Free Banking 

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.

Back in July I posted an excerpt here of a talk I had given on the flaws in the euro. The complete version of my talk on the problems of the euro is now available as an Economic Bulletin from the American Institute for Economic Research.

Below is the written version of the testimony I gave this afternoon before the House or Representatives subcommittee chaired by Rep. Ron Paul. Q&A followed--when a transcript becomes available, I'll post the link here. The text of the Act I spoke about, which is quite brief, is here. UPDATE: Audio/video of today's hearing is here.

STATEMENT ON HR 1098 THE FREE COMPETITION IN CURRENCY ACT OF 2011 SEPTEMBER 13, 2011
_____________________

Lawrence H. White
Professor of Economics, George Mason University

House Committee on Financial Services
Subcommittee on Domestic Monetary Policy and Technology

Thank you for the opportunity to discuss my views on HR 1098, the Free Competition in Currency Act of 2011 (hereafter “the Act”). As an economist specializing in monetary systems I have studied and written for many years about the role of free competition in currency. Indeed the second book of my three books on the topic, published in 1989 by New York University Press, was entitled Competition and Currency.

The benefits of currency competition
It is widely understood that competition among private enterprises gives us technological improvements in all kinds of products, delivering higher quality at lower cost. For example, the competition of FedEx and UPS with the US Postal Service in package delivery has been of great benefit to American consumers. Currency users also benefits from competition. My research indicates that currency has been better provided by competing private enterprises than by government monopoly. For example, private gold and silver mints during the American gold rushes provided trustworthy coins until they were suppressed by legislation. Scientific appraisals have found that the privately minted coins were produced even more precisely than the coins of the US Mint. Private bank-issued currency was the most popular form of money around the world until government-sponsored central banks, with few exceptions, gained exclusive note-issuing privileges.

We do not rely on the Treasury or the Federal Reserve, but rather private financial institutions, to provide our checking accounts, credit cards, and traveler’s checks. The consumer benefits from the competition in payment services among banks. Consumers would likewise benefit from free and fair competition among coin issuers. Although Federal Reserve Notes and Treasury coins should of course be protected from counterfeiting, there is no good case for them to enjoy monopoly privileges in the market for currency.

HR 1098 would give currency competition a chance. It would not remove the Federal Reserve from the currency market, but it would give the Fed a stronger incentive to deliver the kind of trustworthy money that consumers want. The dollar already faces salutary international competition from gold, silver, the euro, the Swiss Franc, and other stores of value. HR 1098 would allow salutary domestic competition between the Federal Reserve Note and other media of exchange. The Fed will have little to fear from competition so long as it provides the highest quality product on the market. Continuing to ban competition from the domestic US currency market, or keeping it at a legal disadvantage, limits the options of American consumers who use money, to their disadvantage.

What sort of competition might we see if currency were free from legislated restrictions? Here is one example. In 1998 a non-profit organization launched the “American Liberty Currency,” a private silver-based currency intended to compete with Federal Reserve currency. In the year 2000 I wrote an article about the project, entitled “A Competitor for the Fed?,” published by The Foundation for Economic Education’s magazine The Freeman (vol. 50, July 2000). I was skeptical that the project would attract many users, absent high inflation in the dollar. But I noted then, and I reiterate today, that in a high-inflation environment “silver-backed currency with widespread acceptance would provide a useful alternative to the Federal Reserve’s product. Then, if you don’t like the way the federal government manages (or mismanages) the value of the fiat dollar, you aren’t limited to complaining. You can switch to the private alternative.” If double-digit inflation should unfortunately return to the United States, then the American public, as I wrote, would “find a very practical advantage in a silver-backed alternative to the free-falling Federal Reserve note.”

The Act offers three reforms. I will comment on them in turn.

Section 2 of the Act repeals 31 USC, §5103, which presently declares that “US coins and currency (including Federal Reserve notes …) are legal tender for all debts, public charges, taxes, and dues.”

What are the likely economic consequences of removing legal tender status from US Treasury coins and Federal Reserve notes? The immediate consequences would be minimal. New forms of currency will not be introduced into the market any faster than the public is prepared to accept them. The longer-run consequence will be to enable a more level playing field for competition in the issue of currency.

Legal tender status is more limited in its scope than is sometimes believed. That Federal Reserve notes and Treasure coins have “legal tender” status does not mean that they are the only legal way to pay. Any seller or creditor may (of course) voluntarily accept payment by transfer of bank-account balances, that is, by ordinary bank check, debit-card transfer, direct deposit, or wire transfer. Traveler’s checks or cashier’s checks may be accepted. The seller or creditor may even accept foreign currency or barter. Measured by dollar volume, payments in Federal Reserve notes or coin are a tiny share of all final payments in the United States (less than 20% of consumer payments, nearly 0% of business-to-business and financial payments). The great bulk of payments are electronic transfers of non-legal-tender bank balances.

Nor does legal-tender status mean that acceptance is mandatory when offered at a point of sale in a spot transaction. Large-denomination Federal Reserve notes are refused at many points of sale, and lawfully so. Vending machines refuse pennies. Mail-order sellers may refuse cash of any denomination. Millions of legal-tender one-dollar coins are piling up in the Federal Reserve’s vault in Baltimore because nobody wants them.

Legal tender relates to the discharge of debts. The phrase “Legal tender for all debts” in 31 USC, §5103, quoted above, means that if Smith owes Jones $125, then Smith’s offering Jones $125 in US coins or Federal Reserve notes legally extinguishes the debt, even if Jones would prefer payment in some other form (say, a check). In other words, the creditor is barred from refusing payment in legal tender notes or coins.

There is already an important exception, however. Debts in gold-clause contracts, made since 1977, are not unilaterally discharged by offer of US coin or Federal Reserve notes. 31 U.S.C. §5118(d)(2) reads: “An obligation issued containing a gold clause or governed by a gold clause is discharged on payment (dollar for dollar) in United States coin or currency that is legal tender at the time of payment. This paragraph does not apply to an obligation issued after October 27, 1977.” [emphasis added] That is, the holder of a gold-clause bond is free to insist on receiving payments in gold, or in an amount of dollars indexed to the price of gold, whichever the bond contract specifies.

Removing legal-tender status from US Treasury coins and Federal Reserve notes generally, as Section 2 of the Act does, essentially broadens the gold-clause exception to allow contractual obligations to specify payment in, or indexed to, any medium that is an alternative to Treasury coins and Federal Reserve notes. It opens the competition not just to private checks and banknotes, but also to gold units, silver units, units of foreign currency, Consumer Price Index bundles, wholesale commodity bundles, Bitcoins, and whatever else a lender and a borrower might agree upon. If they prefer a unit for denominating their debt contract other than the Fed or Treasury dollar, they would be free to write a specifically enforceable contract in the unit of their choice.

Hand-to-hand currency does not need legal tender status to make it circulate easily. In jurisdictions where private commercial banks may issue circulating currency notes or “banknotes” (found today in Scotland, Northern Ireland, and Hong Kong), banknotes have the same legal status as checks. That is, they do not have legal tender status. Any creditor might refuse them if he preferred to be paid in another medium. (In Scotland and Northern Ireland, only pound sterling coins are legal tender.) I have spent a fair amount of time in Northern Ireland, visiting the Finance Department at the Queen’s University of Belfast, and have observed the circulation of banknotes there first-hand. There are four private banks that issue notes, and all of their notes are universally accepted. Legal tender status is clearly not necessary to have currency that circulates widely and is commonly accepted for payment of debts. Currency notes do not need legal tender status any more than credit cards, checks, debit cards, or traveler’s checks.

Section 3 of the Act rules out federal or state taxes on precious-metal coins, whether minted by a foreign government or by a private firm. This section would allow precious-metal coins to compete with the US Treasury’s token coins (made of base metals, and denominated in fiat US dollars) without tax disadvantages (sales taxes on acquisition and capital gains taxes on holding, from which Federal Reserve Notes are exempt), and thereby a level playing field for competition among monetary standards.

 
Section 4 of the Act repeals Title 18 §486 (relating to uttering or passing coins of gold, silver, or other metal) and §489 (making or possessing likeness of coins).

Section 486 is a relic of the Civil War, part of an effort to bolster the use of the wartime paper “greenback” currency by banning competition from the private gold coins I previously mentioned. The repeal of §486, combined with the previous section, would allow silver and gold coins to compete with the Treasury and the Fed on a level playing field.

I previously mentioned the American Liberty Currency project. The mover of that project, Bernard von Not Haus, was convicted in March 2011 of violating §486, and presently awaits sentencing, for the victimless crime of producing one-ounce silver coins, of original design, that he hoped would compete with the Federal Reserve’s currency. Regarding this case I commend to your attention the article by Seth Lipsky, “When Private Money Becomes a Felony Offense,” Wall St. Journal, 31 March 2011.

The repeal of §486 would avoid a repeat of the injustice done to Mr. von Not Haus. I share Mr. Lipky’s view that “it’s a loser’s game to suppress private money that is sound in order to protect government-issued money that is unsound.”

Title 18 §489 of current law outlaws making or possessing “any token, disk, or device in the likeness or similitude as to design, color, or the inscription thereon of any of the coins of the United States or of any foreign country issued as money, either under the authority of the United States or under the authority of any foreign government”. Von NotHaus was also charged with violating this section. In my view §489 is redundant at best and over-reaching at worst. It is redundant at best because if there is any fraudulent intent in making or passing such a device, it is already outlawed under §485, which bans the counterfeiting of US coins. To outlaw “likeness or similitude as to design, color, or the inscription” [emphasis added] in cases where it is not counterfeiting and has no fraudulent intent, is far too sweeping. Taken literally, §489 outlaws all commemorative silver medallions—and if you go on eBay, you’ll find that there are thousands of them for sale—because it says that you are in violation of the law if you make or own any disk that merely has a color similar to that of a US quarter.

Conclusion
Competition in general creates incentives to provide a high quality product by taking business away from low-quality producers. Competition in currency is a practical idea that offers sizable benefits to the public when the quality of the incumbent currency becomes doubtful. In particular, US citizens would benefit from freedom of choice among monetary alternatives though the removal of current legal restrictions and obstacles against currencies that could compete with Federal Reserve Notes and US Treasury coins. HR 1098 would give currency competition a chance.

What follows is the slightly revised first part of remarks I gave at the Estoril Political Forum, in Estoril, Portugal, on 28 June 2011.

Of course the euro is flawed. It is not, after all, a monetary standard evolved by the invisible hand of the marketplace from the decentralized choices of millions of users. Nor is it the next-best thing, divinely ordained. Instead, it is the brainchild of politicians and economic technocrats, assembled in committees.

Google the two terms “euro” and “flawed” together, and you receive back more than 2 million results. And that is only for the commentary in English.

Nearly all commentators agree that the euro is flawed in some way. I say “nearly all” but not “absolutely all” because officials of the European Central Bank sometimes join the discussion. They have yet to identify a flaw in the euro or in the European Central Bank that issues it.

There is much less agreement about how the euro is flawed, or about what a more ideal currency system would look like.

When the currency speculator George Soros says that “the euro is a flawed construct,” as he did in a widely reported speech in Berlin last year, he means that in his view it needs a stronger political union behind it, a single pan-European-Union welfare state, so that one fiscal policy (one set of taxing and spending decisions) could be made for all of Europe together with one monetary policy. The ECB’s head, Jean-Claude Trichet, has similarly begun to complain in recent weeks about the ECB’s lack of a companion Eurozone finance ministry to centralize member countries’ fiscal policies. Europe should resist the siren call that greater centralization of power will solve its problems. As a matter of fact, two or more countries can readily have a common money while keeping fiscal independence. They did so under the classical gold standard, a system to which I will return. Soros hopes that with one pan-European government, financially conservative Germany would no longer rule the roost. The ECB could then pursue looser monetary policy, which he supposes would cure the ills of the countries with weak economies and mounting public sector debts. This view, I fear, is widely shared.

When retired Dutch central banker André Szász says that the euro was flawed from the start, as he did earlier this year, he means almost the opposite, that it is a mistake to have “a monetary policy of one-size-fits-all” because such a monetary policy will be too loose for some countries and too tight for others, or as he puts it, interest rates will be “too low” for some countries and “too high” for others. Paul Krugman has registered the same complaint, as has Marine Le Pen of France’s National Front. This criticism is linked to the so-called “optimum currency area” analysis, which holds that to share a single currency, two or more economies should have “harmonized” business cycles so that a single monetary policy (interest rate) fits them all. Otherwise devaluation or exchange rate depreciation is supposed to help a weak economy dampen unemployment by lowering real wages or by stimulating real growth through greater real exports.

I think that both of these diagnoses begin from false premises. They both rest on the wishful thinking of Keynesian economics, in particular on the fond hope that an artfully timed discretionary monetary policy will improve or stabilize an economy’s real performance by improving or stabilizing real variables. That is to say, these arguments take for granted the ability to exploit the Phillips Curve (to lower unemployment by cheapening the monetary unit), alternatively known as exploiting the “money illusion” of the workforce. I think it is the supposed ability to exploit “money illusion” that is the real illusion. A policy regime of printing more money and devaluing does not in fact improve real economic performance, or dampen business cycles, but the does the reverse. The historical evidence on that question is clear.

A better start to understanding the fundamental shortcoming of the euro is to begin with the simple fact that the euro is a fiat currency, a paper money standard. A former business partner of George Soros, but of very different political persuasion, the investor Jim Rogers, has it right when he notes that “generally … paper money is flawed.”

The time-inconsistency problem

Economists have a technical term for the fundamental flaw in fiat money.  They call it “the time-inconsistency problem” or “the credible commitment problem.”

The classical allegory for the time-inconsistency problem is the episode in the Odyssey in which Odysseus wants to hear the beautiful singing of Sirens, but knows that without some binding constraint to keep him from the ship’s tiller, he would give into the temptation to steer the ship in the direction of the Sirens and end up smashed on the rocks.  Solution?  He has his shipmates tie him to the ship’s mast, and plug all of their own ears with wax. By constraining himself against temptation, Odysseus achieves a better outcome than if he had left himself with moment-by-moment discretion.  In light of today’s news, how ironic that this man who know to bind himself against short-sighted behavior was Greek.

When central bankers who issue fiat money have the discretion to alter monetary policy from month to month, to do whatever seems desirable at the moment, they also have a problem of the same sort.  (Kydland and Prescott brought this problem to the economics profession’s attention, and received a Nobel Prize in large part for doing so.)  Central bankers will find themselves pressured to promise low inflation and then to deliver something else that is inconsistent with low inflation, namely rapid money growth to lower unemployment or to buy up bad debts.  They face no penalty for breaking their promises.  As a result, the private citizens who use euros (for example) don’t know what the euro will be worth 5 or 10 years out, unless there is some binding commitment to a steady policy path.  Without a binding commitment, inflation is unnecessarily high and variable.

The European Central Bank has a commitment on paper, of course, to keep inflation below 2 percent.  But in the face of
pressure to buy the bonds of heavily indebted governments, to delay the day of reckoning for the sovereign debt crises of Greece, Ireland, and Portugal, the ECB’s commitment to low inflation is crumbling.

Contrast a free-market silver or gold standard.  Under such a monetary standard, the private mining firms that dig up the precious metals, the mints that produce coins, and the banks issue redeemable notes and transferable account balances are all constrained by contract and by competition.  There is no time-inconsistency problem in monetary policy because there
is no monetary policy.  Nobody has discretion over the quantity of money.

The challenge, for those who believe in the rule of law, is to reintroduce such constraints on money creation.   If not a gold standard, a serious and enforceable limit on fiat money.  You can’t believe in the rule of law and also believe in discretionary rule by central bankers.

The time-inconsistency problem was known to the designers of the ECB constitution and to some of the bank’s early officials, in particular the German economist and ECB board member Otmar Issing and the ECB’s first president, the Dutchman Wim Duisenburg.  To their credit, they tried to tie the ECB to the mast, to institute a quasi rule of law, to give to give the euro a binding pre-commitment to a steady policy path.  The ECB constitution specified that the ECB is to have an exclusive commitment to “price stability,” and a board statute early on that “price stability” means inflation no higher than 2%. The ECB website continues to declare:  “The ECB aims to maintain annual inflation rates as measured by the HICP [Harmonized Index of Consumer Prices] below, but close to, 2% over the medium term.”

In 2000, I participated in a published exchange with Prof. Issing, then a member of the ECB board.  In a lecture to the Institute of Economic Affairs (London), Issing emphasized that the ECB constitution had solved the time-inconsistency problem by tying the ECB irrevocably to the single goal of price stability.  In my commentary I said it was too soon to tell whether the constitution’s commitment on paper would actually bind the ECB in practice when pressure arose to pursue some other goal.  For a commitment to be a binding commitment, there must be some penalty for going astray.  The ECB constitution unfortunately does not specify any penalty for ECB officials who deviate from an exclusive focus on price stability.  They do not lose their jobs.  This is a fundamental design flaw.  The euro performed well for a decade, but now the sirens are singing.

Today the leadership of the ECB, under pressure from the EU and the national fiscal authorities, is violating its constitutional duty by filling the ECB portfolio with junk bonds from Greece, Ireland, and Portugal, in order to keep prices on those bonds high and yields low.  It is trying to support government bond prices generally, to make debt rollovers cheaper, by holding interest rates at a record low level, a level that is inconsistent with keeping inflation at or below 2 percent.

The result of the new monetary policy is becoming evident.  In 2011, the euro inflation rate has been persistently above the promised 2 percent ceiling.  The HICP has risen from 110.6 in November 2010 to 113.1 May 2011, six months of inflation at an annual rate of 4.5 percent, more than double the constitutional rate.  How much higher will the ECB let it go?

John Tamny in a column over at Forbes argues, rightly, that

there’s no reason that debt problems within certain euro countries should lead to the extinction of what is merely a “unit”, or a concept meant to put a money price on goods and investments.

A default by the Greek government on its euro debts would not bring down the euro any more than a default by the government of California on its dollar debts would bring down the US dollar.

Tamny is also right in arguing that a Greek exit from the Eurozone and adoption of a floating drachma would not improve Greek’s economic prospects.  It didn’t boost Argentina’s economy or solve its governement debt problems when its central bank de-linked from the US dollar and re-floated the peso.

Tamny suggests that Europe would be better off if the ECB “strengthens and stabilizes the euro unit” and in particular its best move “would be to define the euro in terms of gold, and make euros redeemable in the yellow metal.”  I agree that the ECB, while it exists, should keep the euro a strong, low-inflation currency. 

But Tamny unfortunately errs in thinking that a sound-euro policy “will stave off looming default for the euro bloc’s weakest countries.”   On the contrary.  A policy of restraining euro inflation means the end to ECB participation in the bridge-to-nowhere EU loans that are currently postponing Greek and Irish government defaults.  It also means the end to ECB purchases of Greek and Irish government bonds to hold their yields down.  Whatever prevents the ECB from bailing out the fiscally weak countries, and from inflating away their euro debts, makes outright default or debt restructuring (which appears to be unavoidable) arrive that much sooner.

Tamny writes:

For one, if the ECB were to give the euro a gold definition, the cost of servicing euro-denominated debt for Greece and Ireland would decline. With markets suddenly aware of the euro’s extreme credibility, investors would demand lower interest rates due to greater certainty about the value of the money being paid back. This on its own would reduce the pressure presently placed on the governments in Greece and Ireland.  Right now the euro’s weakness serves as a stealth default on euro-denominated debt, so a stronger currency would reduce the cost of a potential “haircut” for holders of Greek/Irish debt.  

The real interest rate a country pays includes not only an inflation-risk premium but also default risk premium. The nominal interest rate adds an expected-inflation-rate premium.  Any move that lowers and stabilizes expected euro inflation by restraining ECB monetization of Greek and Irish debt would reduce the inflation-rate and inflation-risk premia, but such a move would significantly increase the default risk for Greece and Ireland and thereby their bonds’ yield spread over German (low-default-risk) bonds.  In real terms the cost of servicing euro-denominated debt for Greece and Ireland would rise.  

If stealth default by inflation is barred, then outright default -- overt losses for holders of Greek and Irish debt –  becomes the alternative.

It would be better for the average Eurozone citizen to have outright defaults on Greek and Irish government debts than to debauch the euro--have stealth defaults--in order to stave off overt defaults, thereby loading the costs of Greek and Irish government profligacy onto euro-users in other countries.  But that's the choice.  Let’s not imagine that Europe can eat its sound-money cake and keep the Greek and Irish governments from defaulting too.

Free banking as a policy ideal is the result of applying the norms of classical liberalism to money and banking.  Classical liberalism upholds individual liberty and private property rights, including freedom of contract, under the rule of law.  It opposes rule by unconstrained authorities. 

Skipping over ancient thinkers, early modern expressions of classical liberal thought on money may be found in the writings of Nicholas Oresme and other Scholastics who denounced the sovereign’s debasement of the coinage as a dishonest and tyrannical, a violation of the sanctity of contract that a just sovereign must respect.  David Hume in the 1750s refuted the Mercantilist fear that unless the sovereign interfered with freedom of trade and payments the nation’s economy would retain too little silver and gold.  Adam Smith in 1776, and later defenders of free banking in Britain, on the Continent, and in the Americas (my favorite being William Leggett), applied free-trade doctrines to banking and bank-issued currency.  Thomas Hodgskin and Herbert Spencer even dared to defend private coinage.  Walter Bagehot defended the principles of free banking, though he thought it a lost cause politically.  In the twentieth century the Austrian economist Ludwig von Mises gave new subtlety and rigor to the case for free banking.  Friedrich Hayek made somewhat ambivalent cases for gold and free banking earlier in his career, but in the 1970s forcefully called for Choice in Currency and The Denationalisation of Money.

Many leading classical liberals over the centuries, however, have failed to apply their free-trade principles consistently to money.  David Ricardo favored nationalization of coinage and banknote issue, and the forced substitution of redeemable paper notes for coins in all but the largest payments.  John Cobden, the free trader, supported the nationalization of banknotes.  After the Second World War, most of the German Ordoliberals and the Monetarists, led respectively by Walter Eucken and Milton Friedman, made peace with central banking and fiat money.   (Although Friedman, it should be noted, reconsidered his position in the 1980s and began favoring free banking and the abolition of the central bank .)   The otherwise radically free-market theorist Murray Rothbard favored a 100% reserve requirement, with no allowance for capitalist acts among mutually consenting adults who want to contract around that rule. Alternatives to fiat money, central banking,  and deposit insurance were not on the program of the Mont Pelerin Society, a leading international society of classical liberal intellectuals, at its special meeting to discuss the financial crisis in 2009. 

A century ago, before the First World War, economic classical liberals almost unanimously supported the ideals of the international gold standard.  The “classical” period of the gold standard is usually dated from the United States’ resumption of gold payments in 1879 until the suspensions of payments in the First World War.  The gold standard was fatally wounded in the First World War and never fully recovered.  In practice it had not been a completely market-regulated system even before the war.  National governments had long banned market competition in coining by giving themselves a monopoly in the minting of coins.  Many similarly banned market competition in the issue of gold-backed banknotes and gave a monopoly to a government-sponsored central bank.  National central banks violated the “rules of the game” by interfering with, overriding, or suspending the automatic operation of international gold flows.  The centralization of gold reserves, a characteristic feature of central banking, altered the operation of the international gold standard for the worse.

Nonetheless the classical gold standard more nearly approached a self-regulating international monetary system than anything that has followed.  Monetary nationalism and monetary statism since the First World War has brought us to our present system of national fiat monies, central banking, and extensive government interference in financial markets everywhere in the world (with the exception of offshore banking havens).  The global financial crisis that begain in 2007 has exposed the weakness and non-self-regulating character of the present system for all to see. 

Our challenges for the present day, and for this blog, are to discover how we might reform the system in manner consistent with the ideals of freedom. How might we restore healthy self-regulation to our local and international monetary and banking systems? 

Here are some references for the above history, which may also begin to answer Brad Jansen's request for recommendations of classic readings.

Nicholas Oresme, De Moneta (Of Currency) [c. 1355], translated by Charles Johnson, in Lawrence H. White, ed., The History of Gold and Silver (London:  Pickering and Chatto, 2000), vol. 1;  David Hume, “Of the Balance of Trade,” in Essays, Moral, Political, and Literary, ed. Eugene F. Miller (Indianapolis:  Liberty Fund, 1987); Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, ed. R. H. Campbell, A. S. Skinner, and W. B. Todd. (Oxford: Oxford University Press, 1976); Vera Smith, The Rationale of Central Banking [1936] (Indianapolis: Liberty Fund, 1990); William Leggett, Democratick Editorials (Indianapolis: Liberty Fund, 1984); Thomas Hodgskin, Popular Political Economy (London: Charles Tait, 1827); Herbert Spencer, “State-Tamperings with Money and Banks,” in Essays Scientific, Political and Speculative, vol. 3 (London:  Williams and Norgate, 1891); Ludwig von Mises, The Theory of Money and Credit [1912] (Indianapolis:  Liberty Fund, 1980); Mises, Human Action, 3^rd ed. (Chicago: Henry Regnery, 1966); F. A. Hayek, Choice in Currency (London: Institute of Economic Affairs, 1976); Hayek, Denationalisation of Money, 2^nd ed. (London:  Institute of Economic Affairs, 1978).  David Ricardo, Plan for the Establishment of a National Bank [1824] in The Works and Correspondence of David Ricardo, ed. Piero Sraffa with the Collaboration of M.H. Dobb (Indianapolis: Liberty Fund, 2005), vol. 4, Pamphlets and Papers 1815-1823;  Richard Cobden in 1840 Parliamentary testimony cited by Lawrence H. White, Free Banking in Britain, 2^nd. ed (London: Institute of Economic Affairs, 1995), p. 84; Walter Eucken, Grundsätze der Wirtschaftspolitik (Tübingen:  J. C. B. Mohr, 1952); Milton Friedman, A Program for Monetary Stability (New York:  Fordham University Press, 1960); Friedman,  “Monetary Policy for the 1980s” in John H. Moore, ed., To Promote Prosperity (Stanford: Hoover Institution Press, 1984); Murray N. Rothbard, “The Case for a 100 Percent Gold Dollar” in Leland Yeager, ed., In Search of a Monetary Constitution (Cambridge, MA: Harvard University Press, 1962).