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A Hard Anchor for the Dollar

by Bradley Jansen July 31st, 2013 8:29 pm

The following is a guest cross-post from Warren Coats

For the last three years with zero interest rates and “quantitative easing” the Federal Reserve has been pushing on a string. It has been trying to stimulate an economy that suffers from problems that are not basically monetary. In the process it is distorting the limping economic recovery and potentially reflating housing and other asset bubbles. The Federal Reserve has jeopardized its revered independence by undertaking quasi-fiscal operations (buying long-term government debt and MBS to push down longer term interest rates in those markets while paying banks interest on their deposits at the Fed to keep them from lending the proceeds). The result has been an explosion of the Fed’s balance sheet (base money—the Fed’s monetary liabilities—jumped from around $800 billion in mid 2008 to over $3,200 billion in July 2013) while the money supply only grew modestly (over the same period M2 increased from about $8,000 billion to about $10,700 billion- about the same increase as over the five year earlier period from mid 2003 to mid 2008).

There is growing sentiment that our fiat currency system should be replaced with a hard anchor, such as the gold or silver standards in place in much of the world over the two centuries preceding gold’s abandonment by the United States in 1971. In order to avoid the weaknesses of the earlier gold standard, which contributed to its ultimate abandonment, three key elements of its operation should be modified. These are: a) the conditions under which currency fixed to a hard anchor is issued and redeemed; b) what the currency is sold or redeemed for; and c) what the anchor is.

Monetary Policy

During the earlier gold standard, the value of one U.S. dollar was fixed at $19.39 per ounce of fine gold from 1792 to 1934 and $35.00 per ounce from 1934 to 1971 when Nixon ended the U.S. commitment to buy and sell gold at its official price because the U.S. no longer had enough gold to honor its commitment.  None-the-less, the official price was raised to $38.00 per ounce in 1971 and to $42.22 in 1972 before President Ford abolished controls on and freed the price of gold in 1974.

Under a strict gold standard, operated under currency board rules, the central bank would issue its currency whenever anyone bought it for gold at the official price of gold and would redeem it at the same price. In fact, however, the Fed engaged in active monetary policy, buying and selling (or lending) its currency for U.S. treasury bills and other assets when it thought appropriate. Thus rather than being fully backed by gold, the Fed’s monetary liabilities (base money) were partially backed by other assets. Moreover the fractional reserve banking system allowed banks to create deposit money, which was also not backed by gold. The market’s ability to redeem dollars for gold kept the market value of gold and hence the dollar close to the official value. Because the Fed could offset the monetary contraction resulting from redeeming dollars, this link was broken and in 1971 President Nixon closed the “gold window” altogether for lack of gold.

A reformed monetary system should be required to adhere strictly to currency board rules. The Federal Reserve should oversee the interbank payment and settlement systems and provide the amount of dollars demanded by the market by passively buying and selling them at the dollar’s officially fixed price for its anchor (gold, in a gold standard system) in response to market demand. Banks should be denied their current privilege to create deposit money by replacing the fractional reserve system with a 100% reserve requirement (a subject for another time).

Indirect redeemability

Historically, gold and silver standards required that the monetary authority buy and sell its currency for actual gold or silver. These precious metals had to be stored and guarded at considerable cost. More importantly, taking large amounts of gold and/or silver off the market distorted their price by creating an artificial demand for them. Under a restored gold standard the relative price of gold would rise over time due to its limited supply, and the increasing cost of discovery and extraction. The fix dollar price of gold would mean that the dollar prices of everything else would have to fall (perpetual deflation). While the predictability of the value of money is one of its most important qualities, stability of its value (approximately zero inflation) is also desirable.

This shortcoming of the traditional gold standard can be easily overcome via indirect redeemability. The market’s regulation of the money supply in line with the official price of money in terms of its anchor does not require transacting in the actual anchor goods or commodities. As long as an asset of equal market value is exchanged by the monetary authority when issuing or redeeming its currency, the market will have an arbitrage profit incentive to keep the supply of money appropriate for its official value. In a future, hard anchor monetary system, the Federal Reserve could issue and redeem its currency for U.S. treasury bills rather than gold or other anchor goods and services. The difference between that and current open market operations by the Fed is that such transactions would be fully at the initiative of the market rather than of the central bank. The storage cost of such assets would be negligible and in fact would generate interest income for the Fed.

The Anchor

The final weakness of the gold standard was that the relative price of the anchor, based on a single commodity, varied relative to the goods and services (and wages) purchase by the public. In short, though the purchasing power of the gold dollar was highly stable historically over long periods of time, gold did not provide a stable anchor over shorter periods relevant to most business decisions

Expanding the anchor from one commodity to 10 to 30 goods and services carefully chosen for their collective stability relative to the goods and services people actually buy (e.g. the CPI index) would be an important improvement over anchoring the dollar to just one commodity (gold). There have been many such proposals in the past, but the high transaction and storage costs of dealing with all of the goods in the valuation basket doomed them. Replacing such transactions with the indirect convertibility described above eliminates this objection.

A Proposal

The United States could easily amend its monetary policy to incorporate the above features – a government defined value of the dollar as called for in Article 1 Section 8 of the U.S. Constitution and a market determined supply of dollars. First Congress would adopt a valuation basket of 10 to 30 goods and services chosen to give the dollar the most stable value possible in terms of an average family’s consumption (i.e. the Consumer Price Index). The basket would consist of fixed amounts of each of these goods and would define the value of one dollar. As with the gold standard, if the value of the goods in the basket were more in the market than one dollar, anyone could buy them more cheaply by redeeming dollars at the fed for an equivalent value of U.S. treasury bills (indirect redeemability). The resulting contraction of the money supply would reduce prices in the market until a dollar’s value in the market was the same as its official valuation basket value. The money supply would grow with its demand (as the economy grows) in the same way (selling t-bills to the fed for additional dollars). The Federal Reserve would be restricted to passive currency board rules. All active purchases and sales of t-bills by the fed (traditional open market operations) or lending to banks would be forbidden. During a two year transition period the fed would be allowed to lend to banks against good collateral in order to allow banks time to adjust their operations and balance sheets to the new rules.

A global anchor

The gold standard was an international system for regulating the supply of money in each country and between countries and provided a single world currency (fixed exchange rates). This led to a flourishing of trade between countries. This was a highly desirable feature for liberal market economies.

The United States could adopt the hard anchor currency board system described above on its own and others might follow by fixing their currencies to the dollar as in the past. The amendments to the historic gold standard system proposed above would significantly tighten the rules under which it would operate and strengthen the prospects of its survival.

However, there would be significant benefits to developing such a standard internationally as outlined in my Real SDR Currency Board proposal (http://works.bepress.com/warren_coats/25/). One way or the other, replacing the widely fluctuating exchange rates between the dollar and other currencies would be a significant boon to world trade and world prosperity.  Replacing the U.S. dollar as the world’s reserve currency with an international unit would have additional benefits for the smooth functioning of the global trading and payments system.


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Dollarization and competing currencies

by Kurt Schuler July 27th, 2013 10:12 pm

The Austrian Economics Center blog has a post by Finbar Feehan-Fitzgerald on "Hayek versus Friedman: Concurrent Currencies." (The center is located in Vienna, hence it is Austrian by geography as well as by school of thought. I came to the post via a link from Jonathan Finegold's blog, Economic Thought.)  As Feehan-Fitzgerald summarizes their disagreement, Hayek thought that the costs of switching currencies were small, hence competing units of account was a realistic possibility. Friedman thought the costs were large, hence a single unit of account should dominate and fend off rivals unless it becomes quite unstable.

Part of the difference between them, I suspect, was what they explicitly or implicitly counted in the costs of switching. A truly level playing field among currencies is rare. The government typically favors its own currency by making all of own domestic payments in that currency and not giving people the choice of payment in another unit; by requiring taxes to be paid in local currency; by requiring in the case of some countries that all private-sector salaries likewise be paid in local currency; and, often, by provisions of the tax code, other laws, exchange controls, and regulations on financial institutions. The result is to create a minimum level of demand for local currency that might not exist in the absence of those laws and regulations.  (In fact, I think it would make a good master's thesis to ferret out all of the laws and regulations that tilt the playing field in a particular country and to explain just how they do so.)

Where the playing field is so heavily tilted, a substantial depreciation of the local currency is usually necessary to induce a partial switch to a foreign currency--partial dollarization, so called whether or not the foreign currency is the U.S. dollar. In dollarized countries, local currency continues to circulate and be used as a medium of exchange for small retail payments, but yields to the foreign currency as a store of value and as a unit of account for large payments. Foreign-currency deposits, if legal, are preferred to local-currency deposits as stores of value. House and car prices are typically denominated in foreign currency, even if officially it is illegal.

Once dollarization occurs, it can persist even if the local currency becomes more stable, a phenomenon dubbed hysteresis. Hysteresis seems to support Friedman, but I think it really supports Hayek because under partial dollarization, the playing field almost always remains tilted toward the local currency. It isn't that switching back is hard, it's that distrust of the local currency lingers and people prefer some foreign currency as a hedge despite all the legal advantages to holding domestic currency.

There are plenty of examples of partial, unofficial dollarization. Some occur because of instability in the local currency. Others occur because of trade links: the U.S. dollar is widely accepted in Caribbean countries that have good local currencies because merchants catering to the tourist trade find it advantageous. The latter cases are to me another piece of evidence suggesting that the costs of switching currencies are low in the absence of legal restrictions, but in practice typically high because restrictions are common.

The hypothetical monetary system Hayek envisioned in in Denationalisation of Money has constant, vigorous competition among units of account even within small areas such as a single city. In contrast, I would expect one unit to dominate withing small areas, though perhaps multiple units having large world market shares, providing a possibility of switching if the local unit becomes bad. The computer age opens up new possibilities here that did not exist until recently, though. As we move to all-electronic payments, switching from one unit of account to another becomes as easy as pushing a button, even for retail buyers and investors. It is another case where Hayek looks less like a speculative theorist and more like a visionary as time passes.


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Scott Sumner Has Got Me all Confused

by George Selgin July 23rd, 2013 11:08 am

To be specific, he confuses me by his response to Ezra Klein's column quoting former FRB vice chairman Donald Kohn's opinion that “It’s difficult, if not impossible, to create persistent inflation without demand exceeding potential supply over an extended period” along with Lawrence Summers' view that "inflation is mostly driven by demand, and when you increase demand, you increase inflation. And if you don’t increase demand, you don’t increase inflation. But if you’ve solved demand, you’ve solved your problem.” To the question implicit in such remarks, regarding why anyone would expect the Fed to succeed in raising the current rate of inflation despite being incapable of increasing the current growth rate of aggregate demand, Scott's response is "Um, maybe because the Fed promised a more expansionary policy in the future?"

I realize that Scott wants his readers to imagine Kohn and Summers, upon hearing this reply, smacking their lower palms against their foreheads while saying "Dope!" But at the risk of appearing to be a dope myself, I confess that I believe that the statements by Kohn and Summers make perfect sense, whereas Sumner's rhetorical response does not.

It doesn't make sense, first of all, because, assuming a non-declining AS schedule, an increase in the rate at which prices increase that is not accompanied by a corresponding increase in aggregate spending must be accompanied by ever-declining sales and ever-worsening unemployment, and is for that reason unlikely to persist. So it would seem to be true after all that a persistent increase in the rate of inflation requires a persistent increase in the growth rate of aggregate demand relative to that of aggregate supply.

Of course I don't doubt for a moment that Scott understands this last point perfectly well. Unless I'm mistaken, what bothers him about the opinions expressed by Kohn and Summers is their implicit failure to appreciate the possibility that, when it raises its announced inflation target, the Fed also increases the expected rate of inflation, and with it the velocity of money. Consequently the Fed is able to boost aggregate demand and to combat recession without resorting solely to the usual, more direct but less reliable means of more aggressive monetary expansion, and its higher announced inflation target becomes in this respect at least partly self-fulfilling.

But even this more sophisticated objection to Kohn and Summers, understood (as I understand it) to imply that those experts have overlooked a potentially effective means for combating recession, seems wrong to me. True, if prospective buyers expect prices to increase, that's a reason for them to spend more now. But if prospective sellers expect consumers to spend more, that is a reason for them to start raising prices now. So while a higher announced inflation target might be self-fulfilling, there's no reason to suppose that by announcing such a target the Fed can achieve anything other than a higher rate of inflation.

Inflation expectations, in other words, inform the positions and rate of change of both demand and supply schedules--as should be especially obvious to anyone familiar with Wicksteed's famous exposition in which the latter schedules are nothing other than flipped-over portions of total ("communal") demand schedules. Changes in inflation expectations will, in still other words, tend to affect in the same manner the decisions of both buyers and sellers. Consequently, if sellers' expectations have been excessively rosy, so that their pricing decisions have resulted in disappointing sales, there's no reason to suppose that an announced increase in the inflation target won't cause them to become rosier still, ceteris paribus. Expectations are a double-edged sword that policy tends to sharpen on both sides, or not at all.

None of this contradicts the view, which I share with market monetarists, that an increase in aggregate demand that is not merely the result of an increase in the expected rate of inflation can be effective in reducing unemployment. For in that case, and again assuming that sellers' expectations have been excessively rosy, the increase serves, not to boost those expectations further, but to bring reality closer to them. To my way of thinking this difference between a policy that works by fulfilling established demand expectations that have been overly-optimistic, and one that seeks to boost demand by raising the expected rate of inflation, is absolutely crucial. If an economy is depressed because its rate of NGDP growth falls short of sellers' expectations, then surely the best way to close the gap is by raising the actual rate of NGDP growth only, while either leaving NGDP growth and inflation expectations alone or, were it possible to do so, lowering those expectations. I'm not saying that doing this is easy, by means of monetary expansion or otherwise. But it is nonetheless what needs to be achieved, and it is unlikely to be achieved by raising the Fed's inflation target.

It seems to me that monetary economists who overlook this obvious truth risk adding to rather than subtracting from our current monetary troubles. Maybe Scott isn't among them; maybe I've misunderstood him. Or maybe my own reasoning is all wrong. Like I said, I'm confused. But whatever the reason for my confusion I hope that Scott, or someone, will help me out of it.

Addendum (July 24): As the argument of this post is not the easiest to get across, I hope I may be pardoned for adding, by way of clarification, the observation that believers in NGDP targeting who also endorse raising the target (and thus the expected) rate of inflation as a means to end recession appear to subscribe to view, which I think badly mistaken, that, if economic recovery can be encouraged by providing for adequate (but not inflation-enhancing) NGDP growth, then it can be encouraged still further by promising a rate of NGDP growth such as would serve to actually increase the equilibrium inflation rate.


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July issue of Cato Unbound

by Chuck Moulton July 17th, 2013 3:42 pm

I published one of the response essays in July's issue of Cato Unbound.

"It would be entirely reasonable for a developing country to dollarize to bitcoins, embracing sound money as a replacement for a faltering, untrusted national currency. Coupling bitcoins with free banking both introduces elasticity into the money supply to smooth out the price level and also creates a physical manifestation of bitcoins that people can trade for goods and services without needing Internet connectivity."
-- Chuck Moulton, "It’s a Sound-Money Alternative to the Dollar", Cato Unbound

The pieces of my colleagues are also quite interesting. However, I will correct Jim Harper later -- he is far too charitable to governments and dismissive of private money in his remarks concerning monetary history.

July issue of Cato Unbound (The Private Digital Economy):


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My Part in the Great Right-Wing Conspiracy

by George Selgin July 16th, 2013 10:02 pm

Stephen Williamson, a well-known monetary economist with a blog of his own called New Monetarist Economics, was kind enough to draw attention there recently to my remarks concerning Gary Gorton's book. His post in turn elicited a sarcastic comment (anonymous, of course), the gist of which was that it was after all to be expected that a paid flunky of the "right wing" Koch brothers should be against regulating banks.

This isn't the first time someone has tried to tar me with that brush, and I don't suppose it will be the last. Nor do I suppose that by defending myself against such libels I will ever put a stop to them. Nevertheless the comments inspire me to do something I've meant to do for some time now, which is to explain the role that politics and ideology have played in my thinking generally and in my writings on free banking in particular.

First, for the record: I work not for any Koch-sponsored entity but for the University of Georgia, where I've been now for almost 25 years. (True, my first job was at GMU, but (1) my salary there was paid by the taxpayers of the Commonwealth of Virginia, and (2) I got the boot, and it wasn't for being insufficiently anti-Fed.*) Since I'm the only free banker at UGA, and I also haven't exactly been awash in roses and Valentine cards from its administrators, I trust that no one will be inspired by these revelations to claim that I'm a shill for the Georgia State Legislature, or the Board of Regents, or my University President, or any of the other persons responsible for my livelihood.

It's true that I'm also a "Senior Fellow" at the Cato Institute, and proud of it. But "Senior Fellow" is an honorary (that is, unpaid) title only. And though I have been paid to take part in Cato's annual monetary conferences, so too, at one time or another, have about four-fifths of the world's better known monetary economists and monetary policy makers. Finally, I've done some paid consulting for Mercatus and have lectured in the past for the Institute for Humane studies. But to have allowed the pittance I've gotten from both to suffice to turn me into a mere appendage of the so-called "Kochtopus," I'd have to have been a sucker all along.**

If I'm not actually paid, or paid enough, to espouse views not necessarily my own, then is it not at least correct to say that my own thinking has been shaped by my "right-wing" convictions rather than by any detached appeal to theory and evidence? Actually, it isn't. For starters "right wing" is hardly the right phrase for describing my convictions, such as they are, unless one thinks the expression applicable to someone who thinks, among other things, that carbon dating is more reliable than Genesis 1:1-5; that pregnant women are usually more fit than others to decide whether they should give birth or not; that the world would be less rather than more nasty were cocaine sold at Walgreens; and that the Patriot Act ought to be called the Scoundrel Act. In short, if you absolutely must label me, try "libertarian."

But the fact is that I'm not even much of a libertarian. In California back in 1979 I helped to get the Libertarian Party's Presidential candidate, Ed Clark, on the ballot. Since then, I've had nothing to do with politics, which I've come to regard as unseemly. That others can be enthusiastic about this or that politician surprises me in the same way that it might surprise me to learn that there is such a thing as an official streptococcus fan club with a list of dues-paying members. And although I can't claim never to have voted, I can at least say that I would hate to ever have to admit voting for any of the people I voted for. All things considered I'd much rather exercise what Herbert Spencer calls my "Right to Ignore the State."

Ideology admittedly played some part in the development of my views on money. But that part was much smaller than many may imagine. Back in 1980, when I was supposed to be working toward an M.S. in Marine Resource Economics at the University of Rhode Island, I instead spent my time either swimming at Charlestown Beach or reading books on monetary economics, the aim of the last having been that of understanding the double-digit inflation then in progress. I'd already read several dozen books on money when my former college chum Clint Bolick encouraged me to see what von Mises and Hayek, who I'd not yet heard of, had to say. So I read the Theory of Money and Credit, and it was as if someone had taken a broom and swept the cobwebs from inside my skull. Then I read Denationalisation of Money, and it was as if someone set off fireworks there. I wasn't instantly won over by Hayek's thesis. But that thesis got me seriously wondering whether the instability of the U.S. dollar might have its roots in government meddling with money.

That's when I first got involved with IHS. As I recall, they had placed a little ad in some libertarian magazine (yes, I read that sort of thing back then) offering summer grants for economics research. So I proposed to examine Hayek's thesis in light of U.S. experience (or was it the other way around?). Anyway, I got the grant and worked away at my essay and ended up discovering that getting the U.S. facts to fit Hayek's general hypothesis was easier than shooting fish in a barrel. It was while I was working on that project that Walter Grinder, IHS's long-time Academic Director, told me about Larry White's work, then still in progress, on the Scottish banking system. Of course I wrote to Larry and read his chapters as he sent them to me. Then I asked him to let me know as soon as he took a job offer, which is how we both ended up showing up at NYU at the same time. You know the rest.

So ideology pointed me in the direction that was to develop into my research program. But it did so, not by making me want to become an advocate for "libertarian" monetary ideas, but by equipping me with a working hypothesis that was long overdue for testing, and which seemed to me to survive such testing remarkably well, if not with flying colors. I dare say that any young professor finding himself armed with such a hypothesis would have done exactly what I did, which was to run with it as far as it would go. Naturally libertarian groups (but not genuinely "right wing" ones***) have found my research attractive, and have sometimes awarded me for it. But I didn't pursue it just to please them. Indeed I rather prefer having non-libertarians express interest in, if not agreement with, my ideas, because their interest is more likely to depend on the power of my arguments than on the propriety of my conclusions. It's hard, on the other hand, for me to really get a kick out of talking to hard-core libertarians since their way of thinking makes all my hard research seem like so much gimcrack ornament.

But even admitting this doesn't quite get to the bottom of the bearing of ideology upon my work. For after some years as an academic economist I came to think of ideology as an outright hindrance: one cannot, it seems to me, both subscribe to some preconceived "system" of beliefs (as opposed to assumptions that are merely tentative or working) and remain perfectly free to form beliefs of one's own. For that reason I long ago stopped describing myself as a libertarian economist or as an Austrian economist or as anything save a monetary economist or economist sans adjectif. More importantly I stopped thinking of myself as anything other than a plain-old economist or monetary economist, and so no longer concerned myself, if I ever did, with establishing my bona fides with anyone apart from other economists. If I reject or simply question arguments for government intervention in the monetary system, it's only because I don't find the arguments convincing or consistent with available evidence. It's not my fault that so many arguments for government intervention in money turn out to be nothing more than unfounded (though oft-repeated) assertions.

Finally, although I'm used to being called one, I don't even consider myself a "free banker," in the sense meaning an advocate of free banking. Of course I'd like to see a revival of the Scottish currency system, or something like it, because I'm convinced that such a revival would make most people, myself included, better off. But the prospect of changing the world wouldn't float my boat even if it weren't quite so teeny-weeny. What does turn me on, really and truly, is the feeling of having my hands on some truth no one else has yet managed to grab. I know that sounds corny, but I mean it. I think a lot of economists mean it. I just wish people wouldn't find it harder to believe when I say it than when some fan of the Fed does.
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*Don't ask.
**Tyler Cowen, on the other hand, knows how to strike a hard bargain: although as Mercatus's General Director he is presumably on that Koch-sponsored institution's payroll, he nevertheless continues to hold out, even going so far as to defend the Fed against free bankers like myself. I do hope that the Koch Foundation will go ahead and give him the money he wants in return for changing sides. While they're at it, I hope they might also do something about all those monetary economists who are as yet in the Fed's pocket.
***I am still waiting for an invitation to speak at the Heritage Foundation, or the American Enterprise Institute, or the John Birch Society, or the Trilateralist Commission. Probably this post won't make the wait any shorter.


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What we have done for you lately

by Kurt Schuler July 13th, 2013 12:49 am

Noah Smith describes the Austrian tradition in monetary theory as a "(mostly dead) econ research paradigm." I beg to differ. Here is a rather long list of things that what Smith terms the GMU (George Mason University) wing of the Austrian School has done lately in monetary economics--"lately" being defined as within the last generation, the span in which almost everyone listed below began publishing on monetary economics.

1. Revived interest in the historical experience of free banking around the world (Larry White, Free Banking in Britain and the 3-volume edited set Free Banking; Kevin Dowd, The Experience of Free BankingGeorge Selgin in a number of of essays; me to a lesser extent with essays in The Experience of Free Banking).

2. Developed the theoretical underpinnings necessary for understanding better how free banking works (George Selgin, The Theory of Free Banking; Larry White, The Theory of Monetary Institutions; Steve Horwitz, Monetary Evolution, Free Banking and Economic Orderthe late Larry Sechrest, Free Banking; David Glasner as a onetime Austrian fellow traveler, Free Banking and Monetary Reform).

3. Explored the history of thought and theory of the "new monetary economics" (Tyler Cowen and Randy Kroszner, Explorations in the New Monetary Economics).

4. Revived the theory and practice of currency boards (Steve Hanke and me, Russian Currency and Finance and Currency Boards for Developing CountriesGeorge Selgin to a lesser extent in essays).

5. Revived the theory and practice of dollarization (me, "Basics of Dollarization" and "Encouraging Official Dollarization in Emerging Markets"; Steve Hanke in numerous articles in the press).

6. Presciently critiqued inflation targeting back when there were few skeptical voices on the subject (George Selgin, Less than Zero).

7. Documented the influence of the Federal Reserve on monetary economists (Larry White, " The Federal Reserve System's Influence on Research in Monetary Economics").

8. Deepened research on the monetary history of the United States (Larry White; George Selgin; Dick Timberlake as an Austrian fellow traveler, Constitutional Money).

9. Documented how private coinage supplied the needs of the public in England near the start of the Industrial Revolution when government coinage was dysfunctional (George Selgin, Good Money).

10. Uncovered voluminous neglected material on the Bretton Woods conference, a key moment in modern monetary history (me, The Bretton Woods Transcripts, though admittedly the theme is not especially Austrian).

11. Explored agent-based modeling in monetary theory (dissertations by Pedro Romero and Will McBride).

12. Explored the implications of electronic money for monetary policy (Larry White, George Selgin).

13. Written extensively on the history of monetary thought and economic thought more generally(Larry White, The Clash of Economic IdeasGeorge Selgin, essays; Steve Horwitz, Microfoundation and Macroeconomics).

14. Written on the theory of finance and financial regulation (Kevin Dowd, Competition and Finance; George Selgin, Bank Deregulation and Monetary Order).

15. Developed a new database on worldwide monetary history (me--Historical Financial Statistics, which will expand substantially within the next year).

16. Created the definitive list of historical experiences of hyperinflation (Steve Hanke, "World Hyperinflations").

(Some of these works were written with non-Austrian coauthors not listed.)

That's off the top of my head, concentrating on my particular friends and neglecting other achievements by them and others that I invite readers to list in the comments. Noah Smith comments that he has "seen nothing and read nothing from the GMU Austrians." We are only a click away. Look for us in the library (try WorldCat), in EconLit, in Google Scholar, in the popular press, and in blogs. We have written and continue to write a lot, and we have had some practical influence on the way the world works.

(Note: Updated with more detail. And see the comments, which contain still more.)


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Happy 80th birthday, Leonard Liggio

by Kurt Schuler July 12th, 2013 11:51 pm

I belatedly second Steve Horwitz's salute to Leonard Liggio on his 80th birthday, which was July 5. Leonard was and often still is seemingly everywhere. Before the Internet, when the problem was too little information, Leonard was connecting people and ideas that otherwise would not have been connected. In between his more important tasks he found the time to be a member of my dissertation committee two decades ago. Now that the Internet is highly developed and the problem is too much information and too little discernment, Leonard continues to be as valuable as he was before.


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Misunderstanding Financial History

by George Selgin July 11th, 2013 3:45 pm

I've long considered Gary Gorton one of the best economists working in the fields of banking and finance, thanks in no small part to his excellent work on 19th-century U.S. financial history. Gorton's reputation was dealt a hard blow recently owing to his role in supplying AIG with the models it relied upon in assessing the riskiness of credit default swaps it wrote on mortgage-backed securities. Gorton's part in the AIG demise hasn't itself altered my high opinion of his work. I am disappointed, however, with his apology for playing that part, as given in his 2012 Oxford University Press book, Misunderstanding Financial Crises.

Apology? Well, sort of: throughout the book Gorton refers, not to "his" mistakes but of those of "economists" generally, as if the entire profession, rather than a small (though disproportionately influential) part of it, were to blame for the fancy risk models and associated rose-colored prognostications that sank AIG and so many other financial behemoths. His is, in other words, not an outright mea culpa but a mea culpa bundled with such a large number of sua culpas as to expose him to only a miniscule risk of having to shoulder much blame. Indeed, Gorton sees himself as a victim of his profession's errant ways, chief among which was its inclination to treat fancy statistical models as substitutes for a genuine understanding of the lessons of economic history.

That inclination, Gorton says, when combined with excessive reliance upon data limited to the "Quiet Period" since the establishment of the FDIC, caused economists, himself among them, to assume that the underlying causes of financial crises had been successfully eliminated, making such crises a thing of the past. More attention to history, Gorton suggests, would have made him and his peers less sanguine. It would have warned them that the data against which they were calibrating their models did not suffice to uncover the U.S. financial system's "deep parameters." It would, in short, have shown that the root causes of crises had yet to be dealt with.

One can only applaud Gorton for rejecting the view, which is indeed all too prevalent among today's economists, that little can be learned from history because it "comes from a different structure," and for regretting the deletion of economic history courses from PhD curricula that this view has encouraged. "The relevant past," Gorton insists, is the history of market economies, not an arbitrary recent period that is largely determined by data availability" (pp. 95-96):

The past, a rich laboratory for understanding the present, lacks data richness, which is needed for some models, but we need to add economic history to the Facts. Sophisticated econometric methods come at a large cost; the data requirements narrow our field of vision. In this trade-off the loser has been economic history (p. 97).

Amen and amen. But there is right as well as wrong economic history, and wrong economic history can be just as productive of mistaken policies as the most naive formal models. Alas, Gorton's own economic history, as presented in the first part of his book, is wrong in crucial ways.

In brief, that history goes like this: Before the Civil War, banks were set-up by state governments, either through charters or (starting in 1837) by means of so-called "free banking" laws. Notes issues by those banks, though the only paper currency available, circulated, not at their face or "par" values but at varying discounts reflecting the idiosyncratic and uncertain ("secretive") content of particular banks' asset portfolios. The National Bank Acts created a uniform currency, while eliminating banknote-based runs (that is, runs to exchange banknotes for specie or legal tender) by taxing state banknotes out of existence while requiring all national banks to fully back their own notes with safe U.S. government securities. Unfortunately demand deposits, which continued to be backed by idiosyncratic and "secretive" bank assets, become increasingly important, and panics could and did still happen when bank customers lost confidence in the assets backing those deposits. Although the Fed, established in 1914, was supposed to rule-out such panics, it was thanks to the FDIC, established two decades latter, that the U.S. finally entered a "Quiet Period" during which no panics occurred. But the quiet period proved to be something of a fool's paradise, because during it, and especially during its last stages, further financial innovations made it possible for new forms of financial-institution debt, including repurchase agreements, to play a role in payments and other transactions not unlike that once performed only by banknotes and checkable deposits. Because these new types of debt were issued by "shadow" banks operating outside of the limits of the Federal safety net, they in turn became the object of a systemic run--the "Panic of 2007."

From this history Gorton derives the lesson that "financial crises are inherent in the production of bank debt...and, unless the government designs intelligent regulation, crises will continue" (vii). As for what constitutes "intelligent regulation," Gorton's suggestion, informed by his understanding of the lessons of the free banking and National Banking eras, is that all forms of bank debt used to conduct transactions must be backed by collateral "produced in such a way that it is secretless," and all issuers of such transactable debt should have access to the Fed's discount window. In particular, in light of the recent crisis, so-called "shadow" banks should be converted into what Gorton calls "Narrow Funding Banks" (NFBs), which would be prevented from engaging "in any activity other than purchasing asset-backed securities, government [sic] and agency securities (p. 197). As for repos, they need to be more strictly regulated, in part by placing limits on how many repos nonbanks can engage in.

Gorton's recommendations are consistent enough with his understanding of financial developments leading to the 2007-8 crisis. However, that understanding warrants a judgement similar to the one Gorton himself offers regarding less history-conscious attempts to explain that episode, to wit, that it is a "superficial" understanding suggesting "a lack of institutional and historical knowledge" (88-9). The difference is that Gorton has the knowledge in question, as is apparent from his other writings and also from the works, with which he's evidently familiar, discussed in his "Bibiographical Notes." Nevertheless his book fails to make proper use of that knowledge.

Gorton is wrong, first of all, in claiming that financial crises are "inherent" and "pervasive" in market economies. He errs both by not allowing that different "market" economies have had very different kinds and degrees of financial regulation, and by not consistently heeding his own definition of a banking "crisis" as a "systemic" (or at least "widespread") "exit from bank debt," that is, a situation involving "en masse demands by holders of bank debt for cash" (pp. 6-7, my emphasis). According to this definition many of the "crises" listed on Gorton's Table 3.1 were not genuine financial crises at all. Canada, to take one example, did not have a genuine financial crisis in any of the years listed (1873, 1906, 1923, and 1983), though it did have to relax binding capital-based note issue regulations to avoid having a crisis in 1906.

I refer to Canada in particular because, with regard to Gorton's thesis, it is, not the only, but certainly the biggest, elephant in the room. Its record is especially revealing, because the Canadian economy of the 19th and early 20th centuries resembled the U.S. economy in many ways, though it differed in its banking structure and regulations. Unlike U.S. banks, Canadian banks could and did establish nationwide branch networks; they were also allowed to issue notes backed by their assets in general rather than by any specific collateral. It was, finally, no coincidence that the extra degrees of banking freedom that Canada enjoyed were associated with a much better record of financial stability. To put the matter differently, Canada's record suggests that the shortcomings of the U.S. banking system where not shortcomings "inherent" to all private banking and currency systems. They were shortcomings traceable to specific, misguided U.S. banking and currency laws.

Take those discounts on antebellum U.S. banknotes. Gorton attributes them to the fact that different banks, whether "free" or chartered, had different assets backing their notes, with some assets being more "suspect" than others (pp. 15-16). According to his understanding, nothing short of a rule forcing all banks to back their notes with identical, riskless assets could serve to make a uniform, par currency out of notes issues by numerous, otherwise independent banks. State "free banking" laws failed to achieve this result because different states allowed different assets to serve as note collateral, and because some of this collateral was anything but risk free. The problem was only solved when, during the Civil War, state banks were taxed out of the currency business, while new National ones had to back their notes with U.S. government bonds, which, once the war was over, were perfectly safe.

If Gorton's interpretation were correct, we should only expect to find commercial banknotes circulating at par where U.S. style backing requirements are in place. But by the 1890s Canada, despite being far less populous than the U.S., while occupying more square miles, had a uniform currency consisting mainly of private Canadian banknotes that were not subject to any special "backing" requirement. How could that be? That Canada's banking system was a "club oligopoly" may have helped. But there's another explanation, which also accounts better for other instances, such as Scotland's, of uniform currencies consisting of private banknotes backed by bank-specific assets. This is that Canadian banks, unlike their U.S. counterparts, were free to establish branch networks, and that such networks, together with note clearinghouses established in major trade centers, sufficed to eliminate note discounts, by reducing to trivial amounts the cost to banks of presenting rival banks' notes for payment. For a bank's notes to remain on the "current" list thus became a simple matter of its demonstrating a willingness to cooperate in regular (eventually daily) settlements. In the U.S. itself the Suffolk System manged to make all New England banknotes current throughout that region, even despite restrictions on branch banking, decades before the Civil War, not by telling its members what assets they could own or by otherwise monitoring their assets, but simply by insisting that they keep up their settlement accounts. These and many other examples I might cite make it clear that full backing by risk-free assets is not a necessary condition for a uniform private banknote currency.

What's more, it isn't a sufficient condition. For although Gorton claims that the National Currency and Banking legislation of 1863 and 1864 succeeded in finally eliminating banknote discounts by requiring full (or more than full) backing of all national banknotes by U.S. government bonds (p. 18), the truth is otherwise. National banks were no more willing than their state predecessors had been to bear the cost of sorting and shipping rivals' notes to thousands of other (unit) banks, many of them located long distances away, for payment. Consequently national banks did at first occasionally refuse to accept other national banks' notes at par. That changed in 1864, not because national banks suddenly realized that all their notes were equally good, but because a provision of the 1864 Act (sec. 32) required that every national bank receive every other national bank's notes at par.* Similar legislation, had it been imposed on antebellum banks, might also have made their notes current, though not without causing other, perhaps more serious mischief.

Remarkably, Gorton makes hardly any mention in his book of the role of unit banking laws either in preventing the emergence of a unified U.S. currency market or in contributing to the likelihood of bank failures and crises by creating a system consisting of many thousands of mostly tiny and under-diversified banks. In listing the provisions common to the so-called "free banking" laws, for example, he omits the one disallowing branching (pp. 12-13). (Neither "Unit banking" nor "Branch banking" appear among the terms listed in the book's index.) To say that telling the history of U.S. financial instability without mentioning the part played by unit banking is like staging a performance of Hamlet without the Prince of Denmark is to resort to a very tired cliche. But in reading Gorton's book I could not help having the cliche insistently come to mind.

The difference between Gorton's conclusion regarding the "inherent" vulnerability to crises of any economy having lots of bank debt and that of one of his occasional co-authors, Charles Calomiris, in his own recent study, is striking:

[E]mpirical research on banking distress clearly shows that panics are neither random events nor inherent to the function of banks or the structure of bank balance sheets....The uniquely panic-ridden experience of the U.S., particularly during the pre-World War I era, reflected the unit banking structure of the U.S. system. Panics were generally avoided by other countries in the pre-World War I era because their banking systems were composed of a much smaller number of banks operated on a national basis, who [sic] consequently enjoyed greater portfolio diversification ex ante, and a greater ability to coordinate their actions to stem panics ex post.**

Despite the debilitating effects of barriers to branch banking, U.S. panics prior to the passage of the Federal Reserve Act generally did not involve outbreaks of distrust of most, let alone "all" (p. 32) bank deposits. Instead, distrust tended to be confined to banks that had suffered from prior shocks, or to banks that were associated with others that had suffered from such shocks. Bank runs appear, in other words, to have been informed, if only imperfectly, by bank-specific information. According to George Kaufman, a general flight to currency appears to have occurred during one pre-Fed National Banking era panic only--that of 1893. And even in that case, as Gorton himself recognizes (p. 77), the general flight was a response to prior, exceptionally widespread industrial and mercantile failures which, given banks' limited opportunities for portfolio diversification, gave depositors good reason for anticipating similarly widespread bank insolvencies.

That most panics didn't involve general flights to currency doesn't mean that the public's desired currency ratio didn't increase on other occasions, or that those increases were not a cause of financial distress. Of such occasions the most important was the harvest and subsequent "crop moving" season, roughly from August through November, when currency was needed to pay migrant farm workers. Depositors' attempts to convert deposits into currency for the sake of making such payments, for which checks were unsuitable, had nothing to do with them fearing that their banks might be insolvent. However, thanks to binding national banknote collateral requirements such attempts could leave banks with no choice but to draw upon their legal reserves. Those reserves might consist--again thanks to unit banking laws, and also to national banking laws sanctioning the practice--of country-bank deposit credits at so-called "reserve city" banks, whose own reserves might in turn consist of deposits at New York ("central reserve city") banks. To pay out a single dollar of currency a country bank lacking any surplus bonds might, in short, find itself triggering a three-dollar decline in total banking system reserves, with the brunt of the burden being felt in New York. Consequently a sharp-enough rise in the public's desired currency ratio, though itself based on routine transactions motives, might nevertheless lead to a credit crunch and even, in extremis, to a currency famine. That credit tended to tighten every autumn under the pre-Fed national banking system, resulting in a marked seasonal pattern in interest rates, is well established, as is the fact that several panics took place during the harvest and crop-moving months, suggesting, not necessarily that harvest-related currency demands triggered the panics, but that such demands may have contributed to their severity.

Canada avoided both panics and any seasonal tightening of credit thanks again to its banks' ability to branch and also to their ability to give customers all the notes they wanted in exchange for their deposit credits, without having to make costly (let alone impossible) adjustments to their asset portfolios. Although entry into Canadian banking was very strictly regulated, established Canadian banks were genuinely (and not just nominally) "free." That many contemporary experts favored granting national banks Canadian-style freedoms, by allowing them to branch and by repealing the bond-deposit requirement of the National Bank Act, as the most straightforward way to put an end to U.S. currency shortages and panics, is yet more evidence contradicting Gorton's account. If Bordo, Redish, and Rockoff are right, even Canada's dodging of the recent financial crisis is attributable to a significant degree to the freedom it awarded its banks back in the 19th century:

Because of the fragmented US banking system, and because of various restrictions placed on the assets the banks could own, securities markets emerged to finance most economic growth,unlike Canada which developed a bank-based system. Mortgage markets and housing finance also developed differently in the two countries. Investment banks, which participated in the creation and marketing of securities, became an important part of the system. Thus the United States always had something like the ‘Shadow Banking system’ that has been the subject of so much recent discussion.

Unsurprisingly, the lesson taught by this different understanding of financial history itself differs dramatically from the one Gorton offers. It is that there are better ways to avoid financial crises than by trying to regulate risky bank debt out of existence. They are better both because they can actually succeed (whereas the war on debt Gorton proposes would probably prove as futile as the war on drugs) and because they get rid of the financial crisis bathwater without sacrificing the financial intermediation baby. For that reason I'm convinced that, should Gorton's version of history prove persuasive, it could end up proving no less misleading, and far more costly to society, than the models he concocted for AIG.

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*The same law provided facilities--though very inadequate ones--for the centralized redemption of national banknotes. In 1874 a new and and better, though still far from adequate, redemption agency was established.
**In correspondence Professor Calomiris has alerted me to his forthcoming Princeton University Press book, with Stephen Haber, Fragile By Design: The Political Origins of Banking Crises and Scarce Credit, which "provides much more evidence that banking crises are the outcomes of political choices, not inherent fragility." The book is, as, Tyler Cowen might say, "Self Recommending." (Added 7-12-2013).