I did a brief interview with the Seattle NPR station yesterday on the rise of inter-business barter exchanges. Think Bitcoin meets Ithaca Dollars. It can be found here.
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.
A Qualified Defense of Goldbuggery and Some Related Observations on the Regressive Effects of Inflation
[Note: This was originally posted at Bleeding Heart Libertarians and directed at that audience, but I will repost here as well.]
In my recent post responding to Matt Yglesias on the gold standard, at least one commenter was surprised to find a defense of “goldbuggery” here at BHL. I’m guessing this reaction is due to one or both of the following: 1) defenses of the gold standard are associated with more “right wing” forms of libertarianism and 2) the lack of an obvious connection between monetary policy issues and the typical concerns of bleeding heart libertarianism. Let me try to address both of those here by doing two things. First, I want to explain exactly the sort of thing I wish to defend when I argue for a monetary role for gold. Second, I want to argue that such a system will do better by the least well off among us by reducing or eliminating inflation and business cycles/recession, the effects of which are disproportionately felt by the poor.
Let me note that monetary theory is one of the most complex, difficulty, and subtle parts of economics (as Yglesias’s ham-handed post shows), so there’s no way I can do justice to all of the possible nuances here, but I’ll try provide links or responses in the comments as my time allows. I would also point readers unfamiliar with the basics of monetary policy tothis primer of mine, from which some of the material in the next section is taken.
Monetary Competition and Commodity Standards
As I pointed out in the earlier post, the term “gold standard” can mean any number of things, from a system with a monopoly central bank that redeems its money in gold, to a gold-coin or 100% gold reserve system, to “free banking” systems in which all forms of money are produced competitively and banks can make that money redeemable in whatever commodity customers appear to prefer. All of these and others might be considered “the gold standard.” However, I want to make the case for the last of them: monetary competition or “free banking.” (I should also note that such a free banking system should be distinguished from the “Free Banking Era” of the US from 1837-1863, as that period was anything but free of government interventions and those interventions were responsible for the problems of that system, and the National Banking System that followed it. Central banking is not the only way in which government intervention can undermine good monetary systems.)
Over the last several decades, a growing number of economists (see my own work, which builds on the work of colleagues such as Larry White and George Selgin and others) have explored the institutional features and macroeconomic properties of free banking systems, to the point where there is now a substantial literature on the subject. Free banking systems would do away with central banks and their monopoly privileges and allow the competitive market process to produce the kinds and quantity of money that the public demands, just as it does for so many other goods and services. Certainly one long-standing concern of left-libertarians has been an end to all kinds of monopoly privileges, and ending those of central banks are among the most important, especially given the ways in which they have been used to finance wars (about which more later).
Rather than having currency produced monopolistically by a central bank, individual banks in such a system would produce it in the same way that they currently produce their own “brands” of deposits. My checking account deposits at my bank would be held as “private money” that the bank produces competitively against the checking account dollars from your bank. Banks have developed ways of clearing those checkable liabilities through various clearinghouse arrangements, and the same was true historically in those systems where currency production was private. Banks developed very sophisticated institutions for coordinating and overseeing their behavior, even during times of crisis.
Perhaps the greatest advantage of a free banking system is its ability to avoid inflation and deflation. Free banks would want to make their currency and checking accounts redeemable in some sort of commodity as a way to assure customers of their value. Historically, this commodity has been gold, though it need not be. This is the sense in which I am defending a gold standard: historically, the closest models to the kind of banking system I would like to see in place have been ones in which gold played this role as the preferred commodity of redemption. Again, it need not but there are good reasons to think it would, none of which have to do with any magical qualities of gold.
Given that banks will want to provide redeemable currency and deposits, they have reason, even in the absence of regulation, to hold a stock of gold on hand (in addition to the deposits they keep at clearinghouses). Historically, banks in early 19th century Scotland got by on about 3% reserves or less with almost no bank failures. With modern electronic payment systems, banks in such a system would need to hold only a small fraction of their liabilities in the form of gold reserves, so fears that such a system would require a great deal of gold are misguided. It’s more the promise to redeem in gold than holding a great deal of gold itself that makes the system stable. Of course the promise has to be backed up if customers invoke it, but, historical experience and theory suggest that will not happen very often.
With currency and deposits redeemable in gold, customers and other banks can take any excess balances of such liabilities to the issuer for gold. Should any bank produce more money than its customers wish to hold, those customers will either bring it back to the bank directly for redemption or they will spend it, where it will most likely end up in the possession of a different bank. The other bank will not want to hold stocks of a competitor’s money. Instead, it will prefer to redeem it for gold or reserves at the bank directly or at a clearinghouse, either of which will impose a cost on the competitor by taking away the gold or reserves it needs to create loans. This process of “adverse clearings” ensures that if any bank creates too much money, it will pay an economic price for it in the form of reduced reserves. Lower reserves not only limit what the bank can lend and thereby earn in interest, insufficient reserves put the bank at risk of not being able to pay depositors. Should a bank create too little money, it will also pay a price, but in the form of having too many reserves on hand and thereby sacrificing the interest it could earn by expanding its lending. Free banks would avoid deflation because under producing money is costly. If we assume that banks are profit seekers, they would have every reason to avoid both inflation and deflation.
What a free banking system produces is the right degree of flexibility necessary for sound money. Because this system is separate from the government, we need not worry about political incentives working at cross-purposes with sound money. Free banks do not face the lag and information problems of central banks. With banks operating in a truly competitive market, they are able to make use of market signals, such as their reserve holdings and profits, to show them quickly and accurately whether they have produced the right quantity of money. These are exactly the signals that monopoly central banks lack, which helps to explain their inability to get the money supply right. Although banks will not get the money supply exactly right at every moment, a competitive free banking system will ensure that they know they have erred and that they have the knowledge and incentives needed to correct mistakes, and it will do so better than any alternatives. A free banking system also has the advantage of being able to respond to changes in the demand for money, while still being constrained to not over- or under correct, unlike the rule-bound central bank. This “flexibility within constraints” is a product of the competitive environment that free banking creates.
Again, I can’t do justice to the full argument here. My real concern is to demonstrate that such a system fits neatly into broader libertarian arguments about the problems of monopolies and the benefits of competitive markets, and does not reify gold in the way that other proposals made by right-wing defenders of the gold standard tend to do. Gold (really “some commodity”) plays a role here, but the key is allowing competition to drive the production of all forms of money.
Why Competitive Money Matters
If my fellow free banking theorists and I are correct about the system’s ability to dramatically reduce or eliminate inflation, then this has important implications from a BHL perspective as the damage done by inflation disproportionately harms the poor. One of the most important problems inflation creates is that it does not, in the real world, affect all prices equally. Some go up a lot, some not as much. This injects static into communication process of the price system and makes prices much less reliable guides to producers and consumers. Most of inflation’s problems begin there.
As a result, the existence of inflation (or, more precisely, an expectation of a positive rate of inflation), imposes costs on households and firms that can only be avoided by undertaking costly defensive measures themselves. These “coping costs” of inflation are significant and often under-appreciated. They also harm the poor much more than the rich. In addition, inflation redistributes toward those who get the new money first and away from those who get it last.
Once the threat of inflation is real, consumers must start to pay more attention to interest rates and the terms of contracts. If banks start to offer adjustable rate loans, this complicates the borrowing process for consumers and might require additional expertise to make sense of the loan. One can raise similar issues about employment contracts with cost of living clauses. In both cases, it is likely that those with the least resources will be at a disadvantage in dealing with the changing reality of contracts. Not only will the wealthy be more likely to have the knowledge themselves to cope with these costs, if they do not, they have the resources to hire those who do. The result will be a net gain for the wealthy as they are able fend off these costs of inflation better than the poor.
Beyond just contracts, inflation gives both firms and households reasons to reallocate their resources, especially their financial assets, to protect themselves against inflation. For both, either making these changes themselves or hiring someone else to do so involves real costs. And here too, those costs can more easily be borne by the rich. In the case of firms, large firms can more easily bear these costs as they can either spread them across a larger scale of operation and/or are more likely to have in-house expertise to draw upon. Smaller firms will find it more of a struggle to cope either by trying less efficiently to do it themselves, or by having to bear the higher average cost of purchasing such help on the market. Though the effect may not be large, inflation imposes more costs on small firms than large ones. The story across households is similar. Wealthier households, who certainly have more at stake, will be more able to afford financial advice or to hire a financial planner, whereas poor households will find doing so that much more difficult. The result is that wealthier households are better able to protect the value of their assets, while poor households see losses.
Perhaps the most damage that inflation harms the poor is the way in which those who get access to the excess money supply first gain at the expense of those who get it later. This manifests itself several different ways. As excess supplies of money make their way through the economy, those who get the money first are able to spend before prices rise, while those who see it later see prices rise before they see the increase in their nominal incomes resulting from the increased money supply. The most well known example of this process is the way in which inflation harms those on fixed incomes. Workers locked into labor contracts or retirees on pension plans that adjust annually to the cost of living are always running a year behind. Normally, the cost of living adjustments are based on the prior year’s inflation rate, which means that for that year, these people have had no income increase even as prices were rising. They will have been compensated, after the fact, for the past year, but for the year to follow, they will now lose if there are any inflation-driven price increases. It does not matter whether these fixed incomes are public or private; the issue is that they only adjust after the fact.
As inflation causes prices to less accurately reflect the tastes, preferences, and knowledge of market actors, it becomes ever more difficult for both entrepreneurs and consumers to figure out what is happening in the market, which in turn leads to more discoordination and more frustration for market actors. As the market becomes a less reliable resource allocation process, people will, on the margin, turn toward government to address the particular problems or take over more of the responsibility for resource allocation. In addition to the direct gain in wealth that comes from governments creating new money, there is an induced gain in government power from the chaos that inflation produces in the marketplace. As the locus of resource allocation shifts from the decentralized nodes of market power checked by competition to the centralized nodes of monopoly power of the state, the ability of those with fewer resources to make their voices heard shrinks accordingly. Rent-seeking societies favor those with resources to access politics.
If, as Austrian school economists like myself, are correct in arguing that inflation is the cause of the boom and bust of the business cycle, we have yet another way in which a free banking system would work to the benefit of the least well off, as recession and depressions have less impact on those already better off. Concern for the least well off should drive us to find ways of minimizing or eliminating business cycles.
Finally, to the extent that the history of central banks is about being created and having their powers expanded as a way to finance government, especially its imperial adventures, without recourse to taxation or borrowing, bleeding heart libertarianism might have an interest in eliminating them if possible. After all, war and empire have historically taken their worst tolls on the most vulnerable, both in terms of the aggressor countries and the populations they have aggressed against.
All of this adds up to a number of reasons why those sympathetic to bleeding heart libertarianism might take an interest in questions of monetary policy, and why they might reconsider a hasty dismissal of a desire to once again have gold play a monetary role as right wing nonsense.
In a column at Vox yesterday morning, Matt Yglesias gave us 7 reasons to think a gold standard is a terrible idea. They are not all completely wrong (a low bar, I suppose), but it’s worth exploring exactly what the problems are.
1) A gold standard wouldn’t stabilize inflation
His evidence for this is the gold-price of oil since the mid-80s. Aside from the fact that looking at one price alone doesn’t tell us much about inflation (especially with a commodity like oil that has its own constant changes in supply and demand, which are part and parcel of a market economy), using fluctuations in the price of gold or the gold-price of other commodities under a fiat money standard as evidence of gold’s volatility misses the whole point. Gold is an inflation hedge, and to the degree that inflation is more likely under fiat money regimes, of course gold will vary in value a great deal (and therefore so will the gold prices of other commodities). But that’s not a problem with gold, that’s a problem with central bank fiat money. Under a proper gold standard, the inflation threat would be much lower, making fluctuations in the price of gold much less than they are right now. The gold standard might have problems, but this is not a good argument against it.
2) A gold standard wouldn’t stabilize exchange rates
Yglesias points out that unless every country goes to a gold standard, you won’t get the benefits of stable exchange rates. And he does have a point here, but that’s all the more reason to convince those other countries to move to some sort of commodity standard as well! Notice too that this is not a way in which gold makes things worse – it just doesn’t make something better. So if gold has other advantages, this point is a wash with the status quo.
3) There’s no inflation problem to cure
Partial credit here. He’s correct that changes in the price level have been minimal in the last few years, but if we look instead at growth rates in the monetary base, there’s much to still be concerned about. Banks are still flush with reserves and how those are going to be removed or neutralized remains unclear. The Fed still does not appear to have credible exit strategy and, without one, inflation remains, if not a current problem, a serious threat.
But the bigger point is that if we think about the gold standard as an economic constraint on a central bank, it can help prevent the sort of expansionary policy and artificially low interest rates that were major contributors to the housing boom , financial crisis, Great Recession, and Abysmal Recovery. There may or may not be an inflation problem now, but expansionary monetary policy is a big part of what got us into this mess (and several others in the post-gold standard era) and one good argument for the gold standard is that it can reduce the likelihood of that happening again.
4) There’s nothing stopping you from writing gold contracts
This is true - it’s no longer illegal. But again, the variation in the price of gold that results from the uncertainty around the value of the fiat dollar reduces the marginal benefit of a contract stipulated in gold. And, again, that is not evidence against the gold standard, but evidence about the problems of fiat money for which investment in gold is a hedge.
5) Gold recessions could last for years
Yglesias points to the length of recessions before the Fed and then, of all things, the length of the Great Depression as evidence against the gold standard and that “the Federal Reserve is a far-from-perfect manager of the economy, but it does a lot better than that.”
Well, where to begin? First, while we did have a gold standard before the Fed, we certainly did not have the kind of gold standard that most folks are arguing for today, particularly not those of us who are arguing for a free banking system based on gold. The various regulations that prevented banks from adjusting their currency supplies to the demand to hold it were the primary reason (along with the lack of interstate banking) for the long and painful recessions before the Fed. Yglesias has to explain why these were absent in Canada which also had a gold standard, and a more “pure” one than the US. Absent such an answer, this is not evidence against the gold standard.
As for the Great Depression…. Really? The Great Depression is evidence of how much better the Fed is than a gold standard? Even if you don’t accept the Austrian argument that Fed expansion during the 20s (made possible by its monopoly status even under a gold standard), certainly the Friedman-Schwartz argument about its role in the early 30s in deflating the money supply demonstrates that the Fed was a huge problem and that “far from perfect” is the understatement of the monetary century.
And if one wants to count “gold recessions,” one should also count the numerous recession generated by post-1933 and post-1971 inflations here, as well as the inflations themselves. Inflation was nearly absent in the 19th century (whatever that system’s flaws) but has become a huge problem only after the gold standard was totally abandoned in 1971.
The history of the last 100 years of central banking is the best argument there is for getting away from central banking. And the Canadian case shows that the gold standard isn’t the cause of the long US recessions before the Fed.
6) The gold standard wouldn’t eliminate political money
Here Yglesias has a point in two possible ways. First, if by the gold standard one means central banking with a gold standard, then yes, by definition we still have political money. If he means a gold standard without central banking, then he still has a point in claiming that Congress could always change its mind and end the gold standard again. No argument here, but there are steps we could take to make that harder by constitutionalizing the gold standard or limits on government involvement in money. It’s no guarantee, but it helps.
7) Gold-backed money reduces the supply of gold
Yglesias writes “That means forcing banks to hold their reserves in terms of giant piles of physical gold would impose a cost on the real economy. Gold held in bank vaults is gold that is not available for industrial or decorative uses.” Several problems here. First, the gold in bank vaults is not, therefore, useless. To the degree that it serves as a check on central bank expansion, it plays a very useful economic role that is no less important than its other uses. Second, historical gold standards under free banking had very low reserve ratios, on the order of less than 3%, and not all of that was gold. In a modern economy, the amount of gold banks would have to have on hand in their vaults in a fractional reserve free banking system would be minimal. So Yglesias underestimates the benefits and overestimates the costs.
And to the degree that gold would gain a monetary use, the incentive for people to dig it up out of the ground would be greater not less and this would increase the supply of gold. It’s not clear that Yglesias understands what economists mean by “supply.”
One final comment: critics of the gold standard need to specify what they mean by “the gold standard.” Do they mean a central bank whose liabilities are redeemable in gold? Do they mean a 100% reserve private system? Do they mean fractional reserve free banking on a gold standard? These differences matter as these systems perform differently and if you want to criticize the gold standard, you need to be clear on what it is you think that means. That aside, Yglesias fails on most of his 7 objections here and the gold standard, at least in the form I’d like to see it as part of a free banking system, remains a very good idea.
Cross posted at Coordination Problem and Bleeding Heart Libertarians
That's what I have today at the LSE blog on US Politics and Policy. A snippet: "The Federal Reserve’s recent decision to begin to taper off its quantitative easing (QE) program is long overdue. QE was a mistake from thebeginning and the risks it created will outlast the continuation of the program as its effects cannot be as easily unwound. Ending QE will also allow us to focus on the real problems causing the slow recovery, which have little to do with the need for more expansionary monetary policy."
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.
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.
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