A Free Banker's Christmas Wish List

by George Selgin December 21st, 2014 9:40 pm


As is usual this time of year, my mom and brother, and a close friend or two, asked me to share with them some of the items I'd included in the list they assumed I'd already mailed to the North Pole, as I have done diligently every year since I first learned to spell "toy." In the past I've always been happy to indulge them, for my petitions to ol' St. Nick were, truth be told, long enough to raise the eyebrows of more than a few elves. "The man who has everything" described, not the man that I've been, but the one I've always aspired to be.

But this year that's all changed, thanks to my having traded my 2800 square-foot place in Athens for a DC condominium less than a quarter as big. Speaking of her similarly small apartment in Manhattan, Dorothy Parker once said that she just had room enough to lay her hat and...a few other things. My social life is a lot duller than Parker's was, so as far as my place is concerned "my hat" pretty much says it all.

So I faced the question: what should a man who has no room for anything ask for for Christmas? And that's when my bright idea came. Books, paintings, neckties, pottery--love them though I do, they all take up space. So, what do I love that doesn't? You guessed it: free banking! Instead of having Santa or my family and friends deliver stuff to me for which I haven't any room, why not have them deliver me, and everyone else for that matter (for here is a genuine public good if there ever was one), from something, to wit: our crummy, centralized monetary system!

Much as I'd like to take my leave from monetary tyranny lock, stock, and barrel, I don't want to burden my loved ones, or some elves, unnecessarily. So, at the risk of setting off another round of wailing by those hard-core libertarians who prefer uncompromising sloganeering to actual (but namby-pamby) change, I offer here a list of relatively modest requests, with the assurance that fulfillment of any one of them would make me as happy as any other present might--perhaps even happier than I was that first time I wrote to Santa, when he, generous fellow, interpreted "toy" to mean a Tiger Joe tank!


Dear Santa,

I've been a good boy this year, as usual. But this time, For Christmas, instead of more toys or other stuff, I'd like you to see about doing any or all of the following:

1. Make the Fed follow a monetary rule. Any rule beats almost unlimited discretion, which is what we've got now, though a nominal spending growth rule would be best.

2. Send the FOMC packing. It's simple: if you have a rule, you don't need them. All they can do is muck it up. Replace the FOMC with a computer that determines the open-market operations needed to implement the rule. Better still, develop a tamper-proof Bitcoin-style ("Bitdollar") protocol that implements the rule automatically.

3. Abolish the Primary Dealer system: we don't need it any more than any other country does. Getting rid of primary dealers will also make it easier to

4. End Too Big To Fail, which will in turn make it easier to

5. End Fed discount-window lending, or at least "expansive" discount window lending.

6. Consider making sure, while you're at it--and lest the Fed try more funny business--to close the "emergency lending" loophole.

7. Since the Fed has no no reason to keep an eye on banks that can't count on bailouts from it (and can't be counted on to keep an eye on them even when it does have a reason to do so), how's about getting it out of the bank supervision business altogether?

8. Since these are all pretty tall orders, even for a fat fellow who manages somehow to clamber through who knows how many billions of chimneys in a single night, while you work on them perhaps you could get Congress to pass the Centennial Monetary Commission Act, so we can at least get them to start talking about these and other ideas for fixing the Fed.

9. And finally, a real easy one for you: how's about sticking it to those zinc lobby liars by finally getting rid of all those stupid pennies?

10. Oh wait, I almost forgot my most important wish of all, which is that you please see to it that all my pals, and all readers of this blog (including those who don't care a whit for me or my ideas) have a very



Edmund Burke a free banker? (highly speculative)

by Kurt Schuler December 19th, 2014 7:45 am

The journalist and historian Rick Perlstein has a recent book called The Invisible Bridge: The Fall of Nixon and the Rise of Reagan. A reviewer criticized the book, and Perlstein responded here. What piqued my interest was Perlstein's claim that "I first learned to distrust conservatives’ own protestations that theirs is a 'movement of ideas' when I read a speech transcript from a right-wing congressman in 1962 backing his defense of laissez-faire economics by dropping the name of Edmund Burke, who had less than nothing to do with laissez-faire economics.”

If you have read a biography of Burke, or of Adam Smith, or James Boswell's Life of Samuel Johnson, LL.D.,  you will know that Burke and Smith were friends (and members of an illustrious dining club started by Johnson). In fact, Burke's first biographer recounted a conversation in which Burke claimed that “Mr. Smith, he said, told him, after they had conversed on subjects of political economy, that he was the only man who, without communication, thought on those topics exactly as he [Smith] did" (Robert Bisset, The Life of Edmund Burke, 1800, v. 2, p. 429). And as a study of  Burke's economic thought (which I have only skimmed) observes, "Burke often sounded like Smith in his advocacy of economic freedom and the free market economy" (Francis Canavan, The Political Economy of Edmund Burke, 1995, p. 117).

It turns out, then, that Burke had a lot to do with laissez-faire economics, and that the right-wing congressman in 1962 was correct. (Will Perlstein now stop distrusting conservatives?) To my knowledge, as one who has read little of Burke beyond Reflections on the Revolution in France, he did not comment except in passing on monetary matters. But Smith was perhaps the first prominent free banker, in The Wealth of Nations, and Burke was an enthusiastic student  of the book. So perhaps Burke supported free banking but, because of his focus on other matters, never had occasion to express his opinion in his writings?


Post Keynesian free banking

by Kurt Schuler December 14th, 2014 6:27 pm

According to a recent blog post on 538, “post Keynesian” is the phrase in economic research most indicative of “left-leaning” political views and “free banking” is the phrase most indicative of “right-leaning” views. (See also the paper on which the blog post is built.) The authors apparently don’t know how to distinguish between conservatives and libertarians, because to my knowledge, most researchers on free banking are libertarians. Be that as it may, I do not view the correlation between research topics and ideology as inherently dangerous. Researchers in many disciplines have personal motivations for their research related to ideology, personal circumstances, etc. Over time, a wider body of scholars acts as judges of whether the facts and ideas advanced by the small group seem to be correct. The danger lies in the wider body being close-minded, accepting or rejecting without judging carefully. 


Free Banking and the Dollar

by George Selgin December 12th, 2014 5:51 pm

I've been getting some flak lately from hard-core free market types for occasionally saying some nice things about NGDP targeting, and especially for suggesting, in the course of a recent Cato forum contribution, that we might improve upon the present U.S. arrangement by replacing the FOMC with a tamper-proof Bitcoin-type protocol that automatically adjusts the output of base dollars so as to maintain a steady NGDP (or, better, Domestic Final Demand) growth rate. Call the dollar thus reformed the "Bitdollar."

My Bitdollar proposal, my hard-core critics maintain, places me firmly in the ranks of apologists for state "manipulation" of the money supply. Consequently I am, by their reckoning, a turncoat in the fight for monetary freedom, and (since I still have the brass gall to post on a site called "freebanking.org") a hypocrite to boot.

What have I to say in response to such charges? Considering their sources, I'm tempted to settle for a Bronx cheer. But as some others may wonder if there isn't some merit in their accusations, I think I'd better indulge my critics by entering a plea of "Not Guilty."

My defense? It is simply this: that while I'm all for monetary freedom and competition, I'm also for reforming the U.S. dollar, which for me means freeing it from control by discretionary central bankers. Like it or not, the dollar is presently the standard money, not just of several hundred million U.S. inhabitants, but of many millions of inhabitants of other countries. What's more, these millions, unlike holders of U.S. securities, hold fiat dollars under some degree of duress, because a combination of network externalities and legal restrictions makes it almost impossible for them--my hard-core critics included--to survive without equipping themselves with dollar-denominated exchange media, or because they live in places where the dollar seems rock-solid compared to anything local authorities have to offer.

Consider, then, some other purportedly free-market strategies for monetary reform, and the alternative fates to which each would consign the world's hapless dollar holders. There is, first, the inevitable catastrophe strategy, according to which, in the wake of a long-forestalled but nonetheless inevitable hyperinflation, a state of monetary freedom (gold version, usually) emerges Phoenix-like from the dollar's ashes. Then there's the level playing field strategy, which supposes that mere elimination of legal tender laws and other government-erected impediments to free choice in currency would provoke a spontaneous switch from dollars to other currencies, leaving to the Fed the choice of either shedding assets to preserve the dollar's value, or letting it become worthless. Next there's the back to gold strategy, in which the Fed (or some replacement agency) is compelled to turn present "IOU nothings" back into redeemable claims to gold. Finally, there's the frozen Fed strategy, which equates any change in the stock of base dollars with monetary interventionism, and therefore treats a frozen base as the closest fiat-money equivalent to monetary laissez-faire.

Unless you happen to live in a bomb-proof shelter equipped with a lifetime supply of canned goods, the catastrophe strategy will, I trust, strike you as undesirable both because you might be among the people wiped-out by the anticipated hyperinflation, and also because that hyperinflation could be a long-time coming. A long delay is also likely to be in store for those banking on the level-playing field strategy, which downplays, I think severely, the likelihood that the dollar will stay in the saddle so long as catastrophe doesn't strike. As for a return to gold payments, I've explained elsewhere why I doubt such a return could be sustained, assuming it might be achieved at all.

That leaves the frozen Fed strategy. For this alternative I admit to having considerable sympathy: I can hardly do otherwise, having proposed the idea myself in my first book (see chapter 11). Besides, unlike the other plans this one could preserve the dollar network whilst safeguarding dollar holders from the Fed's machinations. But in what sense is this strategy any less of a cop-out than my now favorite plan for replacing the present Federal Reserve dollar with an NGDP- (or Domestic Final Demand) stabilizing Bitdollar? If a tamper-proof Bitdollar is a form of monetary central planning, then so is a frozen Fed dollar. The difference between the schemes is, not that one involves a planned base money stock and the other doesn't, but that one involves a fixed base money stock and the other doesn't.

But, you may ask, isn't a fixed stock of base money more consistent with laissez-faire than a stock that grows at some constant rate while also adjusting, albeit automatically, in response to changes in the real demand for base money? No, it isn't. Consider the classical gold standard, or any commodity-money regime for that matter. Such a regime involves, not a constant monetary base, but one that tends to expand along with growth in the real demand for base dollars. Thus the long-run price-level stability that was one of the gold standard's most noteworthy achievements. Whatever else it might be doing, a discretionary Fed that insisted upon keeping the monetary base constant would not be emulating a gold standard. Instead, it would be pursuing a policy that might well lead to disturbances as serious, if not considerably more serious, than those that could be justly attributed to the historical gold standard or (for that matter) than those that might arise today under a discretion-based regime that yielded low and steady inflation. In any event the belief that a central bank is "doing nothing" when it chooses to maintain a constant monetary base (or constant stock of any monetary aggregate) is my personal choice for top honors (and, take my word for it, the competition is stiff) in the "crudest free market monetary fallacy" contest.

Free banking would, to be sure, go a long way toward reducing the risk of money shortages, and consequent downturns, in a frozen-base regime, both because it would allow changes in the relative demand for currency to be accommodated through greater emissions of private banknotes (or their digital counterparts) without need for more base money, and because changes in the free-banking base-money multiplier would tend (for reasons also given in The Theory of Free Banking) to automatically compensate for changes in the velocity of money. But these tendencies would still not suffice to avoid some risk of unwanted deflation--which is to say, deflation that's not just a reflection of productivity gains.* In particular, they would not allow for monetary expansion to accommodate growth in the supply of factors of production, and of labor especially. An automatic and tamper-proof regime providing for a constant spending growth rate would come closer to avoiding both monetary excess and monetary shortages. And that's why I favor such a regime, now that Bitcoin has suggested a means for implementing it.

It would be unnecessary for me to say, where it not for certain contrary animadversions, that, far from being a monetary freedom apostate, I remain as committed to free banking, and to monetary freedom in the more general sense, as ever. I still pine for truly unregulated banking, minus all the regulatory red-tape but also minus government safety nets and the prospect of Fed (or Treasury) bailouts. I still oppose all artificial restraints upon free trade in currency. I still would rather have private mints coining and private firms issuing our small change, for goodness sake! But I also want to see the dollar made safe and sound, and the sooner the better; and I can think of no better way of making it so than by replacing the present discretion-based version with one that provides for an automatically-determined supply of dollars--an automatic mechanism not unlike the one that characterized the gold standard, though one both more conducive to short-run stability and less dependent upon untrustworthy promises.

*I can hear certain self-styled Austrian economists grumbling to themselves, "but there's nothing wrong with any sort of deflation!" Here is another good candidate for the previously-mentioned contest. Like it or not, in today's world, many prices, and wage rates especially, are notoriously "sticky" downwards, which means that a plunge in general spending is bound to result in otherwise avoidable unemployment. True, Murray Rothbard says otherwise in the theoretical part of America's Great Depression. But then he spends the rest of the book explaining how Hoover changed everything with his silly high-wages doctrine. Whether or not price stickiness originated with Hoover, it certainly didn't end with him!


Bernard von NotHaus case

by Kurt Schuler December 11th, 2014 10:34 pm

Forbes article here, worth reading. Larry White offered testimony in NotHaus's favor, if I recall correctly, and perhaps he will have some comment.


Two belated anniversaries

by Kurt Schuler December 11th, 2014 10:25 pm

The centenary of the opening of the Federal Reserve System was November 16, 1914. The Federal Reserve Act was passed in December 1913 but the organization took nearly a year to open. Here is the Federal Reserve page on the event. Since it was not previously mentioned on this blog, I am bringing it up now.

As you can tell from the date, the Fed did not open until after World War I began. The financial troubles in the United States connected with the outbreak of the war were handled by the private sector and the Treasury Department. William Silber, a professor at New York University, wrote a book several years ago on the episode, When Washington Shut Down Wall Street. Among the subjects he discusses is the closure of the New York Stock Exchange for several months. With the NYSE closed, an unofficial market sprang up in New Street, which ran along the back side of the NYSE building. The establishment press refused to publish stock price data from New Street trading, but Silber found one paper that did so, perhaps because its usual focus was on horse racing and entertainment, hence it was not beholden to Wall Street for stories or advertising revenue. The paper stopped publishing data some weeks before the shutdown period ended, though. Recently two students at Johns Hopkins University filled in the remaining data using a previously untapped source and wrote a paper about it. More generally, I think much work remains to be done about what steps governments and the private sector might take under a free banking system when some catastrophic event occurs. The absence of a central bank does not remove the need to take some steps similar to what a central bank might do, but one hopes such steps could be undertaken with more reliance on voluntary consent.

This year is also the 30th anniversary of the publication of Larry White’s Free Banking in Britain (link is to the second edition, 1995). I have a slight personal connection to the book, having prepared the index to the first edition along with George Selgin. Vera Smith’s Rationale of Central Banking and Hayek’s Choice in Currency (later expanded and retitled Denationalisation of Money) were earlier, but to my mind Larry’s book marks the real start of contemporary free banking theory because it combined theory, economic history, and history of thought in an appealing way. Larry showed that the Scottish free banking system had worked well, and that its workings were both contrary to what was usually taught about laissez faire in money and banking textbooks and consonant with what is taught about markets in microeconomics textbooks. Vera Smith’s fine book was unfortunately neglected when it first appeared (1936, the same year as Keynes’s General Theory of Interest, Employment and Money). What could have been an intellectual movement was stillborn. Larry’s book has borne ample fruit intellectually, if not all that he has wished for in terms of policy.


We Are All Free Banking Theorists Now*

by George Selgin December 7th, 2014 12:33 am

(*And we always have been.)


Yesterday, while giving Cato's interns an impromptu talk about my work, I found myself saying something that seems worth putting in writing. This was that the difference between me and Larry White and Kevin Dowd, among others, and most other monetary economists, isn't that we theorize about free banking, and they don't. It's that we're mindful of our free-banking theories, whereas they're mostly heedless of their own.

Consider: an economist says that central banks prevent or limit the severity of financial crises, or that without mandatory deposit insurance even sound banks are likely to face runs, or that banks can never be expected to hold enough capital unless we force them to, or that commercially-supplied banknotes will tend to be discounted. All such claims--which is to say any claims about the need for or consequences of government intervention in banking--depend, if not on an explicit understanding of the nature and workings of a laissez-faire banking system, then on some implicit understanding. And this understanding in turn implies a theory of some sort, for reference to experience alone won't suffice for drawing the sort of sweeping conclusions I'm talking about. It follows that all economists who have anything to say about the effects of government intervention in the banking system are either self-proclaimed free banking theorists or are free banking theorists who don't admit (and perhaps don't realize) it.

The rub is that tacit or subconscious theories of free banking--the sort people rely upon when they are "doing" free banking theory without being conscious of it--are likely to be bad theories because, being unstated, they can't be challenged, and, being unchallenged, they don't tend to be systematically corrected. A self-conscious free banking theorist confronted with some claim of banking-market failure might point to his own theory suggesting that no such failure exists, and might also point to contrary evidence. But he can't generally infer, and therefore can't directly contradict, the theory behind the claim.

If even economists who've never heard of free banking, or who dismiss both it and the people who take it seriously, nevertheless subscribe to some free banking theories of their own, where do their theories come from? As I can't read other economists' minds, I can't pretend to know the answer. However, I can, and I will, hazard a guess or two.

Consider, if you will, your typical fresh PhD, having monetary or (more commonly) macroeconomics as a specialty, as might have been disgorged by any save a handful of the doctoral programs in the U.S. sometime during, say, the last 30 years. In all likelihood that graduate never took a class on economic history, let alone one on monetary history or (least likely of all) the history of economic thought. Nor is he or she likely to have become familiar with even present day monetary institutions through any other coursework, most of which is devoted to mastering either statistical methods or highly abstract models. As for the monetary sequence itself, it is likely to have involved toying with Overlapping Generations models, which don't even get the definition of money right, or Woodford-style neo-Wicksellian economics, which (unlike the Swedish real McCoy) strives to avoid using the "m" word altogether. Some better students, to be sure, will make up for the lack of institutional meat in their bland graduate-school porridge by grabbing the occasional vitamin from the library. But even when I went to school (NYU, class of '86), that sort of thing was relatively rare. Today, to judge from the many grad students I talk to, a student who dare's to do it, besides risking failure by having less time left to study for prelims, is sure to be regarded as a weirdo.

After graduation, perhaps? So far as most economists employed in research universities are concerned, Fuggedaboudit. Publish or perish means, for the vast majority, polishing up the three-articles that comprise their dissertation, and then milking the same highly-specialized human capital that sufficed for producing those "chapters" for all it's worth, which, with luck, will be additional articles enough to get one over the tenure threshold. With the tenure clock ticking inexorably, and journals taking their sweet time to return reports, who can afford to be intellectually curious? After tenure? Not likely, since most tenured faculty, having developed a shtick which, with the help of some elegant variations, may serve as well in getting them promoted again as it did in getting them tenured, still won't get around to learning stuff that they now regard, with perfect justice, as perfectly irrelevant to mastering their profession. Better to angle for department head, or (for those with higher aspirations) to take up golf.

The upshot of all this is that most of what our monetary economist knows or believes about monetary institutions he or she learned as an undergraduate. And what was that? To infer from the contents of most principles and money and banking textbooks, very little, and much of it misleading. Of monetary history, in particular, such books (1) say very little, if anything at all; (2) refer (if written for the U.S. market or by U.S.-trained economists) only to U.S. experience; and (3) get that wrong. Reading such books, you are quite likely to learn (for examples) that banking started out as a big swindle, that before the Civil War U.S. banks were hardly regulated at all and that, for that reason, American's were saddled with all sorts of banknotes, most of which were worth far less than their face values; that the Federal Government nationalized the currency supply, forcing state banks out of the business, during the Civil War because it was suddenly inspired to establish a uniform currency; that post-Civil War panics were inevitable given that we still lacked a central bank; that during the Great Depression people staged runs willy-nilly on good and bad banks alike until, in early 1933, they lost confidence in every last one of 'em, thus proving beyond doubt the necessity of nationwide deposit insurance; and that the Fed is an independent central bank, having become so in 1951. My conjecture, in short, is that tacit theories of free banking are most likely cobbled together, unconsciously and therefore haphazardly, from such substandard undergraduate building material.

So much for academic economists, or at least for the vast majority of them under the age of 60. If you want an academic economist who really knows his monetary institutions, a good rule of thumb is, the older the better. Try Dick Timberlake (92), or Leland Yeager (90), or Alan Meltzer (86), or Axel Leijonhufvud (81), or Charles Goodhart (78), or David Laidler (76). But beware that, even among Laidler's cohort, there are plenty who don't seem to be know a bank from a hole in the ground, or a redeemable banknote from (say) a durable good.

True, economists who work for the Fed, or at least for research departments of the various reserve banks, are another matter. Their jobs tend to encourage them to be familiar with at least some real-world monetary institutions; and I know quite a few, not all of them yet 60, who know their monetary history pretty well, including a fair bit about free banking. Having actually heard of it and thought about it, their theories of free banking, if still implicit, are at least reasonably well informed. They also tend to be rather more interested in, and favorably disposed to, what we avowed free-banking theorists have been saying, than their academic counterparts.

Would that this were also true of the Fed's higher ups, including its highest-ups of all. Alas, officially at least, their understanding of free banking is not much better than that of our lowly tenure-grubbing assistant professor. Consider even Ben Bernanke, a Fed chair regarded as an expert monetary history. To judge from his GWU lectures, at least, his general take on U.S. monetary experience doesn't seem all that different from the conventional textbook wisdom I mentioned a few paragraphs ago. The Fed's other "educational" productions, aimed at general readers (as opposed to its research intended for other experts) are for the most part even worse.

Some persons hearing me claim that many economists, including those who want nothing to do with free banking theory, are free banking theorists themselves, albeit ones who don't know it (and whose theory is likely to be the poorer for it) will, I imagine, think to themselves, "What in the blazes is Selgin thinking? Of course free banking's critics have a theory, and not just a tacit one. They've got a theory and they know it. They've got...Diamond and Dybvig! What's more, it's a real theory, a rigorous theory, with equations and optimization and all, not like the loosey-goosey stuff free-bankers churn out. What more can Selgin possibly want?"

A lot more, actually. Because, notwithstanding all its bells and whistles and tweakability (the quality of lending itself to publishable variations), the Diamond-Dybvig model isn't a formal representation of free banking at all. It's a formal representation of the same cartoon version of free banking that, if I guess correctly, informs most tacit free banking theories. More precisely, it's a formal model that takes as its starting point the assumption than an unregulated banking system is one that might at any moment fall victim to random yet system-wide runs.

I'm not saying that the D-D model is anything less than ingenious. In fact, it isn't easy at all to come up with a model that obeys the rule of not having agents do anything that doesn't increase their expected utility, and yet have it imply occasional if not frequent disasters. In this case, it took some doing. Diamond and Dybvig had to assume away, among other things, (1) the difference between a bunch of idiosyncratic banks and a single representative bank; (2) bank equity, which would otherwise drive a wedge between adverse shocks and bank insolvency; (3) any distinction between banks' reserves and an economy's consumption goods (which makes consumption equivalent to disintermediation); (4)...well, read Kevin Dowd's excellent survey if you want the whole rather long list. The gist of it all, anyway, is that in Diamond and Dybvig we have, not a formal model explaining the workings of some actual banking system, laissez-faire or otherwise, but a formal and in that sense only "rigorous" re-telling of a hackneyed textbook banking myth.

Does any of this prove that the self-aware free banking theorizing of myself, Kevin Dowd, Larry White, and others is any good? Of course it doesn't. Our theories might be perfectly lousy, and I suppose some of them are so. But at least we've arrived at these theories deliberately, after consulting evidence from actual free (or at least relatively free) banking systems, and with due attention to criticisms that our attempts have elicited. Of course it's possible nonetheless that some of the tacit theories informing the case for intervention are, for all their slap-dashed-ness, closer to the mark. But what are the odds? Better, I'm sure, than those of a chimp typing War and Peace. But not nearly enough to bet on.

But the point of my remarks isn't to pass judgement on the views of critics of free banking. It is merely to encourage more of them to join in a more explicit debate concerning what a free banking system would look like, and how well it might perform.


A 1920-21 Recovery Myth

by George Selgin December 4th, 2014 3:00 pm

The Forgotten Depression, Jim Grant's excellent book about the 1920-21 downturn and the recovery that followed, has generated a burst of critical commentary from persons anxious to reject the principal conclusion Grant draws from that episode. That conclusion, in brief, is that the U.S. was able to recover relatively quickly from at least one deep slump (and the '21 slump was deep, to judge not only from price statistics but also from available if sketchy unemployment statistics) despite authorities' refusal to resort to either fiscal or monetary stimulus. On the contrary, Grant observes, both fiscal and monetary policy were, according to today's Keynesian-influenced understanding, more contractionary than expansionary.

I've no desire to plunge into the general controversy concerning what other lessons one might safely draw from the 1920-21 episode, except to point out (as many of Grant's critics fail to do) that Grant himself resists drawing many other conclusions. He never claims, first of all, that Harding-administration-type policies might have been a dandy solution in 2008. Nor does he insist that post-2008-style expansionary fiscal and monetary policies would have made for a less satisfactory recovery had they been employed in '21. "We can't know what might have been," Grant writes (p. 2) "if Wilson and Harding had intervened as presidents in of the late 20th and early 21st centuries are wont to do." Grant merely settles for observing that "When, as 31st president, Hoover did intervene--notably, in an attempt to prevent a drop in wages--the results were unsatisfactory" (ibid.) The results of FDR's more aggressive interference with price and wage cuts, through the NRA and AAA, were, I would add, still more so.

If there's a foolish generalization lurking about here, or anywhere else in Grant's book (say, for instance, a "citation of the 1921 economic recovery as somehow refuting everything we’ve learned about macroeconomics since then," or an assertion to the effect that "If only we had let wages and prices crash in 2009, we would be in la la land right now,") I hope someone (Paul? Barkley?) will be so kind as to point it out to me. I also hope Barkley will explain to me why, in purporting to refute Grant's thesis, he compares what happened in 1920-21, not with what transpired in 1929-33 (which is the one episode concerning which Grant himself draws comparisons) but with what happened in various post-WWII recessions to which Grant himself never even refers.

My concern here, in any event, isn't with the general lessons that either should or shouldn't be drawn from the post-21 recovery, but with a particular myth concerning that recovery, namely, the myth that, contrary to what Grant and others have suggested, the Fed did in fact help out, and help out in a big way, by loosening of monetary policy.

Barkley Rosser has been particularly anxious to make hay with this claim, especially in the post (linked above) written in response to the recent Cato Book Forum over which I presided, featuring Grant's book. (For his part Krugman settles for a mere link to Barkley's post--this in a post implicitly accusing Grant, whose book Krugman almost certainly didn't bother to read, of laziness!) "In 1921," Barkley writes, "the Fed reversed course and lowered the discount rate back down to 4%. The economy then went into its rapid rebound. I note that in his remarks at Cato, at least Larry White did note this point as a caveat on all the proceedings. Bordo et al also note that both Irving Fisher and also Friedman and Schwartz pinpointed the role of the Fed in all this and declared it to have behaved very irresponsibly in the entire episode. But for Grant and Samuelson, the Fed barely even existed then."

The claim about Fed easing having ended the 21 slump has been repeated by many others, including The Economist, which in its review of Grant's book observes that "The Fed brought on the 1920-21 depression with high interest rates. Those rates drew in gold anew, which, along with deflation and political pressure, eventually caused the Fed to relent and lower rates. The slump and recovery were thus not the spontaneous product of the free market but of deliberate policy, much as in later recessions." Another proponent of this view is Daniel Kuehn, who has written two articles and several blog posts countering Austrian claims about the implications of the 1920-21 episode. In a comment responding to a laudatory David Glasner post concerning his work on the subject, for example, Kuehn claims that Fed "loosening...definitely played a prominent role in the recovery" from the 1921 slump.

What, then, are the facts of the matter? One fact, or set of them, to which Barkley and Co. refer, is that the Fed banks did indeed lower their discount rates, from 7%, where they'd stood since June of 1920, to 6.5% in May 1921, and then all the way to 4.5% in November 1921. (The further reduction to 4% to which Barkley refers did not occur until June 1922.) But, as Scott Sumner has been tirelessly observing for some years now, even under an interest-rate targeting regime, a low policy rate doesn't necessarily mean easy money. Instead, low rates can reflect slack demand for funds, and indeed tend to do just that in any slump. A Wicksellian would say that what matters isn't where rates stand absolutely, but where they are relative to their "natural" counterparts.

But treating the discount rate as an indicator of the stance of monetary policy with reference to the 1920-21 episode is even worse than treating it so in reference to more recent experience. In recent times, you see, the relevant policy rate has been, not the Fed's discount rate--the rate at which it extends discount-window loans--but the federal funds rate, to which, in the good old day's before the recent recession, it assigned a target value, to be achieved using open-market operations, by means of which the supply of federal funds (that is, overnight loans of bank reserves) would be either increased or reduced sufficiently to bring the funds rate to its target level. A decision to "lower interest rates" by the Fed thus tended to imply a decision to expand the monetary base by adding to the Fed's security holdings. Thus, although low rates didn't necessarily mean "easy" money, a decision to target lower rates did at least tend to mean more money.

Back in the 20s, on the other hand, a lowering of the Fed's policy rate--here, not the federal funds rate but the discount rate--might not even imply an increase in Fed lending or security purchases. In reducing its discount rate from 6.5% to 4.5%, for example, the Fed merely allowed banks possessing the requisite commercial paper to discount that paper with it at the newly reduced rates. Whether they would do so, however, depended on whether the rates in question were low, not merely compared to previous rates, but relative to market rates generally or, again, to "natural" rates. If not, the volume of discounting might not budge, and the lower rates would not imply any actual monetary expansion, except perhaps relative to the contraction that might have ensued had rates remained high.

So, did the Fed, by lowering its discount rate, actually give the U.S. economy a dose of monetary stimulus? It did not, as can be readily seen by referring to the chart below, reproduced from Nathan Lewis's New World Economics blog:


As you can see from the chart, although there was some increase in "bills discounted" in response to the Fed's lowering of its discount rate, the increase was slight compared to the massive decline in total Fed non-gold assets since 1920. What's more, it was more-or-less perfectly--and by implication quite intentionally--offset or "sterilized" by means of Fed sales of government securities. The Fed's contribution to recovery, in short, consisted, not of any actual monetary stimulus, but of a mere cessation of what had been a precipitous decline in its interest-earning asset holdings.

This isn't to say that monetary expansion played no part in the post-1921 recovery. In fact, it played a significant part. But the expansion that took place was due solely to gold inflows, which were themselves encouraged by relatively high interest rates as well as by falling prices--that is, by the normal working of the price mechanism rather than by activist Fed policy. (In the 30s as well, by the way, such recovery as took place was entirely the result not of Fed easing--or of fiscal stimulus--but of the dollar's devaluation and subsequent gold inflows from Europe.) That gold flows (as opposed to Fed easing) contributed to the post-1921 recovery is itself a fact that Jim Grant readily acknowledges; his book's 17th chapter is called "Gold Pours into America."

In fine, far from having overlooked the real cause of the recovery, as his critics claim, Grant seems to have gotten it just right, whereas they all seem to have been led astray by an interest-rate red-herring.

While preparing this post I was unaware of Bob Murphy's reply to Krugman's remarks, which is very much worth reading.


Defending dollarization in Ecuador

by Larry White December 4th, 2014 2:52 pm

I visited Quito and Guayaquil in Ecuador last month to speak at conferences celebrating the fifteenth anniversary of official dollarization. The conference in Quito was sponsored by the Universidad de San Francisco de Quito, headed by Dr. Santiago Gangotena; in Guayaquil by the think tank IEEP which is headed by Dora de Ampuero. Although dollarization is popular and successful, the government appears to be working to undermine it. Here are some highlights from the remarks I prepared.

Dollarization and Free Choice in Currency

The dollarization of Ecuador was not chosen by policy-makers. It was chosen by the people. It grew from free choices people made between dollars and sucres. The people preferred a relatively sound money to a clearly unsound money. By their actions to dollarize themselves, they dislodged the rapidly depreciating sucre and spontaneously established a de facto US dollar standard. (Many commentators refer to this decentralized process of voluntary currency switching “unofficial dollarization.” I prefer to call it popular dollarization, or dolarización popular.) Finally, in January 2000, Ecuador’s government stopped fighting their choice. Until that point the state tried to use legal penalties or subsidies to slow currency switching. Today the state threatens an attempt to reverse the people’s choice through legal compulsion. Such policy actions violate the widely accepted principle that the individual is sovereign over his or her own household property.

Everyone knows that free and open competitive markets better serve consumers (and producers) than state-granted monopolies. For example, it is clearly better for consumers to have several mobile phone companies competing for their business than to be subject to monopoly pricing from a single state-licensed monopoly. To make economic policy with the individual’s welfare in mind requires policy-makers to respect the principle of individual sovereignty in markets.

Many economists have thought, however, that currency is an exception to the rule. They don’t understand how there can be a competitive choice among currencies. Theory tells them that “network effects” ensure that a single monetary standard (silver, gold, US dollar, sucre, Mexican peso, euro, et cetera) prevails in any economy. The usual policy conclusion from this line of argument is that, since the market will only have a single provider in any case, the state should run the monetary system in the public interest.

Such economists are only looking at the blackboard and not at what is happening outside the window. (Evidently they have never lived where multiple currencies have been widely used.) Transactional network effects do exist, not only at the national level but at the global level: other things equal, you prefer to use the money that more of your trading partners use. Ecuadorans chose the US dollar over (say) the Swiss franc precisely because of such network effects. But current network size is not the only characteristic that matters to consumers and businesspeople when choosing among currencies for use in transacting, saving, or posting prices. The costs of holding and using a currency also matter. When people are free to choose, they will abandon an established currency, no matter how locally dominant, that is being so rapidly issued that its purchasing power is rapidly disappearing. If the established monetary standard could never be dislodged by free choice, then Ecuador would still be using the sucre.

Economists or policymakers who argue against a country’s dollarization, even when its people clearly demonstrate a preference for the dollar, either fail to think about dollarization as a market phenomenon that grows from individual choices, or they don’t believe that individuals deserve respect. Instead they think about the monetary system only as a tool to be engineered and manipulated by expert policy analysts (presumably themselves). They conduct themselves not as citizen advocates, but as technical advisors to the state.


Ecuador’s success with dollarization

Although some local critics of dollarization in 1999 predicted that the transition from the sucre to the dollar would cause a deep recession with high unemployment, the opposite happened. Due to high inflation, the people had of course already dollarized themselves by the end of 1999. Making dollarization official in January 2000 helped to complete the transition from the disorder of a collapsing currency to the calm of a relatively stable currency. The economy did not fall further into recession but responded with growth. After a steep drop in real output in 1999 (-4.74%), output growth returned to the positive range in 2000 (1.09%), then resumed a healthy pace in 2001 and 2002 (4.02% and 4.10%). Growth under dollarization has continued to be much healthier than under the sucre regime. From 2000 to 2013, Ecuador’s real GDP grew 75% in total, a compound annual rate of 4.4%. During the previous 13 years, 1987 to 2000, total real growth was only 36%, an annual rate of only 2.4%.

Today, the Ecuadoran economy is doing quite well on several standard macroeconomic indicators. The American economist Steve Hanke provides one way to rank its performance in his article in the magazine Globe Asia in May 2014. There he defines and applies a “misery index” in which a country’s current misery index = inflation rate + lending interest rate + unemployment rate (all bad things), minus per capita GDP growth over the previous year (a good thing). Venezuela has the worst score, the #1 highest measured macroeconomic misery not only in South America, but in the world. Ecuador’s score is the best in South America. Is dollarization responsible? Yes. The only two countries with better scores in Latin America are El Salvador and Panama, the only other dollarized countries.

Dollarization has also brought improvement to Ecuador’s banking system, according to two analysts at the Federal Reserve Bank of Atlanta. Mynam Quispe-Agnoli and Elena Whisler, in a 2006 article, noted correctly that dollarization, by ruling out an official lender of last resort able to create dollar bank reserves with the push of a button, eliminates an important source of moral hazard. In this way dollarization has the potential to reduce risky bank behavior, and thus so “make banks runs less likely because consumers and businesses may have greater confidence in the domestic banking system.” Lacking the expectation that “the monetary authority would come to the rescue of troubled banks” whether solvent or insolvent, banks in a dollarized system “have to manage their own solvency and liquidity risks better, taking the respective precautionary measures.”

We have long seen this benefit realized in the stability of banks in offshore centers like the Cayman Islands, the Bahamas, Jersey and Guernsey, and Panama, which have no official lenders of last resort – and no crises. The Atlanta Fed analysts saw it being realized in Ecuador as well. Ecuadoran banks now hold higher reserves and a greater share of liquid assets overall, and hold safer asset portfolios than in the 1990s. Just as importantly, because it has eliminated large swings in the inflation rate and in the expected inflation rate, dollarization “fosters an environment beneficial to financial intermediation.” In particular, it encourages the public to hold greater bank deposits (the ratio of deposits to GDP in Ecuador, which was just below 20 percent in 2000, is today just above 30 percent) and thereby provides a greater volume of funds to investors. On the lending side, loan quality has improved because banks no longer face loan default risks due to exchange rate swings that render borrowing firms unable to repay. Meanwhile, as compared to a system with partial dollarization, banks themselves have become less prone to large devaluation losses, because dollarization eliminates the devaluation risk that used to arise from currency mismatches on bank balance sheets.

While 15 years is only a fraction of a century, it is not too much to hope that Ecuador’s banking system is following in the path of Panama’s. With more than a century of dollarization, Panama has the deepest financial markets and most efficient banks in Latin America.

To summarize, official dollarization in Ecuador has (1) lowered inflation, (2) fostered financial deepening and thereby real growth, and (3) lowered transaction costs for importing, exporting, and making remittances. What it has not done, of course, is to limit the growth of government spending while government revenue has grown, although it has eliminated the ability to cover deficits by printing money.


Ecuador’s prospects

While we celebrate Ecuador’s fifteen years of success with dollarization, and think about extending it, we must take note of two dark clouds on the horizon.

First, Ecuador still has a central bank. Although the BCE is presently precluded from issuing paper currency, it continues to be assigned by public law “the responsibility of implementing the monetary, credit, foreign exchange and financial policies formulated by the Executive.” Why? We should have no doubt that the Executive would dearly love to once again have a monetary policy to conduct. We should expect the BCE’s own funcionarios to seek to enlarge the scope of the bank’s discretionary powers, if only in the sincere hope that they could do more good. But we know that the direction of greater discretion in monetary policy leads back toward the conditions of 1999. With dollarization, a central bank is completely unnecessary.

Second, I have been learning with concern – as I am sure you have – about the plans of the national government of Ecuador to issue its own digital mobile-phone currency. The idea is for the Banco Central to issue dollar-denominated electronic credits that customers of the government-owned mobile phone network CNT can use to make payments by phone. As the Associated Press reported August 2014: “Such mobile payments schemes are already popular in African nations including Kenya and Tanzania, where they are privately run. The new currency was approved, and stateless crypto-currencies such as Bitcoin simultaneously banned, by Ecuador’s National Assembly last month. The official in charge of the new currency, Fausto Valencia, said the software is already used in Paraguay by cellphone companies.”

There is no reason to believe that a national government can run a mobile payment system more efficiently than private firms like Vodafone (which originated and runs the successful M-Pesa system in Kenya) and Tigo (which runs the Giros Tigo system in Paraguay). Why not let the private mobile phone companies also compete to provide mobile payments in Ecuador, issuing their own dollar-denominated account credits? Instead they are banned unless they use the government’s credits. Such a ban is costly to ordinary consumers. Evidence from around the world shows that payment by mobile account credits is the type of service that firms in a competitive market can produce, will produce when there is a normal rate of return to be earned, and produce at lower cost than state-owned enterprises.

The government insists that its new system will be “voluntary.” But when the state gives itself a monopoly on a service, blocking individuals from the voluntary choice to use another provider, the option to “take it or leave it” is not fully voluntary. If the government sincerely wishes to help the poor and unbanked, it should let private providers enter the competition, which will drive down the fees that the poor and unbanked will have to pay.

It is very curious that a law supposedly seeking to provide the poor with low-cost access to payment systems would ban Bitcoin. (The only other country in South America to ban Bitcoin appears to be Bolivia.) In countries that receive income from remittances, Bitcoin has the potential to noticeably increase national income by lowering the cost of remittance. What the family in the home country receives is much closer to the amount that the worker abroad has paid to send when the worker uses Bitcoin rather than Western Union or another old-fashioned high-priced system. Researchers at the Pew Center in the United States estimate that remittances account for about 3% of Ecuador’s GDP. In 2012 the average Ecuadoran working in the United States sent home $2607 dollars. So this is not a trivial matter. Bitcoin remittances could contribute many dollars to the pockets of Ecuador’s poor.

A report from the news service Payment Week says of the government’s mobile payment project: “The currency will serve as… a way for the country to regain some control over its economic system. The production of the new currency would completely depend upon demand.” But these two sentences can’t both be true. The new system can’t both allow the government to “regain some control” over the economy and also make the volume of credits “completely depend on demand,” which implies that the government is passive and exercises no control.

Given that is doesn’t make economic sense, why does the government want to issue mobile payment credits as a monopolist? It seems likely that the project is meant as a fiscal measure. One million dollars held by the public in the form of government-issued credits is a million-dollar interest-free loan from the public to the government. According to Payment Week, “The government has said it won’t use the [new] currency to fund public spending,” but this is hard to fathom. If the project makes a profit, where else would the profit go?

If the government can make a profit at mobile payments, even though they have no expertise or comparative advantage in the area, surely Movistar or Claro can operate more efficiently and make larger profits, even while charging lower fees. Why not let the private sector operate in this area? Why not let the public choose which firm has the most reliable and trustworthy service? If the government desires to subsidize the use of the service by the poor, it has the option of issuing them vouchers. It need not provide the service itself, and certainly not as a monopolist.

Personally, I would find dollar-denominated account credits that are claims on Movistar or Claro more credible than claims on the government of Ecuador. After all, unlike the government, neither company defaulted on its bonds in the past 12 years. Claims on private companies are legally enforceable. The company cannot suspend payment or devalue its IOUs without taken to court and forced to pay or dissolve. Competition for business compels payment firms them to worry about reputation, and so compels them to manage the business so that their readiness, ability and willingness to pay is not in doubt. A government agency, by contrast, cannot be sued for breach of contract, and has no concern about maintaining a good reputation when it has no competitors. If CNT or the BCE decides to devalue mobile credits against the US dollar, holders have no remedy in court. People who are thinking about holding the credits need to consider the default risk. The “backing” requirements in the law are completely toothless against a government that chooses to default.

In sum, there is no plausibly efficient or honorable reason for the Ecuadoran government to go into the business of providing an exclusive medium for mobile payments. Consequently it is hard to make any sense of the project other than as fiscal maneuver that paves the way toward official de-dollarization. I gather that President Correa does not like the way that dollarization limits his government’s power to manage the economy. He has compared the limitation to “boxing with one arm.” But as I have already emphasized, retiring the government from boxing against the economy by means of money-printing is precisely dollarization’s great virtue.


Money, Economic Growth, and the Fed

by George Selgin December 3rd, 2014 1:49 pm

That's the title of my contribution to Cato's online forum on "Reviving Economic Growth." The forum anticipates a conference on "The Future of U.S. Economic Growth" being held at Cato all day tomorrow.

My forum piece is an edited version of a somewhat longer paper I plan to publish separately.

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