I think I posted this when it came out earlier this year, but if not, here's a study I did for Mercatus that is intended as an introduction to US monetary policy, including some history, some theory, some policy, and some discussion of alternative institutional arrangements. I hope folks find it useful.
Steve Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University in Canton, NY. He is the author of two books, Microfoundations and Macroeconomics: An Austrian Perspective (Routledge, 2000) and Monetary Evolution, Free Banking, and Economic Order (Westview, 1992), and he has written extensively on Austrian economics, Hayekian political economy, monetary theory and history, and the economics and social theory of gender and the family. His work has been published in professional journals such as History of Political Economy, Southern Economic Journal, and The Cambridge Journal of Economics. He is also an Affiliated Senior Scholar at the Mercatus Center in Arlington, Virginia where he has published public policy research on Walmart's role in Hurricane Katrina recovery as well as on the ongoing recession. His current project is a book tentatively titled Classical Liberalism and the Evolution of the Modern Family. Horwitz is the book review editor of the Review of Austrian Economics, an associate editor of the Journal of Economic Behavior and Organization, and a co-editor of the book series Advances in Austrian Economics. He is also a contributing editor and weekly online columnist for The Freeman.
He has been a visiting scholar at the Social Philosophy and Policy Center at Bowling Green State University and a past recipient of three fellowship research grants from the Earhart Foundation and an F. Leroy Hill summer fellowship from the Institute for Humane Studies. From 1993 to 1998, he held the Flora Irene Eggleston Faculty Chair at St. Lawrence University, where he also was awarded the Frank P. Piskor Lectureship for 1998-99 and the J. Calvin Keene Award in 2003. From 2001 to 2007, he served as the Associate Dean of the First Year. Horwitz has spoken to professional, student, policymaker, and general audiences throughout the US and Canada, and is also a recurring guest on Fox Business Channel's Freedom Watch program and an occasional contributor to PBS's Nightly Business Report blog. A member of the Mont Pelerin Society, he completed his M.A. and Ph.D. in economics at George Mason University and received his A.B. in economics and philosophy from the University of Michigan.
The LSE has a new blog on American politics and policy and they kindly asked me to be one of the first set of contributors. I shared a few thoughts on recent US monetary policy, many of which I've discussed before in various places, including my recent Mercatus paper.
So while wrapping up QE is a necessary start to avoiding the problem of inflation, figuring out how to reduce the Fed’s balance sheet, which has more than tripled since 2008, is the bigger challenge.
In addition, more attention will have to be paid to the real economy and the various factors that are creating the uncertainty that is making banks hesitant to lend and firms unwilling to borrow and invest.Publish
More at the LSE site.
That's the title of a new paper of mine released today by the Mercatus Center. It is intended to de-mystify monetary policy in a way that the layperson can understand. It might be useful in the classroom as well. Here's the abstract:
This study examines the history and operation of the Federal Reserve System (“the Fed”). It explores the Fed’s origins in American economic history and emphasizes the political compromises that produced it. It seeks to provide an accessible explanation of how the Fed attempts to change the money supply and of the structural challenges it faces as it attempts to get the money supply correct.. The paper uses the framework thereby developed to examine recent monetary policy, including quantitative easing. Inflation and deflation result when the Fed creates too much or too little money, and the study discusses the causes and costs of both in some detail. The paper concludes with an examination of alternatives to central banking, including the gold standard and a system of competition in money production known as free banking.
I have a new op-ed at US News where I discuss a new proposal to create a Centennial Monetary Commission to do a "performance review of the Fed."
The Fed has almost never been held accountable for how it has performed. We have simply assumed that we need a central bank and trusted those in charge to make the right decisions. But the Great Recession may have changed that.
Congressman Kevin Brady, R-Texas, has proposed creating a bi-partisan Centennial Monetary Commission (H.R. 1176) that would engage in a formal performance review of the Fed, exploring both how well it has met its stated goals and what those goals should be. This is an excellent, and long overdue, idea.
An important post from Lars Christensen at The Market Monetarist this morning. Lars argues that many folks have misunderstood the argument for monetary easing in order to target NGDP growth by framing it in terms of discretionary policy. The market monetarists, he argues, are not imagining a world in which the central bank is constantly fiddling with the money supply, nor does their view reject the idea that sometimes monetary policy can be too expansionary. They are neither "doves" nor "hawks," because both of those are, again, couched within a framework of discretion.
Instead, he argues that what they want is what Buchanan wanted: a monetary constitution.
Buchanan was a constitutionalist. He was concerned about one thing and one thing only and that was how to define the rules the game – also in monetary matters. This to me is what Market Monetarism to a large extent is about (or at least should be about).
We want central banks to stop the ad hoc’ism. In fact we don’t even like independent central banks – as we don’t want to give them the opportunity to mess up things. Instead we basically want as Milton Friedman suggested to replace the central bank with a “computer”. The computer being a clear monetary policy rule. A monetary constitution if you like.
The problem with today’s monetary policy debate is that it is not a Buchanan inspired debate, but a debate about easier or tighter monetary policy. The debate should instead be about rules versus discretion and about what rules we should have.
Obviously Market Monetarists have been arguing in favour of monetary easing in both the US and the euro zone, but the argument is made within the framework of NGDP level targeting. We not always “dovish”. In fact most of us would probably have argued that monetary policy in the US and in most Europe have been overly easy for the last 40 years. But that is besides the point. The point is that we really should not have a discussion about easier versus tighter monetary policy. We should debate the rules of the game – James Buchanan would have told us that.
Free banking types might wonder whether NGDP targeting really does operate "like a computer" give the complexities of ensuring that a given change in the monetary base will have the desired effect. However, Lars does make an important point in arguing that NGDP targeting is a rule and that debates over the desirability of further monetary expansion (which Lars, I believe, does not favor at this time) should be framed in terms of what we would want a good "monetary constitution" to generate, rather than our preference over what sort of discretionary path the Fed should take.
I have written on free banking, Buchanan, and the monetary constitution in "Do We Need a Distinct Monetary Constitution?" which is part of the Buchanan symposium in JEBO. The ungated SSRN version is here.
Cross-posted at Coordination Problem.
A few folks have already chimed in on this topic in other places. Lars Christensen has one of the better posts over at Market Monetarist, if for no other reason than rightly pointing out how this gimmick undermines the rule of law and the idea of rule-based monetary policy. I agree with pretty much everything he says there and just want to make an additional point or two here, including noting why it is more likely to be inflationary than open market operations.
My co-bloggers can correct me if I'm wrong on anything below, but it seems to me that minting a trillion dollar coin as a way around the debt ceiling, though gimmicky, is just a more naked form of monetarization than the Fed normally engages in. However, it does carry with it a greater risk of inflation as well as setting a precedent for finding even cheaper ways for the US government to continue its fiscal profligacy.
If the assumption is that the Treasury mints the coin and then the Fed purchases it for $1T, the difference with normal open market operations is just a matter of what's on the asset side of the Fed's balance sheet and the bypassing of the banking system. Normal open market operations, or even quantitative easing, involve purchasing either government bonds or mortgage backed securities or whatever else the Fed is authorized to purchase these days. The Fed buys those from organizations who take the proceeds and put them in their banks, and the banks get credited for that amount in their reserve account at the Fed. The Fed gains the asset of the financial instrument and the liability of the new reserve deposit they owe the bank. When the Fed buys currently existing government bonds, it returns the interest to the Treasury which enables it to issue an equivalent amount of new debt at the same cost. That’s why money creation through normal channels facilitates new borrowing.
With the coin, what the Fed gets on the asset side is the coin and the liability is a direct credit of $1T to the Treasury. At least that's how I presume it would work. Notice that the end result is identical to open market operations: the government can now spend $1T more than it could previously without having to pay any more interest on new debt. The coin involves no new debt at all - just the straight out creation of $1T in new money directly to the Treasury's account. In open market operations, new debt can be issued but those interest payments are (largely) canceled out by the Fed returning to the Treasury the interest on the bonds it purchased. The Treasury gets the $1T not as a direct injection ex nihilo from the Fed, but through the public's willingness (presumably) to buy the newly issued debt.
And this is one major objection to the coin: it's straight monetization. Rather than relying on the willingness of the public to continue to support large deficits by purchasing newly issued debt, it simply creates a trillion dollars and hands it to the Treasury. The Treasury does not have to worry about whether it can sell the new debt it would have had to issue with standard open market operations. And it does not have to worry whether the interest demanded by the public on that new debt is greater than the interest returned to it on the old debt the Fed buys up. The coin is pure, naked monetization that removes any semblance of cost constraints on the Treasury.
The inflationary potential is also great, and moreso than open market operations, because the Treasury will with certainty spend the new funds, while banks might let them sit in their reserves. Note too that injecting a trillion dollars through the banking system is more expensive because those new bank reserves now earn interest. A quarter point doesn't sound like much, but when it's 0.25% of $1,000,000,000,000, you're talking real money.
The trillion dollar coin is a really bad idea for several reasons:
1. It violates the rule of law and undermines anything like a rules-based central bank policy.
2. It further encourages US fiscal profligacy by finding a way to fund excessive government expenditures that does not even bear either the cost of paying interest on reserves or any interest differential between new and old debt, as the Treasury would if the Fed used standard open market operations.
3. It has a much greater inflationary potential than open market operations because a direct infusion to the Treasury will definitely be spent while injections of reserves into the banking system will likely not enter the spending stream.
Bottom line: this is a really, really bad idea as it manages to simultaneously undermine any semblance of sanity in both monetary and fiscal policy simultaneously. That it is being seriously discussed, if not endorsed, by Nobel Prize winners is a sign of how far economics has fallen as well as how much of a mess US fiscal and monetary policy has become.
I don't believe I've shared this lecture here, so I will remedy that. This is a talk I gave in December of 2009 at George Mason University in which I explore the history of banking in the US, the theoretical arguments against central banking, and then the free banking alternative. My theme was that critics of central banking need to have sound arguments from both theory and history and avoid falling into the stereotypical conspiracy theory claptrap. The talk is about an hour, and there's about 25 minutes of questions.
In my Freeman column this week, I discussed the importance of monetary calculation in enabling entrepreneurs to know both what to produce and how to produce it. The ability to make use of money prices to formulate a forward-looking budget and to calculate backward-looking profits/losses is crucial to entrepreneurial planning and the learning process of the market. In that piece I didn't have the space to make an additional point that I'd like to note here.
For monetary calculation to be maximally effective, the monetary system matters. Specifically, the more sound that money is, the more reliable is monetary calculation. This is a point that Mises made in this 1920 article about economic calculation in the socialist commonwealth and one I developed in a HOPE paper in 1998. In an economy subject to periodic inflation and deflation, the reliability of money prices is reduced, and what we might call the "epistemic burden" on entrepreneurs is increased as they have to sort out whether a given price change is due to real or nominal factors. Where money is sound, price movements carry a less ambiguous message. They still require interpretation, but with one less major complicating factor than under inflation or deflation.
Given that different monetary regimes will be more or less likely to avoid inflation and deflation, the monetary system matters for the effectiveness of monetary calculation. If free banking is better than the alternatives at avoiding monetary disequilibria, then it is also better at creating a sound environment for monetary calculation. And, if so, it will be better at promoting economic growth.
Many of these ideas are at the core of my Microfoundations and Macroeconomics: An Austrian Perspective, which if you haven't read, you should!
In his NY Times column Sunday, Paul Krugman tries, in vain, to construct a case for bank regulation in light of the problems at JP Morgan. As usual with Krugman, there’s much to disagree with, but I want to focus on his utterly ham-handed version of the history of US banking, which bears shockingly little resemblance to reality.
Krugman thinks he has the critics of regulation nailed with his take on US financial history:
Why, exactly, are banks special? Because history tells us that banking is and always has been subject to occasional destructive “panics,” which can wreak havoc with the economy as a whole. Current right-wing mythology has it that bad banking is always the result of government intervention, whether from the Federal Reserve or meddling liberals in Congress. In fact, however, Gilded Age America — a land with minimal government and no Fed — was subject to panics roughly once every six years. And some of these panics inflicted major economic losses. So what can be done? In the 1930s, after the mother of all banking panics, we arrived at a workable solution, involving both guarantees and oversight.
This passage is an utter abuse of history in several ways.
Most important, what Krugman calls the “right-wing mythology” is largely correct: government intervention is responsible for the systematic problems with the US banking system. That, however, is not the same as “bad banking.” Banks, like any other business, make mistakes all the time. Bad banking happens in free markets, but markets provide incentives and knowledge signals that help banks avoid and correct such mistakes. The question is not whether there is or isn’t “bad banking,” but which institutional environment minimizes and corrects it best. What doesn’t happen in free markets are the systematic mistakes that lead to panics and massive bank failures.
And that is where Krugman is most wrong. What he calls “Gilded Age America” was emphatically not a land of minimal government in banking. Yes there was no Fed (and no serious critic of regulation has blamed everything on the Fed), but the federal and state governments played a huge role in the banking industry and it was those regulations that were responsible for the pre-Fed panics. The two most relevant regulations were: 1) the prohibition on interstate banking, which created overly small and undiversified banks that were highly prone to failure; and 2) the requirement that federally chartered banks back their currency with purchases of US government bonds, which made it prohibitively expensive to issue more currency when the demand rose, leading to the currency shortages and resulting panics that culminated in the Panic of 1907.
These were not failures of a free market in banking. They were failures of government regulation. And those same restrictions on interstate banking, along with the failure of the Fed to do its job, were largely responsible for the massive failures of the 1930s. Banks during the Great Depression were hardly unregulated, and those bank failures happened after the creation of the Fed. Those banking problems were also failures of government regulation.
But Krugman has a much bigger puzzle to explain away: if free markets in banking are the problem, why did Canada, which, during this period, had a far less regulated banking system than the US, not experience the panics we did, and why did no Canadian banks fail during the Great Depression while around 9000 US banks did? If Krugman’s criticism of the “mythology” is correct, the Canadian banking system of that era should have been a basket case, but instead it was a model for the world precisely because it lacked the two most damaging government regulations present in the US. Canadian banks have always been free to operate nationwide and were, before 1934, able to issue their own currency free of bond collateral requirements. The very free market in Canadian banking dramatically out-performed the much more regulated US system.
So Professor Krugman, what say you? If the reason banks fail is because free markets in banking don’t work, how do you explain the lack of the problems you claim plague free markets in the much less regulated pre-1934 Canadian banking industry? The mythology, Professor, is your history, not mine.
Cross-posted from Coordination Problem.
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