Free Banking 

I regret taxing readers’ patience with another post on the gold standard. As I and other bloggers here have made clear, a free banking system need not be a gold standard system. If people want the standard to be gold, that’s what free banks will offer to attract their business. But if people want the standard to be silver, copper, a commodity basket, seashells, or cellphone minutes, that’s what free banks will offer. Or if they want several standards side by side, the way that multiple computer operating systems exist side by side, appealing to different niches, that’s what free banks will offer. A pure free banking system would also give people the opportunity to change standards at any time. Historically, though, many free banking systems have used the gold standard, and it is quite possible that gold would re-emerge against other competitors as the generally preferred standard.

It is therefore distressing to see economists who should know better failing to distinguish among different kinds of gold standard. Recently, Bruce Bartlett, David Glasner, and, implicitly, David Beckworth have dumped on the gold standard by citing the Great Depression as decisive evidence against it.

The gold standard of the time transmitted the Great Depression from the United States to the rest of the world. One piece of evidence is that countries off gold generally suffered less than those on gold. That is only the first step in the inquiry, though. If the Great Depression was mainly a result of monetary mistakes, as I, Glasner, Beckworth, and probably Bartlettt would all agree, why did those mistakes not occur until 1929, even though in one form or another the gold standard and its twin the silver standard were many centuries old?

The reason, I submit, is that the period between the two world wars was the first in which all the world’s financial powerhouses had activist central banks. Before World War I, central banking was still uncommon outside of Europe. Whether in Europe or elsewhere, the central banks that did exist were often privately owned rather than government owned, and were not activist in the sense that we apply the term to monetary policy today, meaning using it to promote broad economy-wide goals. Rather, they pursued the narrower goals of making modest profits and lending liberally on good collateral during periods of financial distress. World War I changed all that. The pressures of war finance "militarized" central banks in the countries fighting the war, converting them from what they had been in the 19th century to something closer to what we are used to them being in the 21st century. Among the countries so affected was the United States, which passed a central banking law in 1913 and opened the Federal Reserve in 1914 soon after war broke out in Europe. In my view, the combination of activist central banking, a fairly rigid gold standard (which viewed devaluation not merely as undesirable, but as odious), and ignorance about the dangers of combining the two created the framework allowing the world’s leading central banks to make the mistakes that generated the Great Depression.

Among the many monetary historians whose writings on the gold standard I have read, all acknowledge that the interwar gold standard performed far worse than the pre-World War I gold standard or the Bretton Woods standard. They struggle to give a fully satisfactory answer why that was so. A free banking perspective provides an answer. The prewar gold standard was more rigid than the interwar standard, but lacked central banks that aimed at economy-wide stabilization. The Bretton Woods gold standard was full of central banks that aimed at economy-wide stabilization, but was less rigid than the interwar standard because exchange controls and devaluations were in practice accepted parts of the system. The Bretton Woods era was one of widely shared economic growth and few financial crises. (It had important flaws, but that's a subject for another post.) And the prewar period, while more volatile than the Bretton Woods period, looks no more volatile than the post-World War II years as a whole.

So, Bruce, David, and David, if you are going to pursue this line of criticism, particularly if you are going to use try to use it on Republican presidential candidates, remember that Ron Paul, who I think is the only major presidential candidate since the gold standard ended who has explicitly advocated returning to it, called his book End the Fed. It is obvious from the title alone that Paul wants a gold standard without a central bank, that is, without the body that you yourselves acknowledge triggered the Great Depression. Whether you like Paul’s proposal or not, the gold standard he wants differs in a crucial way from the interwar gold standard. Ditto for people who favor a “new Bretton Woods.”

(For a post that addresses some recent criticisms of gold from a more theoretical angle, see this post by Blake Johnson on Lars Christensen’s blog.)

Larry Summers had op-eds in the Financial Times and the Washington Post this week with essentially the same message. (Well played, Larry: apparently the Post’s editors do not read the Financial Times. It would not hurt them to start.) In both, he used the line, “Government has no higher responsibility than ensuring that economies have an adequate level of demand.” So, that stuff about securing life, liberty, and the pursuit of happiness is all secondary to ensuring an adequate level of demand?

That brings me to another recent column, also in the Washington Post, by Robert Samuelson. Though not an economist by training, Samuelson’s curiosity, willingness to listen to different views, and frank admission of how much he (and we) do not know make him consistently interesting to read.  By combining those characteristics with diligence, he has become a better economist than most professional economists. He writes:

"There’s a paradox to economic policy. The more it succeeds at prolonging short-term prosperity, the more it inspires long-run destabilizing behavior by businesses, banks, consumers, investors and government. If they think basic stability is assured, they will assume greater risks — loosen credit standards, borrow more, engage in more speculation, relax wage and price behavior — that ultimately make the economy less stable. Long booms threaten deep busts."

Samuelson expresses a view that the Austrian school of economics is somewhat comfortable with but that most other schools are not. Cross Ludwig von Mises on the drawbacks of interventionism and Joseph Schumpeter on the “creative destruction” of capitalism, and you get the conclusion that an unhindered market economy may in fact seem quite unstable in some ways, but that it is in fact less so than an economy that government is continuously trying to stabilize. It’s a “pay me now or pay me later” view that a market economy contains an irreducible minimum volatility. If you want to stabilize it permanently you have to suppress its dynamism.

I said the Austrians are somewhat comfortable with this view because it is in partial conflict with the idea that absent government intervention, many problems of scarcity would be greatly reduced, improving and even saving lives. I think the key is to understand that, as one of my economics professors, the late Don Lavoie, used to stress, we must ask “Compared to what?” That is, what is the workable alternative to an economy that experiences a shallow bust now and then: an economy that experiences no busts, or an economy that experiences deep busts? This is a topic that requires further development by Austrian economists.

Finally, I note a poll of 40 economists in which they unanimously disagreed that a gold standard would result in better price stability and employment outcomes for the average American. The poll taker remarks that “The panel members are all senior faculty at the most elite research universities in the United States.” That must account for the deadening uniformity of opinion; normally it’s hard to get 40 economists even to agree that the sky is blue. The economists who offer short answers for their votes say something along the lines of “the price of gold would be too volatile.” Compared, for instance, to the dollar, which was $35 per troy ounce about 40 years ago and is now around $1700? What would it take to pry open a few minds among these elite economists? First, evidently, a calamity; the near-calamity of 2008-09 was not enough. Second, they would have to know to distinguish among different types of gold standard, a topic I have discussed before and which I will soon return because it is still not sufficiently appreciated.

ADDENDUM: If the Austrians are somewhat comfortable with the idea of minimum volatility, some economists who work on "real business cycle" theory are completely comfortable. I thought when I wrote the post that after waiting awhile I might have something to say about them later, but I don't. They seem content to stick to their classrooms and their academic papers, and haven't made as much noise in newspapers or in blogs as other tendencies of thought.

Scott Sumner and Paul Krugman have been going back and forth about fiscal multipliers, in a debate with many other participants. (Here are the first post and the latest post by Sumner on the issue.) For those of you who have not followed the debate, the fiscal multiplier is the change in output resulting from an additional dollar of government spending. If the multiplier is greater than one, $1 of additional government spending results in more than $1 of output.

What has been missing from the debate is the concept of the structure of production. Resources, including human abilities, are not just a homogeneous lump. They have a structure: some are less scarce than others, some are easier to switch to new purposes than others, some require less know-how to work with than others. The idea of a fiscal multiplier from spending makes me uneasy because it is basically a supposed case of something for nothing: the government, which almost everywhere in the world cannot even deliver the mail at a profit, steps in to fix a situation that the private sector cannot. How does it happen? The answer has to be that somehow the government is able to put resources to a higher-valued use than the private sector can. Given the specificity of resources and the knowledge that must be applied to use them efficiently, it is hard to imagine how such a thing can happen unless resources are so abundant that is little risk from wasting them.

An early critic of John Maynard Keynes, W.H. (William Harold) Hutt wrote a book on precisely this point in 1939, called The Theory of Idle Resources. Hutt carefully explained how many resources that seem idle to the unpracticed eye are in some kind of use — perhaps not the most active use we can imagine for them, but one that has considerable economic value. Considers cars. Most car owners use their cars for just an hour or two per day. Are the cars idle the rest of the day? True, they are parked, but they not idle in the economic sense. They are held in inventory, set aside by their owners for whatever need may arise to use them. People who don’t wish to hold a car in inventory can ride the bus or hail a taxi to get them where they want to go. (George Selgin or Steve Horwitz, both of whom have used Hutt’s ideas to help develop their own conceptions of the relationship between money and business cycles, may want to chime in with their own posts to say more about Hutt.)

If some resources are so abundant that there is little risk from wasting them, something is restraining the private sector from using them. Either millions of experienced businessmen can find no opportunities for converting something abundant into something more valuable, or government is somehow preventing the private sector from taking the initiative.

I lean to the latter explanation. Why should government, which eats profits (through taxes) rather than generating them, know how to turn resources to more profitable use than the people in the private sector who spend their whole careers trying to do just that?

As Scott Sumner has discussed on his blog, when monetary policy has gone so wrong that it is impeding trades that people would otherwise make, to their mutual benefit, there is a case for certain kinds of fiscal policy as a clumsy work-around. The simpler course, though, is to change monetary policy. And so I wind back up at free banking. Because free banking applies principles of competition that we observe at work in other markets, and that historically have worked in the issuance of money and credit as well, free banking is less likely than central banking to result in economy-wide failures to use resources efficiently. I do not think free banking would eliminate credit booms and busts, but I think they would be less severe than they are under central banking because the scale for making mistakes in monetary policy would be smaller. Then there would be even less reason to debate fiscal multipliers.

Discussion about the gold standard often has advocates and critics talking past one another. One of the reasons is that there are members of both groups who do not know or, during the heat of argument, do not acknowledge that there have been many varieties of the gold standard. A free banking gold standard differs in important respects from other varieties of the gold standard. Here are key questions about the details of a gold standard, and the answers as they apply to its free banking form.

What is the legal foundation for payment in gold? Ordinary contract law. Government may establish a definition of a currency unit in terms of gold, but if so, under free banking the unit (say, the dollar) is merely a convenient name for the weight of gold, rather than saying that “a dollar is a dollar” no matter how much the gold content changes.

Is gold the only legal form of payment? No; payment can occur in any commodity or currency that people wish to use. This contrasts with the practice in some countries under various other forms of the gold standard, in which certain payments were only legal if made in national currency.

Who offers payment in gold? Anybody may do so. This means lenders and borrowers may agree to "gold clauses" in contracts. In many countries, governments have nullified such clauses after abandoning the gold standard or after moving to a more restrictive form of the gold standard where people have less freedom to own and pay in gold.

What forms of money and credit are payable in gold? Any that the issuers of those forms wish to offer.

Is production of any of these forms a legal monopoly? No; in particular, under a pure free banking system there is no legal monopoly of notes or coins, so they are competitive in the same way that deposits are competitive. In most historical free banking systems, issuance of notes was competitive but issuance of coins was not.

Who can demand payment in gold? Anybody who holds a liability that an issuer has made payable in gold. This contrasts with the Bretton Woods gold standard as it existed in the United States, under which Americans were prohibited from owning gold bullion.

Are there restrictions on the purposes for which people can demand payment in gold? No, there are no exchange controls or like restrictions. Again, this contrasts with the Bretton Woods gold standard, under which most countries on the standard imposed exchange controls.

What legal penalties exist for people or organizations that break their promise to pay in gold? The standard penalties applying to breach of contract. Observe that this differs from a central banking gold standard, in which the central bank cannot be sued for breach of contract if it devalues.

Is fractional reserve banking permitted? Yes; so is 100% gold reserve banking, but as George Selgin commented in a post some time ago, there have been no historical cases in which 100% gold reserve banking has dominated in competition with fractional reserve banking. I would expect there to be some 100% gold reserve banks, appealing to people who did not trust regular banks and were willing to forego interest, but I would expect such banks to hold less than 1 percent of all banking assets. 

Are taxes only payable in gold? Perhaps. It should not make much of a difference if a free market in foreign exchange exists.

Is accounting in units other than gold permissible? Yes, but perhaps everything has to be converted into gold units for tax purposes. This is an area where I think more work is needed to explore whether there are important implications for monetary freedom.

A couple of weeks ago, Scott Sumner pointed out that many conservative-leaning economists think that certain types of deflation can be good. The same economists, though, are typically reluctant to acknowledge that by a similar argument, certain types of inflation can be good.

As Sumner points out, there are economists who understand that the argument is symmetrical. He mentions George Selgin. Selgin’s 1997 monograph Less Than Zero: The Case for a Falling Price Level in a Growing Economy implies in its title that in a shrinking economy there may be a case for a rising price level. Selgin in fact discusses the case for such "good inflation" on page 39 of the monograph, although his main focus is on "good deflation" because at the time he wrote, it was a more unusual idea. Selgin, and fellow blogger on this site Steve Horwitz, make remarks in Sumner’s comment section.

Selgin stated his arguments in a way to give them textbook simplicity for ease of understanding. In an actual free banking system, the details of the system might add some wrinkles that would require changes to the  form is arguments while preserving their spirit. Expectations about the supply of the monetary base and thus the path of prices over time might differ considerably depending on whether the monetary standard was gold, silver, a frozen fiat monetary base, a commodity basket, or something else. Under some standards, inflation and deflation might be relative to average expectations for the price level rather than absolute. It remains an open question to me whether a standard in which the monetary base was shrinking and expected to continue shrinking (as was the case in some earlier eras with the supplies of gold, silver, and copper) would be compatible with the monetary system attaining the "full information" ideal of not being a disturbing factor to trade.

Since my last post was about Hayek, I will now say something about John Maynard Keynes. Keynes remains influential today for three reasons. One is that he led the kind of life every economist would like to lead. He was clever; became rich; knew most of the people worth knowing at the time in politics, finance, and the arts; and served Britain superbly during two world wars. The second is that he wrote some great stuff. The Economic Consequences of the Peace (1919), an international bestseller, is a prescient protest against the statesmen’s blunders in the aftermath of World War I that made another world war too likely. A Tract on Monetary Reform (1923) is that rare thing, a book on economics that is a masterpiece of writing style. If I recall correctly, Robert Skidelsky’s biography of Keynes reports that Virginia Woolf admired its style. Even the second volume of the Treatise on Money (1930) remains worth reading for economists interested in central banking.

The third reason Keynes remains influential is that his most important book, The General Theory of Employment, Interest and Money (1936), is a muddle. In a noble quest to explain the Great Depression, Keynes was struggling to express thoughts that were beyond his grasp, and in some areas beyond the grasp of other economists at the time also. Parts of the book contain flashes of insight expressed in Keynes’s vivid style, using metaphors from nature or Biblical parables. Other parts are head-scratchingly obscure, and have given rise to a cottage industry, persisting to this day, of trying to determine what Keynes really meant. The book is worth reading and even rereading for economists, but in the end it does not cohere and it should be read with that in mind.

In the same year as The General Theory was published in London, so was Vera Smith’s book The Rationale of Central Banking. Keynes’s book was the effort of mature scholar. Smith’s book was her Ph.D. dissertation, supervised by Hayek, published when she was just 24. Smith’s book, which is about how central banking came to replace free banking in a number of countries, attracted little notice when it was published, but it has had a long afterlife, and it is still read today, though by a far smaller continuing readership than The General Theory.

To my knowledge, Keynes never discussed free banking. He was willing to think about all sorts of other ideas that at the time were unusual, but despite its historical record, free banking seems to have been almost unthinkable for him as a live possibility for monetary reform. It was to remain so among economists generally for several decades. Keynes was, however, willing to think about other non-central banking systems. He was the guiding spirit behind the currency board that existed in North Russia from 1918-1919.

We are not done with Keynes yet. Even though his collected writings published by the Royal Economic Society run to 30 volumes, some important unpublished material remains scattered in archives and elsewhere. Perhaps one day we will turn up a letter, a memorandum, or a speech showing that he did at some point ponder free banking.

At Marginal Revolution, Alex Tabarrok notes David Warsh’s claim, seconded by Paul Krugman, that “Friedrich Hayek is not an important figure in the history of macroeconomics.” Apparently Warsh and Krugman have no memory of the 20^th century. The big issue of the century in economic theory and economic policy, spanning macroeconomics and microeconomics, was the contest between central planning and markets. Hayek and Ludwig von Mises were by far the most prominent economists who argued long and loud that central planning was disastrous, not just because of the viciousness of communist dictatorships, but because even under ideal conditions it could not generate and use effectively the knowledge necessary to maintain modern standards of living. For a long time they were considered to be naive. As late as 1989, Paul Samuelson was still writing in his best-selling economics textbook, "The Soviet economy is proof that ... a socialist command economy can function and even thrive." About a hundred million people died proving that Karl Marx, his followers, and credulous souls inclined to give central planning the benefit of the doubt, such as Samuelson, were wrong, and that Mises and Hayek were right.

In comparison to the gigantic contest between central planning and markets, all the other economic issues of the century look insignificant. (Yes, even the Great Depression. How many Americans starved to death at the depth of the Depression in 1933? Not many. How many Ukrainians starved to death in the same year as a result of Joseph Stalin's drive to collectivize agriculture? Millions.) Even so, on a lower plane of significance, I think that Hayek’s revival of the idea of free banking will eventually be recognized as an important event in the history of macroeconomics. It took more than half a century for economists to acknowledge the importance of Hayek’s insights on central planning. It may take just as long with free banking.

At his Forbes blog, Ralph Benko calls attention to Nouriel Roubini’s rant against the gold standard. Roubini joins Paul Krugman (of course) and others in this unwise course. The gold standard is becoming a litmus test: haughty dismissal of it is a sign of a closed mind. Dismissal of the gold standard is especially bizarre today. In the 40 years since the abandonment of the last and weakest version of the gold standard, the Bretton Woods system, we have had dozens of episodes of high inflation in poor countries; much lower but still troublesome inflation in rich countries, wrung out of the system in the United States only by a wrenching recession; some highly disruptive episodes of deflation, notably in many rich countries during the Great Recession; and financial crises aplenty, with the prospect of more to come.

One of the main arguments against the gold standard is that smart central bankers can outperform a gold standard. The record of monetary policy around the world over the last 40 years that I have just summarized is not obviously superior to preceding eras. A large dose of humility about both our knowledge and our ability to implement what we know are in order.

The other main argument against the gold standard is that the Great Depression discredits it. If so, by the same token, the Great Recession discredits fiat money — a claim I doubt that any critic of the gold standard would accept.

A monetary system has a number of components, including (1) the monetary standard (the target for monetary policy); (2) the exchange rate regime; (3) the monetary authority (or, under free banking, the lack of a monopolistic authority); (4) the financial system other than the monetary authority; and (5) expectations about how the system works. Any component can make a big difference in how a monetary system works. One must examine all these components, and some other factors besides, to judge just what were the sources of the problems experienced during historical episodes such as the Great Depression or the Great Recession. Critics of the gold standard, even those who have a deeper knowledge of economic history than Roubini or Krugman, tend to lump many or all of the five components together. To do so, however, is as big a mistake as treating monetary policy in Sweden, the United States, and Venezuela over the last decade as essentially similar because all three countries are off the gold standard.

Michael Woodford of Columbia University is acknowledged as probably the most influential academic monetary economist today. His 2003 book Interest and Prices: Foundations of a Theory of Monetary Policy is his magnum opus. It is not a book for laymen, but it is one of the handful of books over the last 40 years that everyone who participates in academic debate on monetary economics needs to have read.

When introducing his theoretical framework, Woodford writes near the bottom of page 63, "I begin by considering price-level determination in an economy in which both goods markets and financial markets are completely frictionless: markets are pefectly competitive, prices adjust continuously to clear markets, and there exist markets in which state-contingent securities of any kind may be traded."

By page 64, though, a central bank somehow becomes part of this system of perfectly competitive markets. It is a perfect example of how limiting it is to know only the present. Free banking has a history centuries long: the first free banking system began in China apparently about 995, more than 600 years before the first central bank. More than 60 countries have had free banking. And yet, Woodford does not even pause for a page to consider what a banking system would look like without a central bank.

During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:

To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.

In normal times, it is a fairly safe assumption that demand is roughly constant or changing predictably, but in abnormal times, it is a dangerous assumption. No high inflation occurred in any country that expanded the monetary base rapidly during the financial crisis. Evidently, demand expanded along with supply. In fact, Scott Sumner and other “market monetarists” think supply did not keep up with demand. Similarly, nobody should be perplexed if a case arises where the monetary base is constant or even falling but inflation is rising sharply. Absent a natural disaster or some other nonmonetary event, it is evidence that demand for the monetary base is falling but supply is not keeping pace.