credible (Mayer 2010, p. 50). Though fiscal restrictions remained in effect de jure, the de facto situation was one of unlimited fiscal sovereignty. That change meant, in effect, that either the ECB’s independence or the no-bailout commitment or both would have to give way, as both have indeed done.
Once any of the commitments essential to a monetary union’s success has lost its credibility, that credibility cannot be easily or quickly restored. In light of this truth the EU’s decision, earlier this year, to sanction Hungary for its excessive deficits, seems an exercise in futility—an attempt, as it were, to close the stable door after the PIGS have bolted.
What, then, are some possible solutions? Most recent proposals for saving the EMU—resort to Eurobonds, the establishment of a “European Monetary Fund,” raising the ECB’s inflation target—fail to address the free-rider problem that is the root cause of the current crisis. Indeed, they appear likely to aggravate the problem by formally acknowledging collective responsibilities that were until now formally (though unconvincingly) repudiated.
In truth there are but two ways in which the EMU can be made viable without sacrificing monetary stability. These are (1) the establishment of a genuine European Fiscal Union, that is, outright rejection of the principle of fiscal sovereignty that has thus far tended to undermine both the ECB‘s independence and the EU’s “no bailout” commitment or (2) replacement of the present politically “constructed” monetary union with a “spontaneous” or “voluntary” one based on the principle of free currency competition. As Pedro Schwartz (2004, p. 190) explained several years ago,
There are two types of monetary union. The first is based on a single money imposed by central authorities. Such a monetary union requires centralized political authority… The other form of ‘monetary union’ arises from the free choice of individuals predominantly using one out of a range of alternative currencies. The latter model does not require centralized political authority and is a better model for ensuring that monetary discipline is maintained.
The new Trilemma is a Trilemma for imposed monetary unions only: it is only such an imposed monetary union that calls for a corresponding fiscal union. When participation in a monetary union is voluntary, there can be no question of participants taking advantage of their fiscal autonomy to hold the union as a whole hostage. Consider, for example, the monetary union consisting of the United States, its trust territories, and those independent nations that have chosen to either officially or unofficially dollarize, such as Ecuador. The Federal Reserve and the U.S. government played no essential part in Ecuador’s decision to join the U.S. dollar zone, and take no responsibility at all for macroeconomic conditions there. They would presumably be able to regard Ecuador’s decision to leave the dollar zone with the same equanimity or indifference with which they reacted to its decision to adopt the dollar in the first place. Although it’s true that the extent of participation in the dollar zone might serve as an indication of the dollars’ relative soundness, a foreign country’s decision to quit the dollar zone poses no serious threat to the integrity of the dollar or to the prosperity of either the U.S. or any other dollarized economy. In short, in a regime of free currency choice, monetary authorities can gain nothing by letting their currencies deteriorate further for the sake of addressing the macroeconomic problems of particular dollarized countries. Doing so would only tend to further undermine the dollar’s popularity.
Such considerations appear, in light of experience, to vindicate former Hayekian proposals for a “hard” ecu or parallel European currency that would (initially at least) have supplemented, instead of replacing, Europe’s established national currencies. In retrospect, as Pedro Schwartz (ibid., pp. 183-4) has observed, we have every reason to regret missing the chance of having the euro as a parallel rather than an imposed currency:
If the EU had accepted the British proposal of a “parallel ecu,” rules guaranteeing the stability of the common currency and its independence from European governments would have been a part of the offer to users of the money by the European bank. There would have been no need for constitutional rules to be made (and broken) by member states, and no need for a Growth and Stability Pact, since the euro would not have been seen as a possible instrument of state finance.
There is, of course, no turning back the clock. But should the euro begin to disintegrate, the occasion, for all the disruption and damage it must cause, will at least renew the prospect for implementing the Hayekian alternative. That, to be sure, is a rather meager bit of silver by which to line a very large, dark cloud. Yet the ability to choose freely among competing currencies remains Europeans’ best hope for a monetary regime that is both stable and sustainable
1. “[T]hough I strongly sympathize with the desire to complete the economic unification of
Western Europe by completely freeing the flow of money between them, I have grave doubts about
doing so by creating a new European currency managed by any sort of supra-national authority. Quite
apart from the extreme unlikelihood that the member countries would agree on the policy to be
pursued in practice by a common monetary authority (and the practical inevitability of some countries
getting a worse currency than they have now), it seems highly unlikely that it would be better
administered than the present national currencies” (Hayek 1978).
Bagus, Philip. 2012. “The Eurozone: A Moral-Hazard Morass.” Mises Daily, April 17
Beck, Hanno, and Aloys Prinz. 2012. “The Trilemma of a Monetary Union: Another Impossible
Trinity.” Intereconomics 1
Chari, Varadarajan V., and Patrick J. Kehoe. 2007. “On the need for fiscal constraints in a
Monetary union.” Journal of Monetary Economics 54: 2399-2408.
__________. 2008. “Time Inconsistency and Free-Riding in a Monetary Union.” Journal of
Money, Credit, and Banking 40 (7) (October): 1329-55.
De Grawe, Paul, and Wim Moesen. 2009. “Common Euro Bonds: Necessary, Wise or to be
Avoided?” Intereconomics (May/June): 132-138.
Eichengreen, Barry and Tamin Bayoumi. 1997. “Shocking Aspects of European Monetary
Unification,” in Barry Eichengreen, ed., European Monetary Unification: Theory, Practice, and Analysis. The MIT Press, Cambridge Mass., pp. 73-109.
Feldstein, Martin. 1997. “EMU and International Conflict.” Foreign Affairs,
Goodhart, C.A.E. 1995. “The Political Economy of Monetary Union.” In P. B. Kennan, ed., The
Macroeconomics of the Open Economy. Princeton: Princeton University Press, pp.
Gros, Daniel, and Thomas Meyer. 2010. “Towards a Euro(pean) Monetary Fund.” CEPS Policy
Brief 202 (February).
Hayek, Friedrich. 1978. Denationalisation of Money - The Argument Refined. Hobart Paper
Special No. 70, 2nd ed. London: Institute for Economic Affairs.
Kornblum, John. 2011. “”Without the euro, would Europe have turned to war?” The Washington
Post, September 24 (updated).
Kydland, Finn E., and Edward C. Prescott. 1977. “Rules Rather than Discretion: The
Inconsistency of Optimal Plans.” Journal of Political Economy 85 (3) (June): 473-92.
Mankiw, Greg. 2006. “Time Inconsistency.” Greg Mankiw’s Blog, April 19,
Mayer, Thomas. 2010. “What more do European governments need to do to save the Eurozone
in the medium run?” In Richard Baldwin, Daniel Gross, and Luc Laeven, eds., Completing the Eurozone Rescue: What More Needs to be Done? London: Centre for Economic Policy Research, pp. 49-53.
Salvatore, Dominick. 1997. “The Common Unresolved Problem with the EMS and EMU.”
American Economic Review 87(2): 224-226.
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Analysis. Cheltenham: Edward Elgar.
Some months ago there was a discussion of Australia’s free banking experience at a site called “Social Democracy for the 21st Century.” I will not go into the particulars of Australia’s experience here, because I have forgotten much of what I once knew about the subject and lack time at the moment to refresh my memory. The gravamen of the criticism, however, was that the financial crisis and resulting depression Australia suffered in the early 1890s under a free banking system was more severe than the Great Depression in Australia, under a quasi-central banking system. (The government-owned Commonwealth Bank of Australia was a commercial bank and in addition exercised certain central banking functions.) This comparison supposedly discredits free banking.
Arguments like this from single instances are not persuasive. It is like saying that Zimbabwe’s hyperinflation of several years ago discredits central banking, case closed. Free banking, central banking, and other monetary systems have a variety of experience, and one must look, insofar as possible, at the totality of the evidence. The facts do not speak for themselves; we have to interpret events and determine what the facts are and which facts are salient.
We do know with certainty, though, that every one of the more than 50 documented hyperinflations of the last 250 years has occurred under central banking, or related monetary arrangements where the government treasury was the issuer of currency. Moreover, in all such cases the central bank or treasury was de jure or de facto not on a gold or silver standard, and in almost all cases was not on a foreign exchange standard either (in which the local currency was redeemable at a set rate in foreign currency). Evidence on that scale is the kind that can serve as the basis for generalizations. Single cases cannot.
The European Central Bank yesterday, in the words of The Washington Post, "announced that it would buy the bonds of struggling governments without limit" (emphasis added). But that can really only mean “without an announced limit.” There is an implicit limit so long as ECB sticks to its also-announced promise to neutralize the monetary-base-expanding effects of its struggling-government bond purchases by selling, euro for euro, other bonds from its portfolio, because its current portfolio is finite and only some of it is not already struggling-government debt. It is difficult to discover exactly what this implicit limit is in billions of euros.
The Eurosystem (the ECB plus the eurozone’s national central banks) can purchase bonds of the struggling GIPSI (Greece, Ireland, Portugal, Spain, or Italy) governments in two ways: directly, or indirectly by making additional loans to commercial banks that purchase GIPSI bonds (and collateralize said loans with said bonds). To sterilize purchases of either kind, the ECB will have to sell its non-GIPSI bonds (or shrink its loans to banks collateralized by non-GIPSI bonds). The Eurosystem’s reported balance sheet shows €3085 b in total assets. It does not reveal what percentage of its current assets are in GIPSI sovereign debts and GIPSI-collateralized loans. We can assume that the €279b of securities acquired under the ECB’s two “covered bond purchase programmes” consists entirely of GIPSI bonds. For the sake of argument let’s assume that gold assets (€434b) and foreign-currency assets (€312b) won’t be touched. We can break the largest asset category, “Lending to euro area credit institutions related to monetary policy operations denominated in euro” into two parts: what was on the balance sheet two years ago (€592b) and what’s been added in the last two years (€618b). Assume that half of the former and one-fourth of the latter is neither GIPSI debt nor the debt of borderline-struggling sovereigns like France and Belgium, but is debt that could be sold for sterilization purposes. That gives us a total of €450b as the upper limit of ECB purchases of the bonds of struggling governments under a policy of full sterilization.
This number is purely a guesstimate. But it probably isn’t off by a factor of two. If the ECB finds itself wanting to make €1000b of GIPSI bond purchases, it is clear that the ECB will have to switch from sterilization to some other strategy for keeping M2 from ballooning, like the Fed’s QE1 strategy of paying higher interest on reserves. Note that the ECB is already paying interest on reserves, and has been since its beginning, whereas the Fed started at zero.
For as long as it lasts, sterilization means that as the ECB buys more GIPSI sovereign debt, it will be shrinking Eurosystem credit to other borrowers, namely to private borrowers and to less-irresponsible sovereign borrowers. Starve the productive and the relatively prudent to lend to the unproductive and imprudent. That is not what anyone could consider a prudent mix of Eurosystem assets, nor a promising way to promote economic growth.
1. With all the recent talk, much of it poorly informed, about the gold standard, I decided to post on SSRN a draft of my paper, "The Rise and Fall of the Gold Standard in the United States," written for an upcoming Hillsdale College Forum.
2. I'm asked, "What is Free Banking?," among other things, at an interview conducted at Guatemala's Francisco Marroquin University in the course of a celebration there last month of Milton Friedman's 100th birthday.
3. "Has the Fed Been a Failure?," in which Bill Lastrapes, Larry White and I do not find much reason to celebrate the approach of the Fed's 100th birthday, has been published online by the Journal of Macroeconomics (full view requires subscription).