Alt-M Ideas for an Alternative Monetary Future Thu, 02 Jul 2015 14:13:46 +0000 en-US hourly 1 Alt-M Redux: Incredible Commitments: Why the Euro is Destroying both Europe and Itself Thu, 02 Jul 2015 14:13:46 +0000 (Every now and then, it seems worthwhile to re-post a seemingly pertinent item from our archives.  Thus the ongoing Greek crisis inspires me to air once more a post I wrote in 2012 concerning the flaws of Europe's currency system that had already begun to set the stage for the events of...

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Euro, Eurozone, ECB, European Union(Every now and then, it seems worthwhile to re-post a seemingly pertinent item from our archives.  Thus the ongoing Greek crisis inspires me to air once more a post I wrote in 2012 concerning the flaws of Europe's currency system that had already begun to set the stage for the events of the last few days.  And so, here is the first item in our new "Alt-M Redux" series.)


Except for omitted section headings what follows is the full text of the paper [since published in The Cato Journal] I presented last week [September 2012] at the Mont Pelerin Society General Meeting in Prague. As the paper had to be completed on time for a May deadline, it could not take into account subsequent developments. Fortunately those developments have mainly been entirely consistent with the paper's general thrust.

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In particular,

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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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


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


Bagus, Philip. 2012. “The Eurozone: A Moral-Hazard Morass.” Mises Daily, April 17

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

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

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

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

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

Feldstein, Martin. 1997. “EMU and International Conflict.” Foreign Affairs,

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

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

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

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

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

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

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

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

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

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

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Why free-banking? Wed, 01 Jul 2015 14:39:04 +0000 The need for and convenience of a central bank are usually taken for granted.  To say that a central bank is a good institution and, therefore, needed, is not enough.  Unfortunately, the assumption that central banks are necessary seems to weigh more heavily than the facts that suggest otherwise. Good...

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Ayr Bank, Scotland, Australia, central bankingThe need for and convenience of a central bank are usually taken for granted.  To say that a central bank is a good institution and, therefore, needed, is not enough.  Unfortunately, the assumption that central banks are necessary seems to weigh more heavily than the facts that suggest otherwise.

Good and bad are relative terms.  With respect to what then is a central bank good?  Some might say to the absence of a central bank- or more specifically, to the presence of a free banking regime.

Historical records, however, show that free banking outperforms central banks in most, if not all, of the cases.

A free banking regime is such where the market for money and banking is free of specific regulation (save, of course, illegal activities such as the violation of third party property rights.)  Let me be clear. The absence of a central bank is not equivalent to free banking.  The absence of regulation is equivalent to free banking.  This is why to think of the pre-Fed era in the United States as a case of free banking shows a superficial understanding of what an unregulated –free– market is.

The literature on free banking is vast.  Let me just give a brief description and comment on a couple of illustrative historical cases.  First, under free banking, each bank is free to issue their own convertible banknotes.  Convertible to what?  To whatever functions as base money in the economy. Historically, this has been gold, but this does not need to be the case.  It could be, like Selgin describes in his Theory of Free Banking, that the Federal Reserve shuts down the FOMC and that the USD becomes the base money to which private convertible banknotes are convertible.  Whether or not the USD will eventually be replaced by gold, silver, or any other asset is up to the market process to sort out.

Second, because all banknotes are convertible to the same base money, there is no multiplicity of units of account.  Under this regime, there should be no fear of confusion about the multiplicity of prices.  If today you travel to Hong Kong, Ireland, or Scotland, you’ll see a strong presence of private money in circulation, but you won’t see multiplicity of units of account.  It could be said that the US banking system is not the most developed and flexible of the developed world.  On the contrary, the heavy regulation imposed on this market suggests that lot of improvement is possible and needed.

Third, the stability of the system comes from banks competing with each other for deposits and therefore for base money.  Surely, mathematical models showing how banking without central banks are instable can be developed.  With the right assumptions, it is possible to shows anything in a mathematical model.  Free banking shows a remarkably good performance, despite the claims that many academic models try to make.

Let me now comment on two examples that show that bank failures are not the same as bank runs. This would likely be the case under a fiat currency regime managed by central banks, but free banking works under a different regime and therefore with different incentives.  The outcome is a different performance.

Consider first free banking in Scotland (1716 – 1844).  In 1772 the “Ayr” bank collapsed, bringing other smaller banks down with it.  As spectacular as the Ayr Bank failure might have been, the Scottish free banking system did not suffer a bank run.  What happened?  The Ayr Bank was doing what any efficient bank would not do: aggressively increasing the issue of their convertible banknotes.  With the increase in circulation of convertible banknotes, the Ayr Bank started to lose reserves until it went bankrupt.  What about the other small banks?  These smaller banks were also doing what an efficient bank should not do.  These small banks invested their reserves in the Ayr Bank.  Why was there no bank run?  Succinctly, because the reserves that the Ayr Bank was losing were being transferred to other more efficiently managed banks.  This is the market outcome of over-expanding credit- no central authority is needed for this to take place.  The result is an increase in the market share of efficient banks at the expense of inefficient banks.  Isn’t that the outcome we want for any market- for efficient firms to displace inefficient firms?

The second case I want to mention is the economic crisis in Australia in 1890 under a free banking regime.  Australia was under free banking between 1830 and 1959.  The first thing to keep in mind is that the 1890 crisis in Australia was the result of Bank of England credit expansion being channeled to Australia.  The result was a bubble in land prices (sound familiar?)  When this process of credit expansion is reverted (in part to the Baring Crisis that was born from Argentina’s default) some banks experience solvency problems, other did not.  Those banks that saw the bubble and adjusted their portfolios where ready to buy the portfolio of the failing banks that did not see the crisis coming (again, sound familiar?)

Namely, the crisis was ready to be reverted.  But the U.K. government thought it knew better and made things worse (I can keep asking if it sounds familiar, but at this point the parallelism is quite obvious.)  The government committed two important mistakes.  First, it forced a bank holiday on banks that were in good standing and wanted to keep their doors open to their customers.  The result?  The market could not sort out which banks were solvent and which were not.  Second, it allowed failed banks to re-open their doors free of their previous liabilities, but this generosity was not extended to efficient banks.  The result was a bank run against efficient banks towards inefficient banks.  It should be patent that this was not a free banking failure, but just another case of regulation failure in one of the more complex and delicate markets.

If one looks at historical facts, rather than just let be guided by pre-conceived ideas, the need and superiority of central banking next to alternative monetary regimes is thrown into serious doubt. Surely, free banking is long gone and gold, which was used as base money under these cases, is not money anymore.

Why then look at free banking?  I can mention at least two reasons: (1) To do away with the almost ideological position that a central bank is needed.  This position, or assumption, needs to be questioned rather than taken as fact if we want to come up with innovative alternatives to our monetary regime.  (2) Even if the old free banking system based on gold standard is not feasible, it certainly helps us to come up with reform that can improve the status-quo.

[Cross-posted from Sound Money Project]

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Greece: A Financial Zombie State Mon, 29 Jun 2015 14:21:28 +0000 Banks in Greece will not open their doors Monday morning.  Greece has been moving towards this dramatic final act ever since it was allowed to enter the Eurozone with cooked fiscal accounts in January 2001 – two years after the euro was launched.  One Greek government after another embraced the...

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Greece Financial Zombie StateBanks in Greece will not open their doors Monday morning.  Greece has been moving towards this dramatic final act ever since it was allowed to enter the Eurozone with cooked fiscal accounts in January 2001 – two years after the euro was launched.  One Greek government after another embraced the idea that it did not have to rein in fiscal expenditures to match revenues because Brussels would cover any shortfalls.  That idea appeared to have worked, until other members of the Eurozone realized that the entire European project would fall apart if it became a transfer union.

This realization was brought into sharp focus by the bailout demands of Prime Minister Alexis Tsipras and his left-wing coalition government.  Brussels finally realized that if the demands of the Tsipras government (read: Europeans must pay for Athens’ largesse) were met, the Eurozone would morph into a giant moral hazard zone.  So, Brussels was forced to throw down the gauntlet: enough is enough.

Where does Athens go from here?  Well, to quote former President George W. Bush, as he observed the unfolding financial crisis in 2008: “If money doesn’t loosen up, this sucker could go down.”  Well, “W” had a point.  Changes in the money supply, broadly determined, cause changes in nominal national income and the price level.

Since October 2008, until the Syriza party took power, the broad measure of the Greek money supply (M3) contracted at an annual rate of just over 6%.  And as night follows day, the economy collapsed, shrinking by over 25% since the crisis of 2008.

Since the Tsipras government took the helm, the monetary contraction in Greece has accelerated. This means that a Greek depression of even greater magnitude is already baked in the cake.

And that’s not all.  It is going to get worse.  The total money supply (M3) can be broken down into its state money and bank money components.  State money is the high-powered money (the so-called monetary base) that is produced by central banks.  Bank money is produced by commercial banks through deposit creation.  Contrary to what most people think, bank money is much more important than state money.  In Greece, for example, bank money makes up just over 84% of the total money (M3) supply.

With banks so wounded, Greece is destined to become a financial zombie state.

[Cross-posted from Cato At Liberty]

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Speaking of Greece… Thu, 25 Jun 2015 14:26:22 +0000 If you think that the Fed isn't involved in the Greek mess, you may want to think again.  Paul-Martin Foss, our good friend at the Carl Menger Center, wrote a very nice post a few days ago concerning how the Fed may be getting itself tangled-up in an impending Greek...

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ECB, Federal Reserve, swap lines, EuroIf you think that the Fed isn't involved in the Greek mess, you may want to think again.  Paul-Martin Foss, our good friend at the Carl Menger Center, wrote a very nice post a few days ago concerning how the Fed may be getting itself tangled-up in an impending Greek default, through its swap lines with the ECB.

According to the Federal Reserve Board of Governors, those swap lines were first established in December 2007 "to improve liquidity conditions in U.S. and foreign financial markets by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress."

Those original swap facilities, never meant to be permanent, were shut-down in February 2010.  But — wouldn't you know it? — similar facilities were announced in May 2010 in response to "the re-emergence of strains in short term funding markets in Europe."  Those facilities were also supposed to be temporary, but then, in October 2013 — what do you know! — they were made permanent. According to the Fed, that step

further supports financial stability by reducing uncertainties among market participants as to whether and when these arrangements would be renewed.  This action results from the ongoing cooperation among these central banks to help maintain financial stability and confidence in global funding markets.

What has all this got to do with Greece?  Here is Paul-Martin:

If you want to get a sense of the Fed’s involvement in Europe, watch the swap lines.  Swap line data is published every Thursday afternoon on the Fed’s balance sheet, the H.4.1 release.  If you look at the St. Louis Fed’s charts and data on swap lines, you’ll see the huge amount of swaps during the financial crisis, and then a smaller but still significant increase in swap lines during the first iteration of the Greek financial crisis back in 2012.  While swaps have been relatively non-existent this year, there was a small blip back in April, likely Greek-related, and more importantly, another blip this week.  While the amount, $114 million, is a drop in the bucket compared to what it has been in the past, this number needs to be watched.  It could very well be an indicator of the Fed getting involved in Europe again.  And if the doomsday scenario ends up taking place next week, expect that $114 million figure to skyrocket.  The Fed seems to want the conversation to revolve around a possible upcoming interest rate hike, so it’s been relatively silent on the topic of Greece and its involvement in bailing out Europe.  But even if the Fed doesn’t say anything about Greece, its money-printing to pump up the swap lines will do plenty of talking.

That was on June 19th.  Well, the CMFA's champion Fed watcher, Walker Todd (who you will be hearing from shortly on these pages) has been keeping a sharp eye on those swap lines.  On June 11th — a  week before the transaction showed up on the Fed's own H.4.1 release — Walker reported  that "Someone in Europe drew a small amount on a dollar swap with FRBNY":

ECB website today has details below on a swap line drawing this week against the US dollar swap line with FRBNY.  It says that there was one bidder; one wonders whom.  Amount is $113 million.  There has been no swap line activity for several months now.  These numbers should show up on FRBNY next week (due to timing of swap drawings and time zone differences, there usually is a one-week lag between a drawing in Europe and the FRBNY report of the same drawing).

(The $1 million difference between the numbers mentioned by Paul-Martin and Walker reflects a Bank of Japan draw of that amount.)

The day after Paul-Martin's post came out, Walker alerted us to another transaction that had not yet been reported by the Fed:

It won't show up until next week in Fed statistics, but ECB statistics show that an unnamed entity (one suspects the same one as last week) borrowed again for a week under the dollar swap line for $115 million.  The drawing was $113 million the last time I checked.  As a purely hypothetical example, a Greek bank could be borrowing dollars under the swap line.  Other than a token $1 million to $2 million that Bank of Japan borrows from time to time to reassure itself, this is the only borrowing outstanding under the Fed's swap line, according to FRBNY statistics. The notable thing is that it is still there and growing.

Today the swap was rolled over yet again.

Stay tuned… .

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Europe's Hard Choice Wed, 24 Jun 2015 19:06:46 +0000 In Monday's Financial Times, columnist Gideon Rachman presented a grim outlook for Greece and the European Union.  He argues there are no good outcomes.  There are three options.  First, the EU can make concessions to Greece.  Second, the EU can stand firm and allow Greece to leave the Euro.  Third, the...

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ECB, Greece, Euro, European Union, IMFIn Monday's Financial Times, columnist Gideon Rachman presented a grim outlook for Greece and the European Union.  He argues there are no good outcomes.  There are three options.  First, the EU can make concessions to Greece.  Second, the EU can stand firm and allow Greece to leave the Euro.  Third, the Greek government can accept the EU's terms.

The first option represents a near-term victory for the Greek government.  It also creates moral hazard within the broader EU.  Governments in other countries implementing austerity measures would come under pressure.  Populist parties would make further electoral gains across Europe. Consensus rule within the EU would become impossible.

It is feared the second route would put pressure on other countries, e.g., Spain and Italy, viewed as being vulnerable to the economic woes besetting the Greeks.  That is an argument for “contagion.”

The third outcome may offer no long-term solution.  Even were the Greek government largely to accept what the EU, the ECB and the IMF want to impose on it, that would likely not solve the Greek problem in the long run.  Greece’s debt level would still likely be unsustainable.  It is not clear that any government can implement the far-reaching economic reforms needed to put the Greek economy on a sustainable growth trajectory.

Rachman’s analysis is cogent, if bleak.

The IMF, and its partners in the troika, first proposed its standard nostrum for a highly indebted sovereign: incur more debt.  Existing debt may be restructured, and payment terms extended, but always new loans are made.  The cure for drinking is more drinking, the cure for over-eating is more food, and the cure for excessive debt is more debt.  It all makes sense in the Alice-in-Wonderland world of the IMF.

True, later some debt-relief was offered to Greece when the utter unsustainability of its existing debt could not be overlooked.  But the relief was too little, too late.  More recently, in a rare moment of humility for the organization, the IMF appears to have accepted that still more debt relief is needed.

Unsustainable debt cannot be repaid.

The unstated reason for policy intransigence in the face of reality is that much of the Greek sovereign debt was owed to important financial institutions, including major banks.  Other global banks were also exposed because of interbank lending.  The rational thing for individual governments to have done was to bail out their own banks and write down the Greek debt.  That was politically unpalatable, however, because it would have involved acknowledging the shaky finances of European banks.  Politicians would have had to acknowledge the bad practices of its banks.  That would have been messy and unpleasant.  Far better to offload the problem on the Greeks.

I will close by offering one possible optimistic scenario.  Contrary to received wisdom, Greece may be better off out of the Euro.  Left to their own devices, including the need to finance sovereign debt, the Greek people and their political leaders might be forced to make the needed economic reforms and to implement fiscal discipline.  The good outcome is not guaranteed, but Grexit from the Euro may be the only feasible way of achieving it.

Alas, it is more likely that the EU and Greek government will muddle through until the next crisis. Perhaps, the next crisis will break out first in another EU country.  Take your pick.

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Driverless Money Tue, 23 Jun 2015 13:13:52 +0000 Last week I happened to be contemplating a post having to do with driverless cars when, wouldn't you know it, I received word that the Bank of England had just started a new blog called Bank Underground, the first substantive post on which had to do with — you guessed...

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Last week I happened to be contemplating a post having to do with driverless cars when, wouldn't you know it, I received word that the Bank of England had just started a new blog called Bank Underground, the first substantive post on which had to do with — you guessed it —  driverless cars.

As it turned out, I needn't have worried that Bank Underground had stolen my fire.  The post, you see, was written by some employees in the Bank of England's General Insurance Supervision Division, whose concern was that driverless cars might be bad news for the insurance industry.  The problem, as the Bank of England's experts see it, is that  cars like the ones that Google plans to introduce in 2020 are much better drivers than we humans happen to be — so much better, according to research cited in the post, that  "the entire basis of motor insurance, which mainly exists because people crash, could … be upended."  Driverless cars therefore threaten to "wipe out traditional motor insurance."

It is of course a great relief to know that the Bank of England's experts are keeping a sharp eye out for such threats to the insurance industry.  (I suppose they must be working as we speak on some plan for addressing the dire possibility — let us hope it never comes to this — that cancer and other diseases will eventually be eradicated.)  But my own interest in driverless cars is rather different.  So far as I'm concerned, the advent of such cars should have us all wondering, not about the future of the insurance industry, but about the future of…the Bank of England, or rather of it and all other central banks.  If driverless cars can upend "the entire basis of motor insurance," then surely,  I should think, an automatic or "driverless" monetary system ought to be capable of upending "the entire basis of monetary policy" as such policy is presently conducted.

And that, so far as I'm concerned, would be a jolly good thing.

Am I drifting into science fiction?  Let's put matters in perspective.  Although experiments involving driverless or "autonomous" cars  have been going on for decades, until as recently as one decade ago the suggestion that such cars would soon be, not only safe enough to replace conventional ones, but far safer, would have struck many people as fantastic.  Consider for a moment the vast array of contingencies such a vehicle must be capable of taking into account in order to avoid accidents and get passengers to some desired destination.  Besides having to determine correct routes, follow their many twists and turns, obey traffic signals, and parallel park, they have to be capable of evading all sorts of unpredictable hazards, including other errant vehicles, not to mention jaywalkers and such. The relevant variables are, in fact, innumerable.  Yet using a combination of devices tech wizards have managed to overcome almost every hurdle, and will soon have overcome the few that remain.

All of this would be impressive enough even if human beings were excellent drivers.  In fact they are often very poor drivers indeed, which means that driverless cars are capable, not only of being just as good, but of being far better – 90 percent better, to be precise, since that's the percentage of all car accidents attributable to human error.

Human beings are bad drivers for all sorts of reasons.  They have to perform other tasks that take their mind off the road; their vision is sometimes impaired; they misjudge their own driving capabilities or the workings of their machines; some are sometimes inclined to show off, while others are dangerously timid.  Occasionally, instead of relying on their wits, they drive "under the influence."

Central bankers, being human, suffer from similar human foibles.  They are distracted by the back-seat ululations of commercial bankers, exporters, finance ministers, and union leaders, among others.  Their vision is at the same time both cloudy and subject to myopia.  Finally, few if any are able to escape altogether the disorienting influence of politics.  The history of central banking is, by and large, a history of accidents, if not of tragic accidents, stemming from these and other sorts of human error.

It should not be so difficult, then, to imagine that a "driverless" monetary system might spare humanity such accidents, by guiding monetary policy more responsibly than human beings are capable of doing.  How complicated a challenge is this?  Is it really more complicated than that involved in, say, driving from San Francisco to New York?  Central bankers themselves like to think so, of course — just as most of us still like to believe that we are better drivers than any computer.  But let's be reasonable.  At bottom central bankers, in their monetary policy deliberations, have to make a decision concerning one thing, and one thing only: should they acquire or sell assets, and how many, or should they do neither?  Unlike a car, which has numerous controls — a steering wheel, signal lights, brakes, and an accelerator — a central bank has basically one, consisting of the instrument with which it adjusts the rate at which assets flow into or out of its balance sheet.  Pretty simple.

And the flow itself?  Here, to be sure, things get more complicated.  What "target" should the central bank have in mind in determining the flow?  Should it consist of a single variable, like the inflation rate, or of two or more variables, like inflation and unemployment?  But the apparent complexity is, IMHO, a result of confusion on monetary economists' part, rather than of any genuine trade-offs central bankers face.  As Scott Sumner has been indefatigably arguing for some years now (and as I myself have long maintained), sound monetary policy isn't a matter of having either a constant rate of inflation or any particular level of either employment or real output.  It's  a matter of securing a stable flow of spending, or Nominal GNP, while leaving it to the marketplace to determine how that flow breaks down into separate real output and inflation-rate components.  Scott would have NGDP grow at an annual rate of 4-5 percent; I would be more comfortable with a rate of 2-3 percent.  But this number is far less important to the achievement of macroeconomic stability than a commitment to keeping the rate — whatever it happens to be — stable and, therefore, predictable.

So: one goal, and one control.  That's much simpler than driving from San Francisco to New York. Heck, it's simpler than managing the twists and turns of San Franscisco's  Lombard Street.

And the technology?  In principle one could program a computer to manage the necessary asset purchases or sales.  That idea itself is an old one, Milton Friedman having contemplated it almost forty years ago, when computers were still relatively rare.  What Friedman could not have imagined then was a protocol like the one that controls the supply of bitcoins, which has the distinct advantage of being, not only automatic, but tamper-proof: once set going, no-one can easily alter it. The advantage of a bitcoin-style driverless monetary system is that it is, not only capable of steering itself, but incapable of being hijacked.

The bitcoin protocol itself allows the stock of bitcoins to grow at a predetermined and ever-diminishing rate, so that the stock of bitcoins will cease to grow as it approaches a limit of 21 million coins.  But all sorts of protocols may be possible, including ones that would adjust a currency's supply growth according to its velocity — that is, the rate at which the currency is being spent — so as to maintain a steady flow of spending, à la Sumner.   The growth rate could even be made to depend on market-based indicators of the likely future value of NGDP.

This isn't to say that there aren't any challenges yet to be overcome in designing a reliable "driverless money."  For one thing, the monetary system as a whole has to be functioning properly: just as a driverless car won't work if the steering linkage is broken, a driverless monetary system won't work if it's so badly tuned that banks end up just sitting on any fresh reserves that come their way.  My point is rather that there's no good reason for supposing that such challenges are any more insuperable than those against which the designers of driverless cars have prevailed.  If driverless car technology has managed to take on San Francisco's Lombard Street,  I see no reason why driverless money technology couldn't eventually tackle London's.

What's more, there is every reason to believe that driverless money would, if given a chance, prove to be far more beneficial to mankind than driverless cars ever will.  For although bad drivers cause plenty of accidents, none has yet managed to wreck an entire economy, as reckless central bankers have sometimes done.  If driverless monetary systems merely served to avoid the worst macroeconomic pileups, that alone would be reason enough to favor them.

But they can surely do much better than that.   Who knows: perhaps the day will come when, thanks to improvements in driverless monetary technology, central bankers will find themselves with nothing better to do than worry about the future of the hedge fund industry.

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Doc Selgin's QE Eye Test Mon, 15 Jun 2015 16:43:22 +0000 Some weeks ago, I made some critical observations concerning the Fed's contribution to  the recovery.  In particular, I complained that, despite the decidedly mixed and ambiguous results of empirical assessments thus far, the view that Quantitative Easing has been a smashing success seemed well on its way to becoming official...

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QEEyeTestSome weeks ago, I made some critical observations concerning the Fed's contribution to  the recovery.  In particular, I complained that, despite the decidedly mixed and ambiguous results of empirical assessments thus far, the view that Quantitative Easing has been a smashing success seemed well on its way to becoming official dogma, if not a more generally-held article of faith.

Even so, I was taken aback by the off-hand manner in which Fed Vice Chairman Stanley Fischer declared a QE victory, in the course of a speech given two weeks ago at the International Monetary Conference in Toronto.   Did the Fed's policies work?  According to Fischer, "The econometric evidence says yes.  So does the evidence of one's eyes" (my emphasis).

In fact, as I've already noted, the econometric evidence concerning the effectiveness of QE is hardly decisive.  For one thing, most studies have looked only at the interest-rate effects of the Fed's purchases, without troubling to ask whether those effects translated into any definite changes in spending, output, and employment.  For another, the interest-rate effect estimates are themselves not to be trusted.   A fairly recent IMF study on "Foreign Investor Flows and Sovereign Bond Yields in Advanced Economies," for example, notes — en passant as it were — that, controlling for such flows, the Fed's large-scale asset purchases resulted, not in the 90-200 basis point decline in long-term rates reported in various other studies, but in a decline of just thirty basis points, which is peanuts.  Other studies may, in other words, have conflated the effects of the Fed's asset purchases with those of concurrent "flights" from lower-quality Eurozone securities to higher-quality Treasuries.

But why bother with fancy econometrics when one can simply refer, as Vice Chairman Fischer did, to the "evidence of one's eyes"?   Fischer, apparently, found in that evidence compelling proof that QE worked wonders.  Fischer actually mentions only one piece of evidence, to wit: the fact that "the recent inauguration of the ECB's QE policy seemed to have an immediate effect not only on European interest rates, but also on longer-term rates in the United States."  But here, as with other inferences drawn by looking at interest-rate movements, connecting the dots isn't nearly as easy as  Fischer supposes.

Evidence that some good has come from the ECB 's belated easing is, in any event, not evidence that the Fed's easing did any good.  Try as I might, I just can't seem to get my eyes to focus on any clear and unambiguous evidence that it did.  Has Fischer, I wonder, been looking at the same things I've looked at?  If so, is he perhaps looking through rose-colored glasses, or is it my own vision or prescription that's faulty?

With such questions in mind, I decided to put the matter to a test.  Call it Doc Selgin's QE Eye Test, or Eye QE Test, or whatever else you wish to call it.  The instructions are simple: eyeball the following charts, gathered from various internet sources, recording all sorts of basic information pertaining to Quantitative Easing on one hand and the post-2008 recovery on the other.  Then decide for yourself whether the evidence of your eyes agrees with Mr. Fischer's relatively sunny impression, or with my own much gloomier one.

Please don't misunderstand me: I am not saying that my QE Eye Test, or any eye test at all, is a good way to evaluate the effectiveness of the Fed's post-crisis policies.  On the contrary: I only wish to cast doubt upon Vice-Chairman Fischer's suggestion that one's eyes are all one needs to determine that those policies worked.  My own belief, FWIW, is that it's going to take a lot more fancy econometric footwork to arrive at convincing answers.  I just hope it doesn't take as long to come to a proper understanding of the Fed's role as it took following that other "Great" calamity.


Doc Selgin's QE Eye Test

1) Fed Assets and Bank Excess Reserve Holdings.

Source: Gold, Stocks, and Forex, November 12, 2014,

2) Growth in Monetary Base, M2, and NGDP.

Source: Ed Dolan, EconMonitor,

3) Nominal GDP Gap.

Source: Michael Robert's Blog,

4) QE and Treasury Yields.

Source: Calafia Beach Pundit, October 29, 2014,

5) Unemployment and Labor Force Participation Rates.

Source: Conversible Economist (Timothy Taylor), December 11, 2013,

6) Unemployment Using June 2009 Participation Rate.

Source: Sean Davis, The Federalist, January 10, 2014,

7) Employment as Percent of Population.

Source: Infinite Unknown, March 8, 2015,

8) Employment as Percent of Population, Comparison with Great Depression.

Great Depression Growth Employment to Total Population Ratio
Source: Rise Up, the System is Broken,

9) Real GDP: Actual and Pre-CrisisTrend.

Source: Cecchetti and Schoenholz, The Blog (Huffington Post),

10) Economic Output as Percent of Potential Output.

Source: Andrew Fieldhouse, The Blog (Huffington Post), June 26, 2014,

11) Comparison with Other Postwar Recoveries.

Source: Planet Money, March 7, 2013,


That's it.  If these pictures make you feel all warm and fuzzy about the great job the Fed has done, then so far as you're concerned, Vice Chairman Fischer's beliefs are vindicated.  If, on the other hand, you find yourself doubting that all those trillions of new dollars have accomplished anything, then you can either count yourself among the pessimists, or have Doc Selgin write you a prescription for some rose-colored lenses.

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"The New Mediocre Is Not Good Enough" Fri, 12 Jun 2015 17:23:59 +0000 Commissioner Christopher Giancarlo of the Commodity Futures Trading Commission delivered the morning keynote address at the Cato Institute’s Center for Monetary and Financial Alternatives’ recent Capital Unbound summit in New York.  His remarks applied the principles of individual liberty, limited government, and peace—principles that Cato’s namesake, Cato the Younger, steadfastly...

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financial markets, cftcCommissioner Christopher Giancarlo of the Commodity Futures Trading Commission delivered the morning keynote address at the Cato Institute’s Center for Monetary and Financial Alternatives’ recent Capital Unbound summit in New York.  His remarks applied the principles of individual liberty, limited government, and peace—principles that Cato’s namesake, Cato the Younger, steadfastly stood for–to today’s capital markets.

Commissioner Giancarlo also addressed issues such as the slow economic recovery from the last recession, noting that “the plethora of federal regulations is a major drag on the U.S. economy.  Regulations now cost the U.S. more than 12 percent of GDP, or $2 trillion annually.”  Reviewing the shortcomings of the Dodd-Frank Act, he observed that the route to genuine reform  “lies in economic freedom and opportunity: the same combination of ingredients that invariably leads to more prosperity – even for the poor – than does centralized political planning.”

He called for all Americans to “reject the false promise of government provided safety, security and a riskless future and, instead, hold fast to personal liberty, free markets and the fruits of their own hard work and ingenuity.”

You can view his full remarks here.  They are also available as a podcast.

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Alternatives to Central Banking: Toward Free-Market Money Wed, 10 Jun 2015 14:32:08 +0000 According to many experts, the Federal Reserve’s discretionary policies didn’t just fail to prevent the Great Depression of the 1930s, the stagflation of the late 1970s and early 1980s, and the Great Recession of 2009.  Instead, the Fed’s policies directly contributed to each dismal episode. So it's only natural to...

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monetary policy, monetary reform, gold standard, bitcoin, cryptocurrencyAccording to many experts, the Federal Reserve’s discretionary policies didn’t just fail to prevent the Great Depression of the 1930s, the stagflation of the late 1970s and early 1980s, and the Great Recession of 2009.  Instead, the Fed’s policies directly contributed to each dismal episode.

So it's only natural to ask whether we could do better.  Could a rules-based, free-market monetary system—one which is spontaneous, self-regulating, and independent of government meddling—serve us better than the existing fiat standard?  And if that’s the case, how could we get from here to there?

The latest issue of the Cato Journal, containing the proceedings of Cato's 32nd Annual Monetary Conference: Alternatives to Central Banking: Toward Free-Mark Money, addresses these very questions.  Its papers examine the constitutional basis for alternatives to central banking, the role of gold in a market-based monetary system, the obstacles to fundamental reform and how they might be overcome, the advent of cryptocurrencies, and much else besides.  Highlights from the conference proceedings include Axel Leijonhufvud's  look at expansionary monetary policy’s effects on resource allocation and the distribution of income, Norbert Michel's strategy for implementing a rules-based monetary framework, and the very different views of Edwin Viera Jr., Jerry L. Jordan, and George Selgin concerning the prospects for a revived gold standard.

In addition to the conference proceedings the issue features original articles by Peter Bernholz on the de-pegging of the Swiss Franc, and by Tyler Watts and Lukas Snyder on the resource costs of irredeemable paper money.

Here is a complete listing of the articles:

The Cato Journal, a valuable resource for public policy scholars that’s also accessible to the non-specialist reader, is published three times a year: Spring/Summer, Fall, and Winter.  To subscribe, please visit the Cato Institute’s online store.

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Ten Things Every Economist Should Know about the Gold Standard Thu, 04 Jun 2015 14:44:07 +0000 At the risk of sounding like a broken record (well, OK–at the risk of continuing to sound like a broken record), I'd like to say a bit more about economists' tendency to get their monetary history wrong.  In particular, I'd like to take aim at common myths about the gold...

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?????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????At the risk of sounding like a broken record (well, OK–at the risk of continuing to sound like a broken record), I'd like to say a bit more about economists' tendency to get their monetary history wrong.  In particular, I'd like to take aim at common myths about the gold standard.

If there's one monetary history topic that tends to get handled especially sloppily by monetary economists, not to mention other sorts, this is it.   Sure, the gold standard was hardly perfect, and gold bugs themselves sometimes make silly claims about their favorite former monetary standard.   But these things don't excuse the errors many economists commit in their eagerness to find fault with that "barbarous relic."

The false claims I have in mind are mostly ones I and others–notably Larry White–have countered  before.  Still I thought it would be useful to address them again here, because they're still far from being dead horses, and also so that students wrapping-up the semester will have something convenient to send to their misinformed gold-bashing profs (though I urge them to wait until grades are in before sharing!).

For the sake of those who don't care to wade through the whole post, here is a "jump to" list of the points covered:

1. The Gold Standard wasn't an instance of government price fixing. Not traditionally, anyway.
2. A gold standard isn't particularly expensive. In fact, fiat money tends to cost more.
3. Gold supply "shocks" weren't particularly shocking.
4. The deflation that the gold standard permitted  wasn't such a bad thing.
5.  It wasn't to blame for 19th-century American financial crises.
6.  On the whole, the classical gold standard worked remarkably well (while it lasted).
7.  It didn't have to be "managed" by central bankers.
8.  In fact, central banking tends to throw a wrench in the works.
9.  "The "Gold Standard" wasn't to blame for the Great Depression.
10.  It didn't manage money according to any economists' theoretical ideal.  But neither has any fiat-money-issuing central bank.


1.  The Gold Standard wasn't an instance of government price fixing.  Not traditionally, anyway.

As Larry  White has made the essential point as well as I ever could, I hope I may be excused for quoting him at length:

Barry Eichengreen writes that countries using gold as money 'fix its price in domestic-currency terms (in the U.S. case, in dollars).'   He finds this perplexing:

But the idea that government should legislate the price of a particular commodity, be it gold, milk or gasoline, sits uneasily with conservative Republicanism’s commitment to letting market forces work, much less with Tea Party–esque libertarianism.  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.

To describe a gold standard as "fixing" gold’s "price" in terms of a distinct good, domestic currency, is to get off on the wrong foot.  A gold standard means that a standard mass of gold (so many grams or ounces of pure or standard-alloy gold) defines the domestic currency unit.  The currency unit (“dollar”) is nothing other than a unit of gold, not a separate good with a potentially fluctuating market price against gold.  That one dollar, defined as so many grams of gold, continues be worth the specified amount of gold—or in other words that one unit of gold continues to be worth one unit of gold—does not involve the pegging of any relative price. Domestic currency notes (and checking account balances) are denominated in and redeemable for gold, not priced in gold.  They don’t have a price in gold any more than checking account balances in our current system, denominated in fiat dollars, have a price in fiat dollars.  Presumably Eichengreen does not find it curious or objectionable that his bank maintains a fixed dollar-for-dollar redemption rate, cash for checking balances, at his ATM.

Remarkably, as White goes on to show, the rest of Eichengreen's statement proves that, besides not having understood the meaning of gold's "fixed" dollar price, Eichengreen has an uncertain grasp of the rudimentary economics of gold production:

As to what a believer in the free market would argue, surely 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, that this rise will in fact give the gold-mining industry an incentive to produce more, and that the increase in gold output will in fact eventually bring the relative price back down.

I've said more than once that, the more vehement an economist's criticisms of the gold standard, the more likely he or she knows little about it.  Of course Eichengreen knows far more about the gold standard than most economists, and is far from being its harshest critic, so he'd undoubtedly be an outlier in  the simple regression, y =   α + β(x) (where y is vehemence of criticism of the gold standard and x is ignorance of the subject).  Nevertheless, his statement shows that even the understanding of one of the gold standard's most well-known critics leaves much to be desired.

Although, at bottom, the gold standard isn't a matter of government "fixing" gold's price in terms of paper money, it is true that governments' creation of monopoly banks of issue, and the consequent tendency for such monopolies to be treated as government- or quasi-government authorities, ultimately led to their being granted sovereign immunity from the legal consequences to which ordinary, private intermediaries are usually subject when they dishonor their promises.  Because a modern central bank can renege on its promises with impunity, a gold standard administered by such a bank more closely resembles a price-fixing scheme than one administered by a commercial bank.  Still, economists should be careful to distinguish the special features of a traditional gold standard from those of  central-bank administered fixed exchange rate schemes.


2.  A gold standard isn't particularly expensive.  In fact, fiat money tends to cost more.

Back in the early 1950s, and again in 1960,  Milton Friedman estimated that the gold required for the U.S. to have a "real" gold standard would have cost 2.5% of its annual GNP.  But that's because Friedman's idea of a "real" gold standard was one in which gold coins alone served as money, with no fractionally-backed bank-supplied substitutes.  As Larry White shows in his Theory of Monetary Institutions (p. 47) allowing for 2% specie reserves–which is more than what some former gold-based free-banking systems needed–the resource cost of a gold standard taking advantage of fractionally-backed banknotes and deposits would be about one-fiftieth of the number Friedman came up with.  That's a helluva bargain for a gold "seal of approval" that could mean having access to international capital at substantially reduced rates, according to research by Mike Bordo and Hugh Rockoff.

Friedman himself eventually changed his mind about the economies to be achieved by employing fiat money:

Monetary economists have generally treated irredeemable paper money as involving negligible real resource costs compared with a commodity currency.  To judge from recent experience, that view is clearly false as a result of the decline in long-term price predictability.

I took it for granted that the real resource cost of producing irredeemable paper money was negligible, consisting only of the cost of paper and printing.  Experience under a universal irredeemable paper money standard makes it crystal clear that such an assumption, while it may be correct with respect to the direct cost to the government of issuing fiat outside money, is false for society as a whole and is likely to remain so unless and until a monetary structure emerges under an irredeemable paper standard that provides a high degree of long-run price level predictability.*

Unfortunately, neither White's criticism of Friedman's early calculations nor Friedman's own about-face have kept gold standard critics from repeating the old canard that a fiat standard is more economical than a gold standard.  Ross Starr, for example, observes in his 2013 book on money  that "The use of paper or fiduciary money instead of commodity money is resource saving, allowing commodity inventories to be liquidated."  Although he understands that fractionally-backed banknotes and deposits may go some way toward economizing on commodity-money reserves, Starr (quoting Adam Smith, but failing to look up historic Scottish bank reserve ratios) insists nonetheless that "a significant quantity of the commodity backing must be maintained in inventory to successfully back the currency," and then proceeds to build a case for fiat money from this unwarranted assertion:

The next step in economizing on the capital tied up in backing the currency is to use a fiat money.  Substituting a government decree for commodity backing frees up a significant fraction of the economy's capital stock for productive use.  No longer must the economy hold gold, silver, or other commodities in inventory to back the currency.  No longer must additional labor and capital be used to extract them from the earth.  Those resources are freed up and a simple virtually costless government decree is substituted for them.

Tempting as it is to respond to such hooey simply by noting that the vaults of the world's official fiat-money managing institutions presently contain rather more than zero ounces of gold–31,957.5 metric tons more, to be precise–that response only hints at the fundamental flaw in Starr's reasoning, which is his treatment of fiat money as a culmination, or limiting case, of the resource savings to be had by resort to fractional commodity-money reserves.  That treatment overlooks a crucial difference between fiat money and readily redeemable banknotes and deposits, for whereas redeemable banknotes and deposits are generally understood by their users to be close, if not perfect, substitutes for commodity money, fiat money, the purchasing power of which is unhinged from that of any former money commodity, is nothing of the sort.  On the contrary: its tendency to depreciate relative to real commodities, and to gold in particular, is notorious.   Consequently holders of fiat money have reason to hold  "commodity inventories" as a hedge against the risk that fiat money will depreciate.

If the hedge demand for a former money commodity is large enough, resort to fiat money doesn't save any resources at all.  Indeed, as Roger Garrison notes, "a paper standard administered by an irresponsible monetary authority may drive the monetary value of gold so high that more resource costs are incurred under the paper standard than would have been incurred under a gold standard."  A glance at the history of gold's real price suffices to show that this is precisely what has happened:

real price of gold since 1800
From "After the Gold Rush," The Economist, July 6, 2010.

Taking the long-run average price of gold, in 2010 prices, to be somewhere around $470, prior to the closing of the gold window in 1971, that price was exceeded on only three occasions, and never dramatically: around the time of the California gold rush, around the turn of the 20th century, and for several years following FDR's devaluation of the dollar.  Since 1971, in contrast, it has exceeded that average, and exceeded it substantially, more often than not.  Here is Roger Garrison again:

There is a certain asymmetry in the cost comparison that turns the resource-cost argument against paper standards.  When an irresponsible monetary authority begins to overissue paper money, market participants begin to hoard gold, which stimulates the gold-mining industry and drives up the resource costs. But when new discoveries of gold are made, market participants do not begin to hoard paper or to set up printing presses for the issue of unbacked currency.  Gold is a good substitute for an officially instituted paper money, but paper is not a good substitute for an officially recognized metallic money. Because of this asymmetry, the resource costs incurred by the State in its efforts to impose a paper standard on the economy and manage the supply of paper money could be avoided if the State would simply recognize gold as money. These costs, then, can be counted against the paper standard.

So if it's avoidance of gold resource costs that's desired, including avoidance of the very real environmental consequences of gold mining, a gold standard looks like the right way to go.


3.  Gold supply "shocks" weren't particularly shocking

Of the many misinformed criticisms of the gold standard, none seems to me more wrong-headed than the complaint that the gold standard isn't even a reliable guarantee against serious inflation.  The RationalWiki entry on the gold standard is as good an example of this as any:

Even gold can suffer problems with inflation.  Gold rushes such as the California Gold Rush expanded the money supply and, when not matched with a simultaneous increase in economic output, caused inflation.  The "Price Revolution" of the 16th century demonstrates a case of dramatic long-run inflation. During this period, western European nations used a bimetallic standard (gold and silver). The Price Revolution was the result of a huge influx of silver from central European mines starting during the late 15th century combined with a flood of new bullion from the Spanish treasure fleets and the demographic shift brought about by the Black Plague (i.e., depopulation). 

Admittedly the anonymous authors of this article may not be professional economists; but take my word for it that the same arguments might be heard from any number of such professionals.  Brad DeLong, for example, in a list of "Talking Points on the Likely Consequences of re-establishment of the Gold Standard" (my emphasis), includes observation that "significant advances in gold mining technology could provide a significant boost to the average rate of inflation over decades."

Like I said, the gold standard is hardly free of defects.  But being vulnerable to bouts of serious inflation isn't one of them.   Consider the "dramatic" 16th century inflation referred to in the RationalWiki entry.  Had that entries' authors referred to plain-old Wikipedia's entry on "Price revolution," they would have read there that

Prices rose on average roughly sixfold over 150 years. This level of inflation amounts to 1-1.5% per year, a relatively low inflation rate for the 20th century standards, but rather high given the monetary policy in place in the 16th century.

I have no idea what the authors mean by their second statement, as there was certainly no such thing as "monetary policy" at the time, and they offer no further explanation or citation.    So far as I can tell, they mean nothing more than that prices hadn't been rising as fast before the price revolution than they did during it, which though trivially true says nothing about how "high" the inflation was by any standards, including those of the 16th century.   In any case it was not only "not high" but dangerously low according to standards set, rightly or wrongly, by today's monetary experts.  Finally, though the point is often overlooked, the European Price Revolution actually began well in advance of major American specie shipments, which means that, far from being attributable to such shipments alone, it was a result of several causes, including coin debasements.

What about the California Gold rush, which is also supposed to show how changes in the supply of gold will lead to inflation "when not matched with a simultaneous increase in economic output"?  To judge from available statistics, it appears that producers of other goods were almost a match for all those indefatigable forty-niners:  as Larry White reports, although the U.S. GDP deflator did rise a bit in the years following the gold rush,

The magnitude was surprisingly small. Even over the most inflationary interval, the [GDP deflator] rose from 5.71 in 1849 (year 2000 = 100) to 6.42 in 1857, an increase of 12.4 percent spread over eight years. The compound annual price inflation rate over those eight years was slightly less than 1.5 percent.

Once again, the inflation rate was such as would have had today's central banks rushing to expand their balance sheets.

Nor do the CPI estimates tell a different story.   See if you can spot the gold-rush-induced inflation in this chart:

*Graphing Various Historical Economic Series," MeasuringWorth, 2015.

Despite popular beliefs, the California gold rush was actually not the biggest 19th-century gold supply innovation, at least to judge from its bearing on the course of prices.  That honor belongs instead to the Witwatersrand gold rush of 1886, the effects of which later combined with those of  the Klondike rush of 1896 to end a long interval of gradual deflation (discussed further below) and begin one of gradual inflation.

Brad DeLong is thus quite right to refer to the South African discoveries in observing that even a gold standard poses some risk of inflation:

For example, the discovery and exploitation of large gold reserves near present-day Johannesburg at the end of the nineteenth century was responsible for a four percentage point per year shift in the worldwide rate of inflation–from a deflation of roughly two percent per year before 1896 to an inflation of roughly two percent per year after 1896.

Allowing for the general inaccuracy of 19th-century CPI estimates, DeLong's statistics are correct.  But that "For example" is quite misleading.  Like I said: this is the most serious instance of an inflationary gold "supply shock" of which I'm aware.  Yet even it served mainly to  put an end to a deflationary trend, without ever giving rise to an inflation rate substantially above what central banks today consider (rightly or wrongly) optimal.  As for the four percentage point change in the rate of inflation "per year," presumably meaning "in one year," it's hardly remarkable:  changes as big or larger are common throughout the 19th century, partly owing to the notoriously limited data on which CPI estimates for that era are based.   Even so, they can't be compared to the much larger jumps in inflation with which the history of fiat monies is riddled, even setting hyperinflations aside.  Keep this in mind as you reflect upon Brad's conclusion that

Under the gold standard, the average rate of inflation or deflation over decades ceases to be under the control of the government or the central bank, and becomes the result of the balance between growing world production and the pace of gold mining.

Alas, keeping matters in perspective–that is, comparing the gold standard's actual inflation record, not to that which might be achieved by means of an ideally-managed fiat money, but to the actual inflation record of historic fiat-money systems, is something many critics of the gold standard seem reluctant to do, perhaps for good reason.

While we're on the subject, nothing could be more absurd than attempts to demonstrate the unsuitability of gold as a monetary medium by referring to gold's unstable real value in the years since the gold standard was abandoned.  Yet this is a favorite debating point among the gold standard's less thoughtful critics, including Paul Krugman:

There is a remarkably widespread view that at least gold has had stable purchasing power. But nothing could be further from the truth.  Here’s the real price of gold — the price deflated by the consumer price index — since 1968:


Compare Professor Krugman's chart to the one in the previous section.  Then ask yourself (1) Has gold's price behaved differently since 1968 than it did before?; and (2) Why might this be so?  If your answers are "Yes" and "Because gold and paper dollars are no longer close substitutes, and gold is now widely used to hedge against depreciation of the dollar and other fiat currencies," you understand the gold standard better than Krugman does.  But don't get a swelled head over it, because it really isn't saying much: Krugman is one of the observations that sits squarely on the upper right end of y =   α + β(x).


4. The deflation that the gold standard permitted  wasn't such a bad thing.

The complaint that a gold standard doesn't rule out inflation is but a footnote to the more frequent complaint that it suffers, in Brad DeLong's words, from "a deflationary bias which makes it likely that a gold standard regime will see a higher average unemployment rate than an alternative managed regime."   According to Ben Bernanke "There is…a high correlation in the data between deflation (falling prices) and depression (falling output)."

That the gold standard tended to be deflationary–or that it tended to be so for sometimes long intervals between gold discoveries–can't be denied.  But what certainly can be denied is that these periods of slow deflation went hand-in-hand with high unemployment.   Having thoroughly reviewed the empirical record,  Andrew Atkeson and Patrick Kehoe conclude as follows:

Deflation and depression do seem to have been linked during the1930s. But in the rest of the data for 17 countries and more than 100 years, there is virtually no evidence of such a link.

More recently Claudio Borio and several of his BIS colleagues reported similar findings.  How then (you may wonder), did Bernanke arrive at his opposite conclusion?  Easy:  he looked only at data for the 1930s–the worst deflationary crisis ever–ignoring all the rest.

Why is deflation sometimes depressing, and sometimes not?  The simple answer is that there is more than one sort of deflation.  There's the sort that's caused by a collapse of spending, like the "Great Contraction" of the 1930s, and then there's the sort that's driven by greater output of real goods and services–that is, by outward shifts in aggregate supply rather than inward shifts in aggregate demand.   Most of the deflation that occurred during the classical gold standard era (1873-1914) was of the latter, "good" sort.

Although I've been banging the drum for good deflation since the 1990s, and Mike Bordo and others have made the specific point that the gold standard mostly involved deflation of the good rather than bad sort,  too many economists, and way too many of those who have got more than their fare share of the public's attention, continue to ignore the very possibility of supply-driven deflation.

Of the many misunderstandings propagated by economists' tendency to assume that deflation and depression must go hand-in-hand, none has been more pernicious than the widespread belief that throughout the U.S. and Europe, the entire period from 1873 to 1896 constituted one "Great" or "Long Depression ."  That belief is now largely discredited, except perhaps among some newspaper pundits and die-hard Marxists, thanks to the efforts of G.B. Saul and others.   The myth of a somewhat shorter "Long Depression," lasting from 1873-1879,  persists, however, though economic historians have begun chipping away at that one as well.


5.  It wasn't to blame for 19th-century American financial crises.

Speaking of 1873, after claiming that a gold standard is undesirable because it makes deflation (and therefore, according to his reasoning, depression) more likely, Krugman observes:

The gold bugs will no doubt reply that under a gold standard big bubbles couldn’t happen, and therefore there wouldn’t be major financial crises. And it’s true: under the gold standard America had no major financial panics other than in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933.  Oh, wait.

Let me see if I understand this.  If financial  crises happen under base-money regime X, then that regime must be the cause of the crises, and is therefore best avoided.  So if crises happen under a fiat money regime, I guess we'd better stay away from fiat money.  Oh, wait.

You get the point: while the nature of an economy's monetary standard may have some bearing on the frequency of its financial crises, it hardly follows that that frequency depends mainly on its monetary standard rather than on other factors, like the structure, industrial and regulatory, of the financial system.

That U.S. financial crises during the gold standard era had more to do with U.S. financial regulations than with the workings of the gold standard itself is recognized by all competent financial historians.    The lack of branch banking made U.S. banks  uniquely vulnerable to shocks, while Civil-War rules linked the supply of banknotes to the extent of the Federal government's indebtedness., instead  of allowing that supply to adjust with seasonal and cyclical needs.   But there's no need to delve into the precise ways in which  such misguided legal restrictions to the umerous crises to which  Krugman refers.  It should suffice to point out that Canada, which employed the very same gold dollar, depended heavily on exports to the U.S., and (owing to its much smaller size) was far less diversified, endured no banking crises at all, and very few bank failures, between 1870 and 1939.


6.  0n the whole, the classical gold standard worked remarkably well (while it lasted).

Since Keynes's reference to gold as a "barbarous relic" is so often quoted by the gold standard's critics,  it seems only fair to repeat what Keynes had to say, a few years before, not about gold per se, itself, but about the gold-standard era:

What an extraordinary episode in the economic progress of man that age was which came to an end in August, 1914! The greater part of the population, it is true, worked hard and lived at a low standard of comfort, yet were, to all appearances, reasonably contented with this lot.  But escape was possible, for any man of capacity or character at all exceeding the average, into the middle and upper classes, for whom life offered, at a low cost and with the least trouble, conveniences, comforts, and amenities beyond the compass of the richest and most powerful monarchs of other ages.  The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages… He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighboring office of a bank or such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference.  But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.

It would, of course, be foolish to suggest that the gold standard was entirely or even largely responsible for this Arcadia, such as it was.  But it certainly did contribute both to the general abundance of goods of all sorts, to the ease with which goods and capital flowed from nation to nation, and, especially, to the sense of a state of affairs that was "normal, certain, and permanent."

The gold standard achieved these things mainly by securing a degree of price-level and exchange rate stability and predictability that has never been matched since.  According to Finn Kydland and Mark Wynne:

The contrast between the price stability that prevailed in most countries under the gold standard and the instability under fiat standards is striking. This reflects the fact that under commodity standards (such as the gold standard), increases in the price level (which were frequently associated with wars) tended to be reversed, resulting in a price level that was stable over long periods. No such tendency is apparent under the fiat standards that most countries have followed since the breakdown of the gold standard between World War I and World War II.

The high degree of price level predictability, together with the system of fixed exchange rates that was incidental to the gold standard's widespread adoption, substantially reduced the riskiness of both production and international trade, while the commitment to maintain the standard resulted, as I noted, in considerably lower international borrowing costs.

Those pundits who find it easy to say "good riddance" to the gold standard, in either its classical or its decadent variants, need to ask themselves what all the fuss over monetary "reconstruction" was about, following each of the world wars, if not achieving a simulacrum at least of the stability that the classical  gold standard achieved.  True, those efforts all failed.  But that hardly means that the ends sought weren't very worthwhile ones, or that those who sought them were "lulled by the myth of a golden age."  Though they may have entertained wrong beliefs concerning how the old system worked, they weren't wrong in believing that it did work, somehow.


7. It didn't have to be managed by central bankers.

But how?  The once common view that the classical gold standard worked well only thanks to its having been carefully managed by the Bank of England and other central banks, as well as the related view that its success depended on international agreements and other forms of central bank cooperation, is now, thankfully, no longer subscribed to even by the gold-standard's more well-informed critics.    Instead, as Julio Gallarotti observes, the outcomes of that standard "were primarily the resultants [sic] of private transactions in the markets for goods and money" rather than of any sort of government or central-bank management or intervention.   But the now accepted view doesn't quite go far enough.  In fact, central banks played no essential part at all in achieving the gold standard's most desirable outcomes, which could have been achieved as well, or better, by systems of competing banks-of-issue, and which were in fact achieved by means of such systems in many participating nations, including the United States, Switzerland (until 1901), and Canada.  And although it is common for central banking advocates to portray such banks as sources of emergency liquidity to private banks, during the classical gold standard era liquidity assistance often flowed the other way, and did so notwithstanding monopoly privileges that gave central banks so many advantages over their commercial counterparts.  As Gallarotti observes (p. 81),

That central banks sometimes went to other central banks instead of the private market suggests nothing more than the fact that the rates offered by central banks were better, or too great an amount of liquidity may have been needed to be covered in the private market.


8.  In fact, central banking tends to throw a wrench in the works.

To the extent that central banks did exercise any special influence on gold-standard era monetary adjustments, that influence, instead of helping, made things worse.   Because an expanding central bank isn't subject to the internal constraint of reserve losses stemming from adverse interbank clearings,  it can create an external imbalance that must eventually trigger a disruptive drain of specie reserves.   During liquidity crunches, on the other hand, central banks were more likely than commercial banks to become, in Jacob Viner's words, "engaged in competitive increases of their discount rates and in raid's on each other's reserves."    Finally, central banks could and did muck-up the gold standard works by sterilizing gold inflows and outflows, violating the "rules of the gold standard game" that called for loosening in response to gold receipts and tightening in response to gold losses.

Competing banks of issue could be expected to play by these "rules," because doing so was consistent with profit maximization.  The semi-public status of central banks, on the other hand, confronted them with a sort of dual mandate, in which profits had to be weighed against other, "public" responsibilities (ibid., pp. 117ff.).  Of the latter, the most pernicious was the perceived obligation to occasionally set aside the requirements for preserving international  monetary equilibrium ("external balance") for the sake of preserving or achieving preferred domestic monetary conditions ("internal balance").   As Barry Ickes observes, playing by the gold standards rules could be "very unpopular, potentially, as it involves sacrificing internal balance for external balance."   Commercial bankers couldn't care less.  Central bankers, on the other hand, had to care when to not care was to risk losing some of their privileges.

Today, of course, achieving internal balance is generally considered the sine qua non of sound central bank practice; and even where fixed or at least stable exchange rates are considered desirable it is taken for granted that external balance ought occasionally to be sacrificed for the sake of preserving domestic monetary stability.  But to apply such thinking to the classical gold standard, and thereby conclude that in that context a similar sacrifice of external for internal stability represented a turn toward more enlightened monetary policy, is to badly misunderstand the nature of that arrangement, which was not just a fixed exchange rate arrangement but something more akin to an multinational monetary union or currency area.    Within such an area, the fact that one central bank gains reserves while another looses them was itself no more significant, and no more a justification for violating the "rules of the game," than the fact that a commercial bank somewhere gained reserves at the expense of another.

The presence of central banks did, however, tend to aggravate the disturbing effects of changes in international trade patterns compared to the case of international free banking.  Central-bank sterilization of gold flows could, on the other hand, lead to more severe longer-run adjustments, as it was to do, to a far more dramatic extent, in the interwar period.


9.  "The "Gold Standard" wasn't to blame for the Great Depression.

I know I'm about to skate onto thin ice, so  let me be more precise.  To say that "The gold standard caused the Great Depression " (or words to that effect, like "the gold standard was itself the principal threat to financial stability and economic prosperity between the wars”), is at best extremely misleading.  The more accurate claim is that the Great Depression was triggered by the collapse of the jury-rigged version of the gold standard cobbled together after World War I, which was really a hodge-podge of genuine, gold-exchange, and gold-bullion versions of the gold standard, the last two of which were supposed to "economize" on gold.    Call it "gold standard light."

Admittedly there is one sense in which the real gold standard can be said to have contributed to the disastrous shenanigans of the 1920s, and hence to the depression that followed.  It contributed by failing to survive the outbreak of World War I.  The prewar gold standard thus played the part of Humpty Dumpty to the King's and Queen's men who were to piece the still-more-fragile postwar arrangement together.  Yet even this is being a bit unfair to gold, for the fragility of the  gold standard on the eve of World War I was itself largely due to the fact that, in most of the belligerent nations, it had come to be administered by central banks that were all-too easily dragooned by their sponsoring governments into serving as instruments of wartime inflationary finance.

Kydland and Wynne offer the case of the Bank of Sweden as illustrating the practical impossibility of preserving a gold standard in the face of a major shock:

During the period in which Sweden adhered to the gold standard (1873–1914), the Swedish constitution guaranteed the convertibility into gold of banknotes issued by the Bank of Sweden.  Furthermore, laws pertaining to the gold standard could only be changed by two identical decisions of the Swedish Parliament, with an election in between. Nevertheless, when World War I broke out, the Bank of Sweden unilaterally decided to make its notes inconvertible. The constitutionality of this step was never challenged, thus ending the gold standard era in Sweden.

The episode seems rather less surprising, however, when one considers that "the Bank of Sweden," which secured a monopoly of Swedish paper currency in 1901, is more accurately known as the Sveriges Riksbank, or "Bank of the Swedish Parliament."

If the world crisis of the 1930s was triggered by the failure, not of the classical gold standard, but of a hybrid arrangement, can it not be said that the U.S. , which was among the few nations that retained a full-fledged gold standard, was fated by that decision to suffer a particularly severe downturn?  According to Brad DeLong,

Commitment to the gold standard prevented Federal Reserve action to expand the money supply in 1930 and 1931–and forced President Hoover into destructive attempts at budget-balancing in order to avoid a gold standard-generated run on the dollar.

It's true that Hoover tried to balance the Federal budget, and that his attempt to do so had all sorts of unfortunate consequences.   But the gold standard, far from forcing his hand, had little to do with it.  Hoover simply subscribed to the prevailing orthodoxy favoring a balanced budget.  So, for that matter, did FDR, until events forced him too change his tune: during the 1932 presidential campaign the New-Dealer-to-be assailed his opponent both for running a deficit and for his government's excessive spending.

As for the gold standard's having prevented the Fed from expanding the money supply (or, more precisely, from expanding the monetary base to keep the broader money supply from shrinking), nothing could be further from the truth.   Dick Timberlake sets  the record straight:

By August 1931, Fed gold had reached $3.5 billion (from $3.1 billion in 1929), an amount that was 81 percent of outstanding Fed monetary obligations and more than double the reserves required by the Federal Reserve Act.  Even in March 1933 at the nadir of the monetary contraction, Federal Reserve Banks had more than $1 billion of excess gold reserves.


Whether Fed Banks had excess gold reserves or not, all of the Fed Banks’ gold holdings were expendable in a crisis.  The Federal Reserve Board had statutory authority to suspend all gold reserve requirements for Fed Banks for an indefinite period.

Nor, according to a statistical study by Chang-Tai Hsieh and Christina Romer, did the Fed have reason to fear that by allowing its reserves to decline it would have raised fears of  a devaluation.    On the contrary: by taking steps to avoid a monetary contraction, the Fed would have helped to allay fears of a devaluation, while, in Timberlake's words,  initiating a "spending dynamic" that would have  helped to restore "all the monetary vitals both in the United States and the rest of the world."


10.  It didn't manage money according to any economists' theoretical ideal.  But neither has any fiat-money-issuing central bank.

Just as "paper" always beats "rock" in the rock-paper-scissors game, so does managed paper money always beat gold in the rock-paper monetary standards game economists like to play.   But that's only because under a fiat standard any pattern of money supply adjustment is possible, including a "perfect" pattern, where "perfect" means perfect according to the player's own understanding.    Even under the best of circumstances a gold standard is, on the other hand, unlikely to achieve any economist's ideal of monetary perfection.  Hence, paper beats rock.  More precisely, paper beats rock, on paper.

And what does this impeccable logic tell us concerning the relative merits of gold versus paper money in practice?   Diddly-squat.  I mean it.   To say something about the relative merits of paper and gold, you have to have theories–good ol' fashioned, rational optimizing firm and agent theories–of how the supply of basic money adjusts under various conditions in the two sorts of monetary regimes.    We have a pretty good theory of the gold standard, meaning one that meshes well with how that standard actually worked.  The theory of fiat money is, in contrast,  a joke, in part because it's much harder to pin-down central bankers' objectives (or any objectives apart from profit-maximization, which is at play in the case of gold), but mostly thanks to economists' tendency to simply assume that central bankers behave like omniscient angels who, among other things, understand the finer points of DSGE models.   That may do for a graduate class, or a paper in the AER.  But good economics it most certainly isn't.


I close with a few words concerning why it matters that we get the facts straight about the gold standard.  It isn't simply a matter of winning people over to that standard.  Though I'm perhaps as ready as anyone to shed a tear for the old gold standard, I doubt that we can ever again create anything like it.   But getting a proper grip on gold serves, not just to make the gold standard seem less unattractive than it is often portrayed to be, but to remove some of the sheen that has been applied to modern fiat-money arrangements using the same brush by which gold has been blackened.  The point, in other words, isn't to make a pitch for gold.  It's to make a pitch for something –anything– that's better than our present, lousy money.


*I'm astonished to find that Friedman's important and very interesting 1986 article, despite appearing in one of the leading academic journals, has to date been cited only 64 times (Google Scholar).  Of these, nine are in works by myself, Kevin Dowd, and Lawrence White!  I only wish I could attribute this neglect to monetary economists' pro-fiat money bias.  More likely it reflects their general lack of interest in alternative monetary arrangements.

The post Ten Things Every Economist Should Know about the Gold Standard appeared first on Alt-M.

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