A Monetary Policy Primer, Part 12: Monetary Alternatives

commodity money, monetary policy primer, federal reserve, fiat money, alternative monetary policy, monetary alternatives
Cryptocurrency Mining Farm by Marco Krohn. CC BY-SA 4.0) https://commons.wikimedia.org/wiki/File:Cryptocurrency_Mining_Farm.jpg
Cryptocurrency Mining Farm by Marco Krohn

This primer is supposed to introduce readers to the workings of the present U.S. monetary system. So it's only natural that it should take established monetary arrangements for granted, including an official, "fiat" dollar currency managed by the Federal Reserve System.

And while I haven't hesitated to point out shortcomings in the Fed's management of the dollar, and have even dared to suggest some ways in which that management might be improved upon, I haven't questioned the fact that, whether it does so competently or not, the Fed is indeed ultimately "in charge" of the U.S. monetary system. That is, I've assumed that the U.S. dollar is the only important domestic currency unit, and that the total quantity of dollar-denominated exchange media, the behavior of the general level of prices, U.S. dollar exchange rates, and the periodic flow of domestic dollar-denominated payments, remain under the discretionary control of the FOMC.

Monetary Policy, Broadly Understood

But while a monetary policy primer must generally deal with existing monetary arrangements, it doesn't follow that it should overlook others altogether. "Policy," according to Webster, is "a high-level overall plan embracing the general goals and acceptable procedures especially of a governmental body." And though, within the set of possible plans, the most readily-implemented ones take existing institutional arrangements for granted, there are always other, more radical options that involve either replacing established arrangements or confronting them with rival ones with which they must compete.

Radical policy alternatives are, inevitably, controversial ones as well; so a primer is hardly the place for any detailed consideration, let alone a defense, of any of them. Instead, we must settle for a quick glance at several especially prominent or intriguing possibilities, all of which involve moving away from the present, discretionary system and towards a more-or-less "automatic" alternative.

Back to Gold?

Among various proposals for reforming the present U.S. dollar, none are more controversial than those for re-instating an official gold standard, meaning an arrangements in which official paper U.S. dollars are once again made fully convertible into a fixed quantity of gold, as they had been until 1933. The proposal is controversial in no small part because, so far as many economists are concerned, the historic gold standard was itself a disastrous failure, the passing of which calls, not for tears of regret, but for cries of "good riddance!"

How to account, then, for the gold standard's enduring appeal, especially among conservatives and libertarians? Part of the answer is that, whatever its shortcomings, a gold standard has the indisputable merit of serving to automatically stabilize the long-run purchasing power of any money tied to it. That property, far from being mysterious, stems from the simple fact that under a gold standard the profitability of gold prospecting and mining increases, other things equal, as prices generally fall, and declines as prices generally rise. Consequently although the general level of prices can fluctuate, it tends to revert over time to a fixed mean.

Another part of the answer is that the gold standard's critics often exaggerate its shortcomings, especially relative to those of actual (as opposed to idealized) fiat standards. On a blackboard, of course, a fiat standard can readily be shown to outperform a gold standard in the long-run perhaps, but certainly in the short-run. But that's true only because, on a blackboard, a fiat standard can be made to do whatever the chalk-wielder likes. In practice, on the other hand, fiat standards can and often do behave very badly indeed. What self-respecting economist, right now, would relish the opportunity to lecture a roomful of Venezuelans on the theoretical advantages of irredeemable paper money?

Moreover, while the international gold "exchange" standard that was cobbled together after World War I was a disaster waiting to happen, the prewar "classical" gold standard's commerce-invigorating combination of generally fixed exchange rates and reasonable (if less than perfect) price-level stability has never been matched since.

But the most important reason why gold still commands such a following is, if you ask me, more prosaic: it's simply that, for those who distrust bureaucratic control, whether of money alone or of economic activity more generally, the gold standard is simply the most salient alternative. Gold was the last, the most universally embraced, and the most successful of all commodity standards, as well as the one that coincided with a period of remarkable economic progress concerning which even John Maynard Keynes — that arch critic of the "barbarous" gold standard — waxed eloquent:

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…  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 dispatch 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.

Nostalgia versus Expediency

But however much one may regret the passing of the classical gold standard, it doesn't follow that we can do no better than to try and restore it. "In commerce," the great William Stanley Jevons famously said, "bygones are forever bygones"; and what Jevons says of commerce goes for money as well. Gold may have served as a relatively successful monetary standard in the past. But it doesn't follow that there's anything sacrosanct about gold today, or that a gold standard is still the best of all possible options for fundamental monetary reform.

On the contrary: an official attempt to once again make paper dollars convertible into gold today would be a step no less arbitrary or "constructivist" (in F.A. Hayek's sense of the term), than an attempt to make them convertible into silver, palladium, or Japanese yen. To be sure, gold has a nostalgic appeal lacking in the rest. But allowing that consideration to be decisive would be like deciding to replace an aging fleet of jet aircraft, not with newer jets, but with as many propeller-driven biplanes. Don't get me wrong: I'm not saying that gold convertibility couldn't possibly be a good idea. I'm just saying that it wouldn't qualify as a great idea simply by virtue of its historical preeminence. The only real test ought to be whether a revived gold standard would deliver better results than any equally practical (and not merely theoretical) alternative.

Finally, even if no new system could beat a restored classical gold standard, it doesn't follow that such a restoration is possible. If getting one nation alone to return to gold is bound to be extremely difficult, getting a large number of advanced nations to do so simultaneously, so as to have a truly "classical" set-up like the one that existed before 1914, would be a truly Herculean challenge.

Furthermore, official gold standards can survive only if citizens trust their governments and central banks to generally keep promises to trade gold for paper. Such trust, having been dealt a severe blow by World War I, died a slow and painful death in the decades that followed it. A new gold standard commitment by the Fed, or by any other central bank, today, is bound to run afoul of this reality, especially by becoming the object of attacks by skeptical speculators. If history is any guide, sooner or later those attacks would force even the most well-meaning central bankers to break their gold-standard promises all over again, though perhaps not on time to avoid leaving their economies in shambles.

Self-Regulating Fiat Money

If trying to revive the classical gold standard, or something close to it, is like trying to piece Humpty-Dumpty back together, that doesn't mean that we have no choice but to settle for a paper dollar managed by a committee of fallible (and occasionally fumbling) bureaucrats. In particular, the difficulties inherent in trying to tame the dollar by once again making it convertible into a scarce commodity can be avoided by relying instead on a quantity-based monetary rule. Because such a rule provides for automatic adjustments in the quantity of standard money without allowing people to convert that money into something else, it can't fall victim to a speculative attack, and is that much more likely to endure.

As we've already reviewed some general arguments in favor of having a monetary rule, there's no need to review those arguments again here. Instead, I'd like to consider a radical variation on the old theme, consisting of a quantity rule that's enforced, not by a committee, either voluntarily or with the help of sanctions imposed whenever the rule is breached, but by means of some sort of automatic, fail-safe mechanism.

The general idea is one Milton Friedman entertained for many years. "We don't need the Fed," he said (in one of many similar interviews he gave in the 1990s). “I have, for many years, been in favor of replacing the Fed with a computer” programmed to "print out a specified number of paper dollars…month after month, week after week, year after year.”

Although the constant ("k-percent") money growth rate rule that Friedman once favored has itself fallen out of fashion, his idea for a computer-driven money supply couldn't be more à la mode. Computers are, for one thing, capable of doing a lot more than they were back in the 90s. And even in the 90s they might have been capable of managing the money supply so as to maintain, not a stable growth rate for B or M1 or M2 or some other monetary aggregate, but a stable level of nominal spending. The smooth growth of spending would in turn supply, for reasons we've considered previously, robust protection against severe economic fluctuations.

Indeed, while it's easy to imagine a circumstance in which a constant money growth rule could turn out to be a recipe for macroeconomic chaos, it's darn difficult to imagine a situation in which there'd be much to gain, and little to lose, by sacrificing a stable and customary overall growth rate of spending growth for some other monetary policy objective. A bout of exceptionally rapid spending? A fine way to boost asset prices, no doubt, until one considers the inevitable denouement!  Slower spending than usual? Tell it to your average businessman, or employee! Those (mainly Fed insiders) who rail against what they like to characterize as "inflexible" rules (as if a "rule" could be anything but inflexible!) forget — or pretend not to know — that while some rules would indeed prevent the Fed from having the flexibility to do the right thing, others would mainly serve to deny it the flexibility to do wrong things. A stable spending rule, including one that's "rigidly" enforced by a computer, though it would rule out many bad monetary policy options, would also "rule in" the good ones.

NGDP Futures

Scott Sumner has come up with an alternative plan for targeting nominal spending, which relies not on a computer but on trading in futures to keep spending on target. The plan, called "NGDP Futures Targeting ," starts with the Fed settling on an NGDP growth-rate target — say, 4 percent — and then offering to enter into NGDP futures contracts, with payoffs depending on the future level of NGDP, to anyone who expects it to either exceed or fall short of target. Traders who expect NGDP to come in above target will go long on the futures, while those expecting it to fall short will go short.

How, then, does the Fed manage to actually achieve its target? The answer becomes evident when one considers the link between the futures contracts it enters into for its monetary policy operations. When the Fed sells futures to investors who are betting on excessive NGDP growth, it is withdrawing base dollars from the economy, just as it might by engaging in open-market asset sales. In contrast, when it buys contracts from short sellers, it expands the monetary base. In other words, the very persons who are betting that the Fed will miss its target are also driving it to adjust its policy in a direction calculated to make them lose their bets! As a means for further reinforcing this built-in feedback mechanism, Sumner would also have the Fed engage in "parallel" open-market operations for each NGDP contract purchase or sale. In short, by offering to "peg" the price of its futures by engaging in as many contracts as it takes to keep the price on target, the Fed essentially stands ready to expand or contract the monetary base by whatever it takes to keep expected NGDP on target.

That, at least, must suffice for the barest of summaries of a plan that has since appeared in several, subtly-distinct versions, each of which has spawned its share of subtle (and not-so-subtle) controversy, with some critics claiming that Sumner's scheme, or some versions of it, unworkable. Do those critics have a point? Perhaps they do, but that's not our concern. We're here neither to praise nor to bury, but only to have a gander at, this and other intriguing future possibilities for monetary policy.

Bitcoin and All That

Of these possibilities none are more intriguing than those held out by so-called cryptocurrencies, including Bitcoin and its various "altcoin" offshoots. As I observed some years ago (and as Tim Sablik explains in this Richmond Fed piece), when it was just starting to gain economists' attention, Bitcoin has properties in common with both gold and other commodity monies on the one hand and deliberately managed fiat monies on the other. Like gold, Bitcoin is unalterably scarce: just as there is only so much gold on the planet, whether mined or as-yet unmined, there are only so many bitcoins to be had — 21 million, to be precise — of which not quite 17 million have been mined as of this writing. And like gold mining, bitcoin "mining," which involves the use of computer-power to solve a mathematical puzzle, is costly. Since bitcoin "miners" compete for the privilege of being responsible for some share of any periods' bitcoin output, the marginal resource costs of mining a batch (or "block") of bitcoin tends to equal the market value of the coins produced.

Yet unlike gold, and like a fiat money, both the maximum possible output of bitcoin and the number of coins mined in any given period is controlled, not by mother nature, but by a protocol programmed into Bitcoin's open-source software. The protocol adjusts the difficulty of the puzzle bitcoin miners must solve so as to keep total bitcoin output on a predetermined schedule, according to which bitcoin output gradually tapers off, asymptotically approaching, but never quite reaching, its 21 million coin limit. The decentralized nature of Bitcoin's software means that no one is either "in charge" of the protocol or capable of altering it. A majority of miners can, however, agree to form themselves into a new branch network or "fork" that uses a modified copy of Bitcoin's original protocol, as happened on August 1, 2017, when "Bitcoin Cash" split-off from what became known thereafter as "Bitcoin Core." Although the fork created as many new "Bitcoin Cash" coins as there had been Bitcoin Core coins beforehand, it left the Bitcoin Core protocol itself unchanged.

Bitcoin's odd blend of commodity- and fiat-money properties led me to dub it a "synthetic commodity money" some years ago. But the exciting thing about Bitcoin and its various spinoffs and rivals isn't merely that they comprise a distinct sort of basic money, but that their combination of commodity- and fiat-money features is capable, in principle at least, of combining the best properties, while avoiding the worst, of each of those more traditional alternatives.

One of the more common complaints against a commodity standard is that it exposes the value of money to shocks stemming from either new commodity discoveries or from changes in the non-monetary demand for the standard commodity. Bitcoin and other such "synthetic" commodity monies are, on the other hand, not subject to similar shocks, because the amount miners can extract is strictly pre-programmed, and because they have no non-monetary (e.g. ornamental or industrial) value.

The big beef against fiat money, on the other hand, is that its quantity can be altered by the authorities placed in charge of it, not only for the sake of promoting economic stability, but for other reasons, if not arbitrarily.

It doesn't follow, of course, that any old  cryptocurrency would be a hands-down winner in a race against any established fiat money. Despite its ultimate limit of 21 million coins and skyrocketing transactions fees, Bitcoin might still seem a safer gamble than, say, the Venezuelan Bolivar. But would it really supply a better or more durable monetary standard than the present U.S. dollar?

But the question isn't whether Bitcoin can beat the present fiat dollar. It's whether the basic technology pioneered by Bitcoin might allow some other self-regulating cryptocurrency to do so. Besides giving rise to its own "Cash" spinoff, Bitcoin has already spawned dozens of "altcoin" rivals, with others yet to come. It's at least conceivable some one or more of these might harbor such properties as would make it a worthy opponent to the present dollar, if not something clearly superior. Consider, if you will, the immense variety of ordinary commodities that either have served as money in the past, or that might have done so, from cowrie shells and tobacco to silver, gold, and even (as more than one prominent economist once proposed) common bricks. Each had its merits and its drawbacks; and every one of them was imperfect. But now consider that the cryptocurrency revolution presents us with a whole new universe of new, albeit synthetic, options to draw upon, each of which has been deliberately endowed with properties calculated to make it an attractive medium of exchange. Call me an optimist, but it seems to me only natural to suppose that one of these innovative products might someday prove just the thing to give even the best discretion-wielding central bankers a run for their (that is, our) money.

Choice in Currencies

For an upstart currency to make inroads on an established fiat money requires, at very least, that established and would-be monies compete on a reasonably level playing field. That means having rules and regulations that make it relatively easy for persons to either partly or entirely "opt out" of an official currency network, and to "opt in" to one or more alternative networks. I say "relatively easy" because it's inevitably costly to switch from one currency network to another, and especially so when the switch is from a bigger network to a smaller one. A level playing field therefore means, not one where rivals are necessarily well-matched, but one where the game isn't rigged in the home team's favor. In other words, the laws should not themselves favor official money over other alternatives.

It was with that intent in mind that F.A. Hayek, in making his now-famous 1976 case for "Choice in Currency," called upon

all the members of the European Economic Community, or, better still, all the governments of the Atlantic Community, to bind themselves mutually not to place any restrictions on the free use within their territories of one another's — or any other — currencies, including their purchase and sale at any price the parties decide upon, or on their use as accounting units in which to keep books.

"There is no reason whatever," Hayek went on to argue,

why people should not be free to make contracts, including ordinary purchases and sales, in any kind of money they choose, or why they should be obliged to sell against any particular kind of money. There could be no more effective check against the abuse of money by the government than if people were free to refuse any money they distrusted and to prefer money in which they had confidence. Nor could there be a stronger inducement to governments to ensure the stability of their money than the knowledge that, so long as they kept the supply below the demand for it, that demand would tend to grow. Therefore, let us deprive governments (or their monetary authorities) of all power to protect their money against competition: if they can no longer conceal that their money is becoming bad, they will have to restrict the issue.

Although Hayek's advice seems perfectly reasonable, putting it into practice turns out to be a lot harder than he seemed to think, and not just because governments' would rather keep currency playing fields slanted their way. Consider the case of Bitcoin. In March 2014, the IRS classified it and other cryptocurrencies as capital assets (“intangible property”) rather than as currency, making any trade involving them the basis for either a short- or a long-term capital gains tax, depending on how long the coins were held before being disposed of. As the folks in the Coin Center (a non-profit cryptocurrency advocacy group) explain, this tax treatment puts cryptocurrencies at a disadvantage, not just relative to the U.S. dollar, but relative to official foreign currencies, which enjoy an exemption when it comes to relatively small transactions:

Say you buy 100 euros for 100 dollars because you’re spending the week in France. Before you get to France, the exchange rate of the Euro rises so that the €100 you bought are now worth $105. When you buy a baguette with your euros, you experience a gain, but the tax code has a de minimis exemption for personal foreign currency transactions, so you don’t have to report this gain on your taxes. As long as your gains per transaction are $200 or less, you’re good to go.

Such an exemption does not exist for non-currency property transactions. This means that every time you buy a cup of coffee, or an MP3 download, or anything else with bitcoin, it counts as a taxable event. If you’ve experienced a gain because the price of Bitcoin has appreciated between the time you acquired the bitcoin and the time you used it, you have to report it to the IRS at the end of the year, no matter how small the gain. Obviously this creates a lot of friction and discourages the use of Bitcoin or any cryptocurrency as an everyday payment method.

The obvious solution, the Coin Center goes on to suggest, is "to simply create a de minimis exemption for cryptocurrency the way it exists for foreign currency." But hold on: to really achieve Hayek's ideal, it won't do to level the capital gains tax portion of the currency playing field for cryptocurrencies only, rather than for all potential, unofficial dollar substitutes. But then, just what shouldn't count as such a potential substitute? Surely gold qualifies. But why not silver, or cigarettes, or… the point, as we know from experience, is that all sorts of things are "potential" exchange media, and therefore potential currencies. So, to really allow them all to compete on equal terms, one would at very least have to exempt all of them — from taxes to which official dollar trades aren't subject.

In short, Hayek's ideal is just that: something to have governments strive for, rather than something they can be expected to fully achieve in practice.

What's more, Hayek was far too optimistic regarding the likely consequence of making it easier for people to choose among rival currencies. "Make it merely legal" for them to switch to something else, he wrote, "and people will be very quick indeed to refuse to use the national currency once it depreciates noticeably." But would they? Unlike, say, shoes or soda water, money is a "network" good, meaning that one of the most important, if not the most important, determinant of the attractiveness of any particular money is the size of the network of persons prepared to accept it. You might think gold an ideal monetary commodity, and I might hold that Bitcoin is to the dollar what sliced bread is to bread of the old-fashioned sort. Yet when it comes to going shopping, what either of us must first consider is, not what sort of money we like, but what the shopkeepers are prepared to take in exchange for their goods.

It follows that, even if official and unofficial currencies really could have a level playing field to compete on, that field would still be one on which official money would generally enjoy a huge "home team" advantage. For this reason, the mere fact that an official currency is depreciating "noticeably" isn't enough to incite people to abandon it in droves. Instead, it might take a very substantial rate of depreciation, or some like cataclysm, to bring about rapid change. Cataclysms aside, upstart currencies are more likely to have to start by clawing their way into established currency markets one painful inch at a time, though with each becoming easier than the last as their own, initially tiny networks begin to blossom.

Free Banking

The alternatives I've considered so far have all consisted either of potential replacements for the U.S. dollar or of novel means for regulating the stock of official (that is, Fed-created) U.S. dollars themselves. Emphasizing such alternatives makes sense, after all, in a primer concerned with "monetary policy," where the most fundamental choices are those concerning what type or types of basic money to employ, and how best to regulate the supply of basic money, assuming that it doesn't adequately regulate itself.

But what about alternatives consisting  of banks' readily convertible IOUs, like most bank deposits today that, by virtue of their instant convertibility into official dollars, are very close substitutes for them? Because such bank-created substitutes necessarily "piggy back" on the basic monies into which they can be converted, their presence can't generally make up for misbehavior or mismanagement of the quantity of basic money itself, and might even aggravate that misbehavior. A fiat money stock that's allowed to grow so rapidly that it would result in a 20 percent annual rate of inflation in a pure fiat money system will, for example, produce the exact same rate of inflation in an economy in which payments are made exclusively by means of bank IOUs backed by a fixed fractional reserve of the same basic money.

Moreover there's nothing at all radical about having banks supply such alternatives, at least to a limited extent. Today and for some time past bank deposits of various kinds have served, with the aid of checks and, more recently, debit cards, as close substitutes for official monies, to the point of being far more extensively employed in exchange than official monies themselves.

It would, nevertheless, be wrong to suppose that there's no scope for a potential beneficial radical reform involving bank-supplied alternatives to basic money. On the contrary: plenty of scope exists for expanding the role of such alternatives, particularly by doing away with long-standing restrictions on commercial banks' ability to challenge central banks' monopoly of circulating (or hand-to-hand) payments media.

Once upon a time commercial banks routinely issued their own circulating paper notes; indeed, until the latter half of the 19th century bank notes were the most important liability on banks' balance sheets, which were far more commonly employed in making payments than either checks or coins. Nor did central bank notes, which themselves started out as mere IOUs redeemable in gold or silver, only to be transformed into inconvertible fiat money later on, come to generally displace notes of commercial banks until the last decades of the 19th century, and the opening ones of the 20th, when the proliferation of central banks typically went hand-in-hand with laws forcing commercial banks out of the paper currency business.

Received opinion has it that commercial bank notes had to go because central bank currency was better. But now and then received opinion is nothing but hokum, and this happens to be one of those instances. Had central bank notes been better than their commercial counterparts, it shouldn't have been necessary for governments to suppress the latter. Instead, the mere availability of official alternatives should have sounded the death knell of the commercial stuff. Yet instead of that having been the case, in every instance the commercial bank notes had to be snuffed-out, leaving people no choice but to employ official paper money. Nor did the commercial bank currency go down without a fight, in which prominent economists often took part, with many of the most prominent (and most better ones, if I may say so) challenging governments' efforts to establish official currency monopolies, and championing the alternative of free trade in banking, or "free banking," for short.

Strictly speaking, "free banking" means more than just allowing ordinary banks to issue paper currency. It also means leaving them free of other restrictions, including restrictions upon their ability to establish branch networks, lend to whomever they wish, charge whatever rates they wish, and hold whatever levels of cash reserves and capital they wish to. Freedom of note issue is only the most controversial of these many aspects of freedom in banking, in part because allowing it would make it possible for the public to rely exclusively on privately-supplied exchange media, with official dollars playing their part only behind the scenes, as bank reserves. Furthermore, in times past, when official money consisted, not of any central bank's inconvertible "liabilities," but of gold or silver coin, not having to rely on a central bank as a source of paper money meant not having to have a central bank at all !

Could a monetary system lacking a central bank possibly have been any good? Darn tootin'!

Of all relatively modern monetary systems, none have earned more kudos than the two that most closely approximated the free-banking ideal, namely, the systems of Scotland between the latter 18th century and 1845 and Canada from 1870 and 1914. In both of these, bank-supplied notes and deposits commanded such a high degree of confidence that gold and silver coin hardly circulated. The public's disdain for precious metal money in turn allowed Scottish and Canadian banks to operate on reserve cushions that were slim even by today's standards. That in turn made Scottish and Canadian banks highly efficient intermediaries, with almost all of their clients' savings going to fund relatively productive bank loans and investments. Yet despite this high degree of efficiency, bank runs were extremely rare in both systems, while banking crises, involving simultaneous problems at many banks at once, were almost unheard of.

Why, in that case, does free banking, and especially the idea of letting banks issue their own currency, seem so far-fetched today?

Partly it's because the Fed and other central banks, upon which we're now all too inclined to turn to for information about monetary history, have underplayed such success stories as those of Scotland and Canada whilst sugarcoating their own records. But in the U.S. case it's also due to confusion about the meaning of "free banking." Whereas that phrase can refer to genuinely free banking systems like those of Scotland and Canada, it can also refer to any of the systems established through so-called "Free Banking" laws passed by eighteen states between 1837 and 1860. Despite their names the later laws didn't come close to allowing genuine freedom in banking. Instead, they all imposed important restrictions upon the banks established under them, including the requirements that those banks refrain from establishing branches, and that they back their notes entirely with specific securities — usually consisting of state government bonds. In several instances such restrictions, far from guaranteeing the soundness of the banks that were forced to abide by them, led to notorious abuses and failures, including episodes of "wildcat" banking. All in all, the misnamed "Free Banking" era proved to be one of the most unfortunate chapters in U.S. monetary history, because of the direct damage done by bank failures, of course, but also because those failures gave freedom in banking a bad name it didn't deserve.

But what relevance has free (that is, genuinely free) banking today? It's relevant, first of all, because an understanding of its workings suggests that freedom in banking isn't necessarily inimical to soundness in banking, and that the wrong sort of regulations can in fact be worse than no regulations at all. It also suggests that, even if we are determined to rely on a fiat-money issuing Fed as our ultimate source of monetary control, we need not rely upon them to supply hand-to-hand currency. Instead, we might let commercial banks back into that business, while limiting the Fed's ordinary involvement in the market for money to the "wholesale" part of that market — that is, to supplying banks with reserves. Commercial banks that could issue their own notes would presumably also be free to experiment with other forms of non-deposit money, including "smart" stored value cards, that might eventually replace paper money altogether, except on rare occasions when people lost confidence in the private stuff. I dare say, indeed, that had commercial banks been left in charge of supplying currency all along, paper money would some time ago have gone the way of horses, buggies, spittoons, and slide-rules. What else save a bunch of government monopolists could have managed to keep such low-tech stuff as paper currency in play for so long?

Should We, Can We, "End the Fed"?

While in times past free banking was an alternative to central banking, that's no longer so. Today's commercial bank deposits are claims, not to gold or silver coin, but to central bank issued fiat money; and were commercial banks able to supply their own notes or stored value cards to take the place of central bank notes in payments that don't involve drawing upon bank deposits, those notes and cards would also represent claims to central bank money.

In short, so long as we stick to the present fiat dollar standard, instead of replacing it with either a natural or a synthetic commodity standard, no amount of freedom in commercial banking will suffice to render the Fed entirely otiose. No wonder that, when former U.S. Representative Ron Paul and his many devotees campaign to "End the Fed," they have in mind, not just letting bulldozers loose on the Eccles Building, but once again making official dollars claims to some fixed quantity of gold.

Whether one is a hard-core libertarian or not, it's interesting to ponder the extent to which the Fed's role might be reduced, with the help of various more-or-less radical reforms, without either abandoning the present, inconvertible U.S. dollar or sacrificing its integrity.

We've already considered how a carefully-programmed computer, or having the Fed peg the price of NGDP futures, could render the FOMC redundant — in so far at least as that body's challenge can be boiled down to one of maintaining a stable level of overall spending. We've also seen how letting commercial banks issue circulating currency would make it unnecessary for the Fed to be in the currency business, though it would still require keeping plenty of Federal Reserve notes on hand in case a banking panic should break out. Finally, in an earlier chapter we've seen how allowing "flexible" open-market operations could make it unnecessary for the Fed to ever make any direct loans to troubled financial institutions.

Yet these are far from being the only possibilities for having a leaner, if not a meaner, Fed. The Fed's reduced involvement in currency provision and last-resort lending would mean a corresponding decline in the importance of the regional Fed banks, apart from the New York Fed, which handles the system's open-market operations. The Fed's involvement in check clearing could also be reduced, by returning that activity to the private sector, which handled it perfectly well until the Fed muscled its way in after 1913. Finally, most of the vast army of economists and other staff personnel presently employed at the Fed, who even now are mainly busy performing tasks that have nothing much to do with fulfilling the Fed's mandate, could be made to seek more productive employment elsewhere.

In short, sticking to a fiat dollar doesn't rule out reforms that would dramatically reduce the Fed's role in the monetary system. Instead of the present, Leviathan Fed, one might have what might be called a "Nightwatchman" Fed, capable of doing those things that any responsible fiat money issuing central bank ought to do, but incapable of doing many of the things that irresponsible central banks do all too often.

A Concluding Plea for Open-Mindedness

By surveying some more radical options for monetary reform, I don't pretend to have made a compelling case for any of them. My only goal has been to suggest that all sorts of alternatives exist, and that each of them has its merits. Will any of them really help? Is one better than the rest? Are there others not mentioned that deserve our consideration? The correct answer to all these questions, and others like them, is "Maybe." In other words, such alternatives are, or ought to be, worth thinking about, even if some might ultimately be judged unattractive. Allowing ourselves to think outside the established monetary policy box can never do us any harm. Nothing could be more dangerous, on the other hand, than for all of us to assume that, despite its obvious faults, ours happens to be the best of all possible monetary systems.

  • Ray Lopez

    A tour de force, not farce, by Dr. Selgin. The expert on gold is Bardo, read a couple of his books. The free banking idea using Scotland and Canada as proxies shows indeed money supply increases during the fall harvest, but what practical effect this has is unclear (Canada GDP per capita was no higher than the USA's during the 19th century seems to me). Canada banks being safer than US banks may be a function of branch vs unit banks. Mundell's idea of a world currency (Terra or DEY, https://en.wikipedia.org/wiki/World_currency ) is a sound 'neo-gold' standard. But finally–here it comes–money is largely long and short term neutral so none of this really matters!

    • LOL you are not real. You are some bot, I know it.

      But, this is a good example of what I am attempting to say in another comment above. In my view, I have found George's historical contrast of various money and banking regimes to be quite convincing in favor of private competing monies and free banking, though other's might have differing interpretations.

      I personally believe the only solid foundation for money, banking, or anything else, including the existence of State, is guaranteeing the unalienable natural rights.

      • Ray Lopez

        That's right, I'm a bot, personalized just for you [Milton Churchill]. Natural rights FYI went out of style all over the world except England and the USA, and even in the USA they are increasingly joining the "legal positivism" aka "Napoleonic Code" or "Codex Justinianus" or Continental system. In other words, law is whatever the state says it is. Singapore is a perfect example of this: if you spit out chewing gum you are imprisoned, even if you did it to keep from choking. Such mitigating factors don't go to guilt, but rather, they go to how harsh your sentence will be. The Common Law is dead, sadly, [your name here]. – the RayLopezBot

        • LOL I have news for you. Natural rights are not recognized now, and never have been, in the U.S. nor U.K. Common law is produced through judicial decision and has nothing to do with natural rights or natural law. Legal positivism, et al, represents the state of nature, the absence of law.

          • Ray Lopez

            Not by conventional definitions, but you can march to your own drumbeat MC.

          • Prerogative versus law. Calling a prerogative a law, doesn't make it a law.

  • Henri LEPAGE

    Hi George ! May be a stupid question : Isn't the "Global Wholesale Money (Eurodollar) Market" an already existing quasi free-banking system with the automatic central banks swap network – as described by Perry Mehrling – acting as a limited central bank with power reduced to a dealer-of-last-resort function ? Isn't our most pressing present political challenge to save this Global Money System from the grips of the Fed aiming at reinstating its total control over global eurodollars ?

    • George Selgin

      At most, Henri, I would say that there is a parallel. The conventional understanding of free banking refers to retail rather than wholesale dealings, of course; and with regard to the wholesale dollar market there is no escaping from the fact that the Fed is and long has had "total" (if often highly imperfect) control of the world supply of dollars, including offshore ones. I believe that Mehrling himself acknowledges this in observing that the Fed remains the sole "last resort" source of dollars.

  • "Don't get me wrong: I'm not saying that gold convertibility couldn't possibly be a good idea. I'm just saying that it wouldn't qualify as a great idea simply by virtue of its historical preeminence. The only real test ought to be whether a revived gold standard would deliver better results than any equally practical (and not merely theoretical) alternative."

    I would agree with the first sentence, but would say, with regards to the second sentence, that the only real test ought to be whether or not private property rights, and liberty to contract without interference from State governments, are the foundation of any future monetary regime. Personally, I believe freedom of choice will deliver the best value for all of society, but attempting to deliver the best value, achieve greater utility, more growth, better results, etc., is how we got here in the first place.

    • Ray Lopez

      Did you see the Financial Times analysis of growth in the USA with gold vs with fiat today? Growth was the same per capita. No difference Milton. Money is neutral. This whole debate about "gold is better" and even "free banking is better" reminds me of CDMA vs FDMA vs TDMA in telecoms. CDMA is "free banking using gold" while FDMA/TDMA is 'fiat money with a central banker'. Which is better? In theory CDMA is better, because as more people crowd into a cell phone coverage area, nobody loses their coverage (no dropped calls) but only the quality goes down a bit (voices sound a bit tinny and distant). Think of a room full of people: TDMA/FDMA is where a central authority passes a baton or token around, real fast, and allows each person to speak for a fraction of a second. If there are not too many people, and if the central authority is skillful enough, nobody loses the right to speak (the baton is passed quickly). By contrast, CDMA is everybody speaking at will, simultaneously, but in different languages so there's no interference (French speakers understand each other since they tune out the other languages, ditto for Japanese, Navajo speakers, etc). So clearly CDMA (which Qualcomm has perfected) is superior. But guess what Milton? The superiority is so small–like the fact money is neutral–that nobody really cares. Sorry, but it's a fact. Free banking using gold is indeed slightly better for arguments sake let's agree–but since money is largely short and long term neutral, nobody cares. Sad but true. Peace!

      • Plenty of people, from time eternal, have cared about money for the very reason that it is not neutral. To the degree goods remain scarce, all goods are non-neutral, including money.

        My view is based on a priori logical foundation, not empirical or historical examples, (such as what the Financial Times is citing) as neither can provide any definitive proof for one conclusion or the other. That is the basis of what I am saying and why I believe advocates for private money and free banking should compliment empiricism and history with logic, which George does, and natural rights theory. 1) Competition creates better products at lower prices, including money, compared to monopoly or cartelization. 2) Monopoly and cartelization, only possible through State enforcement, must necessarily involve a violation of property rights, theft, and freedom to contract with others. If we can agree that theft should be punished, and in no way promoted, condoned, or placated, we agree that State involvement in money and banking should end.

      • George Selgin

        "Growth was the same per capita." Actually, U.S. per capita growth was a bit higher in the post-WWII period than in the pre-WWI period. It would, however, be extremely unwise to attribute the change to the move from gold to fiat money, as if there weren't many other things involved!

        • Ray Lopez

          Yes, wise words professor. I was thinking of growth since 1971, when labor wage growth slowed down. So what again is the short elevator pitch for adopting free banking again? Something a pol can remember. Another blog on this is kindly requested. Maybe 'fewer nominal shocks', lower interest rates, less easy money for Wall Street bankers? Reading through your latest book, it's quite good, albeit I initially misread the Canadian seasonal money supply graph.

    • George Selgin

      "The only real test ought to be whether or not private property rights,
      and liberty to contract without interference from State governments, are
      the foundation of any future monetary regime." Like the great Leonard Read, I'm for "anything that's peaceful" when it comes to monetary reform and innovation. My reference to "better results" refers to the specific context of alternatives for reforming the established dollar currency, where many such alternatives might be regarded as equally "peaceful" (or not).

  • Principled, non-partisan, factual, logical, honest… Lot's of people are going to dislike what you have written here, George ; )

    • George Selgin

      Thanks, Milton. I will try to keep your perspective in mind as the criticisms roll in!

  • Mattyoung

    The standard chip based debit card is becoming the secure element. Hold it in your hand, it has a couple of buttons and will bit double spend. It can be configured for a variety of clearing systems. It can hold digital coins for trade without clearing. Money, the universal form, becomes the plastic in your hand.

    The resulting 'ringed' fence has an interesting property, no humans allowed. Everything is auto-traded via trading bots under the control of your intelligent cash card. The new monetary standard is designed with Dr. Selgin in mind. The new monetary standard is simply free competitive money. Techies read this blog.

  • "Free Banking" laws …imposed important restrictions upon the banks established under them, including the requirements… that they back their notes entirely with specific securities — usually consisting of state government bonds. In several instances such restrictions, far from guaranteeing the soundness of the banks that were forced to abide by them, led to notorious abuses and failures”

    Sounds to me somewhat like Basel’s 0% risk weight given to (friendly) sovereigns. With Basel II a German bank had to hold 8% of capital (100% risk weight) lending to a German SME but only 1.6% (20% risk weight) when lending to a sovereign rated as Greece was till early 2007. (Actually European regulators allowed Greece a 0% risk weight as otherwise it would be not simpatico to a EU member.

    • George Selgin

      "Sounds to me somewhat like Basel’s 0% risk weight given to (friendly) sovereigns." I agree, Per. In both cases political and fiscal considerations took precedence over genuine concern for safety, and the public paid the price. Plus ça change… .

  • Warren

    At some point in the future there will be an app that has every national currency, every cyber currency, phone minutes, MMORPG in-game money, various tokens from online companies (like Amazon's coins and so forth), links to precious metal storage companies redemption services, and privately issued banknotes plus whatever else people might be willing to use as electronic fiduciary media.

    There will be 1000s of options and you'll be able to choose what ever you like to use in your transaction. Also you will be able to store your money as any of these things and since fees will be very low because of competition you'll be able to move your funds about at will. By spreading out your funds you will run a much smaller chance of losing them to theft or a disaster that strikes any given provider.

    Governments are trying to stop this sort of thing now, but they don't have much of a chance. One day we will look back and wonder what all the fuss was about. And we will look back and remember our present days as the bad times.

  • Fed Up

    "While in times past free banking was an alternative to central banking, that's no longer so. Today's commercial bank deposits are claims, not to gold or silver coin, but to central bank issued fiat money; and were commercial banks able to supply their own notes or stored value cards to take the place of central bank notes in payments that don't involve drawing upon bank deposits, those notes and cards would also represent claims to central bank money."

    As long as the commercial bank(s) is/are solvent, does the central bank (the fed) peg currency to demand deposits at a fixed exchange rate that just happens to be 1 to 1 even if that pegging would end up violating the price inflation target?

    • George Selgin

      It is the commercial banks that do the "pegging," because they issue fixed claims to central bank money. They're contractually obliged to honor their promises. The central bank isn't fixing its currency to their IOUs, and so isn't at all constrained by them.

      • Fed Up

        Not sure I am describing the situation correctly. Assume all the commercial banks are solvent. Preferences change. All entities want to use currency and no demand deposits. There is not enough currency. Will the fed expand its balance sheet (issue more currency)?

        I am trying to describe the system as demand deposits and currency are pegged both ways.

        • George Selgin

          In principle, yes, the Fed could supply all the wanted currency, just as it supplies enough at Christmas.

  • George, if the US had had a genuine free banking system since, say, 1900 through to the present day, would we have a higher per capita GDP than we have today?

    Related question: Over the long run, are we provably worse off for having had the Fed and its legal monopoly on notes? That seems like a critical question when examining the merits of central banking, government monopolies on currency issue, etc. Many third-world countries have had an obviously bad time of it, but it's never been clear to me how central banking in more developed countries impacts growth or productivity over the long run.

  • George, I think this primer series is extremely valuable. Could you combine them into one document, perhaps a PDF? You're the Platonic form of a libertarian monetary policy and free banking scholar. Your collegial tone, scholarly rigor, and clear writing is just the perfect combination of qualities to do the job you've been given (and a rare combination in libertarian policy circles). Cato nailed it when they hired you, and I think your primer, as a unified document, would come in handy in lots of contexts.

  • Michael Kendall

    "That property, far from being mysterious, stems from the simple fact that under a gold standard the profitability of gold prospecting and mining increases, other things equal, as prices generally fall, and declines as prices generally rise.

    This statement demonstrates a lack of understanding of gold and why gold standards work. We could easily return to a gold standard today with no difference in efficacy of any other properly operated gold standard established over the last 300 years. There is nothing new under the sun in this regard. The monetary world requires a standard of reference the same as the mathematical and scientific world. Gold is the monetary Polaris.

    It is gold's unique properties and preciousness that have proven its stability of value over millennia. Prices do not determine gold mining production; it is gold's unchanging value that establishes the standard of reference for the prices of goods and services.

    There is no capital component to the price of gold. Gold's preciousness negates technological advances and population growth. That's why gold is the only commodity that is in contango, it's future price equal to the spot price plus the rate of interest over that time period.

    The dollar has lost 97% of its value since Nixon ended Bretton Woods in 1971. Gold has risen from $35/oz in 1971 to near $1300/oz today. Did profitability in the increase in the price of gold over the last 46 years lead to an explosion in gold production? No, absolutely not. Gold production has remained constant at around 2 percent annually for centuries. The last 46 years has seen no change in this historical annual mining rate despite dollar devaluation and the corresponding rise in the price of gold.

  • Does anyone know how good the spending data is right now? I mean the spending data a central bank would use to follow or implement George's spending rule.

    It seems like an automated, real-time VAT would provide the best spending data, and would complement a spending rule very well. I support an automated VAT anyway, as a replacement for the income tax. (Automated in that VAT payment would be part of the payment processing workflow for card-based and electronic payments. Cash transactions would be reported instantly using the same network, and settled later.)

    George seems to be thinking of a piles-o-gold gold standard, but I think the more compelling version is the gold price standard that Steve Forbes likes. Even better would be a gold price standard where the price is a long-term moving average price, like 200 or 365 days – much smoother and easier to manage.