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Fedophilia

Posted By George Selgin On December 3, 2012 @ 9:46 am In Uncategorized | 28 Comments

Although the movement to “End the Fed” has a considerable popular following, only a very tiny number of economists—our illustrious contributors amongst them—take the possibility seriously. For the rest, the Federal Reserve System is, not an ideal currency system to be sure (for who would dare to call it that?), but, implicitly at least, the best of all possible systems. And while there’s no shortage of proposals for reforming it almost all of them call only for mere tinkering. Tough though their love may be, the fact remains that most economists are stuck on the Fed.

This veneration of the Fed has long struck me as perverse. Its record can hardly be said, after all, to supply grounds for complacency, much less for the belief that no other system could possibly do better. (Indeed that record, as Bill Lastrapes, Larry White and I have shown [1], even makes it difficult to claim that the Fed has improved upon the evidently flawed National Currency system it replaced.) Further, as the Fed is both a monopoly and a central planning agency, one would expect economists’ general opposition to monopolies and to central planning, as informed by their welfare theorems [2] and by the general collapse of socialism, to prejudice them against it. Yet instead of ganging up to look into market-based alternatives to the Fed, the profession for the most part has relegated such inquiries to its fringe.

Why? The question warrants an answer from those of us who insist that exploring alternatives to the Fed is worthwhile, if only to counter people’s natural but nevertheless mistaken inclination to assume that the rest of the profession isn’t interested in such alternatives because it has already carefully considered—and rejected—them.

It’s tempting to blame Fedophilia, or what Larry White calls “status quo” bias in monetary research [3], on the Fed’s direct influence upon the economics profession. According to White, in 2005 the Fed employed about 27 percent more full-time macro- and monetary (including banking) economists than the top 50 US academic economics departments combined, while disseminating much of their research gratis through various in-house publications or as working papers. Perhaps not surprisingly, despite a thorough review of such publications White could not find “a single Fed-published article that calls for eliminating, privatizing, or even restructuring the Fed.” That professional monetary economics journals are not much better may in turn reflect the fact, also documented by White, that Fed-affiliated economists also dominate those journals' editorial boards.

But I doubt that a reluctance to bite the hand that feeds them is the only, or even the most important, reason why most economists seldom question the Fed’s desirability. Another reason, I suppose, is their desire to distance themselves from…kooks. Let’s face it: more than a few persons who’d like to “End the Fed” want to do so because they think the Rothschilds run it, that it had JFK killed because he planned to revive the silver dollar, and that the basic plan for it was hatched not by the Congressional Committee in charge of monetary reform but by a cabal of Wall Street bankers at a top-secret meeting on Jekyll Island.

Oh, wait: the last claim is actually true. But claims like the others give reasonable and well-informed Fed critics a bad name, while giving others reason for wishing to put as much space as possible between themselves and the anti-Fed fringe. (And please don’t bother to write telling me that the Fed really is a Zionist conspiracy or whatever, or I will personally arrange to have you tracked down and assassinated by someone named Rothschild, even if I have to have some hit man’s name legally changed for the purpose.)

I’m convinced that imagination, or the lack of it, also plays a part. To some extent the problem is too much rather than too little imagination. With fiat money, and a discretionary central bank, it’s always theoretically possible to have the money stock (or some other nominal variable) behave just like it ought to, according to whichever macroeconomic theory or model one prefers. In other words, a modern central bank is always technically capable of doing the right thing, just as a chimpanzee jumping on a keyboard is technically capable of typing-out War and Peace. Just as obviously, any conceivable alternative to a discretionary central bank, whether based on competition and a commodity standard or frozen fiat base or on some other “automatic” mechanisms, is bound to be imperfect, judged relative to some—indeed any—theoretical ideal. Consequently, an economist need only imagine that a central bank might somehow be managed according to his or her own particular monetary policy ideals to reckon it worthwhile to try and nudge it in that direction, but not to consider other conceivable arrangements.

That there’s a fallacy of composition of sorts at play here should be obvious, for a dozen economists might hold as many completely different monetary policy ideals; yet every one might be a Fedophile simply because the Fed could cater to his or her beliefs. In actual fact, of course, the Fed’s conduct can at most satisfy only one of them, and is indeed likely to satisfy none at all, and so might actually prove distinctly inferior to what some non-central bank alternative would achieve. So in letting their imaginations get the best of them, all twelve economists end up endorsing what’s really the inferior option. And if you don’t think economists are really capable of such naievete, I refer you to the literature on currency boards, in which one routinely encounters arguments to the effect that central banks are always better than currency boards because they might be better. Or how about those critics of the gold standard who, having first observed how, under such a standard, gold discoveries will cause inflation, go on to conclude, triumphantly, that a fiat-money issuing central-bank is better because it might keep prices stable?

But if economists let their imaginations run wild in having their ideal central banks stand in for the real McCoys, those same imaginations tend to run dry when it comes to contemplating radical alternatives to the monetary status quo. Regarding conventional beliefs concerning the need for government-run coin factories, which he (rightly) dismissed as so much poppycock, Herbert Spencer observed, “So much more does a realized fact influence us than an imagined one, that had the baking of bread been hitherto carried on by government agents, probably the supply of bread by private enterprise would scarcely be conceived possible, much less advantageous.” Economists who haven’t put any effort into imagining how non-central bank based monetary systems might work find it all too easy to simply suppose that they can’t work, or at least that they can’t work at all well. The workings of decentralized markets are often subtle; while such markets' ability to solve many difficult coordination problems is, not only mysterious to untrained observers, but often difficult if not impossible even for experts to fathom except by means of painstaking investigations. In comparison monetary central planning is duck soup—on paper, anyway.

Nor does the way monetary economics is taught help. In other subjects the welfare theorems are taken seriously. In classes on international trade, for example, time is always spent, early on, on the implications of free trade: never mind that the world has never witnessed perfectly free trade, and probably never will; it’s understood that the consequences of tariffs and other sorts of state interference can only be properly assessed by comparing them to the free trade alternative, and no one who hasn’t studied that alternative can expect to have his or her pronouncements about the virtues of protectionism taken seriously. In classes in monetary economics, on the other hand, the presence of a central bank—a monetary central planner, that is—is assumed from the get-go, and no serious attention is given to the implications of “free trade in money and banking." Consequently, when most monetary economists talk about the virtues of this or that central bank, they’re mostly talking through their hats, because they haven’t a clue concerning what other institutions might be present, and what they might be up to, if the central bank wasn’t there.

Since monetary systems not managed by central banks, including some very successful ones, have in fact existed, economists’ inability to envision such systems is also evidence of their ignorance of economic history. That ignorance in turn, among younger economists at least, is a predictable consequence of the now-orthodox view that history can be safely boiled down to a bunch of correlation coefficients, so that they need only gather enough numbers and run enough regressions to discover everything worth knowing about the past.

Those who’ve been spared such “training,” on the other hand, often have a purblind view of the history of money and banks—one that brings to mind Saul Steinberg’s famous New Yorker cover [4] depicting a 9th-Avenuer’s view of the world, with its almost uninhabited desert between the Hudson and the Pacific, and China, Japan, and Russia barely visible on the horizon. If he or she knows any monetary history at all, the typical (which is to say American) economist knows something about that history in the U.S., and perhaps considerably less about events in Great Britain. Theirs is, in short, just the right amount of knowledge to be very dangerous indeed.

And dangerous it has been. In particular, because the U.S. before 1914, and England before the Bank of England began acting as a lender of last resort, happened to suffer frequent financial crises, economists' historical nearsightedness has given rise to the conventional wisdom that any fractional-reserve banking system lacking a lender of last resort must be crisis-prone, and to clever (if utterly fantastic [5]) formal models serving to illustrate the same view (or, according to economists’ twisted rhetoric, to “prove” it “rigorously”). It has, correspondingly, led economists to ignore or at least to underestimate the extent to which legal restrictions, including unit banking laws in the U.S. and the six-partner rule in England, contributed to the deficiencies of those countries’ banking systems. Finally, and most regrettably, it has caused economists to overlook altogether the possibility that the monopolization of paper currency has itself been more a cause of than a cure for financial instability [6].

The good news is that Fedophilia is curable. Milton Friedman, for one, was a recovering Fedophile [7]: later in his career he repudiated the mostly-conventional arguments he’d once put forward in defense of a currency monopoly. Friedman, of course, was a special case: a famous proponent of free markets, he had more reason than most economists do to view claims of market failure with skepticism, even if he’d once subscribed to them himself. Even so his was only a half-hearted change of heart [8], in part (I believe) because he still hadn't drawn the lessons he might have from the banking experiences of countries other than the U.S. and England.

Friedman’s case suggests that it will take some pretty intense therapy to deprogram other Fed inamoratos, including a regimen of required readings. Charles Conant’s History of Modern Banks of Issue [9] will help them to overcome their historical parochialism. Vera Smith’s The Rationale of Central Banking [10] will do more of the same, while also exposing them to the lively debates that took place between advocates and opponents of currency monopolies before the former (supported by their governments’ ravenous Treasuries) swept the field. The Experience of Free Banking [11], edited by Kevin Dowd (with contributions by several Freebanking.org contributors including yours truly) gathers studies of a number of past, decentralized currency systems, showing how they tended to be more stable than their more more centralized counterparts, while another collection, Rondo Cameron’s Banking in the Early Stages of Industrialization [12], shows that less centralized systems were also better at fostering economic development. Finally, instead of being allowed to merely pay lip service to Walter Bagehot’s Lombard Street [13], Fedophile’s should be forced, first to read it from cover to cover, and then to re-read out-loud those passages (there are several) in which Bagehot explains that there’d be no need for lenders of last resort had unwise legislation not created centralized (“one reserve”) currency systems in the first place. The last step works especially well in group therapy.

Of course even the most vigorous deprogramming regimen is unlikely to alter the habits of hard-core Fed enthusiasts. But it might at the very least make them more inclined to engage in serious debate with the Fed’s critics, instead of allowing the Fed's apologists to go on believing that they answer those critics convincingly simply by rolling their eyes.


28 Comments (Open | Close)

28 Comments To "Fedophilia"

#1 Comment By Keith Weiner On December 3, 2012 @ 10:13 am

George: great point. I think the problem is that people do not blame central planning as such. They have a feeling of "well, if I had my way, the central bank would..."

I am surprised you said that the central planner could theoretically do the right thing (I realize that you used this as a foil and were not seriously advocating it). Conceding this does nothing to disabuse wannabe central planners.

I think that as economists, we need to bellow from the rooftops that central planning is impossible. And the reason is simple. The central planner and his gun can dictate a price, or even order factors of production directly to be employed doing whatever he wishes. But the end result cannot be even close to the result that occurs in a free market, which is to say the end result of countless arbitrages. It is not a mere matter of setting the "right" price. But of directly the innumerable actions that led to that "right" price.

#2 Comment By George Selgin On December 3, 2012 @ 10:51 am

Thank you, Keith. I appreciate your point, and have amended the text to make my meaning less subject to misinterpretation.

#3 Comment By ludwigvandenhauwe On December 3, 2012 @ 12:18 pm

The evolution of ideas is slow and is characterized by considerable inertia, but it is not inexistent.... A few decades ago one could still read in economics textbooks such as Samuelson's that the planned economies of the former Soviet Union were functioning by and large satisfactorily; today there is not one textbook on the market making such claims.... Let's hope that the economists' consensus as regards the role of central banks will change too; it's not impossible even if somewhat unlikely to happen in the very near future... Ludwig van den Hauwe, PhD

#4 Comment By Mike Sproul On December 3, 2012 @ 6:52 pm

Economists' failure to put free banking on a par with free markets is partly a result of a theory of money that says that worthless bits of paper called dollars can have value without having any backing. This makes them think that money is governed by a different set of rules than other goods and securities, and opens the door for a belief that the provision of money is the proper duty of the government.

#5 Comment By nickik On December 3, 2012 @ 7:49 pm

I have a few things, in no order I like to add

- I would like to read "The Experience of Free Banking" but it is quite expensive and hard to find. Is there any other way to get essentally the same information, paper on the subject or something?

- I know that it is not the point about the article but what do you think of the sumner idea to target the market forcast, I mean both the general idea and his future market idea.

- The always new about rothbard clameing that the FED kind of took over economics profesion but the numbers you present are scary. Are there simular numbers for the ECB?

- I think the oberservation that economists really like to have a tool with witch the can construct there vision is a really, really deep on, without the FED or more extreamly goverment economists would be reduced to pure observers of what is going on (or at least the can only construct as much as anybody else can) or maybe pridictors. Economics kind of developed out of helping the state, did people like hayek and mises not study 'policy' in a way. Economists sometimes see themslef as the kings of the social siences (even into deluding themself that they are natural sientists) taking away there constractivist tools will probebly not get there approvel. Hayek talked about this too, almost all economists are constractivsts.

- Your list of books seams to be a good start but I imagen a short essay with a mini rational for free banking and guide threw the essential books plus references further readings. If you meet a monetary economists and debate with him you could say, well you belive in central banking are convinced enougth to do the ultimative challange to your belives? Follow this guide and trully consider yourself a hardend central bank advocate. Not sure if many would actually try it but at least if you find somebody open you could just hend him that essay.

- Fantastic Blogpost. Thank you. I should really blog more often, you could make a huge impact in the econblog-scene.

#6 Comment By johnpapola On December 4, 2012 @ 12:34 am

Mike,

All modern economics views value as being entirely subjective, not the result of any intrinsic quality. This is one of the great contributions of Austrian economist Carl Menger. So, yes, paper money can have value, and it actually does have value (which we plainly observe in real life) so long as it remains generally accepted as a medium of exchange. That's not to say that I believe fiat money is a good idea. I do not. But the problem is not its lack of "backing" as a source of value. Rather, it's the fact that a central planning monopoly produces the money and thus serially screws up the supply relative to demand, causing booms and busts while bailing out the richest cronies on earth and funding government excess.

#7 Comment By Free Radical On December 4, 2012 @ 2:12 am

I wonder how you would explain the fact that dollars in fact do have value...?

#8 Comment By vikingvista On December 4, 2012 @ 3:15 am

I would like to hear Bernanke's response to the Bagehot quotes that you refer to. Have you ever succeeded in getting a scholarly Bagehot-referencing Fedophile to comment on those quotes? Do you think their recognition would result in the Fedophile losing esteem for central banking, or for Bagehot?

#9 Comment By Mike Sproul On December 4, 2012 @ 11:42 am

Economic theory, by which I mean what is deceptively called microeconomic theory, is about the valuation of GOODS, not about the valuation of bits of paper laying claim to goods. The value of an apple is explained by supply and demand, which is based on subjective value. A bit of paper that (reliably) says "IOU 1 apple" is worth 1 apple. Its value is determined by its backing, and not by subjective value. If the issuer of that IOU one day suspends convertibility into apples, but still accepts them for 1 apple's worth of taxes, bonds, furniture, etc., then macroeconomists (by which I mean people who don't understand economics) will mistakenly think that inconvertible=unbacked. They will develop all sorts of crazy theories (MV=PT, regression theorems, etc.), to explain why those inconvertible bits of paper have value, when the right answer was in front of them the whole time: Those bits of paper are the liability of their issuer, and they are backed by the issuer's assets.

#10 Comment By Eelco Hoogendoorn On December 5, 2012 @ 8:07 am

Thats a great article; and thanks for the reading recommendations. I recently read hayeks work on free banking, and toroughly enjoyed that.

I was looking for some affordable print editions of any such books, for the holiday season. Would you happen to know of any? Preferably a cook-free, not too adacemic condensed primer to free banking. Hayek is a great read, but he assumes a fair bit of shared outlook and terminology.

I see [14] has a lot of good books on offer, at reasonable prices. Including your good money, which looks interesting. But if you have any particular opinion what is the best choice in the 'affordable but good primer holiday present' category (as opposed to the thorough acedemic debate category), im all ears.

#11 Comment By Warren On December 5, 2012 @ 11:15 pm

Don't know if it's authorized by Dowd et al to be out there, but here you go...

[15]

#12 Comment By George Selgin On December 6, 2012 @ 10:00 am

I'm sorry, Mike, but you persistently confuse the determinants of the value of an IOU (such as a redeemable banknote) with those of fiat money. "Backing" is relevant in the first instance because it bears on the issuer's solvency and hence on it's ability to make good on it's promises. It is irrelevant in the case of fiat money where there's no question of redeemability. In that case what matters is the quantity (and expected future quantity) of the stuff in circulation.

If ever there was a slam-dunk proof of this, it was in the course of the last few years, during which the composition of assets backing" Federal Reserve dollars changed dramatically, from consisting almost exclusively of U.S. gov't securities to consisting to a substantial extent of sub-prime junk. If backing mattered as you say, that ought to have resulted in a substantial decline in the dollar's purchasing power. Yet it did not have that consequence.

#13 Comment By George Selgin On December 6, 2012 @ 10:05 am

Thank you for your comment, Nickik. Regarding essential books, have a look at Kurt Schuler's May 2011 post on some free banking classics.

#14 Comment By George Selgin On December 6, 2012 @ 10:11 am

Thanks for the praise, Eelco. Regarding hard copy free banking books, I'm afraid there's not a lot out there. Vera Smith's Rationale of Central Banking is available for a low price from Liberty Press; but it isn't really a primer on free banking (or anyone's idea of bedtime reading). Kevin Dowd has a number of books, including on of those IEA pamphlets you mention, called "Private Money." My Good Money isn't about free banking at all, alas: but I did try to make it a good read. It also has pictures FWTW.

#15 Comment By Mike Sproul On December 6, 2012 @ 12:01 pm

The key issue here is redeemability. The Fed will not currently use its gold to buy back its FR notes, but it will use its bonds and other assets to buy back FR notes. So on the spectrum of convertibility, the dollar is not all the way over into complete gold convertibility, but it is not all the way onto complete inconvertibility either. If the Fed were to take all its assets and dump them in the ocean, and if there were zero chance that the US government or the IMF would bail the Fed out, then we would all agree that the dollar is completely inconvertible and completely unbacked. But of course the Fed does hold assets, which it identifies on its balance sheet as 'Collateral Held Against Federal Reserve Notes', and the Fed does list Federal Reserve Notes on the liability side of its balance sheet. If the Fed were to be liquidated someday (as we both hope), then Federal Reserve Notes would be a first and paramount lien against the assets of the Fed, including its gold.

Mainstream monetary theory speaks of fiat money as if there were no question that as soon as convertibility is suspended, all the assets held by the issuing bank pop out of existence. When the Bank of England suspended convertibility in 1797 (gold convertibility, not bond convertibility), people like Ricardo and Thornton began thinking that the pound was fiat money, even though the B of E's assets were still there in its vault, still recognized (by accountants, anyway) as the B of E's assets. This put Ricardo and Thornton in the awkward position of thinking that the pound became fiat money in 1797, only to change into backed money in 1821, when gold convertibility was restored. The truth is that the B of E's notes were backed by the B of E's assets the whole time.

The US dollar has been inconvertible since 1933, but of course its assets are still there. We could tell a similar story about every central bank that exists today. If it were true that modern paper money is fiat money, then we should see many central banks that hold no assets against the notes they issue. We see no such central banks.

As for your empirical example, Finance professors tell me that in their empirical work they find it difficult to confirm the proposition that the value of stocks and bonds is determined by the assets and liabilities of their issuers. It is therefore not surprising that we often think that we see the Fed's assets going one way while the value of the dollar goes the other way. There are just too many complications. For example, FR notes are a senior claim against the Fed's assets. Thus the Fed's assets could lose a lot of value, and FR notes could hold their value while the Fed's other liabilities lose all value.

#16 Comment By JP Koning On December 6, 2012 @ 2:23 pm

Good essay, George.

What happens to all the monetary economists if the Fed disappears? Do they go to work for big banks? Do they work in private clearinghouses? Do they devise private liquidity insurance schemes?

#17 Comment By George Selgin On December 7, 2012 @ 12:45 pm

Not sure, JP: but my guess is that more would end up flipping hamburgers than showing up at "End the Fed" rallies (though some might do both).

#18 Comment By Martin Brock On December 7, 2012 @ 10:03 pm

Do you deny that pure fiat money is possible? Can a state not imbue a currency with value by forcing it to circulate through taxing and spending and buying and selling entitlement to the tax revenue? What's difference between money forced to circulate this way and money "backed" by entitlement to the tax revenue? If the Fed holds only Treasury securities, as assets backing its circulating notes, how does this "backing" differ from pure fiat money?

#19 Comment By Mike Sproul On December 7, 2012 @ 11:48 pm

Martin:

A pure fiat money gives a free lunch to its issuer, and this free lunch would attract rival issuers until the value of the fiat money was zero. Also, the act of borrowing and spending fiat money puts the borrower in a short position in the money, at the same time that the borrowing creates substitutes for the money, thus reducing its value. This creates a nonsensical situation where the short seller profits from the very inflation he caused. The puzzle disappears if we recognize that so-called fiat money is actually backed by its issuer's assets. This helps to explain why every central bank I ever heard of holds assets against the money it has issued. Why hold assets if you can issue a true fiat money?

States do give their money value by accepting it for taxes, but only because 'taxes receivable' are an asset that backs the money. Think of a landlord whose land is worth 1000 oz. of silver. The landlord buys groceries by handing the grocer a 1 oz IOU that he accepts for rent. The land (or, equivalently, the landlord's 'rents receivable') backs the IOU's in the same sense that taxes receivable back the dollar. Of course, if the landlord goes crazy and issues 2000 of those IOU's, and spends them all on candy, then each of his IOU's will be worth only .5 oz. The story for government-issued paper money is similar.

If the Fed holds only T bonds, all denominated in $, and if it uses those T bonds to back its dollars, then we have the absurd situation of backing a dollar with another dollar. But all central banks hold some real assets, which act as an anchor to stabilize its money, even if it does hold some assets denominated in its own money. Let E=the value of the dollar (oz./$) and suppose that a bank has issued $300, against which it holds 100 oz of silver plus bonds, denominated in dollars, worth $200. Setting assets (100 oz plus bonds worth 200E oz) equal to liabilities (dollars worth 300E oz.) yields

100+200E=300E

Or E=1 oz/$

#20 Comment By Martin Brock On December 9, 2012 @ 7:42 pm

An issuer’s assets back circulating notes ideally and must do so practically in a free, competitive market, but to be clear, I associate “fiat money” with a state commanding a monopoly of note issue and raising taxes in the notes. "Fiat" means "backed by coercive force", not "unbacked".

Notes issued by a free bank, and backed by assets at least as valuable as the face value of the notes, are not “fiat money” at all in my way of thinking, because the issuer cannot force the notes to circulate by forcing people to collect them to pay taxes and other rents or debts. Freely issued notes circulate only while people trust their value, and issuers maintain their value for this reason.

Taxes receivable are an “asset” (regrettably), but states effectively inflate by promising to raise more taxes than they ultimately raise. The state is a monopoly issuer, but today’s politician competes with yesterday’s politician, and these rival issuers can drive the value of a fiat currency to zero. The dollar and other fiat currencies consistently lose value for this reason, right? The CPI has more than quadrupled in my lifetime, so the Fed does issue notes less valuable than assets it holds. Doesn’t it?

The Fed buying back its dollars with Treasuries isn’t exactly buying dollars with dollars, because Treasuries promise interest payments. Holding a Treasury is holding entitlement to a portion of the state’s tax revenue. A state theoretically could raise enough taxes to pay its “debts” without inflating, but states don’t raise enough taxes in practice. I prefer holding a Treasury to holding a dollar if the real interest rate is positive or if my other options seem likely to fall in dollar value faster than the Treasury, given that I must have dollars to pay taxes and to obtain other things.

#21 Comment By Mike Sproul On December 11, 2012 @ 12:58 am

Martin:

See answers below.

"An issuer’s assets back circulating notes ideally and must do so practically in a free, competitive market, but to be clear, I associate “fiat money” with a state commanding a monopoly of note issue and raising taxes in the notes. "Fiat" means "backed by coercive force", not "unbacked"."

A landlord who collects rent in silver can buy things with his own 1 oz. IOU's, which he accepts for rent. That's just like a government buying things with dollars that it accepts for taxes, but there's nothing but gray areas when it comes to defining "coercive force". One kind of bank note is backed by a promise to redeem it in silver, and another is backed by a Mafia thug's promise that he will accept it for protection money. Both notes are backed, not fiat.

"Notes issued by a free bank, and backed by assets at least as valuable as the face value of the notes, are not “fiat money” at all in my way of thinking, because the issuer cannot force the notes to circulate by forcing people to collect them to pay taxes and other rents or debts. Freely issued notes circulate only while people trust their value, and issuers maintain their value for this reason."

Agreed.

"Taxes receivable are an “asset” (regrettably), but states effectively inflate by promising to raise more taxes than they ultimately raise. The state is a monopoly issuer, but today’s politician competes with yesterday’s politician, and these rival issuers can drive the value of a fiat currency to zero. The dollar and other fiat currencies consistently lose value for this reason, right? The CPI has more than quadrupled in my lifetime, so the Fed does issue notes less valuable than assets it holds. Doesn’t it?"

Yes; loss of backing can cause notes to lose value. It can also get more complicated, like when the Fed has plenty of assets to make a dollar worth 1 oz., but decides to maintain convertibility at .6 oz.

"The Fed buying back its dollars with Treasuries isn’t exactly buying dollars with dollars, because Treasuries promise interest payments. Holding a Treasury is holding entitlement to a portion of the state’s tax revenue. A state theoretically could raise enough taxes to pay its “debts” without inflating, but states don’t raise enough taxes in practice. I prefer holding a Treasury to holding a dollar if the real interest rate is positive or if my other options seem likely to fall in dollar value faster than the Treasury, given that I must have dollars to pay taxes and to obtain other things."

Things get interesting when you try to back a dollar with something denominated in dollars. Then a loss of assets makes the dollar fall, which makes the dollar-denominated assets fall more, which makes the dollar fall more, etc.

#22 Comment By Martin Brock On December 11, 2012 @ 10:45 am

That's just like a government buying things with dollars that it accepts for taxes, but there's nothing but gray areas when it comes to defining "coercive force".

I'll withdraw "coercive" and substitute "improper" while conceding the gray areas; however, "fiat" commonly refers to official or statutory force, and dictionaries record this usage. Bitcoin for example is unbacked money that is not fiat money, and fiat money can be backed by forces other than taxing and spending as you say. This distinction will become clearer in the future as people encounter things like Bitcoin.

One kind of bank note is backed by a promise to redeem it in silver, and another is backed by a Mafia thug's promise that he will accept it for protection money. Both notes are backed, not fiat.

Both notes are backed, but "backed by silver" and "backed by thug" is not the salient distinction. If the landholder holds only the land, however forcibly, his IOU is backed by the value of his land which can be exchanged for silver. His note promises silver rather than land only because silver is the standard of value and he may exchange his land for silver.

Both a silver holder and a land holder must enforce his possession of his good. "Thuggish" does not describe the holding per se (in common parlance), and a Mafia thug need not hold either land or silver to demand protection money. A gun alone can suffice. In the gray fog of "property", we shouldn't lose sight of this distinction.

A note backed only by my own promise of my own labor is backed by other people's trust in the security offered. If I hold my own labor exclusively by force, if no one may take my labor from me against my will without overcoming my own force and even the force of a state I support, we could say that my promissory note is "backed by force", but my note is nonetheless backed by people's trust in my promise of my labor, including my implicit promise to protect my labor forcibly from other forces, including statutory forces.

Things get interesting when you try to back a dollar with something denominated in dollars. Then a loss of assets makes the dollar fall, which makes the dollar-denominated assets fall more, which makes the dollar fall more, etc.

I don't follow you here. If I hold land and promise silver and if I then lose some of the land (or it falls in value relative to silver), then my notes can also fall in value; however, this fall in the value of my notes is a rise in the value of other goods denominated in my notes. My notes promising an ounce of silver may be worth only half an ounce of silver, so an acre of land formerly worth a hundred of my notes becomes worth two hundred of my notes, including the acreage backing my notes.

I don't assume here that I may seize as much silver as I need to maintain the face value of my notes. I assume that my land and only my land backs my notes.

#23 Comment By Mike Sproul On December 12, 2012 @ 8:11 pm

"My notes promising an ounce of silver may be worth only half an ounce of silver, so an acre of land formerly worth a hundred of my notes becomes worth two hundred of my notes, including the acreage backing my notes."

The inflationary feedback problem results when you issue notes denominated in dollars, while at the same time holding assets denominated in dollars. So you're not backing your dollar notes with an acre of land. You're backing your dollar notes with a dollar's worth of land. For example, if you lose some of your assets, your dollar notes lose value. This makes the dollar's worth of land worth less, so assets fall still more, and the dollar falls still more, etc.

#24 Comment By Martin Brock On December 12, 2012 @ 8:49 pm

This makes the dollar's worth of land worth less, so assets fall still more, and the dollar falls still more, etc.

I'm still not seeing it. Say I have a hundred acres all worth $1000, and I issue 100,000 notes each promising a dollar. Each acre of my land is worth 1000 of my notes. I then lose 50 acres somehow. Now, my notes are worth only fifty cents, so each acre of my remaining land is worth 2000 of my notes.

My acre is still worth $1000 in someone else's, undepreciated notes but not in my notes. The depreciation of my notes does not cause the dollar generally to fall in value. I'm not a state. I can't impose my losses on holders of other dollar notes. The falling value of my dollar notes has no effect on the value of anyone else's dollar notes.

If my notes fall in value, people start demanding redemption until I'm forced to sell my land and finally driven out of business. Forcing me to sell does lower the value of my land further, because it increases supply of my land relative to demand, but that's not a problem for anyone else circulating dollar notes. Other people circulating dollar notes are buying my notes at a discount in order to obtain my land, and that's exactly what's supposed to happen. Holders of my dollar notes lose, while banks circulating other dollar notes gain, and that's also supposed to happen.

#25 Comment By Mike Sproul On December 13, 2012 @ 1:28 am

The feedback process only happens when some of the issuer's assets are denominated in the issuer's own money. It doesn't happen when assets are physical amounts of something. So a bank has issued 300 dollars against which it holds 100 oz of silver, plus bonds (denominated in dollars) worth $200. Initially, setting assets=liabilities yields 100+200E=300E, or E=1 oz/$.

The bank is robbed of 30 oz. (10% of its total assets), and the above becomes
70+200E=300E, for E=.7 oz./$, or 30% inflation.

If that bank had instead held 300 oz assets against $300, and then lost 30 oz, the equation would be 270=300E, or E=.9 oz/$. With no dollar-denominated assets there is no feedback effect, and a 10% loss of assets causes just 10% inflation.

#26 Comment By Martin Brock On December 13, 2012 @ 3:54 am

In your formulation, if I lose all of my silver, my notes become worthless, and this formulation still makes no sense to me. If your formulation applies in some central banking theory, then the theory involves incredible assumptions. If my $300 notes become worthless when I lose only $100 worth of silver from the asset side of my ledger, then I never had bonds worth $200 on the asset side of my ledger.

If I hold bonds actually worth $200, then someone credibly owes me $200 (present value). To credibly owe me $200, someone must actually have assets worth $200. The assets could be someone's labor, but something of value must back the bonds; otherwise, the bonds are not actually worth $200.

If I have 100 ounces of silver worth $100 plus these bonds on the asset side of my ledger, my silver cannot be the collateral backing the bonds, so if I lose 30 ounces of silver, I still have assets worth $270, even if owe the $200 to myself. If I owe the $200 to myself, then my own labor worth $200, not my silver, backs the bonds. Losing this silver does not affect the value of my bonds, so it only lowers the value of my notes by ten percent, not thirty percent.

In a fiat money system, entitlement to revenue from a tax on labor can back the value of currency, and at some point, the tax revenue necessary for stable prices can equal the value of all labor less the laborers' subsistence. At this point, everyone holding only his labor is a slave of the state's bond holders.

#27 Comment By Mike Sproul On December 13, 2012 @ 11:44 am

A comparable situation would be a corporation that buys some call options on its own stock and holds them as an asset. If the corporation loses wealth then the stock falls. This causes the calls to fall. Since those calls are an asset the stock falls still more, etc.

Of course, corporations rarely hold assets whose value depends on the price of their stock, but central banks always hold assets whose value depends on the value of the money that they issued. If the bank lost all of its silver, its money would lose all value.

#28 Comment By Martin Brock On December 13, 2012 @ 6:49 pm

I understand the call option scenario, but the Fed holding Treasury securities does not seem comparable. I don't accept dollars because the Fed holds silver or gold or home mortgages or anything similar. I accept dollars, because the Federal government compels me to pay taxes and other statutory rents in dollars. I must either accept payment in dollars or trade some other currency for dollars to pay the taxes, and accepting dollars typically is my best option under the circumstances.

Since I accept payment in dollars, others may trade dollars for the value of my labor and other goods I possess, and dollars are valuable for this reason. Since dollars are valuable for this reason, the Federal government may also sell entitlement to its tax revenue, so when the Fed holds entitlement to tax revenue as an asset, the value of this asset does not depend upon any silver or anything else the Fed holds other than its entitlement to the goods of taxpayers.

The value of a Treasury security is the value of the Federal government's force, not the value of silver or anything else held by the Fed. If the Fed held nothing but Treasuries, dollars could still have value. If the Fed doesn't exist at all and the Federal government spends dollars into existence directly, the dollar can still have value as long as the Federal government doesn't spend too much compared with the taxes is raises.

The Federal government is like a pump forcing its currency to circulate by pulling it out of economic channels at certain points and pumping it back in at other points. I'm not defending this machinery, of course, but it does seem to operate. This state theory of money is not inevitable, but it does describe the monetary system in my neck of the woods.


Article printed from Free Banking: http://www.freebanking.org

URL to article: http://www.freebanking.org/2012/12/03/fedophilia/

URLs in this post:

[1] as Bill Lastrapes, Larry White and I have shown: http://www.sciencedirect.com/science/article/pii/S0164070412000304

[2] welfare theorems: http://en.wikipedia.org/wiki/Fundamental_theorems_of_welfare_economics

[3] what Larry White calls “status quo” bias in monetary research: http://econjwatch.org/articles/the-federal-reserve-system-s-influence-on-research-in-monetary-economics

[4] Saul Steinberg’s famous New Yorker cover: http://en.wikipedia.org/wiki/View_of_the_World_from_9th_Avenue

[5] if utterly fantastic: http://onlinelibrary.wiley.com/doi/10.1111/j.1467-6419.1992.tb00147.x/abstract

[6] monopolization of paper currency has itself been more a cause of than a cure for financial instability: http://www.independent.org/publications/tir/article.asp?a=774

[7] a recovering Fedophile: http://www.sciencedirect.com/science/article/pii/030439328690005X

[8] a half-hearted change of heart: http://www.cato.org/pubs/journal/cj28n2/cj28n2-12.pdf

[9] History of Modern Banks of Issue: http://books.google.com/books?id=VDE5AAAAMAAJ&printsec=frontcover&dq=conant+history+of+modern+banks+of+issue&hl=en&sa=X&ei=t6a8UKrQOo2K8QSZ8IGwBA&ved=0CC4Q6AEwAA

[10] The Rationale of Central Banking: http://www.econlib.org/library/LFBooks/SmithV/smvRCB.html

[11] The Experience of Free Banking: http://www.amazon.com/Experience-Free-Banking-Kevin-Dowd/dp/0415048087?tag=freebank07-20

[12] Banking in the Early Stages of Industrialization: http://www.tandfonline.com/doi/abs/10.1080/03585522.1963.10414345#preview

[13] Lombard Street: http://www.econlib.org/library/Bagehot/bagLom.html

[14] : http://www.iea.org.uk

[15] : http://analyseeconomique.files.wordpress.com/2011/07/kevin-dowd-the-experience-of-free-banking.pdf

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