Free Banking 

(Larry White assisted me in writing this article.)

A number of recent exchanges between Market Monetarists and their critics, and especially those of their critics associated with the Austrian school, have debated the contribution of excessively easy Fed policy toward the housing boom and bust. The issue boils down to this: can monetary policy really be said to have contributed to the housing boom in light of the fact that the NGDP growth rate during the 2003-2007 period was, as the figure below illustrates, only a percentage point or so above its previous 5 percent trend?

Market Monetarists tend to answer, "surely not," while Austrians (and some others, like John Taylor) insist that it is "yes." The difference has to do in part with the very different theoretical frameworks employed by the different sides. For Market Monetarists, like their old-fashioned monetarist predecessors, the framework consists of short- and long-run AS schedules, with the slope of the short run AS schedule reflecting the degree of short-run price and wage stickiness, among other things. AD innovations, including more rapid than usual AD growth, influence real activity by moving the economy along the short-run AS schedule. The stickier prices are, the flatter the schedule, and the greater the change in output.

Like other monetarists Market Monetarists tend to assume that prices and wages exhibit considerably less upward than downward stickiness. That perspective informed Friedman's so-called "plucking model" of the business cycle, according to which the plot of real output resembled a string glued to an incline plane, rising from left to right, that was "plucked" downward here and there owing to slow (or negative) demand growth. According to the plucking model, output drops below its "natural" rate whenever slow spending occurs, because there's a fair degree of downward rigidity in prices and wages. But output seldom rises much above its natural rate, because prices and wages are relatively flexible upwards, so that rapid demand growth tends instead to manifest itself in corresponding upward price movements. A steady rate of NGDP growth avoids the occasional downward “plucking” of output.

To make their case for stable NGDP growth Market Monetarists don't need to refer to interest rates generally or to the federal funds rate as an indicator of the stance of monetary policy--with a low funds rate indicating "loose" money and a high one indicating "tight" money. Indeed, they regard the common tendency to treat the federal funds rate this way as misleading at worst and a distraction at best, and would rather have monetary policy makers pay no attention to interest rates at all, and simply focused on the course of aggregate spending.

To be sure, the Market Monetarists have a point. Nothing could be more naive than the (Keynesian) treatment of interest as the "price" of money, with low rates signifying an abundance of money and high ones signifying a shortage. We can applaud their efforts to put the "money" back into monetary economics and policy, albeit not by drawing attention to the causal role of monetary aggregates but rather by emphasizing M x V or, equivalently, P x y.

But in seeking to free monetary theory and policy from the Keynesian overemphasis on interest rates, the Market Monetarists tend to downplay the extent to which central banks can cause or aggravate unsustainable asset price movements by means of policies that drive interest rates away from their "natural" values. Such distortions can be significant even when they don’t involve exceptionally rapid growth in nominal income, because measures of nominal income, including nominal GDP, do not measure financial activity or activity at early stages of production. When interest rates are below their natural levels, spending is re-directed toward those earlier stages of production, causing total nominal spending (Fisher’s P x T) to expand more than measured nominal income (P x y). Assets prices, which are (appropriately) excluded from both the GDP deflator and the CPI, will also rise disproportionately. It is the possibility that such asset price distortions may significantly misdirect the allocation of financial and production resources that lies at the heart of the "Austrian" theory of boom and bust.

The notion of a "natural" rate of interest comes, of course, from Knut Wicksell, who, starting with the premise that new money is delivered to the economy by way of the credit market, argued that excess money creation would result first in a lowering of interest rates, and only subsequently in a general increase in spending and prices. His approach differs from the naive Keynesian one in treating the interest rate effect of money supply innovations as temporary only, and in allowing that the "natural" rate of interest might itself vary quite independently of monetary conditions. Wicksell's approach ultimately connects the temporary interest rate effects of monetary innovation to nominal income and price level effects. Thus nothing prevents a Market Monetarist from also being a thoroughgoing Wicksellian.

Both Market Monetarists and Wicksell himself differ from the Austrians in paying little if any attention to the direct bearing of short-run interest rate changes on real activity, and especially real activity in asset markets. The Market Monetarists consider interest rate movements an unimportant sideshow without significant knock-on effects, and therefore a distraction from what really matters; Wicksell considered them only as a harbinger of changes in spending. Missing in both perspectives is any attention to the way in which interest rate movements redirect demand from certain markets to others. Monetary policy innovations can, in other words, involve both (nominal) “income” and “substitution” effects.

They needn't do so, of course. "Helicopter" money approximates the case in which monetary innovations boost nominal wealth, and thereby stimulate spending and nominal income, without necessarily involving any particular relative-price changes. The short-run/long-run AS-AD framework tells us all, or almost all, of what we need to know about the potential real consequences of helicopter money drops; and deviations of nominal income from trend supply a reliable indicator of the degree to which monetary policy has been either excessively easy or excessively tight.

But open-market purchases aren't helicopter drops. Instead (as Wicksell took for granted) they initially involve increases in the relative price of the securities being purchased, and corresponding reductions in market-clearing (but not in underlying "natural") interest rates. Lower interest rates in turn encourage a re-orientation of spending toward investment, and especially toward those prospective investment projects whose present values increase most in response to a marginal reduction in the cost of funds. This "substitution" effect of easy money--an effect that depends on real interest rate movements rather than on changes in aggregate spending per se--is the key to unsustainable asset price movements, where “unsustainable” indicates a movement than can only go on while interest rates remain unnaturally low. It is possible, at least in principle, to conceive of a monetary policy that gives rise to large substitution effects--that is, to a substantial increase in the perceived present value of particular investments--while having only a modest ultimate effect on the growth rate of nominal final income. The narrower the initial credit channel through which excess liquidity is injected into the economy before spreading out to the rest of the economy--the further removed we are from helicopter drops--the greater the likely importance of relative-price and substitution effects.

The possibility of substitution effects stemming from “unnatural” (monetary-innovation based) interest rate movements supplies reason for taking even modest innovations to NGDP growth, and upward innovations especially, seriously. The possibility suggests that such deviations are likely to be associated with disproportionate deviations of total spending—that is, of spending on both final and intermediate goods—from its own trend. In so far as money supply innovations tend to drive interest rates either below or above their natural levels, increases in the growth rate of NGDP and other nominal income measures may understate the extent to which monetary policy is excessively easy or excessively tight (and are likely to continue to understate the laxness of monetary policy while a boom persists), because the amplitude of short-run deviations of total spending from trend will be greater than that of nominal income, and because velocity and money multiplier declines that typically accompany the bursting of asset bubbles will suppress the acceleration in nominal income growth that might otherwise be observed once substitution effects have worn off. Just how much this difference in amplitude mattered in any particular case, including that of 2003-2007, is of course, a matter that cries out for further study.

In reply to Larry White's recent post, my former student David Beckworth has rushed to the defense of QE3, prompting me to offer the following remarks, originally posted to his site, on some of the points he makes:

"there have been a series of negative money demand shocks."

I find this language unhelpful: a "negative" demand shock ought, strictly speaking, to mean that demand for the affected thing goes down, not up. So, the "shocks" must have called for less rather than more easing. But that evidently isn't what is meant here. "Negative" apparently has not its usual sense but that of "unwanted" or "undesirable."

"Institutional investors also need assets that facilitate transactions, but the assets in M2 are inadequate for them given the size and scope of their transactions. Consequently institutional investors have found ways to make assets like treasuries, commercial paper, repos, GSEs and other safe assets serve as their money"

This begs the question, for if it is these assets, rather than those found in narrower aggregates, for which there is excess demand, it is not in the Fed's power to increase their abundance. On the contrary: when it swaps FR liabilities for any of these very assets, it presumably reduces the supply of precisely those things that institutional investors supposedly have to have for their transacting! To help them, the Fed should have been doing "reverse" QE!

"household portfolios are still inordinately weighted toward liquid assets. Take a look at the figure below. It comes from the flow of funds data and show households' total deposit assets and treasuries as a percent of total household assets. There is a sudden jump in this series in 2008 that has yet to return to pre-crisis levels, a sure sign of elevated money demand."

An awkward claim, since the date [sic] suggest a slowdown in demand for time deposits during precisely the period--2007-209--when the "shortage" of money was presumably most acute, as evidenced by shrinking NGDP.

"interest rates are low because of ongoing economic weakness that has decreased the demand for credit. Excess money demand is at the heart of this slump. If money demand were not elevated and the public expected higher nominal incomes these interest rate would be rising. The fact they haven't speaks volumes to the ongoing demand for safe assets or money."

The argument here begs the question. Yes, credit demand is low; and that's because the economy is in a slump. But it doesn't follow that the slump is due to a lack of spending, as opposed to having structural or "real" causes. There is no guarantee that higher spending will lead to higher real rates, rather than simply raising nominal rates by boosting inflation expectations.

"It is hard to believe we have been in this slump since mid-2008. That is a long stretch and one would think enough time for money demand shocks to work themselves out. But the U.S. economy has been subject to a spate of money demand shocks and the Fed has consistently failed to fully respond to them."

The shock of 2008-9 is evident enough in the NGDP and other spending series. But the "shocks" after that do not show up in the one place that should matter most, especially to proponents of NGDP targeting. Instead all concede that NGDP has recovered its pre-2008 level and approximate growth rate; the question is whether it needs to grow faster to "catch up" to its former trend. That claim, in turn, depends heavily in how one constructs the "correct" trend, and especially on the extent to which one is prepared to allow "boom" period NGDP growth (e.g. from the dot.com and subprime bubbles) to inform estimates of "normal" trend growth. Draw the trend at 5% or more, as you and Scott prefer to do, and NGDP is "behind" where it "ought" to be. Draw it for 4.5% or less, and "catching up" looks like just the thing for blowing yet another bubble.

Ah, just like the good old days, David! And, no less than back then, I expect you will not be short of rejoinders and retorts!

Postscript (added 9/24 at 5:41): All these appeals to different measures of the money stock as offering evidence as to the extent to which money is in short supply or has been exposed to demand shocks really are, or should be, considered quite beside the point in the MM and other nominal spending targeting frameworks. After all, nominal spending targeting makes sense precisely to the extent that fluctuations in nominal spending serve as a good indicator of money shortages or surpluses. So who cares what M2 or M3 or m$ or other still fancier M measures are of have been up to? If spending has remained stable, the presumption is that the economy has been getting all the liquidity or exchange media it needs, and that it is therefore not tending to ride up or down a short-run Philips curve. It is precisely because NGDP targeting and similar schemes dispense with the need to track particular monetary aggregates, or worry about the stability of demand for them, while still sticking to a nominal target, that they constitute an alternative and appealing alternative to conventional "monetarist" rules.

So, when it comes to demonstrating that money is or has been in short supply, a consistent Market Monetarist has no reason to appeal to the behavior of any measure of M. What matters is whether a plausible case can be made that spending is too low, or has been growing too slowly. That of course leads to thorny questions concerning the choice of an ideal growth rate and, what amounts in the short run to the same question, the fitting of a trend to past data with the aim of finding the once that would have been most conducive to the avoidance of booth booms and busts. This latter task, it seems to me, is not quite as simple a matter as some MM's have made it out to be.

In my Saturday post warning of the dangers of QE3, I wrote, among other things,

Having kept the federal funds rate at 1.75 percent for a year after the economy began to recover in November 2001, the Fed lowered it to 1.25 percent in November 2002, and to 1 percent in June 2003. Then, in August 2003, the FOMC, still unhappy with the sluggish pace of the recovery, and especially with the high unemployment rate, announced that the f.f.r. was “likely” to remain low for an “extended” period of time. Not for the first time, the Fed in its zeal to assist recovery was in fact setting the next boom in motion. And how!

To which Scott Sumner replies,

I’m tempted to respond; and how? Most people, including George Selgin and market monetarists like David Beckworth, believe that an easy money policy during the early 2000s led to an overheated economy in the middle of the decade, and that this was one factor in the crash during the latter part of the decade. I’m not convinced, or perhaps I should say I doubt the effect was as strong as most people believe. First of all, I see little evidence that monetary policy was particularly expansionary during the early 2000s. Some people cite the low rates, but we all know what Milton Friedman said about that. I agree with Ben Bernanke that NGDP growth is a good indicator of whether money is easy or tight. Here are the facts about NGDP growth during the previous expansion:

1. NGDP grew at a slower rate during the 2001-07 expansion than during any other expansion during my lifetime.

2. NGDP growth modestly exceeded 5% during the peak of the housing boom.

Scott's reply in turn provokes me to recall an important issue which, though occasionally raised in what I'm going to start calling simply the M-M-osphere for short, deserves a lot more attention. It concerns the question, "Which spending measure ought the Fed to keep stable?"

Although the focus on NGDP has been such as to allow "NGDP targeting" to become the favored way of referring to what Scott and other Market Monetarists have been plugging for, in fact NGDP is but one of many measures of spending or aggregate demand stabilization of which might be broadly consistent with the underlying economics of Market Monetarism. What's more, there are compelling arguments for regarding some alternative measures of spending as superior. And yes, it does make a non-trivial difference which measure one chooses to look at in assessing the degree to which instability of spending may contribute to booms as well as busts, as I hope to show.

Among the alternatives to NGDP one in particular, the Dept. of Commerce's measure of (nominal) "final sales to domestic consumers" deserves particular attention. It is the measure that was favored by the late Bill Niskanen--yet another largely unrecognized but long-standing proponent of nominal income targeting--who offered several good reasons for preferring it to NGDP targeting, the most fundamental of which was that "demand for money in the United States appears to be more closely related to final purchases by Americans than to the dollar level of total output by Americans."

In an article published just after the dot.com crash, from which I just quoted, Niskanen looked at the behavior of final sales from early 1992 until 2001. He found that until early 1998 the annual growth rate of domestic final sales was remarkably steady at 5.5 percent. But as Niskanen's chart, reproduced below, shows clearly, from early 1998 to the second quarter of 2000, coinciding with the dot.com boom, it shot up to almost 8 percent. The end of the boom brought, per usual, a collapse in spending. Niskanen argued, reasonably, that the Fed should strive next time to maintain the steady 5.5 percent growth rate it had managed to maintain, intentionally or not, throughout the early nineties.

Now, none of this is particularly earth-shattering. But the course of domestic final sales during the longer sample period including that since Niskanen wrote, yields a more striking picture, and especially so if one includes along with the plot for domestic sales those for both NGDP growth and core CPI inflation:

Among things worth noting here are, first, that the coincidence--to settle at calling it that--between periods of exceptionally rapid growth in final sales and "booms" is hardly less evident than that between periods in which domestic sales collapse and "busts"; second, that the coincidence is more evident in considering the behavior of final sales than it is w.r.t. NGDP, because of the more pronounced cyclical amplitude of the former series; third, that the "core" CPI tells us nothing at all about about either booms or busts; and, finally, that, yes, as of the last data record spending remains below Scott's preferred 5 percent target, and still further below the "Niskanen" growth target--but not by much.

The plain-old CPI is better than the core in reflecting both booms and busts, of course. But even with regard to it it seems entirely mistaken to assume that mere avoidance of >3 percent inflation (or something like that) should itself suffice to guard against the risk of another boom and bust cycle.

None of this, of course, amounts to a proof that excessive spending growth played a major part in either the last boom or any boom before it. But it certainly should suggest the presence of such a correlation as ought to rule out any temptation to reject a causal connection out of hand, and especially so in light of the many theorists, including both monetarists and Austrians (whose agreement concerning this matter is itself striking) who have offered independent evidence of the existence of such a link. Perhaps it's true that, had the Fed heeded Niskanen's advice, we would still have gone through the same subprime boom and financial meltdown. But I, for one, wouldn't bet on it.

P.S. (added at 3:50 EST): I fear that, in failing to say anything regarding the Fed's decision to direct its latest round of easing toward the purchasing of mortgage-backed securities, I may be thought to have no objection to that aspect of its new initiative. Nothing could be further from the truth. For the record, if the Fed is going to expand the stock of high-powered money, it should do so either the old-fashioned way, that is, by sticking to "Treasuries only," or it should offer to buy a wide range of investment grade securities, of the sort it might routinely accept as discount-window collateral (as I've suggested in my "L Street" paper), or it should scatter the new dollars from helicopters. Anything else is encroaching unnecessarily on fiscal policy, that is, is making decisions about who gets what that should be left to Congress, or to the states, or (lest we forget them) to the people, rather than sticking to the Fed's assigned function of tending to the economy's overall state of liquidity.

In the title of a recent post Scott Sumner jokingly wonders whether, having been credited by the press for badgering Ben Bernanke's Fed until it at last cried "uncle!" by announcing QE3, he now needs to worry about going down in history as the guy who gave the U.S. its first episode of hyperinflation.

Well, probably not. But if Scott and the rest of the Market Monetarist gang don't start changing their tune, they may well go down in history as the folks responsible for our next boom-bust cycle.

I'm saying that, not because, like some monetary hawks, I'm dead certain that no substantial part of today's unemployment is truly cyclical in the crucial sense of being attributable to slack demand. I have my doubts about the matter, to be sure: I think it's foolish, first of all, to assume that 8.1% must include at least a couple percentage points of cyclical unemployment just because it's more than that much higher than the postwar average; and (as I noted in a previous post), I'm far from convinced that NGDP is still substantially below where it should be given both the extent of the actual increase in spending since 2009 and the fact that there has surely been at least some downward adjustment in demand expectations since that time. Still, for for the sake of what I wish to say here, I'm happy to concede that some more QE, aimed at further elevating the level of nominal GDP to restore it to some higher long-run trend value to which the recession itself and overly tight monetary policy have so far prevented it from returning, might do some good.

But although QE3 is in that case something that might do some real good up to a point, it hardly follows that Market Monetarists should treat it as a vindication of their beliefs. On the contrary: if they aim to be truly faithful to those beliefs, they ought to find at least as much to condemn as to praise in the FOMC's recent policy announcement. And yes, they should be worried--very worried--that if they don't start condemning the bad parts people will blame them for the consequences. What's more, they will be justified in doing so.

So what are the bad parts? Two of them in particular stand out. First, the announcement represents a clear move by the Fed toward a more heavy emphasis on employment or "jobs" targeting:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Yes, there's that bit about fighting unemployment "in a context of price stability," and yes, it's all perfectly in accord with the Fed's "dual mandate." But monetarists have long condemned that mandate, and have done so for several good reasons, chief among which is the fact that it may simply be beyond the Fed's power to achieve what some may regard as "full employment" if the causes of less-than-full employment are structural rather than monetary. The Fed should, according to this view, focus on targeting nominal values only, which can serve as direct indicators of whether money is or is not in short supply. Many old-fashioned monetarists favor a strict inflation target because they view inflation as such an indicator. Market Monetarists are I think quite right in favoring treating the level and growth rate of NGDP as better indicators. But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don't start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.

The second, even more troublesome part of QE3 consists of the FOMC's implicit promise to keep the federal funds rate near to its present, unprecedentedly low level for a very long period of time:

the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

What's wrong with that? It is well to remember the Fed's response to the last slow recovery--the one that followed the dot.com bust. Having kept the federal funds rate at 1.75 percent for a year after the economy began to recover in November 2001, the Fed lowered it to 1.25 percent in November 2002, and to 1 percent in June 2003. Then, in August 2003, the FOMC, still unhappy with the sluggish pace of the recovery, and especially with the high unemployment rate, announced that the f.f.r. was "likely" to remain low for an "extended" period of time. Not for the first time, the Fed in its zeal to assist recovery was in fact setting the next boom in motion. And how! And it did so, by the way, without having ever substantially exceeded its inflation target. Of course, so long as the boom lasted, the FOMC was confident that everything was just dandy.

The two aspects of QE3 that I think Market Monetarists had better start complaining about have nothing to do with targeting either the level or the growth rate of nominal income. On the contrary: both imply a risk, and perhaps a very substantial risk, that QE3 will devolve into a policy that leads to excessive nominal income growth instead of being terminated before that can happen. And though the excessive growth is hardly likely to be such as might lead to hyperinflation, and may not even be such as might lead to any considerable overshooting of the Fed's favorite (2 percent) inflation rate, that doesn't mean that it won't be capable of generating another serious asset price bubble, whether in the real estate market or elsewhere.

So, Market Monetarists: quit gloating and start complaining, loudly, about the dangerous aspects of the Fed's latest move--aspects that, far from reflecting your beliefs, are quite contrary to those beliefs. If you fail to do so now (and especially if you appear to endorse those aspects of the Fed's new policy), you may not have much to gloat about (though you may well end up getting lots more press coverage!) following the "long and variable lag" that started a few days ago and that may end, for all we know, sometime after 2015.

P.S.: To be fair, Scott in particular, and other MM's as well, haven't really been doing all that much gloating--they are in truth a remarkably modest bunch. But quite a few others have been doing plenty of gloating on their behalf.

The advice is for self-styled Austrian economists, and younger ones especially, who want to do good economics, and not just to "belong" to a school of thought. It is simple, and it applies to any research that's not intended to be a contribution to the history of economic thought.

Here it is: search for the word "Austrian" in your research papers, delete it, and rewrite where necessary. Next ask yourself whether what's left can stand on its own merits. Would your fellow Austrians find it interesting and persuasive without the help of all the winking, nodding, and fraternal handshaking aimed at declaring yourself one of the team, and at thereby evading friendly fire? Would they find the conclusions firmly attached by a series of solid links to some indisputable premises, as they should if you are really a competent praxeologist? Are they likely to find the evidence you supply persuasive, should you be so bold as to offer such? Would they, in short, find merit in what you've written even if they had no reason to suspect that you are one of the gang, or even a fellow traveler? If not, then your paper is good for nothing but joining a club that is, face it, all too willing to have you as a member.

But being able to win over Austrians without declaring yourself one of them is the least of it. The more important question you need to ask is, "Can my stealth-Austrian paper not only sneak past mainstream radars, but do some persuading once across enemy lines?" It surely will not be less persuasive than it would be with all that Austrian flag-waving, since the flags might as well be bright red so far as the rest of the profession is concerned. But if it still can't persuade at least some persons who aren't pals of yours at the Mises Institute or at GMU or at some other Austrian hang-out, what good is it?

Persuading non-Austrian economists with what are, in substance, "Austrian"-style arguments is, admittedly, rough going: all too many so-called economists today are mere technicians who care only for the latest mathematical and statistical gimmicks, and give not a jot for genuine economics. But there are thank goodness also plenty of real economists who aren't Austrians and who don't want to hear about Austrian economics, but are willing to hear any good argument and to be persuaded by it and by evidence that seems to support it. Persuading them is hard too. It's also every economist's job.

Except for omitted section headings what follows is the full text of the paper I presented last week at the Mont Pelerin Society General Meeting in Prague. As the paper had to be completed on time for a May deadline, it could not take into account subsequent developments. Fortunately those developments have mainly been entirely consistent with the paper's general thrust.

Otmar Issing, a former ECB chief economist and Executive Board member, also took part in my session. Although Mr. Issing's paper and public remarks put a much more favorable spin on the Euro's prospects for survival than my own, I believe--as I remarked during the session--that the only substantial disagreement between us concerned the conditions in which it would be appropriate to pronounce the Euro "dead." In brief, while Mr. Issing for his part appears to regard the merest heartbeat from Frankfurt as a sign of vitality, I say that, heartbeat or no heartbeat, the Euro is for all intents and purposes already brain-dead.

***

When the merits of a European Monetary Union were first being debated, many skeptics fell into one of two camps. The first camp consisted of “Keynesians” (for example, Eichengreen and Bayoumi 1997; Salvatore 1997) who, referring to the theory of optimal currencies areas, doubted that Europe constituted such an area, and believed that the proposed monetary union would eventually fall victim to country-specific (“idiosyncratic”) shocks: unemployment and other burdens stemming from such shocks would, these critics argued, eventually force the monetary authority to either abandon its commitment to price-level stability in order to offer relief to adversely-affected members, or cause the members to abandon the union so as to be able to re-align their exchange rates.

The other camp was comprised of “Hayekians” who, drawing upon theories of international currency competition, claimed that monetary unification, by reducing the extent of such competition, would give rise to a relatively high seignorage-maximizing Eurozone inflation rate, and thereby result in a level of actual Eurozone inflation that was bound to disappoint the monetary union’s more inflation-phobic members.[1] It was in light of such reasoning that British Prime Minister John Major made his alternative proposal for a parallel European currency—the so-called “hard ecu”— to supplement rather than supplant the British Pound and other established European currencies.

Today the euro is indeed failing. But its failure has in large part been the result of fundamental shortcomings other than those pointed out by either of these prominent camps of early euroskeptics. Rather than merely being wrenched apart by pressure from idiosyncratic shocks, or by disappointments stemming from the ECB’s temptation to profit from its monopoly status, the euro is unraveling because commitments upon which its ultimate success depended—commitments that had to be credible if it was to work as intended—have instead proven to be perfectly or almost perfectly incredible. The euro, in other words, was built upon a set of promises that the authorities concerned were unable to keep. Orthodox theory—theory that is neither particularly “Keynesian” nor particularly “Hayekian” in flavor, suffices to explain—admittedly, with the help of hindsight—why the promises in question could not possibly have been kept so long as the EMU’s members enjoyed substantial fiscal sovereignty. The combination of effectively unconstrained fiscal sovereignty and a lack of credible commitments to avoid both centralized debt monetization and outright member-state bailouts created a perfect storm of perverse incentives.

The theory in question builds upon Kydland and Prescott’s (1977) well-known treatment of the time-inconsistency problem that confronts ordinary central banks. That analysis, it bears observing, takes for its starting point a benevolent (social-welfare maximizing) though discretionary central bank, while making no reference to region-specific shocks or imperfect factor mobility. Greg Mankiw (2006) offers the following summary of the standard time-inconsistency problem:

Consider the dilemma of a Federal Reserve that cares about both inflation and unemployment. According to the Phillips curve, the tradeoff between inflation and unemployment depends on expected inflation. The Fed would prefer everyone to expect low inflation so that it will face a favorable tradeoff. To reduce expected inflation, the Fed might announce that low inflation is the paramount goal of monetary policy.

But an announcement of a policy of low inflation is by itself not credible. Once households and firms have formed their expectations of inflation and set wages and prices accordingly, the Fed has an incentive to renege on its announcement and implement expansionary monetary policy to reduce unemployment. People understand the Fed's incentive to renege and therefore do not believe the announcement in the first place.

Monetary policy will also tend to be time-inconsistent when unanticipated inflation is capable of lowering the real value of outstanding nominal debts, thereby reducing the government’s fiscal burden. In this case the central bank has an incentive to announce a low inflation target so as to achieve a favorable inflation-taxation trade-off. Once again, were the central bank able to establish low inflation expectations, it would have an incentive to exploit those expectations so as to reduce the debt burden. Consequently the announced, low inflation target is not credible.

In the context of a monetary union whose members enjoy unlimited fiscal sovereignty, the usual time-inconsistency problem is compounded by a free-rider problem, with far more serious consequences. Here, as Chari and Kehoe (2007, 2008) have shown, a discretionary monetary authority’s optimal (benevolent) policy consists of setting “high inflation rates when the inherited debt levels of the member states are high and low inflation rates when they are low” (Chari and Kehoe 2007, p. 2400). Assuming that costs of inflation are borne equally by the member states, the ability to free ride off of other members of the union causes member states to be become more indebted than they would in a cooperative equilibrium, thereby bringing about an excessively high rate of inflation. Moreover, the free-rider problem gets worse as the number of countries gets larger, with the non-cooperative inflation rate rising, other things equal, as union membership increases (Chari and Kehoe 2008). The incentive to free ride will, finally, be especially great for relatively small participants, and for participants with relatively high debts ratios, other things being equal, for these participants will be capable of externalizing a relatively large share of the cost of any deficits they incur.

Observe that, although the suboptimal outcomes predicted here—excessive government deficits and higher inflation—resemble those predicted by Hayek and his followers, the causal mechanism is much different. For here a benevolent authority, concerned only with maximizing social welfare, is led inadvertently to engage in undesirable levels of debt monetization. Were there no externalities, or were the authority capable of committing to policy invariant to the extent of union indebtedness, the problem would not arise.

Chari and Kehoe first establish the presence of a “free rider” problem for the case in which national fiscal authorities issue nominal debt only to lenders who live outside the monetary union to which they belong (2007, p. 2400); they then go on to show that the problem holds as well in the case where governments borrow from within the union. The latter case, however, raises the additional possibility that union members can hold the union hostage, and thereby ultimately undermine it, by threatening either to default on their debt or to quit the union if it does not ease their debt burden by means of higher inflation or outright transfers (bailouts) or both. In the words of Thomas Mayer (2010, p. 51), if heavily-indebted member countries “pose a threat to Eurozone financial stability, they can blackmail their partners into open-ended transfers to cover both fiscal and external deficits. Or they can press the ECB to buy up and monetize their debts so as to avoid default.”

The “threat” to monetary stability can develop in several ways. First, foreign commercial banks may hold substantial quantities of the debt of the hostage-taking country, so that its decision to default would threaten the rest of the zone with a financial crisis. Second, the central monetary authority may itself hold substantial amounts of the troubled member’s debt, and so may also need to be recapitalized, at other participant countries’ expense, in the event of a default. Alternatively, the bad debts would have to be reduced by means of more aggressive monetization and consequent, higher inflation (ibid., p. 52). In either case, the decision to avoid the danger in question by instead supporting member governments in fiscal difficulties will tend to undermine public support for the monetary union while increasing the likelihood of further ransom demands.

Philip Bagus (2012) explains the particular course by which Greece was able to take the European Monetary Union hostage. Banks throughout the Eurozone, he says, bought Greek bonds in part because they knew that either the ECB or other Eurozone central banks would accept the collateral for loans. Thus a Greek default threatened, first, to do severe damage to Europe’s commercial banks, and then to damage the ECB insofar as it found itself holding Greek bonds taken as collateral for loans to troubled European banks.

In short, in a monetary union sovereign governments, like certain banks in single-nation central banking arrangements, can make themselves “too big to fail,” or rather “too big to default.” As Pedro Schwartz (2004, p. 136-9) noted some years before the Greek crisis: “[I]t is clear that the EU will not let any member state go bankrupt. The market therefore is sure that rogue states will be baled [sic] out, and so are the rogue states themselves. This moral hazard would increase the risk margin on a member state’s public debt and if pushed too could lead to an Argentinian sort of disaster.”

Indeed, the moral hazard problem as it confronts a monetary union is all the worse precisely because sovereign governments, unlike commercial banks, can default without failing, that is, without ceasing to be going concerns. This ability makes their ransom demands all the more effective, by making the implied threats more credible. A commercial bank that tries to threaten a national central bank using the prospect of its own failure is like a suicide bomber, whereas a nation that tries to threaten a monetary union is more like a conventional kidnapper, who threatens to harm his innocent victim rather than himself.

The free-rider and hostage-taking problems present in a monetary union that combines discretionary monetary policy with unrestricted national fiscal sovereignty has led some experts to speak of a new “Impossible Trinity” or “Trilemma," complementing the “classical” Trilemma long recognized in discussions of alternative international monetary regimes. The original Trilemma refers to the fact that, a country cannot pursue an independent monetary policy while both adhering to a fixed exchange rate and dispensing with capital controls. According to Hanno Beck and Aloys Prinz (2012), in the context of a monetary union it is impossible for authorities to adhere to all three of the following commitments: 1) Monetary Independence, including a commitment on the part of the monetary authority to avoid either excessive inflation or the monetization of sovereign debts; 2) No bailouts, meaning no outright loans or grants to national governments in danger of defaulting; and 3) Fiscal Sovereignty, meaning a commitment to refrain from interfering with member nations’ freedom to resort to debt financing.

As we’ve seen, so long as unlimited fiscal sovereignty prevails, member states can find themselves in a position to take the monetary union hostage, forcing the central authorities to renege on one or both of heir other commitments. It follows that either the principle of fiscal sovereignty must be abandoned in favor of something like an outright fiscal union, or that the union must abandon its commitment to either independent monetary policy or the no-bailout clause, exposing the union to the consequences of unconstrained fiscal free riding, with all the regrettable consequences that must entail.

Nor is the EMU’s experience the first to bear out these claims. Having reviewed the lessons taught by previous monetary unions, in a work published between the signing of the Masstricht Treaty and the actual launching of the euro, Vanthoor (1996, p. 133) concluded that

monetary union is only sustainable and irreversible if it is embodied in a political union, in which competences beyond the monetary sphere are also transferred to a supranational body. In this respect, the Maastricht Treaty provides insufficient guarantees, as budgetary policy as well as other kinds of policy…remain the province of national governments.

The euro’s flawed design, and the poor incentives created by it, have not merely caused the scheme itself to fail, but have done extensive damage to the European economy. Philip Bagus (2012) supplies an excellent summary of its more regrettable consequences. “To make an understatement,” he writes,

the costs of the Eurosystem are high. They include an inflationary, self-destructing monetary system, a shot in the arm for governments, growing welfare states, falling competitiveness, bailouts, subsidies, transfers, moral hazard, conflicts between nations, centralization, and in general a loss of liberty.

The euro, Bagus adds, has allowed European governments generally, and those of the peripheral nations in particular,

to maintain uncompetitive economic structures such as inflexible labor markets, huge welfare systems, and huge public sectors … Multiple sovereign-debt crises have in turn triggered a tendency toward centralization of power in Brussels [bringing us] ever closer to a more explicit transfer union.

In particular,

The Greek government used the lower interest rate to build a public adventure park. Italy delayed necessary privatizations. Spain expanded the public sector and built a housing bubble. Ireland added to their housing bubble a financial bubble. These distortions were partially caused by the EMU interest-rate convergence and the expansionary policies of the ECB.

In light of all of these ill consequences, Bagus concludes, “the project of the euro is not worth saving. The sooner it ends, the better.” In other words, given the other consequences stemming from the euro’s poor design, it is just as well that that design is also causing the euro to self-destruct.

But perhaps the gravest of all consequences of the euro’s demise is also the most ironic, to wit: the harm done to inter-European relations. Instead of cementing European unity, as its proponents claimed it would do, the euro is bearing-out Martin Feldstein’s (1997) prediction that it would ultimately supply grounds for new inter-European squabbles, culminating in the emergence of a new and vehement nationalism, all too reminiscent of the nationalism that twice set Europe aflame during the previous century. As John Kornblum (2011), the U.S. Ambassador to Germany from 1997-2001, wrote last September, with the outbreak of the Greek crisis, “[t]he polite tone cultivated for decades by E.U. partners” has given way to “a tirade of insults”:

Germans have called the Greeks lazy, corrupt and just plain stupid. The news media in Germany gleefully point out Greek billionaires who pay no taxes, workers who retire at 50 and harbors filled with the yachts of the idle rich. German politicians have suggested that Greece sell some islands to repay its debt. In return, Greeks have pulled out the Nazi card, claiming that the Germans owe them billions in wartime reparations.

Rather than being specifically related to conditions in Greece this outcome, Kornblum observes, has its roots in the euro’s basic design:

Rather than being kept free of politics, as was originally intended, management of the currency has become a political football knocked back and forth by the growing resentments between richer and poorer Europeans. The poorer countries reject the austerity measures necessary to meet German standards. The Germans refuse to take the steps necessary to build a true economic community. The result is a standoff…. [I]f the euro hadn’t been implemented as a political project in a Europe not ready for a common currency, experts could probably clean up such a situation fairly fast. But now, they can’t. Because in the end, such decisions are still about the war.

***

In examining the cause of the euro’s failure, it may seem that I’ve only succeeded in raising a different question, namely, how, did the euro manage to survive for so long?

The answer hinges on the fact that the credibility of various commitments made at the time of the euro’s launching was not something that could be ascertained in advance. Instead, it had to be discovered. In particular, the public had to discover whether European authorities had avoided the “Impossible Trilemma” discussed above, by strictly limiting participants’ fiscal independence.

That such limits were necessary if the common currency was not to fall victim to the “free rider” problem was recognized by several authorities before the euro’s actual establishment (e.g. Goodhart 1995, p. 467). Indeed, it was generally understood that the EU would not allow any of its member states to go bankrupt, and that special steps would therefore have to be taken to guard against members’ tendency to free-ride on the union.

In principle, the time-inconsistency problem that sets the stage for free riding in a monetary union could itself have been avoided by means of a credible commitment to an independent ECB, unresponsive to European fiscal crises. Such credibility might have been achieved by means of explicit rules, with corresponding incentive-compatible sanctions, or it might have been the result of a reputation for independence established over time. But neither solutions was actually realized. As Chari and Kehoe (2007, p. 2401) observe, “notwithstanding the solemnly expressed intend to make price stability the monetary authority’s primary goal, in practice, monetary policy is set sequentially by majority rule. In such a situation, the time inconsistency problem in monetary policy is potentially severe, and as our analysis shows, debt constraints are desirable.”

The euro’s capacity for escaping the Trilemma, and hence for long-run survival, therefore had to depend entirely on meaningful constraints placed upon member states indebtedness. For a time the 1997 Stability and Growth Pact appeared to impose such constraints: the Pact appeared to provide for either the prevention or the timely correction of “excessive” government deficits (that is, deficits exceeding 3% of national GNP) or their rapid correction, thereby ruling-out “even the slightest possibility that a fiscal crisis in one country affect the entire Eurozone” (Mayer 2010, p. 49). But it was not long before the Pact began crumbling. The first fissures appeared in 2003, when France and Germany both exceeded the 3% target, and ECOFIN failed to impose sanctions on either. By the outbreak of the current crisis, the Pact had ceased to be credible (Mayer 2010, p. 50). Though fiscal restrictions remained in effect de jure, the de facto situation was one of unlimited fiscal sovereignty. That change meant, in effect, that either the ECB’s independence or the no-bailout commitment or both would have to give way, as both have indeed done.

Once any of the commitments essential to a monetary union’s success has lost its credibility, that credibility cannot be easily or quickly restored. In light of this truth the EU’s decision, earlier this year, to sanction Hungary for its excessive deficits, seems an exercise in futility—an attempt, as it were, to close the stable door after the PIGS have bolted.

What, then, are some possible solutions? Most recent proposals for saving the EMU—resort to Eurobonds, the establishment of a “European Monetary Fund,” raising the ECB’s inflation target—fail to address the free-rider problem that is the root cause of the current crisis. Indeed, they appear likely to aggravate the problem by formally acknowledging collective responsibilities that were until now formally (though unconvincingly) repudiated.

In truth there are but two ways in which the EMU can be made viable without sacrificing monetary stability. These are (1) the establishment of a genuine European Fiscal Union, that is, outright rejection of the principle of fiscal sovereignty that has thus far tended to undermine both the ECB‘s independence and the EU’s “no bailout” commitment or (2) replacement of the present politically “constructed” monetary union with a “spontaneous” or “voluntary” one based on the principle of free currency competition. As Pedro Schwartz (2004, p. 190) explained several years ago,

There are two types of monetary union. The first is based on a single money imposed by central authorities. Such a monetary union requires centralized political authority… The other form of ‘monetary union’ arises from the free choice of individuals predominantly using one out of a range of alternative currencies. The latter model does not require centralized political authority and is a better model for ensuring that monetary discipline is maintained.

The new Trilemma is a Trilemma for imposed monetary unions only: it is only such an imposed monetary union that calls for a corresponding fiscal union. When participation in a monetary union is voluntary, there can be no question of participants taking advantage of their fiscal autonomy to hold the union as a whole hostage. Consider, for example, the monetary union consisting of the United States, its trust territories, and those independent nations that have chosen to either officially or unofficially dollarize, such as Ecuador. The Federal Reserve and the U.S. government played no essential part in Ecuador’s decision to join the U.S. dollar zone, and take no responsibility at all for macroeconomic conditions there. They would presumably be able to regard Ecuador’s decision to leave the dollar zone with the same equanimity or indifference with which they reacted to its decision to adopt the dollar in the first place. Although it’s true that the extent of participation in the dollar zone might serve as an indication of the dollars’ relative soundness, a foreign country’s decision to quit the dollar zone poses no serious threat to the integrity of the dollar or to the prosperity of either the U.S. or any other dollarized economy. In short, in a regime of free currency choice, monetary authorities can gain nothing by letting their currencies deteriorate further for the sake of addressing the macroeconomic problems of particular dollarized countries. Doing so would only tend to further undermine the dollar’s popularity.

Such considerations appear, in light of experience, to vindicate former Hayekian proposals for a “hard” ecu or parallel European currency that would (initially at least) have supplemented, instead of replacing, Europe’s established national currencies. In retrospect, as Pedro Schwartz (ibid., pp. 183-4) has observed, we have every reason to regret missing the chance of having the euro as a parallel rather than an imposed currency:

If the EU had accepted the British proposal of a “parallel ecu,” rules guaranteeing the stability of the common currency and its independence from European governments would have been a part of the offer to users of the money by the European bank. There would have been no need for constitutional rules to be made (and broken) by member states, and no need for a Growth and Stability Pact, since the euro would not have been seen as a possible instrument of state finance.

There is, of course, no turning back the clock. But should the euro begin to disintegrate, the occasion, for all the disruption and damage it must cause, will at least renew the prospect for implementing the Hayekian alternative. That, to be sure, is a rather meager bit of silver by which to line a very large, dark cloud. Yet the ability to choose freely among competing currencies remains Europeans’ best hope for a monetary regime that is both stable and sustainable

Note

1. “[T]hough I strongly sympathize with the desire to complete the economic unification of
Western Europe by completely freeing the flow of money between them, I have grave doubts about
doing so by creating a new European currency managed by any sort of supra-national authority. Quite
apart from the extreme unlikelihood that the member countries would agree on the policy to be
pursued in practice by a common monetary authority (and the practical inevitability of some countries
getting a worse currency than they have now), it seems highly unlikely that it would be better
administered than the present national currencies” (Hayek 1978).

References

Bagus, Philip. 2012. “The Eurozone: A Moral-Hazard Morass.” Mises Daily, April 17
(http://mises.org/daily/6008/The-Eurozone-A-MoralHazard-Morass)

Beck, Hanno, and Aloys Prinz. 2012. “The Trilemma of a Monetary Union: Another Impossible
Trinity.” Intereconomics 1

Chari, Varadarajan V., and Patrick J. Kehoe. 2007. “On the need for fiscal constraints in a
Monetary union.” Journal of Monetary Economics 54: 2399-2408.

__________. 2008. “Time Inconsistency and Free-Riding in a Monetary Union.” Journal of
Money, Credit, and Banking 40 (7) (October): 1329-55.

De Grawe, Paul, and Wim Moesen. 2009. “Common Euro Bonds: Necessary, Wise or to be
Avoided?” Intereconomics (May/June): 132-138.

Eichengreen, Barry and Tamin Bayoumi. 1997. “Shocking Aspects of European Monetary
Unification,” in Barry Eichengreen, ed., European Monetary Unification: Theory, Practice, and Analysis. The MIT Press, Cambridge Mass., pp. 73-109.

Feldstein, Martin. 1997. “EMU and International Conflict.” Foreign Affairs,
November/December):

Goodhart, C.A.E. 1995. “The Political Economy of Monetary Union.” In P. B. Kennan, ed., The
Macroeconomics of the Open Economy. Princeton: Princeton University Press, pp.

Gros, Daniel, and Thomas Meyer. 2010. “Towards a Euro(pean) Monetary Fund.” CEPS Policy
Brief 202 (February).

Hayek, Friedrich. 1978. Denationalisation of Money - The Argument Refined. Hobart Paper
Special No. 70, 2nd ed. London: Institute for Economic Affairs.

Kornblum, John. 2011. “”Without the euro, would Europe have turned to war?” The Washington
Post, September 24 (updated).

Kydland, Finn E., and Edward C. Prescott. 1977. “Rules Rather than Discretion: The
Inconsistency of Optimal Plans.” Journal of Political Economy 85 (3) (June): 473-92.

Mankiw, Greg. 2006. “Time Inconsistency.” Greg Mankiw’s Blog, April 19,

http://gregmankiw.blogspot.com/2006/04/time-inconsistency.html

Mayer, Thomas. 2010. “What more do European governments need to do to save the Eurozone
in the medium run?” In Richard Baldwin, Daniel Gross, and Luc Laeven, eds., Completing the Eurozone Rescue: What More Needs to be Done? London: Centre for Economic Policy Research, pp. 49-53.

Salvatore, Dominick. 1997. “The Common Unresolved Problem with the EMS and EMU.”
American Economic Review 87(2): 224-226.

Schwartz, Pedro. 2004. The Euro as Politics. London: Institute of Economic Affairs, Research
Monograph 48.

Vanthoor, W. F. V. 1996. European Monetary Union since 1848: A Political and Historical
Analysis. Cheltenham: Edward Elgar.

1. With all the recent talk, much of it poorly informed, about the gold standard, I decided to post on SSRN a draft of my paper, "The Rise and Fall of the Gold Standard in the United States," written for an upcoming Hillsdale College Forum.

2. I'm asked, "What is Free Banking?," among other things, at an interview conducted at Guatemala's Francisco Marroquin University in the course of a celebration there last month of Milton Friedman's 100th birthday.

3. "Has the Fed Been a Failure?," in which Bill Lastrapes, Larry White and I do not find much reason to celebrate the approach of the Fed's 100th birthday, has been published online by the Journal of Macroeconomics (full view requires subscription).

I couldn't help being glad to see The Economist refer to Carl Menger's theory of the origins of money just as I was about to explain that theory to my undergraduate classes. Nor did I at all mind having Menger's ideas contrasted with those of another of my favorite economists, Charles Goodhart. I was, however, sorry to see that venerable publication, whose first two editors, James Wilson and Walter Bagehot, were among the more important 19th-century proponents of free banking, embrace Professor Goodhart's "Cartalist" theory of money, and do so on grounds that won't stand up to critical scrutiny.

Menger, of course, famously argued that commodity money, far from having to be deliberately designed, can evolve spontaneously or, as The Economist puts it, "is a market-led response to barter costs."

But while The Economist allows that Menger's account offers "a good description of how informal monies, such as those used by prisoners, originate," it claims that the theory comes up short when it comes to explaining the origins of the most convenient of all commodity monies: those consisting of precious metals. Why? Because metals only make for convenient money once they have been packaged into coins, and "history shows that minting developed not as a private-sector attempt to minimize the costs of trading, but as a government operation." Consequently, the article continues, "another theory is needed, in which the state plays a bigger role." Cartalism is one such theory, according to which money, and efficient money especially, is a creature of the state, which invented coins with the ulterior motive of enhancing its revenues by making taxes payable in them and by occasionally resorting to debasement.

But is it true that minting developed, and could only develop, as a government operation? Goodhart's article is supposed to offer proof that this was so, by pointing to two instances in which the collapse or withdrawal of government coinage gave way, not to private coinage but to barter (in the former Roman empire) or to the use of a non-metallic money (rice in 10th-century Japan).

One needn't be a logician to recognize the inherent shortcomings of such a "proof by example." That the withdrawal of state-run mints has sometimes failed to prompt the establishment of private ones hardly establishes that private mints have never existed, much less that they never could exist. One may, on the other hand, disprove the claim that private mints have never existed by means of a single, contradictory example.

As a matter of fact, there have been numerous episodes of private coinage, including some very successful ones. What's more, it is far from clear that the very first coins ever made--the famous electrum lumps of Lydia, in Asia Minor--were government products. On the contrary: according to Thomas Figueira, one of the leading experts on the subject today, “It is uncertain whether it was someone endowed with political authority acting on behalf of his community or an individual acting on his own behalf who conceived of the idea of coinage.” Indeed, no one is even sure what those early coins were for, or even whether they ought to be called "coins" at all, since they were uniform in weight alone, but varied considerably in their gold and silver blend.

Of course it's hardly likely than any Tom, Dick, or Harry would have been able to have his markings treated as credible certifications of weight or purity or anything else. Whoever made the first coins had to be some sort of big shot, or its corporate equivalent. Being a tyrant might suffice; but that hardly means that it was essential. Nor does the fact that almost every coin produced since the obscure beginnings of coinage has come from a government mint mean that only governments were fit to coin money. It could instead mean that governments found the fiscal gains to be had by monopolizing coinage too good to pass up. That governments frequently took advantage of their coinage monopolies, not to mint good coins, but to mint lousy ones that they then compelled their citizens to accept, would seem to favor the latter hypothesis.

It ought to go without saying that there is no technological reason why coins couldn't have been a private invention, or couldn't have been privately manufactured at any time to the same standards, if not better ones, than their government-made counterparts . "A mint, Sir" Edmund Burke once reminded Parliament, "is a manufacture, and it is nothing else." A factory, we would now say. And since when are governments very good at, let alone uniquely capable of, running factories? As for state-sponsored enterprises generally doing a better job of quality control than their private-sector counterparts, if you believe it I must see about coming up with a few tons of ca. 1958 Chinese steel to sell to you.

In fact, all of the most significant coinage-related inventions--the manual screw press and its steam-powered counterpart are only the most famous examples--came from the private sector, and most were taken up by governments only reluctantly and after (sometimes deadly) resistance from government mint authorities. How often, on the other hand, have government authorities themselves been responsible for technological breakthroughs? (No, Tang wasn't invented by NASA.) Were it to come to a wager, I for one would much sooner keep a grip on my money than stake it on Croesus or Pheidon or any other ancient king.

But why speculate? In fact, Goodhart's contrary suggestion notwithstanding, there have, as I've already noted, been occasions on which coinage was handled by the private sector, and in the best documented ones the coins that resulted were not only as good as but superior to those from the government's own mints. That was certainly the case in the U.S. after the Appalachian and Californian gold discoveries, when private mints sprung up to supply convenient coining services to miners who would otherwise have had to send their gold to Philadelphia or (after 1835) to either Philadelphia or Charlotte for coining. The high quality of the private gold coins produced during these episodes is attested to, both by the extant coins themselves, and by the fact that the U.S. Mint, having failed to put the West Coast mints out of business merely by finally opening a San Fransisco branch, relied instead on coercion to do the trick.

Another instance of successful private coinage is one with which Professor Goodhart is now familiar, though he didn't know of it in 1998, when he published the article to which The Economist refers. It is the episode of private token coinage in Great Britain that is the topic of my book, Good Money. Professor Goodhart did me the honor of writing that book's introduction. And although he makes clear there that the story I tell did not at all cause him to abandon Cartalism, I am sure that he would agree that it proves that, in at least one instance, the state's withdrawal from coining did in fact lead to private entrepreneurs rushing in to fill the void.

That private coiners didn't always or even often rush in whenever governments failed to supply coins is itself hardly surprising in light of the fact that unauthorized coining, even of coins not meant to imitate official ones, has almost always been illegal, and has more often than not been a capital crime. So the absence of acknowledged private mints following both the fall of Rome in the 5th century and the Japanese government's abandonment of copper coinage in the 10th might prove nothing more than that no one wanted, literally, to stick his neck out.

Might. Except for the fact that the claim that no private coinage took place in either of these instances doesn't seem to be true. I do not merely mean that there was surreptitious private coining, that is, counterfeiting: despite the death penalty Japanese copper coins were aggressively counterfeited. I mean that after the Japanese government got out of the business of making coins--after having, that is, debased its coins until they were more-or-less worthless--legitimate privately minted substitutes, manufactured by local clans and wealthy merchants, did in fact take their place, along with Chinese coins and (yes) rice. That, at least, is what it says on the website of the Bank of Japan's Currency Museum. Nor is it true that coinage simply gave way entirely to barter after Rome fell. No doubt it did so to some degree everywhere, and perhaps to a large degree in some places; but private coinage also took place, and did so notoriously in Merovingian Gaul, where thousands of local mints supplied coins modeled (sometimes crudely) on their Roman predecessors, and bearing the names of coiners very few of whom were known rulers. In short, it seems that, even as proofs by example go, those offered by The Economist are rather paltry.

Yet I suppose that we will never see the end of the myth that only governments are fit to coin money. Were bread a government monopoly long enough, Herbert Spencer once remarked, people would react with horror to the suggestion that it might instead be supplied, and supplied with better results, by the private sector. Spencer was probably right. I'm just glad I'll never live to see The Economist prove it.

For an upcoming conference I've been writing a brief history of the gold standard in the United States. So naturally I've been reading or re-reading books on the subject, both new and old, and discovering or rediscovering their merits. My overarching discovery is, not to put too fine a point on it, that almost all of the newer books are a great bore, and none too informative at that.

Why is that so? A clue is that these books are all written by academics, and mainly by academic economists and historians, whereas at least some older ones were written by amateurs, which is to say, by people who considered writing itself their craft, and who had no reason to expect their books to be purchased and read if the books weren't reasonably entertaining as well as informative. But even the older books by academics aren't so bad. It's only relatively recent academic books (which for me means ones written during the last twenty years or so) that are almost uniformly godawful. And the reason for this, I suddenly realized, is that the real subject of recent academic books is, not the subject their titles advertize, but the books themselves.

To be clear: if the title of a modern academic book is "The History [or theory or whatever] of X," the real subject is "My book on the History [or whatever] of X." Such books are, in other words, not so much contributions to history or economics or whatever as they are exercises in literary criticism where the critic just happens, conveniently, to be the author of the book under appraisal, or (more accurately) the would-be author of the "urbook" that the actual book appraises, which urbook has not actually been written, and generally never can be, because if it were it would be an article rather than a book, and most likely a trite or banal article at that.

Once you realize what most academic books today are about, recognizing one of this sort is a piece of cake. You might, of course, infer that you're reading one from the fact that, as you slog through it, you don't seem to learn much at all about X, and so are tempted to skip, first paragraphs, then pages, and finally entire chapters in the hope or finding the place where the author gets to the point. What's more you may never find that place, or it may prove so fleeting that you skip past it. That of course shouldn't happen if the book you are reading really is about X; but if the book is really a critique of a book about X, what you are looking for, without realizing it, is what critics sometimes disparagingly call a "plot summary"--disparagingly because it's the sort of thing one finds in mere book "reviews" rather than in works of "higher" criticism; and academics' criticism of their own urbooks strives to be nothing if not "high."

But as the test above, besides being painful to administer, doesn't distinguish the true academic book-about-itself from a merely thoroughly bad book about X, there are other, surer clues to look for. These include endless throat-clearing introductory materials, announcing over and over again the book's "purpose" and telling how the author intends to go about achieving it ("though maybe not just yet," an honest author might add), followed by a no less endless disquisition on how the book's arguments differ importantly--really!--from those to be found in other (also academic) books, followed at last by concluding chapters saying more or less the same thing as the introductory ones, only tossing in a little sprig of "told you so!" triumphalism.

Imagine, for a still clearer picture, a great, classic work that really is about X. Once upon a time, though far less often today, a genuine critical undertaking might have consisted of the preparation of a new edition of the work, undertaken not by the (usually deceased) author but by an editor well-versed in the whole literature on the subject. That editor might author a lengthy introduction to the new edition, and numerous footnoted commentaries on the text, some perhaps rather arcane, and an explanatory appendix or two.

Well, your modern academic book writer erects the same sort of critical scaffolding, but does it, not for someone else's book, but for a 'classic' that exists only in his own head. He then serves up the scaffolding alone, packaged to look just like the imagined classic, much as the scaffolds one occasionally sees around Baroque buildings in Europe are disguised by tromp l'oeil curtains meant to fool people into mistaking them for the buildings themselves. The difference is that those tromp l'oeil-curtained scaffoldings disguise a real work in progress, whereas the academic equivalent surrounds so much hot air.

In June, 2010 the Cobden Centre in London released a report on "Public Attitudes on Banking," based on a questionnaire to which 2000 Britons responded. The findings of that report have since been offered, both by the Cobden Centre itself and by others, as proof that many people today believe that banks store rather than lend money surrendered to them in exchange for deposits payable on demand.

This week, for instance, a blogger named James Miller (whose article appears as well at Mises.ca and ZeroHedge, among other sites) wrote:

[U]sually depositors don’t fully realize that their funds are not really there in whole. In a 2010 study commissioned by The Cobden Center, it was found that 74% of U.K. residents polled believed they were the legal owners of their banking deposits. And while 61% answered that they wouldn’t mind if their money was used for additional lending, 67% responded that they wanted convenient access to what they saw as their money. Whether or not one regards fractional reserve banking as a clear case of fraud, it seems that a good portion of the public is wrongly informed on the mechanics of modern day banking.

But as even a careful reading of Miller's own summary of it should make clear, whatever else the Cobden survey may demonstrate, it most certainly does not demonstrate that most depositors think that the money they hand over to banks sits in the banks' vaults (or perhaps in those of a central bank) until some or all of it is either withdrawn or transferred to specific others by order of the original depositors.

Unless the questions they pose are chosen very carefully, survey results can easily mislead, and are indeed sometimes designed precisely with that end in mind. That isn't to say that the Cobden survey was intended to mislead--I am in fact inclined to believe that it wasn't. But it misleads nonetheless, thanks to the utter ambiguity of several of the questions it poses.

Consider the first survey question: "Why do you keep some of your money in a current account?" 15% of respondents answered "For safekeeping" and 67% answered "For convenient access," while only 10% answered "Because it earns interest." The predominance of the first two replies over the third might appear to suggest that most people suppose that their money is being stored. But the responses may be just as readily interpreted to mean that they consider fractionally-backed deposits to be both more convenient and safer than cash kept on one's person, at home, or in a cash register. Indeed, in these days of deposit insurance, it is hard to see why anyone concerned with safety, even exclusive of other considerations, would hesitate to prefer a fully-insured demand deposit balance to cash, while being perfectly indifferent to the dangers stemming from the lending of "their" deposits.

In reply to the survey's second question, "Who do you think owns the money in your current account(s)?", 74% answered "The account holder," while only 8% said "The bank." Another 20% answered, "Both the bank and the account holder." Proof that many British bank depositors don't know what their banks are about? Hardly. The responses instead prove nothing more than that the question posed can be interpreted in two different ways, depending on the meaning given to the word "money." Cobden Centre types, steeped in Austrian monetary economics, may insist that "money" ought to mean what others call "base" or "high-powered" money; but the fact remains that for most people, including most economists, a fractionally-backed bank deposit or note is itself "money." The latter, more common usage is implicit in standard working measures of national money stocks such as M1, M2, and so forth.

So, who owns the "money" in someone's current account? Well, it is in fact owned by the account holder, or by the bankers, or by both depending on how money is defined. If "money" is taken to mean "base money," than when someone accepts a demand-deposit credit from a banker in exchange for "money," that person surrenders ownership of the "money" to the banker, while becoming the owner of a deposit credit--a claim against the bank--of the same nominal value as the surrendered sum. But now suppose that by "money" we mean money in the broader sense, including demandable bankers' IOUs. By this definition, of course, the depositor continues to "own" the deposited sum, because instead of merely surrendering ownership to "money" he must now be understood to have merely exchanged one kind of money for another. The banker now owns the surrendered base money, while the depositor owns broad money consisting of a redeemable deposit balance. It thus follows that all of the respondents to the survey question, including the 2% who said "I don't know," may have been perfectly well informed of what their banks were up to, differing only in their interpretation of the question, or in the extent to which they were (understandably) baffled by it.

The survey's third question is equally ill-posed. It asks respondents to say what percentage of their current accounts is (1) held as reserves; (2) lent; (3) used to speculate on financial derivatives. That 66% answered "I don't know" is surprising only because one would expect the percentage replying so to such a question, calling as it does for a specific magnitude of which even many expert economists must have been unaware, while posing as alternatives two possibilities that are not in fact mutually exclusive (money might be simultaneously "lent" and "used to speculate on financial derivatives"), to have been closer to 100! The response proves, in any event, that at least two-thirds of those surveyed were not convinced that their "deposits" were fully backed by reserves.

Oddly, we are not given (as we are with regard to the other questions) a breakdown of the other responses to question 3, and so cannot say more than this. But it is at least possible that none of the 2000 respondents actually believed that his or her current account was backed 100% by reserves. If anything, the fact that we are not told what percentage of those surveyed answered this key question in accordance with the presuppositions of the anti-FR crowd ought to lead one to suspect that the percentage was in fact very low. Survey question 4, however, asks respondents to indicate "how they feel" about their banks making loans using current account deposits, and finds that 33% think the practice wrong because "they have not given [their bankers] permission to do so." Thus support appears to be given to the upper-bound ignorance quotient of 2/3.

But here once again the question is ill-conceived, not to be sure because it is ambiguous, but because it is what survey designers call a "suggestive" question, and as such one that nudges respondents in a particular direction. The question, in full as it appears in the report, reads as follows:

You may or may not have been previously aware that banks lend out some of the money deposited within current accounts by their customers to fund loans [sic]. Which of the following best describes how do [sic] you feel about the fact that your bank lends out some of the money in your account as loans [sic]?

The subtle, implicit suggestion here, perhaps unintended, is that banks are not systematically informing their customers about what they do (so that customers "may or may not" be aware of it), and that their conduct is such as might be expected to arouse some definite "feelings" among those customers.

If you doubt that the manner in which the question is posed favors the most-frequently offered response--that is, if you doubt that the question is such as tends to favor expressions of dismay regarding what bankers' regard as business as usual--imagine getting the following message in your voicemail, where the words indicated by **** are inaudible: "Hello. You may not be aware of it, but **** has been **** your ****. How do you feel about that?" Forced to say either "fine" or otherwise, I venture to guess that you'd admit that such a message leaves you "feeling" like someone who has been decidedly, albeit mysteriously, snookered.

Addendum (August 4 at 5:05PM): I had not bothered to comment on the Cobden survey's fifth and final question, because I found it so loopy that I hardly knew where to begin. I ought to have observed, nonetheless, that 26% of those surveyed responded to it by choosing, of several alternatives, the one that said "We should ensure that banks keep reserves equal to 100% of deposits." Would the respondents have made the same choice had the response in question been lengthened by adding the words "while allowing them to collect from us annual fees of somewhere between 5% and 10% of our average balances"? Unless Cobden redoes the survey, I suppose we'll never know.