Free Banking 

I interviewed Prof. Hugh Rockoff of Rutgers University for the latest installment of the Econ Journal Watch Audio podcast. We chat about his research on episodes of lightly regulated banking, and his take on others' research. Along the way we discuss Milton Friedman's views on free banking, and the recent banking debacle in Cyprus.
Listen or download here.

I have a book review now up on reason.com of Bernard Lietaer and Jacqui Dunne's Rethinking Money: How New Currencies Turn Scarcity Into Prosperity. I wanted to like the book more, because I too like alternative currencies. Unfortunately Lietaer and Dunne make some very crankish arguments, suggesting that the phenomenon of a positive interest rate creates problems for the economy, and that a proliferation of free currencies will ameliorate those problems.

Scott Sumner told us in September 2009 that "the real problem was nominal," that is, the recession and its high unemployment were primarily due to an unsatisfied excess demand for money (combined with real effects on debt burdens of nominal income being below its previous path). In AS-AD terms, the AD curve (representing combinations of M times V equal to a given level of nominal income Py) had shifted inward, and the economy was sliding down the SR aggregate supply curve. The price level had not yet adjusted enough to clear the market of unsold goods corresponding to deficient money balances. This was a reasonable – almost inescapable – diagnosis in 2009, when the price level and real income were both falling.

Market Monetarists who have been celebrating the Fed’s recent announcement of open-ended monetary expansion ("QE3') seem to believe that Sumner’s 2009 diagnosis still applies. But what is the evidence for believing that there is still, three years later, an unsatisfied excess demand for money? Today (September 2012 over September 2011) real income is growing at around 2% per year, and the price index (GDP deflator) is rising at around 2%. If the evidence for thinking that there is still an unsatisfied excess demand for money is simply that we’re having a weak recovery, then as Eli Dourado has pointed out, this is assuming what needs to be proved. Dourado writes (I take his “in the short run” to mean “in a situation of unsatisfied excess demand for money”):

So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment, but even if unemployment is cyclical, it doesn’t mean that monetary adjustment has failed to occur—real sector recalculation may just take longer than monetary recalculation.

… If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

While saluting Sumner 2009, like Dourado I favor an alternative view of 2012: the weak recovery today has more to do with difficulties of real adjustment. The nominal-problems-only diagnosis ignores real malinvestments during the housing boom that have permanently lowered our potential real GDP path. It also ignores the possibility that the “natural” rate of unemployment has been hiked by the extension of unemployment benefits. And it ignores the depressing effect of increased regime uncertainty.
To prefer 5% to the current 4% nominal GDP growth going forward, and a fortiori to ask for a burst of money creation to get us back to the previous 5% bubble path, is to ask for chronically higher monetary expansion and inflation that will do more harm than good.

The European Central Bank yesterday, in the words of The Washington Post, "announced that it would buy the bonds of struggling governments without limit" (emphasis added). But that can really only mean “without an announced limit.” There is an implicit limit so long as ECB sticks to its also-announced promise to neutralize the monetary-base-expanding effects of its struggling-government bond purchases by selling, euro for euro, other bonds from its portfolio, because its current portfolio is finite and only some of it is not already struggling-government debt. It is difficult to discover exactly what this implicit limit is in billions of euros.

The Eurosystem (the ECB plus the eurozone’s national central banks) can purchase bonds of the struggling GIPSI (Greece, Ireland, Portugal, Spain, or Italy) governments in two ways: directly, or indirectly by making additional loans to commercial banks that purchase GIPSI bonds (and collateralize said loans with said bonds). To sterilize purchases of either kind, the ECB will have to sell its non-GIPSI bonds (or shrink its loans to banks collateralized by non-GIPSI bonds). The Eurosystem’s reported balance sheet shows €3085 b in total assets. It does not reveal what percentage of its current assets are in GIPSI sovereign debts and GIPSI-collateralized loans. We can assume that the €279b of securities acquired under the ECB’s two “covered bond purchase programmes” consists entirely of GIPSI bonds. For the sake of argument let’s assume that gold assets (€434b) and foreign-currency assets (€312b) won’t be touched. We can break the largest asset category, “Lending to euro area credit institutions related to monetary policy operations denominated in euro” into two parts: what was on the balance sheet two years ago (€592b) and what’s been added in the last two years (€618b). Assume that half of the former and one-fourth of the latter is neither GIPSI debt nor the debt of borderline-struggling sovereigns like France and Belgium, but is debt that could be sold for sterilization purposes. That gives us a total of €450b as the upper limit of ECB purchases of the bonds of struggling governments under a policy of full sterilization.

This number is purely a guesstimate. But it probably isn’t off by a factor of two. If the ECB finds itself wanting to make €1000b of GIPSI bond purchases, it is clear that the ECB will have to switch from sterilization to some other strategy for keeping M2 from ballooning, like the Fed’s QE1 strategy of paying higher interest on reserves. Note that the ECB is already paying interest on reserves, and has been since its beginning, whereas the Fed started at zero.

For as long as it lasts, sterilization means that as the ECB buys more GIPSI sovereign debt, it will be shrinking Eurosystem credit to other borrowers, namely to private borrowers and to less-irresponsible sovereign borrowers. Starve the productive and the relatively prudent to lend to the unproductive and imprudent. That is not what anyone could consider a prudent mix of Eurosystem assets, nor a promising way to promote economic growth.

Here is a link to video of Ron Paul's subcommittee hearing Thursday on fractional reserve banking. Below it is the text of my written statement.

Hearing June 28 2012 Fractional Reserve Banking

Statement of
Lawrence H. White
Professor of Economics, George Mason University
before the
House Subcommittee on Domestic Monetary Policy and Technology
United States House of Representatives
June 28, 2011

Chairman Paul and members of the subcommittee: Thank you for the opportunity to discuss the fractional-reserve character of modern banking, its positives and negatives, its relationship to financial instability, and to offer my thoughts on how to promote greater banking stability. I will begin by describing the historical origins of fractional-reserve banking (hereafter FRB), then move on to the effect of FRB on the money supply process, its connection to bank runs and financial instability, and finally the reforms needed to improve our banking system.

The origins of fractional reserve banking

A “bank” is a firm that both gathers funds by taking in “deposits” (or creating account balances) and makes loans with the funds gathered. A moneylender who draws only on his own wealth is not a banker, nor is a warehouseman who does not lend. A “deposit,” in ordinary modern usage, is a debt claim, an IOU issued by the banker and held by the “depositor,” which the banker is obliged to repay according to the terms of the contract. We can distinguish between a “time deposit,” which the banker is obliged to repay only at a specified date in the future, and a “demand deposit,” which gives the customer the legal right to repayment “on demand,” that is, whenever the customer chooses (on any day the bank is open).

Historically, deposit-taking grew out of the coin-changing and safekeeping businesses. Medieval Italian money-changers would (for a fee) swap coins from one city for those from another. Some traveling merchants, who brought in coins of one type, would chose to hold balances “on account” for the time being, preferring to receive coins of another type later when it was more convenient. The earliest deposit-takers in London were goldsmiths, artisans who made gold jewelry and candlesticks, who were also coin-changers. Like the Italian coin-changers, they provided safe-keeping in the vaults where they kept their own silver and gold.
A key to the development of fractional-reserve banking was that vault-keepers (money-changers and goldsmiths) began to provide payment services by deposit transfer. The earliest record of payment by deposit transfer is from Italy around 1200 AD. Before deposits became transferable, suppose Alphonso wanted to pay (say) 100 ounces of coined silver to Bartolomeo, both of them customers of the same vault-keeper. Al would go to the vault-keeper, have him weigh out the requisite amount of coins, and transport the coins to Bart, who would then have to transport the coins back to the vault-keeper to have them weighed again and placed back in the vault. There was great inconvenience, not to say risk, in transporting the coins across town and back. And there were fees to pay for weighing the coins. At the end of the day, Al’s account balance or claim on the vault-keeper would be down by 100 ounces (plus transaction fees), and Bart’s would be up by 100 ounces (minus transaction fees).

A less burdensome and safer way to accomplish such a payment was for Al and Bart to meet at the bank, and simply tell the banker to transfer 100 ounces on his books by writing Al’s account balance down and Bart’s up. No coins had to be weighed or moved, or even touched at all. Payment was now made not by handing over coins, but by handing over claims to coins.

Other methods for authorizing deposit transfer were often more convenient and soon displaced the three-party meeting in the banker’s office. For example, Al could sign a written authorization, what we now call a check. Today we have electronic funds transfer, but all of these methods accomplish the same end, which is to make a transfer funds from one account to another.

Some of the earliest deposit-taking was simple warehousing, in which the coins deposited were merely stored, and the exact same coins would be returned to the depositor on demand assuming all storage fees had been paid. (In legal parlance such a claim on the warehouseman is a “bailment” and not a debt.) In the early Middle Ages a customer who wanted this kind of storage would bring the coins to the vault in a sealed bag. The bag was not to be opened by the warehouseman. For each specific bag of coins that could be claimed by Al or Bart, those specific bag of coins were always in the vault. Supposing that the bags’ contents were recorded on the books (which they need not have been), we could say that for each ounce of coined silver claimed by depositors there was always an ounce of coined silver in the vault. This arrangement, which resembles the business today of renting safety deposit boxes, is sometimes described as “100 percent reserve banking,” although strictly speaking it isn’t banking at all, but simply warehousing.
As payment by deposit transfer became popular, goldsmiths and coin-changers found that they could offer a different kind of contract to customers who primarily wanted not storage but economical payment services. In a “fractional reserve” contract, the vault-keeper becomes a banker, able to lend out some of the funds deposited. In the early Middle Ages a customer who wanted this kind of account would bring loose coins to the vault. The coins could be mingled with other depositors’ coins, whereas in money warehousing there is no evident rationale for mingling. The customer would receive a redeemable claim, entitling him to get back equivalent coins on demand, but not to receive back the identical coins he brought in. The account is now a debt claim and not a bailment. Now the coins in the vault are a fraction of immediately demandable deposits. We can describe them as a reserve for meeting the redemption claims that will actually be made.

Later, beginning perhaps in the 1400s, banks began to issue deposit receipts that could be signed over, making them something like traveler’s checks today. For their customers’ convenience, they soon provided them in bearer form (no signing-over necessary) and round denominations. These we call banknotes, paper currency claims on banks that were payable to the bearer (whoever presented them), typically on demand. As currency, they could be transferable anonymously, and without bank involvement (unlike deposits transfers, which need to be recorded on the books). London goldsmiths were issuing banknotes in the mid-1600s. Banks also held fractional reserves against the total of their banknote liabilities.

When is a fractional reserve feasible?

For a unique or specific coin, which the customer wants to have back, it isn’t. A specific coin lent cannot be instantly recalled from the borrower who has spent it. But for coins that customers regard as interchangeable with other coins, it is. Likewise, you count on a coat check stand to keep your specific coat there all evening, and not to lend it out, because you don’t want back just any coat of the same size. Unlike coat-checkers, most depositors are willing to treat coins as interchangeable. Depositors do not insist on getting the very same coins back, so any equivalent coin in reserve will be satisfactory.

To avoid defaulting, or breaching the contractual obligation to repay, the bank obviously needs to keep enough coins in reserve. How can the bank count on having enough coins to meet all requests? It is a matter of practical calculation: the bank needs to know from experience the probability of any given amount of coins being demand on a given day. If it wants to be 99.99% safe, it needs to hold a reserve (or have ways of replenishing its reserves) sufficient to cover 99.99% of cases.

The economist Ludwig von Mises offered the following illustration. Consider a baker who issues 100 tokens, each stamped “good for one loaf of bread.” Leaving aside lost tokens, it is clear that the baker will need 100 loaves. All the tokens will be redeemed, because using them to get bread is their only use. By contrast, transferable claims to coin (bank deposits or banknotes) are useful even without being redeemed. Unlike bread tokens, which cannot be eaten with butter and jam, transferable bank accounts or banknotes can do the job of the coins in making payments. Once payment by deposit transfer and banknote becomes popular, the banker will reliably find that not all deposits notes or deposits are redeemed for coins on a given day, even if all are used to make payments. Thus a banker who issues $100 in demand deposits or notes will need less than $100 in coin to meet all the redemptions that will actually be demanded.

How much less than 100% the banker can hold, and still meet all the redemption demands that he does face, is a problem that the banker must solve by practical statistical calculation. There is no reason to think that a central authority can do the calculation better, and can improve matters by imposing an arbitrary percentage requirement. To provide the right incentive to hold enough reserves, it is important that the imprudent banker who miscalculates, holds too little in reserves, and fails to pay when obligated to pay, be subject to the ordinary legal penalties for breach of contract.

Advantages and disadvantages of fractional reserves

The advantage to the bank from keeping fractional reserves is clear: it earns interest on the lent-out funds. A few commentators have declared that FRB must be a fraud: the gain is all on the bank’s side, and no customer would agree to it if she realized what the bank was up to. But this claim assumes that there are no advantages to the bank’s customers. In fact there are clear advantages to the bank’s customers, at least under competition. To compete for customers, all experience shows, banks offering fractional-reserve accounts charge zero storage fees and even pay interest on deposits, up to point where the interest they pay falls short of the interest they earn only by just enough to cover the bank’s operating costs for safekeeping and payment services. In this way FRB creates a synergy between payments services (checkable deposits, banknotes) and intermediation (pooling savers’ funds for lending to selected borrowers). When the deposited funds that are not needed as reserves can be lent out, depositors enjoy lower (or zero) storage fees and interest on checking deposit balances.

By contrast to money warehousing, the savings of fractional-reserve banking do carry a disadvantage in the form of greater default risk. If the bank’s investments go sour, the depositor may not be repaid in full. The warehouse, by contrast, makes no investments. So the customer choosing between a bank account contract and a warehousing contract needs to consider: is the saving in storage fees and the interest paid on deposits high enough (relative to the increased risk of not being paid promptly)? Historically, in competitive systems where banks were free to diversify and capitalize themselves well, the answer was yes for most people. Thus well informed consumers who want economical payment services typically prefer a fractional-reserve bank to a warehouse. In sound banking systems historically, before deposit insurance, the risk of loss was a small fraction of one percent, while the interest was more than one percent, and the sum of interest and storage fee savings was even higher. Thus FRB can arise and survive without fraud.
The economist George Selgin has examined the record of the London goldsmith bankers, and debunked the myth that they pulled a fraudulent switcheroo, promising 100% reserves but holding less, at the beginning of the practice of FRB. Goldsmith bank accounts became enormously popular in the mid-1600s because they offered interest on demand deposits. The offer of interest is a clear signal that the contract is not a warehousing contract.

For payment by account transfer, FRB offers a more economic way of providing payment services. A money warehouse or 100% reserve institution could also offer payments by account transfer, but its services would be significantly more expensive. The other bank payment instrument, redeemable banknotes circulating in round denominations, simply cannot exist without fractional reserves. Banknotes are feasible for a fractional-reserve bank because the bank doesn’t need to assess storage fees to cover its costs. It can let the notes can circulate anonymously and at face value, unencumbered by fees, and cover its costs by interest income. An issuer of circulating 100% reserve notes would need to assess storage fees on someone, but would be unable to assess them on unknown note-holders. There are no known historical examples of circulating 100% reserve notes unemcumbered by storage fees.

Under a gold or silver standard, the introduction and public acceptance of fractionally backed demand deposits and banknotes means that the economy needs less gold or silver in its vaults to supply the quantity of money balances (commonly accepted media of exchange) that the public wants to hold. Thus money is supplied at a lower resource cost, that is, with less labor and capital devoted to mining or importing precious metals and fashioning them into coins or bars. Looking at the change in balance sheets from money warehouses to fractional reserve banks, the economy can now fund productive enterprises where before it only held metal. Gold can be exported, and productive machinery imported. This development in Scotland was praised by Adam Smith as a source of his country’s economic growth. As the economist Ludwig von Mises put it, “Fiduciary media [fractionally backed demand deposits and banknotes] … enrich both the person that issues them and the community that employs them."

Under a fiat money standard, as we have today with the Federal Reserve dollar, things are different. There are no mining or minting costs saved by holding fractional rather than 100% reserves in the form of fiat money. For commercial banks to hold 100% reserves in the form of fiat money issued by the federal government would, however, change drastically the function of the banks. Instead of funding productive enterprises, the banks would instead only fund the federal government. Fewer loanable funds would be available to the private economy, and more to the government. Private investment would be suppressed, and public spending enlarged.

The effect of FRB on the money supply process

With banks holding fractional reserves of Federal Reserve dollars (notes and deposit claims on the books of the Fed, whose sum is called “the monetary base”), when the Fed increases the quantity of Federal Reserve dollars by $1 billion, the banking system ordinarily creates a multiple amount of deposit dollars. The total stock of money held by the public (“M1”) increases, say by $2.3 billion. At the moment, however, we are in an anomalous situation. Banks are sitting on such vast quantities of excess reserves – paid to do so by the Federal Reserve as it pays a relative high interest rate on reserves – that the monetary base is larger than M1. Thus the US banking system today actually has more than 100% reserves against its demand deposits.

The problems of financial instability, bank runs, and crises

Perhaps the leading leading argument made in favor of government regulation of banks is the argument claiming that a fractional-reserve banking system is inherently fragile and so needs deposit insurance. The argument rests on three underlying propositions:
(a) An uninsured fractional-reserve banking system is inherently prone to runs and (due to “contagion”) panics. (A run means that many depositors seek to withdraw at the same time, out of fear of a reduced payoff if they wait. A panic means that many banks suffer runs at the same time.)
(b) Runs and panics have net harmful effects.
(c) Deposit insurance can reduce runs and panics below their laissez-faire level at a cost less than the benefit of doing so.

My research into banking history convinces me that (a) and (c) are actually false, and even proposition (b) requires some qualification.

A run is always possible against fractionally backed bank deposits that are unconditionally redeemable on demand. Against such deposits, a run can even, in theory, be self justifying: if a run forces the bank to conduct a hasty sale of illiquid assets, the bank may receive such a reduced value for its assets that it becomes insolvent (liabilities exceed assets), so that all depositors can no longer be paid in full. From this theoretical possibility, some economic theorists have jumped to the conclusion that fractional-reserve banks are in practice inherently run-prone. (The best known statement is a 1983 article by Douglas Diamond and Phillip Dybvig.) According to this view, a run can happen at any time, in any place, on any bank, triggered by nothing more than random fears or events that have no basis in the target bank’s solidity.
But are real-world deposit contracts so fragile? Historical evidence says no. Please consider: If real-world deposit contracts really were as fragile as the self-justifying-run theory supposes, it would be a mystery how they survived centuries of Darwinian banking competition before the first government deposit insurance schemes began. Wouldn’t a more robust arrangement have come to dominate the field?

The theory of runs that better fits the historical record is that runs occur, not randomly, but when depositors receive bad news indicating that their bank might be already (pre-run) insolvent. Receiving such news, depositors run because if assets are already be too small to pay all depositors back, the last in line get little or nothing. Unlike the self-justifying-run theory, the bad-news theory explains why runs typically occurred at onset of recessions (when bad news arrived about the banks’ borrowers declaring bankruptcy), and explains why countries that did not weaken their banks with legal restrictions (e.g. Scotland, Canada) very seldom experienced runs and almost never panics.

What makes a deposit contract run prone? Assume that depositors are rational. There must be a greater expected payoff to arriving sooner rather than later to redeem one’s deposit. This implies that the deposit is unconditionally redeemable on demand (and that the bank pays on a first-come-first-served basis), and that default is likely on last claim serviced. To make an account non-run-prone it suffices to modify either one of these two conditions. First, the deposit contract can make redemption conditional rather than unconditional. An important historical example was the “notice of withdrawal clause” that many savings banks and trust companies included in their deposit contracts. If withdrawals were too great for a bank to satisfy without suffering severe losses from hasty asset liquidation, the banker had the option to defer redemption for 60 or 90 days by requiring notice of intent to withdraw to be given that far in advance.

More importantly, banks made default unlikely by providing their depositors with credible assurances that the bank would maintain solvency, that is, assets sufficient to pay in full even the last in line, even under adverse circumstance. To provide credible assurance, banks before deposit insurance held much higher capital than they do today, in the neighborhood of 20%. They invested much more conservatively, so that they faced much less risk of large asset losses. They avoided loans with high default risk, high risk of loss from interest-rate movements, and loans that were illiquid (hard to resell). Banks that relied on demand deposits and banknotes did not make long-term fixed-rate housing loans, for example. They invested primarily in short-term, high-quality, liquid business IOUs, what were then called “bills of exchange” and is today called “commercial paper.” In some countries, banks had an additional backstop in the form of the right to call for more capital from their shareholders if otherwise depositors would go unpaid. Shareholders had extended liability, and in some systems unlimited liability, for the bank’s debts.

The historical record does of course indicate that runs and banking panics were a problem in United States during the pre-Fed or “National Banking” era (1863 1913), and also under the Fed’s watch during the early years of the Great Depression. But few other countries have had similar experiences. It is therefore clear that run-proneness and panics are not inherent to fractional-reserve banking. If we look for a pattern across countries, this is what we find: countries like Canada, Scotland, Sweden, and Switzerland, where the banking systems had no more than minimal restrictions on entry, note-issue, branching, and capitalization, had virtually no problem from runs and none from panics, in contrast to the more restricted and hence weaker banking systems of the United States and England.

The US banking system was made fragile by the federal and state ban on interstate branching, and even branching within many states. Branch banking limits reduced diversification of assets and deposit sources, indirectly limited capitalization, and hampered the effective allocation of reserves. Poorly diversified and poorly capitalized banks could not offer credible solvency assurances, which made them more vulnerable to “bad news” runs.

The US system was also made fragile by federal restrictions on banknote issue that prevented banks from meeting peak demands for currency. Because of those restrictions, seasonal demands for currency became scrambles for reserve money that occasionally escalated into panics.

Reforms to strengthen our banking system

The weakness in the US banking system today stems from a different set of government policies than the ban on branching (eroded in the 1980s and finally eliminated in 1995) and restriction on banknote issue (commercial banks stopped being allowed to issue any notes in the 1930s). Today the weakness is due not to restrictions, but to privileges. One indication of that is that the weakest banks today are not the smallest, but the largest banking companies.

Federal deposit insurance, since its birth in the 1930s, has meant that a comparatively risky bank (one with capital less adequate to cover potential losses on its asset portfolio) no longer faces a penalty in the market for retail deposits. Insured depositors have no incentive to shop around for a safe bank, so they no longer demand a higher interest rate to give it their deposits. Risk-taking is thereby effectively subsidized. Attempts to price deposit insurance according to risk, so as to recreate a penalty for holding on a risk bank portfolio, were mandated by the FDIC improvement act, but the attempt has failed. The FDIC insurance fund has been exhausted by bank failures, and now has a negative balance. Taxpayers are on the hook for the morally hazardous banking that the FDIC has fostered. Some way of rolling back and ultimately ending federal deposit insurance must be found.

The “too big to fail” doctrine compounds the problem. It gives even blanket protection even to a bank’s legally uninsured depositors and subordinated debt holders, removing their incentive to shop around for a prudently managed bank. “Too big to fail” treatment went from the exceptional event to the routine event during the last five years, as the Federal Reserve and the FDIC have deliberately declined to close several large insolvent banks. If no large bank is ever allowed to fail, then large depositors flock to the large banks that have the privilege of an implicit guarantee for all. On such a tilted playing field, an unnaturally large a share of deposits flows into the largest banks. We are already there. Some way of ending “too big to fail” must be found – quickly.

Conclusion

The evidence shows that a fractional-reserve banking system is not unstable when the banking system is free of hobbling legal restrictions and free of privileges. The US banking system in the 19th century was weakened by legal restrictions. In response to that weakness, rather than let the banking system become robust by repealing its restrictions, Congress in the 20th century patched over the problem by creating the Federal Reserve system (to act a “lender of last resort”) and federal deposit insurance. As a result, the US banking system in the 21st century is chronically weakened by government privileges (especially taxpayer-backed deposit insurance and taxpayer-backed “too big to fail” bailouts) that generate moral hazard. Banks take advantage of these guarantees by holding asset portfolios too full of default risk and interest-rate risk. They finance their portfolios with excess leverage (too much debt, not enough equity). Rather than trying to come up with another patch, Congress should seek to dismantle the restrictions and the privileges that have left the American people saddled with an unhealthy banking system.

Presented at the Cato Institute Annual Monetary Conference, 16 November 2011

Suppose for the sake of argument that we all agree to the following proposition: If we could change the monetary regime with zero switching cost, merely by snapping our fingers, we would prefer the US to be on a gold standard. In the most general terms a gold standard means a monetary system in which a standard mass (so many grams or ounces) of pure gold defines the unit of account, and standardized pieces of gold serve as the ultimate media of redemption. Currency notes, checks, and electronic funds transfers are all denominated in gold and are redeemable claims to gold.[1] The question then arises: What would be the least costly way for the United States to make the transition to a new gold standard? We need to choose a low-cost method to insure that the agreed benefits of being on the gold standard exceed the costs of switching over.

Two transitional paths suggest themselves. (1) One path is to let a parallel gold standard grow up alongside the current fiat dollar. (2) The more conventional path, as followed after the suspension of the gold standard during the US Civil War, is to set a date after which the US dollar is to be meaningfully defined as so many grams of pure gold. Or as it is more commonly put, an effective parity is established stipulating so many dollars per fine troy ounce of gold. In our present situation, where Federal Reserve liabilities (book entries and currency notes) and Treasury coins constitute the basic dollar media of redemption, that implies converting the Federal Reserve System’s liabilities and the Treasury’s coins into gold-redeemable claims at so many grams of gold per dollar (or equivalently so many dollars per ounce of gold).

We see analogs to these two transitional paths when we observe how peso-using countries have made the transition to using the US dollar. In Ecuador in 1998-2000, a parallel unofficial US dollar system emerged as the annual inflation rate in the local currency rose from low to high double-digits, then to triple-digits. The private sector of the economy was already heavily dollarized when the plug was finally pulled on the heavily depreciated local currency unit in 2000. In El Salvador in 2001, the government chose to permanently lock in the dollar value of the currency—by switching from a dollar-pegged exchange rate to outright adoption of the US dollar—while inflation was low and the local currency still dominant. In a nutshell, when the official switch to the harder currency came in Ecuador, it was an act of necessity in the midst of a hyperinflation crisis. In El Salvador it was an act of foresight, to rule out such a crisis.

Allowing a parallel gold standard

Clearing away the legal barriers to a parallel gold standard is fairly simple and can be done without immediately altering existing financial institutions. Rep. Ron Paul’s HR1098, the Free Competition in Currency Act of 2011, represents one straightforward approach. It would (1) ensure the enforceability of contracts denominated in units other than fiat dollars be removing legal tender status from Federal Reserve notes and Treasury coins, (2) remove taxes on gold and silver coins that FR notes do not face, and (3) remove sections of the US Code that have been used to criminalize the victimless activity of privately minting distinctive private pieces of metal intended to circulate as money.[2] If these steps seem unprecedented, note that Federal Reserve Notes did not become legal tender until 1933. Bank of England notes are not legal tender today in Scotland or Northern Ireland, where private banknotes (also not legal tender) predominate. Note also that in Switzerland “the purchase and sale of Gold is not subject to taxes (such as value-added tax or capital gains tax) under current Swiss law.” [3]

Further legal and regulatory changes are necessary to allow citizens who adopt the parallel gold standard to have access to gold-denominated banking services. Banking services, including the issue of gold-redeemable paper currency notes and token coins, are of special importance for the success of a gold standard given the awkwardness of making small transactions in physical gold coins. Either existing bank holding companies would have to be free to operate separate gold-denominated subsidiaries, or new gold-based institutions would have to be free to open.

The case for a level playing field between the fiat dollar and other monetary standards rests on the simple fact that the well-being of consumers is better served by competition than by monopoly. Keeping alternatives to fiat dollar at a legal disadvantage, like silver- and gold-backed bank-issued monies, or foreign currencies, limits the options of American consumers to their disadvantage. The option to use an alternative to the fiat dollar is naturally most valuable in an environment of high dollar inflation. Consumers who don’t like the ongoing shrinkage of the value of the currency in their pocketbooks and wallets are then not limited to complaining, or trying to lobby the Fed or Congress for better policy, but can “vote with their pocketbooks” to protect their assets by moving into less inflationary alternative currencies.

We should not expect a spontaneous mass switchover to gold, or to Swiss Francs, as long as dollar inflation remains low. The dollar has an incumbency advantage due to the network property of a monetary standard. The greater the number of people who are plugged into the dollar network, ready to buy or sell using dollars, the more useful accepting dollars is to you. Conversely, if you are the first on your block to go shopping with gold coins or a gold-denominated debit card, you will find few stores ready to accept payments in gold. But like the benefit from using dollars in a peso economy, the willingness to accept gold-denominated money in a fiat dollar economy increases with the incumbent currency’s inflation rate and its uncertainty. As Gabriele Camera, Ben Craig, and Christopher J. Waller express the general theoretical proposition, “the local currency sustains internal trade if the purchasing power risk is kept very low, but once that risk gets very high substantial currency substitution kicks in.” [4] Should the US inflation rate return to double digits, consumers would find it very helpful to have an alternative currency network available. Potential competition might even help incentivize the Fed to keep inflation low.

Who is likely to produce private gold coins once they are recognized as legal? Gold medallions and biscuits in various sizes, from private producers around the world, are already widely held. Investors in coined gold normally pay a premium over the value of uncoined gold, which covers the cost of coining. In a recent working paper Olivier Ledoit and Sébastien Lotz, two economists at the University of Zurich, raise an interesting possibility while discussing a proposal to allow private gold coinage in Switzerland. They envision that “Gold Francs would be minted by Commercial Banks, [and] the Banks would be allowed to put their brand name and/or logo on one side of the coin. The marketing benefits from having the bank logo in every citizen’s wallet would clearly cover any minting costs, so these coins could be sold at par value with the market value of their weight in Gold.”[5] It is actually not clear, but remains to be seen, that marketing benefits would cover minting costs. It is true that if the public prefers to use full-bodied coins, gold coins could circulate practically in larger denominations. Historically, however, the everyday circulation of gold coins became rare once people found banknotes more convenient and sufficiently trustworthy. At $1600 per ounce, full-bodied gold coins are completely impractical at perhaps $50 and below.

We can therefore expect most bank-issued coins to be tokens, essentially metallic banknotes, redeemable in gold (upon presentation of a minimum quantity) at the bank. Such tokens can carry the bank’s logo, but they will pay for themselves by sparing the issuer the expense of using precious metal in coin production, and will save the system the burdens of incidental wear- and-tear and deliberate shrinkage that accompany full-bodied precious-metal coinage. As with paper banknotes, the float revenue rather than only the advertising value will cover the production and circulation costs. Ledoit and Lotz appear to overlook the standard historical solution to the problem of keeping small currency at par—redeemable tokens and banknotes—because they assume that payment services would be provided only by money warehouses, and do not consider that money-users might be incentivized by banks to prefer the lower-cost alternative of fractional gold-reserve bank liabilities.

Re-establishing a gold definition of the US dollar

The network property of a monetary standard supports the case for not simply legalizing a parallel gold standard, but re-establishing a gold definition for the US dollar. If network effects mean that an uncoordinated piecemeal switchover to a superior standard would not occur except during a painful period of high and uncertain inflation in the incumbent standard, there is a strong case for avoiding that pain through a coordinated switchover before high inflation occurs. That is, we would do well to follow the Salvadoran model of transition rather than the Ecuadoran model.

In considering the re-establishment of a gold dollar now, more than forty years after President Nixon closed the gold window, the question of the appropriate new parity (how many dollars per gold ounce) naturally arises. It is widely recognized that it would be foolish to try to relink the dollar to gold at the pre-1933 parity of $20.67 per ounce, the 1934-71 parity of $35 per ounce, or the post-1972 accounting price of $42.22 per fine troy ounce. It would be foolish because the US price level has risen more than 5-fold since 1971, and the real price of gold has risen in addition, so that $42.22 per ounce or anything lower implies a massive deflation not anticipated in existing nominal contracts. Great Britain’s painful deflation during Churchill’s ill-considered attempt to return to gold at the pre-War parity, after its high inflation during the First World War, stands as a stern warning. The purchasing power of gold was greater in the rest of the world than in Britain at that old rate, gold accordingly fled Britain, and pound-sterling values faced inescapable downward pressure. Fortunately this point is widely appreciated today, and nobody advocates returning to such a low parity.

By similar logic, it would be foolish to declare a new parity of (say) $8000 per ounce, five times the current price. The result would be a sharp transitional inflation, and a very expensive importation of gold from around the world. Gold would rush in to take advantage of its higher purchasing power in the US, until the US price level rises approximately five-fold, to the point that $8000 no longer buys more than one ounce of gold.
The gold parity that would avoid any transitional inflation or deflation is something close to the current price dollar price of gold. “Close to” because there will be some change in the real demand for monetary gold following the stabilization of the gold value of the dollar. On the one hand, with lower expected inflation, the cost of holding non-interest-bearing money will be lower, and hence the real demand to hold money in the form of M1 dollars will rise. On the other hand, with dollar inflation risk dramatically reduced, the dollar-inflation-hedging demand for gold Krugerrands and Eagles and bullion will fall dramatically. The latter effect is likely to dominate, seeing that hedging demand is the main reason why the real price of gold is higher now than it was when the United States abandoned the last vestiges of gold redeemability in 1971.

Does the US Treasury own enough gold to return to a gold-redeemable dollar at the current price of gold? Yes, assuming that they have what they say they do. At a market price of $1600 per fine Troy oz. (to choose a recently realized round number) the US government’s 261.5m ounces of gold are worth $418.4b. Current required bank reserves are only $83b. Looked at another way, $418.4b is 19.9 percent of current M1 (the sum of currency and checking account balances), a more than healthy reserve ratio by historical standards.[6] Combined with the likelihood that US citizens’ hedging demand for gold will shrink by more than banks’ reserve demand will grow with larger real demand for M1 balances, I expect that the denationalization and remonetization of the US bullion stock at the current price would allow the US economy to export some excess gold. There will be a small transitional windfall for US citizens, getting imported goods and services in exchange for excess gold.

Expeditiously establishing a new gold definition for the US dollar thus requires the following two steps:
1) Withdraw most of the $1.6 trillion in non-required reserves that banks have accumulated since September 2009 by eliminating interest on reserves and selling the mortgage-backed securities that the Fed acquired in QE1, plus enough Treasuries to bring total bank reserves down to the current value of the US government gold stock.
2) Redeem Federal Reserve liabilities with the US government’s gold at the then-current market price.

Why not establish 100% reserves for M1?

$8000 is the approximate figure we get if we divide October 2011’s M1 ($2105b) by the stock of gold ounces held by the US government (261.5m oz.).[7] Some economists who favor 100 percent gold reserves for currency and checking accounts have offered this approach as the way to set a new parity. As noted above, however, such a high parity implies a large influx of gold from the rest of the world, a large loss of other US wealth in exchange, and a sharp transitional US inflation. The US cannot establish 100% gold backing for currency and checking accounts without great expense. (Even more expensive, because it implies an even higher dollar-per-ounce parity, would be to set the parity by dividing M2 or any broader aggregate by the existing stock of government gold.)

To be specific, at $1600 per ounce of gold, the difference between M1 (about $2.1 t) and the current stock of Ft. Knox gold (about $400b) is about $1.7t. American taxpayers would have to buy $1.7t worth of gold, a very expensive proposition. And that is only the one-time cost. In an economy with 3 percent per annum real GDP growth, assuming a flat trend in the ratio of gold to GDP, a constant purchasing power of gold implies the importation each year of 3% of the gold stock. For a gold stock of $2.1 trillion (100 percent of M1), that would mean an annual expense of $63 billion. With a 20 percent (or alternatively 2 percent) fractional reserve against M1, the annual expense would be one-fifth (or one-fiftieth) of that figure.

It should also be noted that with 100% reserves, the historically familiar sort of currency, circulating redeemable private banknotes and token coins, are infeasible. A money warehouse would be unable to assess storage fees on anonymous currency holders. Debit cards would still be feasible, but the warehouses issuing them would have to charge storage fees.[8]

What about the central bank?

Because the nation’s stock of money becomes endogenous under a gold standard, no monetary policy is needed.[9] Retaining a central bank committee to “manage” the gold standard undermines its automatic operation, creates uncertainty by opening the door to policies that lead to devaluation or suspension, and thus does more harm than good. A central bank inevitably faces political pressures to pursue monetary policies inconsistent with redemption for gold at a fixed rate. It can endanger or suspend redemption so with legal impunity, and it faces no competitive pressure to maintain its reputation. When the central bank runs a policy inconsistent with maintaining the gold standard, typically the gold standard gives. Competing private banks, which do face legal and competitive constraints, have a better historical track record than central banks for maintaining gold redemption.[10] The classical gold standard of 1879-1914 functioned quite well without a central bank in countries like Canada that did not weaken their commercial banks with legal restrictions. Even in the United States, despite several financial panics that (to judge from the Canadian example) could have been avoided by banking deregulation, the business cycle was not worse than it has been under the Fed’s watch since 1914. [11]

Nor does the gold standard require a central bank for other purposes. Many of the banks that issue checking accounts may also be relied upon to issue gold redeemable circulating currency notes, as they did before the Federal Reserve monopolized banknote issue, and token coins. The Fed’s other useful functions can be returned to private clearinghouse associations, namely the clearing and settlement of payments, the setting and enforcement of membership standards for solvency and liquidity, and the last-resort lending of temporary liquidity support to solvent member banks. Because their members’ own money is at stake and they cannot simply print fiat money, clearinghouse associations do not and cannot bail out insolvent banks at taxpayer expense, whether through direct capital injections, asset purchases at above-market prices, or loans at below-market rates.

The journalist Martin Wolf has written that “the obvious form of a contemporary gold standard would be a direct link between base money and gold. Base money — the note issue, plus reserves of commercial banks at the central bank (if any such institution survives) — would be 100 per cent gold-backed. The central bank would then become a currency board in gold, with the unit of account (the dollar, say) defined in terms of a given weight of gold.”[12] Actually, although irredeemable central bank notes are base money today, under a gold standard only coined gold and bullion reserves are base money. Notes in circulation are redeemable liabilities of the issuers and not part of actual or potential bank reserves. And although a currency board is less likely than a central bank to undermine the gold standard, there is no need for either. The most efficient form of a contemporary gold standard makes gold the base money, i.e. the medium of redemption and unit of account, while currency and other common media of exchange are the fractionally backed gold-redeemable liabilities of commercial banks. Wolf rightly recognizes that “It is wasteful to hold a 100 per cent reserve in a bank, if depositors do not need their money almost all of the time,” but does not draw the obvious conclusion that “a currency board in gold” is therefore less efficient than fractional-reserve banking under a gold standard. [13] Wolf expresses the common worry that “Such a system is unstable. In good times, credit, deposit money and the ratio of deposit money to the monetary base expands. In bad times, this pyramid collapses. The result is financial crises, as happened repeatedly in the 19th century.” But the banking system is more robust than he suspects, as seen in Scotland, Canada, Sweden, and other less-regulated systems without central banks under the gold standard. Repeated financial crises were a feature of the nineteenth-century banking systems in the United States and England, weakened as they were by legal restrictions, but not of the less restricted systems elsewhere.[14]

Barry Eichengreen’s recent critique of reinstating the gold standard

In a recent critique of proposals for reinstating a gold standard, the economic historian Barry Eichengreen has repeated the often-made but nonetheless absurd claim that a gold numeraire is equivalent to a commodity price support, writing: “Surely a believer in the free market would argue that if there is an increase in the demand for gold, whatever the reason, then the price should be allowed to rise, giving the gold-mining industry an incentive to produce more, eventually bringing that price back down. Thus, the notion that the U.S. government should peg the price, as in gold standards past, is curious at the least.”[15] Surely Professor Eichengreen understands that if there is an increase in the demand for gold under a gold standard, whatever the reason, then the relative price of gold (the purchasing power per unit of gold over other goods and services) will in fact rise, which will in fact give the gold-mining industry an incentive to produce more, which will in fact eventually bring the relative price back down. That one unit of gold continues be worth one unit of gold does not involve the pegging of any price.

“More curious still,” Eichengreen continues, “is the belief that putting the United States on a gold standard would somehow guarantee balanced budgets, low taxes, small government and a healthy economy.” Of course “guarantee” is too strong a term, and a budget balanced each and every fiscal year is not the right goal. But a gold standard does help to ensure budget balance in the desirable present-value or long-run sense, by requiring a government that wants to sell its bonds in the international market to stay on a fiscal path consistent with full repayment in gold.[16]

“Most curious of all” to Eichengreen “is the contention that under twenty-first-century circumstances going back to the gold standard is even possible.” This time is somehow different, apparently. But going back to the gold standard by re-establishing a dollar-gold parity requires today only what it has always required: (1) a sufficient real gold stock, which as shown above the US government already has on hand, and (2) the political will to do so. Developing a parallel gold standard, using present-day technologies for money transfer, would probably be easier today than it has ever been.

Notes
[1] For the generic definition and supply-demand analytics of a gold standard see Lawrence H. White, The Theory of Monetary Institutions (Oxford: Basil Blackwell, 1999), ch. 2.
[2] See Lawrence H. White, “Statement on HR 1098, The Free Competition in Currency Act of 2011,” http://financialservices.house.gov/UploadedFiles/091311white.pdf.
[3] Olivier Ledoit and Sébastien Lotz, “The Coexistence of Commodity Money and Fiat
Money, University of Zurich Department of Economics Working Paper No. 24 (August 2011), p. 2.
[4] Gabriele Camera, Ben Craig, and Christopher J. Waller, “Currency competition in a fundamental model of money,” Journal of International Economics 64 (Dec. 2004), pp. 535–36.
[5] Ledoit and Lotz, op. cit., p. 5.
[6] Note: In counting all the gold as bank reserves I’m assuming that coins in circulation would become redeemable tokens, not become full-bodied gold coins. The current numbers update Lawrence H. White, “Will the Gold in Fort Knox Be Enough?” in Prospects for a Resumption of the Gold Standard: Proceedings of the E. C. Harwood Memorial Conference [Economic Education Bulletin vol. 44, no. 9] (Great Barrington, MA: American Institute for Economic Research, 2004), 23-32.
[7] The Fed’s gold certificate entry as reported on its balance sheet (H.4.1, 6 October 2011) is $11,041 million, the product of the bookkeeping price of $42.22 times 261.511 million oz. Au. See also Federal Reserve Bank of New York, “The Key to the Gold Vault” (2008), p. 17, which notes: “A majority of these reserves are held in depositories of the Treasury Department at Fort Knox, Kentucky, and West Point, New York. Most of the remainder is at the Denver and Philadelphia Mints and the San Francisco Assay Office.” I ignore the US share of IMF gold.
[8] Lawrence H. White, “Accounting for Fractional-Reserve Banknotes and Deposits,” The Independent Review 8 (Winter 2003), pp. 423– 441.
[9]As Alan Greespan told Jon Stewart on the Daily Show, 19 Sept. 2007: “You didn’t need a central bank when we were on the gold standard, which was back in the nineteenth century. And all of the automatic things occurred because people would buy and sell gold, and the market would do what the Fed does now.”
[10] George Selgin and Lawrence H. White, “Credible Currency: A Constitutional Perspective,” Constitutional Political Economy 16 (March 2005), pp. 71-83.
[11] George A. Selgin, William D. Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?,” Cato Institute Working Paper no. 2 (November 2010), forthcoming in Journal of Macroeconomics.
[12] Martin Wolf, “Could the World Go Back to the Gold Standard?,” Martin Wolf’s Exchange blog (1 Nov. 2010), http://blogs.ft.com/martin-wolf-exchange/2010/11/01/could-the-world-go-back-to-the-gold-standard/#axzz1aPjGlRV6
Wolf incidentally remarks that “Economists of the Austrian school wish to abolish fractional reserve banking,” but this is true only of a fraction of Austrian-school economists.
[13] See Kevin Dowd, ed., The Experience of Free Banking (London: Routledge, 1992); also George Selgin, “Bank-lending ‘Manias’ in Theory and History,” in Selgin, Bank Deregulation and Monetary Order (London: Routledge, 1996).
[14] Barry Eichengreen, “A Critique of Pure Gold,” The National Interest (Sept. –Oct. 2011), http://nationalinterest.org/article/critique-pure-gold-5741.
[15] The recent Nobel laureate Thomas Sargent made this point in “An Interview with Thomas Sargent,” The Region (Federal Reserve Bank of Minneapolis), September 2010.

Alan Blinder in the Wall St. Journal today urges his readers to "remember the two fundamental determinants of exchange rates: (1) productivity in different countries—so, other things equal, faster productivity growth should lead to a rising exchange rate; and (2) prices and wages in different countries—so lower inflation should lead to a rising exchange rate. Thus, for a currency union to succeed, its member nations need to register approximately equal productivity growth and approximately equal wage and price inflation."

Really? There are at least two curiosities here, which I will label A and B.

(A) In standard usage, when an economist speaks of an exogenous shift that "should lead to a rising exchange rate," he is applying a theory of the market exchange rate in a regime of floating exchange rates. Here Blinder is talking about a currency union, within which there "should" be no changes in exchange rates because there is a common currency. If factor x would cause an appreciation of Germany's currency under floating rates but does not within the eurozone, that is not prima facie a failing of the currency union. Some other mechanism will provide the appropriate monetary adjustment, typically money flows into Germany from other countries.

(B) According to the standard Purchasing Power Parity theory of floating exchange rates, Blinder's (2) is the only fundamental determinant of exchange rates. If (1) matters, it matters only so far as it works though (2). There is in fact no need for currency union members to have approximately equal productivity growth. Example: Panama and the US have been in a successful currency union for 107 years. Likewise Maine and Florida.

Can any of my economist friends explain to me why on earth Blinder thinks that you can't have a currency union between countries with disparate productivity growth?

Here is the prepared version of my opening statement for the Keynes-Hayek debate sponsored by Reuters that was held in New York City tonight. Due to time constraints, I skipped over some bullet points.

The video recording is now available: here.

• Friedrich Hayek developed a business cycle theory that explains how overly cheap credit from the central bank gives rise to an investment boom. In the boom, because interest rates are unsustainably low, investment is badly misallocated
o The boom is bound to go bust.
o Hayek’s theory doesn’t explain every recession in history, but it certainly does fit our recent housing boom and bust.
• The fit between Hayek’s theory and recent events is why we see the revival of interest in Hayek
o It’s why there’s a Hayek-Keynes rap video (“Fear the Boom and Bust”) with 3 million views.
o It’s why Nick Wapshott made Hayek the co-star of his book
o It’s why we are here discussing Hayek as the alternative to Keynes in anti-recession policy.
• By the way, for an account of the broader intellectual context of the Keynes-Hayek dispute, let me modestly recommend my forthcoming book, The Clash of Economic Ideas: Policy Debates and Experiments of the Last Hundred Years
o Available April 2012 from Cambridge University Press.

• In stark contrast to Hayek, the Keynesian theory of depressions offers no theory of the boom-bust cycle.
o Keynesian models completely abstract from the structure of production in the economy.
o The Capital stock is just one big uniformly productive lump
 Investment just makes the lump bigger, so there is no such thing as over-investment or wrongly directed investment
 it doesn’t matter where investment goes
 Employment is just employment.
o Keynesian models consequently fail to see how labor and capital are misallocated in a credit boom
o Or why economic recovery and sustainable growth are not just about aggregate demand.

• After the dot-com bubble burst in 2001, the Fed ramped up aggregate demand with rapid monetary expansion and ultralow interest rates, as Keynesians recommended.
o The Fed almost seemed to be trying to create a housing bubble to replace the Nasdaq bubble
o That experiment didn’t work out so well, did it?
o We have permanently reduced our real standard of living for wasting so much capital overinvesting in housing during the boom.

• So, What would Hayek have us do? Two things:
o Create a consistent monetary environment for saving and investment, without interest-rate distortions
o let necessary economic recalculation and adjustment take place.
• Critics have tried to tar Hayek as someone indifferent to the deflationary collapse of spending in the early 1930s, as though he counseled doing nothing to stop it.
o It's a bum rap.
o If they would actually read Hayek’s 1931 book Prices and Production, or his 1937 book Monetary Nationalism and International Stability, they would learn that he actually counseled central banks to prevent a collapse in spending.
o Hayek understood that a spending collapse has dire real consequences due to price stickiness.
o He did not subscribe to the Panglossian model of frictionless markets that some critics find a convenient straw man.
• Hayek explicitly called for constancy of what he called “the total money stream,” i.e. stabilization of nominal GDP.
o He was a forerunner of NGDP targeting
o To keep “the total money stream” constant means expanding the quantity of high-powered money to offset any forces shrinking the broader stock of money, or any increase in hoarding
o We can fault Hayek personally for failing to stay on this message consistently in the early 1930s.
 He himself later pleaded mea culpa on that.
o But his explicit monetary policy norm – to maintain nominal spending, is clear, and sensible, and not “do nothing”
 It would have prevented the deflationary spiral of the early 1930s, if the Fed had listened
 It would be an improvement today over the Fed’s unanchored policy

• Hayek’s perspective has further implications for re-starting sustainable economic growth after the bust:
o Don’t undertake public works whose costs exceed benefits—they are a waste
o Let market forces correct the real capital misallocations created by easy money during the boom
o Let artificially high asset prices fall relative to consumer prices
 Preferably not by inflating consumer prices.
o Let unemployed talent and idle machines move as rapidly as possible into appropriate and sustainable new employments.
 This means avoiding bailouts and subsidies and other forms of cronyism that misdirect investment
• If our goal is sustainable real growth, then we need to recognize that, contrary to Keynes, we cannot restore prosperity by building pyramids.

In honor of Tom Sargent's prize, I extract the last section of (forgive the self-promotion) my forthcoming book The Clash of Economic Ideas (due out in April from Cambridge University Press).

Unpleasant monetarist arithmetic

During the early 1980s a group of economists then at the University of Minnesota and the Federal Reserve Bank of Minneapolis, Thomas J. Sargent, Neil Wallace, and Preston Miller, spelled out a worrisome potential connection between the growth of government debt and the resort to inflationary finance. Their basic message was that the ability to finance government spending with borrowing will eventually hit a ceiling, leaving money-creation the only method left for covering continued budget deficits. The resulting inflation cannot then be stopped, because money-creation cannot be stopped, unless there is a fiscal reform: “the monetary authority is forced to create money” to satisfy a need for seigniorage revenue.

In a much-discussed 1981 article entitled “Some Unpleasant Monetarist Arithmetic,” Sargent and Wallace asked their readers to consider a fiscal and monetary regime in which the fiscal authority (say, the Congress) first announces the path of future budget deficits. By rearranging the budget constraint, we see that the size of a budget deficit (G – T) must be matched by the sum of new borrowing and monetary expansion:

G - T = ΔD + ΔM.

In other words, a budget deficit implies some combination of bond finance and inflationary finance.

To explain the limit on bond finance, Miller and Sargent defined G as spending on things other than debt service, and defined ΔD as the proceeds from borrowing net of debt service (i.e. net of interest and principal payments on the public debt). From an ordinary upward-sloping supply curve for loanable funds it follows that the real interest yield required by bond-buyers (lenders) rises with the volume of a government’s debt, other things equal. The size of ΔD then eventually hits a ceiling for “Laffer Curve”-type reasons. At some high ratio of debt to GDP, issuing new debt is a wash (nothing is gained for government spending) because the rising bond yield demanded by the market raises the cost of debt service on the entire debt (as it is rolled over) by as much as the new amount borrowed. Only inflationary finance then remains to meet ongoing deficits.

To avoid this “unpleasant” fate, Sargent and Wallace advised, the path of deficits must be kept in check. They suggested that the monetary authority should announce its plans for future money growth first, thus limiting the feasible path of deficits. Alternatively, a switch from fiat money regime to a commodity money regime could effectively restrict the path of M. As Sargent commented elsewhere:

Remember that under the gold standard, there was no law that restricted your debt-GDP ratio or deficit-GDP ratio. Feasibility and credit markets did the job. If a country wanted to be on the gold standard, it had to balance its budget in a present-value sense. If you didn’t run a balanced budget in the present value sense, you were going to have a run on your currency sooner or later, and probably sooner. So, what induced one major Western country after another to run a more-or-less balanced budget in the 19th century and early 20th century before World War I was their decision to adhere to the gold standard.

Sargent here seemed to assume that a government central bank issues the country’s gold-redeemable currency, and bears the brunt of a speculative attack. Many countries under the classical gold standard before World War I, like the United States, Canada, and Australia, had in fact no central bank, but instead decentralized private note-issue. A more general statement of the disciplinary mechanism would be: If a country didn’t run a balanced budget in the present value sense (spending balanced by present taxes or a credible commitment to future taxes), the international bond market would put a high default premium on its bonds, eventually making further bond finance impossible.

Some critics regarded Sargent and Wallace’s scenario as far-fetched. In a 1984 comment, Michael Darby argued that their model was “seriously wrong as a guide to understanding monetary policy in the United States.” An economy reaches the “unpleasant” zone in their model when the real yield on government bonds exceeds the economy’s growth rate. The real yields on US Treasury bonds and bills from 1926-81, Darby pointed out, had averaged close to 1 percent per annum, while the economy grew at around 3 percent per annum. Deficits were financed by new debt without the real yield appreciably rising or the revenue from bond finance coming close to a ceiling. The monetary authority’s hands were therefore never tied by fiscal policy, and it could choose the rate of money creation independent of the size of the deficit. The United States, one might say, remained in Pleasantville.

In a reply, Miller and Sargent emphasized that the real yield on government bonds isn’t given, but rises with the real debt or debt-to-GDP ratio. Darby’s evidence about United States’ past does not rule out the real yield on US government bonds someday rising above the economy’s growth rate if the debt-to-GDP continues to rise (a point Darby had already conceded in theory, but thought far from currently relevant). They noted two other effects working toward unpleasantness as the debt-to-GDP ratio rises: (1) Private capital and real income decline as government debt crowds out capital formation, therefore T falls and the deficit grows relative to GDP; and (2) The real demand to hold money falls as bond yields rise, therefore the tax base for real seigniorage falls. As if anticipating the events in Greece and Ireland twenty-five years later, they warned that a large jump in the size of government budget deficits can push a previously pleasant economy it into the unpleasant zone where real government bond yields rise above the economy’s growth rate and the debt-to-GDP ratio begins to grow without limit.

Sargent would go on to explain the Greek and Irish fiscal crises by applying the unpleasant-arithmetic argument. Despite the European Central Bank’s rules against any member country running a large deficit or accumulating a high debt-to-GDP ratio, a number of countries at the European Union economic periphery—Greece, in particular—violated the rules convincingly enough to unleash the threat of unpleasant arithmetic in those countries. The telltale signs were persistently rising debt-GDP ratios in those countries. Of course, the unpleasant arithmetic allows them to go up for a while, but if that goes on too long, eventually you’re going to get a sovereign debt crisis.

Time will tell whether—or how soon—the governments of Japan, the United States, the United Kingdom, or other countries will get a debt crisis. But seeing government debt sharply rising in those countries, and having observed events in Greece and Ireland, one can no longer dismiss the unpleasant scenario of a sovereign debt crisis as far-fetched.

I gave the following talk this morning at the Heritage Foundation Conference on a Stable Dollar, held at the Ritz-Carlton Hotel in Arlington, VA.

I’m going to talk about some of the choices we face among monetary regimes, including choices among various types of gold standards. But let me begin with a story.

One day I saw this guy about to jump off a bridge. I said to him, "Don't do it!" He said, "Why not? Nobody loves me." I said, "God loves you. Do you believe in God?" He said, "Yes." I said, Me, too!”

"Are you a Christian or a Jew?," I asked. He said, "A Christian." I said, "Me, too! Protestant or Catholic?" He said, "Protestant." I said, "Me, too! What franchise?" He said, "Baptist." I said, "Me, too! Northern Baptist or Southern Baptist?" He said, "Northern Baptist." I said, "Me, too! Northern Conservative Baptist or Northern Liberal Baptist?"

He said, "Northern Conservative Baptist." I said, "Me, too! Northern Conservative Baptist Council of 1879, or Northern Conservative Baptist Council of 1912?" He said, "Northern Conservative Baptist Great Lakes Region Council of 1912." I said, "Die, heretic!" And I pushed him off the bridge.

I tell this story – borrowed from the comedian Emo Phillips—in order to emphasize that in discussing the choices among types of gold standars I don’t intend to declare anyone a heretic. If you think that the questions of whether and how to completely privatize money can wait until after we re-establish a gold dollar, I don't propose to push you off the bridge.

What should Congress do?

1) Immediately allow private individuals to put themselves on a parallel gold standard if they so choose. Ron Paul’s HR1098, the Free Competition in Currency Act of 2011, is one approach: ensure the enforceability of contracts denominated in units other than fiat dollars, remove taxes on gold and silver coins that FR notes do not face, and remove federal statutes that criminalize the victimless activity of minting distinctive private pieces of metal intended to circulate as money. (See my testimony on the Act at freebanking.org.)

2) Re-establish a gold definition for the US dollar. Why isn’t free competition in standards enough? Incumbency advantage / network properties. People don’t abandon pesos until inflation is very high, measured per month rather than per year.

3) Direct the Fed to withdraw most or all of the $1.6 trillion in excess reserves that the Fed is currently paying banks to hold (eliminate interest on reserves and sell the MBSs that the Fed acquired in QE1), then redeem FR liabilities in gold at the current market price.

4) There is more than enough gold in Fort Knox, at current prices, to provide banks with sufficient reserves for backing the current money supply. Redeeming FR liabilities at the current price of gold is necessary to avoid both painful transitional deflation (as experienced in Britain in the 1920s, after it returned to gold at a parity too high for the price level) or transitional inflation (from returning at a parity too low). Here are the relevant numbers: Fort Knox contains 245.2m fine Troy ounces of gold. At $1615 / oz., that gold is worth $396b. This well exceeds currently required US bank reserves, which are only $83b. Current M1 is $2105b. Dividing the gold stock value by the M1 value, we find the available reserve ratio: $396b / $2105b = 18.8%, a gold reserve ratio more than sufficient for a stable monetary system, based on historical evidence.

5) Why not establish 100% reserves for M1, as some advocate?

a. At today’s price of gold, the difference between M1 (~$2.1 t) and the current stock of Ft. Knox gold (~$400b) is ~$1.7t. The US taxpayers would have to buy $1.7t worth of gold, a very expensive proposition.

b. Or, to back M1 100% with Fort Knox gold, the US dollar would have to be defined such that 1 oz. Au = $8479. This is not a costless fix. At that gold/dollar rate, with our current level of goods prices, gold would come flooding into the US. The purchasing power of $8479 available in the US for one ounce of gold, would greatly exceed the purchasing power of one ounce of gold elsewhere in the world. US citizens would again end up paying about $1.7 trillion in exports of goods in exchange for the incoming gold. On top of that the US would suffer massive price inflation in the transition as M and P rose to support the high dollar price of gold.

c. Plus, with 100% reserves, circulating banknotes are infeasible without an ongoing taxpayer subsidy to cover storage costs. Warehouse owners couldn’t collect storage fees on bearer notes given that the holders are anonymous, because they would know whom to assess for storage costs.

6) Once the Fed’s liabilities are converted into gold, my own preference is to decommission the Fed.

a. We already rely on commercial banks to issue most of M1, which consists of dollar-redeemable checking deposits. Let them issue gold-dollar redeemable circulating currency notes as well.

b. Privatize the Fed’s other useful functions by returning them to private CHAs: payments clearing and settlement, membership rules for solvency and liquidity, lender of last resort (not bailouts, but in the true sense of temporary liquidity support to solvent banks).

c. No monetary policy needed once we’re on a gold standard. Retaining the FOMC to “manage” the gold standard would do more harm than good. The classical gold standard of 1879-1914 functioned quite well without a central bank in the US, thank you very much. Despite the financial panics, which could have been avoided with banking deregulation, the business cycle wasn’t worse than under the Fed’s watch. For the evidence see George Selgin, William Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?,” available at cato.org in the Cato Working Papers series.

d. Why end the Fed? Wouldn’t a gold standard constrain it strictly enough to render it harmless? It would if the Fed would play by the “rules of the game.” But it wouldn’t. Note that the ECB had a constitution that was supposed to constrain it to the single goal of 2% inflation. That constraint lies in tatters—Eurozone inflation is running close to 4%--as the ECB loads up on junk sovereign bonds to help Greece, Ireland, Portugal, Spain and Italy.

e. In general, central banks face temptations to pursue monetary policies that are inconsistent with redemption for gold at a fixed rate. They can alter the redemption rate at will, and can do so with legal impunity. Private banks historically have a better track record for maintaining the gold standard.

Closing remark: Now that fiat money and central banking have failed, let’s try letting the monetary system regulate itself.