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A Qualified Defense of Goldbuggery and Some Related Observations on the Regressive Effects of Inflation

[Note:  This was originally posted at Bleeding Heart Libertarians and directed at that audience, but I will repost here as well.]

In my recent post responding to Matt Yglesias on the gold standard, at least one commenter was surprised to find a defense of “goldbuggery” here at BHL. I’m guessing this reaction is due to one or both of the following:  1) defenses of the gold standard are associated with more “right wing” forms of libertarianism and 2) the lack of an obvious connection between monetary policy issues and the typical concerns of bleeding heart libertarianism.  Let me try to address both of those here by doing two things.  First, I want to explain exactly the sort of thing I wish to defend when I argue for a monetary role for gold.  Second, I want to argue that such a system will do better by the least well off among us by reducing or eliminating inflation and business cycles/recession, the effects of which are disproportionately felt by the poor.

Let me note that monetary theory is one of the most complex, difficulty, and subtle parts of economics (as Yglesias’s ham-handed post shows), so there’s no way I can do justice to all of the possible nuances here, but I’ll try provide links or responses in the comments as my time allows.  I would also point readers unfamiliar with the basics of monetary policy tothis primer of mine, from which some of the material in the next section is taken.

Monetary Competition and Commodity Standards

As I pointed out in the earlier post, the term “gold standard” can mean any number of things, from a system with a monopoly central bank that redeems its money in gold, to a gold-coin or 100% gold reserve system, to “free banking” systems in which all forms of money are produced competitively and banks can make that money redeemable in whatever commodity customers appear to prefer.  All of these and others might be considered “the gold standard.” However, I want to make the case for the last of them: monetary competition or “free banking.”  (I should also note that such a free banking system should be distinguished from the “Free Banking Era” of the US from 1837-1863, as that period was anything but free of government interventions and those interventions were responsible for the problems of that system, and the National Banking System that followed it.  Central banking is not the only way in which government intervention can undermine good monetary systems.)

Over the last several decades, a growing number of economists (see my own work, which builds on the work of colleagues such as Larry White and George Selgin and others) have explored the institutional features and macroeconomic properties of free banking systems, to the point where there is now a substantial literature on the subject.  Free banking systems would do away with central banks and their monopoly privileges and allow the competitive market process to produce the kinds and quantity of money that the public demands, just as it does for so many other goods and services. Certainly one long-standing concern of left-libertarians has been an end to all kinds of monopoly privileges, and ending those of central banks are among the most important, especially given the ways in which they have been used to finance wars (about which more later).

Rather than having currency produced monopolistically by a central bank, individual banks in such a system would produce it in the same way that they currently produce their own “brands” of deposits. My checking account deposits at my bank would be held as “private money” that the bank produces competitively against the checking account dollars from your bank. Banks have developed ways of clearing those checkable liabilities through various clearinghouse arrangements, and the same was true historically in those systems where currency production was private. Banks developed very sophisticated institutions for coordinating and overseeing their behavior, even during times of crisis.

Perhaps the greatest advantage of a free banking system is its ability to avoid inflation and deflation. Free banks would want to make their currency and checking accounts redeemable in some sort of commodity as a way to assure customers of their value. Historically, this commodity has been gold, though it need not be. This is the sense in which I am defending a gold standard:  historically, the closest models to the kind of banking system I would like to see in place have been ones in which gold played this role as the preferred commodity of redemption. Again, it need not but there are good reasons to think it would, none of which have to do with any magical qualities of gold.

Given that banks will want to provide redeemable currency and deposits, they have reason, even in the absence of regulation, to hold a stock of gold on hand (in addition to the deposits they keep at clearinghouses).  Historically, banks in early 19th century Scotland got by on about 3% reserves or less with almost no bank failures. With modern electronic payment systems, banks in such a system would need to hold only a small fraction of their liabilities in the form of gold reserves, so fears that such a system would require a great deal of gold are misguided. It’s more the promise to redeem in gold than holding a great deal of gold itself that makes the system stable.  Of course the promise has to be backed up if customers invoke it, but, historical experience and theory suggest that will not happen very often.

With currency and deposits redeemable in gold, customers and other banks can take any excess balances of such liabilities to the issuer for gold.  Should any bank produce more money than its customers wish to hold, those customers will either bring it back to the bank directly for redemption or they will spend it, where it will most likely end up in the possession of a different bank. The other bank will not want to hold stocks of a competitor’s money.  Instead, it will prefer to redeem it for gold or reserves at the bank directly or at a clearinghouse, either of which will impose a cost on the competitor by taking away the gold or reserves it needs to create loans. This process of “adverse clearings” ensures that if any bank creates too much money, it will pay an economic price for it in the form of reduced reserves.  Lower reserves not only limit what the bank can lend and thereby earn in interest, insufficient reserves put the bank at risk of not being able to pay depositors. Should a bank create too little money, it will also pay a price, but in the form of having too many reserves on hand and thereby sacrificing the interest it could earn by expanding its lending. Free banks would avoid deflation because under producing money is costly. If we assume that banks are profit seekers, they would have every reason to avoid both inflation and deflation.

What a free banking system produces is the right degree of flexibility necessary for sound money. Because this system is separate from the government, we need not worry about political incentives working at cross-purposes with sound money. Free banks do not face the lag and information problems of central banks. With banks operating in a truly competitive market, they are able to make use of market signals, such as their reserve holdings and profits, to show them quickly and accurately whether they have produced the right quantity of money.  These are exactly the signals that monopoly central banks lack, which helps to explain their inability to get the money supply right. Although banks will not get the money supply exactly right at every moment, a competitive free banking system will ensure that they know they have erred and that they have the knowledge and incentives needed to correct mistakes, and it will do so better than any alternatives. A free banking system also has the advantage of being able to respond to changes in the demand for money, while still being constrained to not over- or under correct, unlike the rule-bound central bank. This “flexibility within constraints” is a product of the competitive environment that free banking creates.

Again, I can’t do justice to the full argument here. My real concern is to demonstrate that such a system fits neatly into broader libertarian arguments about the problems of monopolies and the benefits of competitive markets, and does not reify gold in the way that other proposals made by right-wing defenders of the gold standard tend to do.  Gold (really “some commodity”) plays a role here, but the key is allowing competition to drive the production of all forms of money.

Why Competitive Money Matters

If my fellow free banking theorists and I are correct about the system’s ability to dramatically reduce or eliminate inflation, then this has important implications from a BHL perspective as the damage done by inflation disproportionately harms the poor. One of the most important problems inflation creates is that it does not, in the real world, affect all prices equally.  Some go up a lot, some not as much. This injects static into communication process of the price system and makes prices much less reliable guides to producers and consumers. Most of inflation’s problems begin there.

As a result, the existence of inflation (or, more precisely, an expectation of a positive rate of inflation), imposes costs on households and firms that can only be avoided by undertaking costly defensive measures themselves.  These “coping costs” of inflation are significant and often under-appreciated.  They also harm the poor much more than the rich.  In addition, inflation redistributes toward those who get the new money first and away from those who get it last.

Once the threat of inflation is real, consumers must start to pay more attention to interest rates and the terms of contracts.  If banks start to offer adjustable rate loans, this complicates the borrowing process for consumers and might require additional expertise to make sense of the loan.  One can raise similar issues about employment contracts with cost of living clauses.  In both cases, it is likely that those with the least resources will be at a disadvantage in dealing with the changing reality of contracts.  Not only will the wealthy be more likely to have the knowledge themselves to cope with these costs, if they do not, they have the resources to hire those who do.  The result will be a net gain for the wealthy as they are able fend off these costs of inflation better than the poor.

Beyond just contracts, inflation gives both firms and households reasons to reallocate their resources, especially their financial assets, to protect themselves against inflation.  For both, either making these changes themselves or hiring someone else to do so involves real costs. And here too, those costs can more easily be borne by the rich.  In the case of firms, large firms can more easily bear these costs as they can either spread them across a larger scale of operation and/or are more likely to have in-house expertise to draw upon.  Smaller firms will find it more of a struggle to cope either by trying less efficiently to do it themselves, or by having to bear the higher average cost of purchasing such help on the market.  Though the effect may not be large, inflation imposes more costs on small firms than large ones.  The story across households is similar.  Wealthier households, who certainly have more at stake, will be more able to afford financial advice or to hire a financial planner, whereas poor households will find doing so that much more difficult.  The result is that wealthier households are better able to protect the value of their assets, while poor households see losses.

Perhaps the most damage that inflation harms the poor is the way in which those who get access to the excess money supply first gain at the expense of those who get it later.  This manifests itself several different ways.  As excess supplies of money make their way through the economy, those who get the money first are able to spend before prices rise, while those who see it later see prices rise before they see the increase in their nominal incomes resulting from the increased money supply.  The most well known example of this process is the way in which inflation harms those on fixed incomes.  Workers locked into labor contracts or retirees on pension plans that adjust annually to the cost of living are always running a year behind.  Normally, the cost of living adjustments are based on the prior year’s inflation rate, which means that for that year, these people have had no income increase even as prices were rising.  They will have been compensated, after the fact, for the past year, but for the year to follow, they will now lose if there are any inflation-driven price increases.  It does not matter whether these fixed incomes are public or private;  the issue is that they only adjust after the fact.

As inflation causes prices to less accurately reflect the tastes, preferences, and knowledge of market actors, it becomes ever more difficult for both entrepreneurs and consumers to figure out what is happening in the market, which in turn leads to more discoordination and more frustration for market actors.  As the market becomes a less reliable resource allocation process, people will, on the margin, turn toward government to address the particular problems or take over more of the responsibility for resource allocation.  In addition to the direct gain in wealth that comes from governments creating new money, there is an induced gain in government power from the chaos that inflation produces in the marketplace.  As the locus of resource allocation shifts from the decentralized nodes of market power checked by competition to the centralized nodes of monopoly power of the state, the ability of those with fewer resources to make their voices heard shrinks accordingly. Rent-seeking societies favor those with resources to access politics.

If, as Austrian school economists like myself, are correct in arguing that inflation is the cause of the boom and bust of the business cycle, we have yet another way in which a free banking system would work to the benefit of the least well off, as recession and depressions have less impact on those already better off. Concern for the least well off should drive us to find ways of minimizing or eliminating business cycles.

Finally, to the extent that the history of central banks is about being created and having their powers expanded as a way to finance government, especially its imperial adventures, without recourse to taxation or borrowing, bleeding heart libertarianism might have an interest in eliminating them if possible.  After all, war and empire have historically taken their worst tolls on the most vulnerable, both in terms of the aggressor countries and the populations they have aggressed against.

All of this adds up to a number of reasons why those sympathetic to bleeding heart libertarianism might take an interest in questions of monetary policy, and why they might reconsider a hasty dismissal of a desire to once again have gold play a monetary role as right wing nonsense.