Archive for the 'free banking' Category

Larry White on the Gold Standard and Me

A little over three months ago on a brutally hot day in Washington DC, I gave a talk about a not yet completed paper at the Mercatus Center Conference on Monetary Rules for a Post-Crisis World. The title of my paper was (and still is) “Rules versus Discretion Historically Contemplated.” I hope to post a draft of the paper soon on SSRN.

One of the attendees at the conference was Larry White who started his graduate training at UCLA just after I had left. When I wrote a post about my talk, Larry responded with a post of his own in which he took issue with some of what I had to say about the gold standard, which I described as the first formal attempt at a legislated monetary rule. Actually, in my talk and my paper, my intention was not as much to criticize the gold standard as it was to criticize the idea, which originated after the gold standard had already been adopted in England, of imposing a fixed numerical rule in addition to the gold standard to control the quantity of banknotes or the total stock of money. The fixed mechanical rule was imposed by an act of Parliament, the Bank Charter Act of 1844. The rule, intended to avoid financial crises such as those experienced in 1825 and 1836, actually led to further crises in 1847, 1857 and 1866 and the latter crises were quelled only after the British government suspended those provisions of the Act preventing the Bank of England from increasing the quantity of banknotes in circulation. So my first point was that the fixed quantitative rule made the gold standard less stable than it would otherwise have been.

My second point was that, in the depths of the Great Depression, a fixed rule freezing the nominal quantity of money was proposed as an alternative rule to the gold standard. It was this rule that one of its originators, Henry Simons, had in mind when he introduced his famous distinction between rules and discretion. Simons had many other reasons for opposing the gold standard, but he introduced the famous rules-discretion dichotomy as a way of convincing those supporters of the gold standard who considered it a necessary bulwark against comprehensive government control over the economy to recognize that his fixed quantity rule would be a far more effective barrier than the gold standard against arbitrary government meddling and intervention in the private sector, because the gold standard, far from constraining the conduct of central banks, granted them broad discretionary authority. The gold standard was an ineffective rule, because it specified only the target pursued by the monetary authority, but not the means of achieving the target. In Simons view, giving the monetary authority to exercise discretion over the instruments used to achieve its target granted the monetary authority far too much discretion for independent unconstrained decision making.

My third point was that Henry Simons himself recognized that the strict quantity rule that he would have liked to introduce could only be made operational effectively if the entire financial system were radically restructured, an outcome that he reluctantly concluded was unattainable. However, his student Milton Friedman convinced himself that a variant of the Simons rule could actually be implemented quite easily, and he therefore argued over the course of almost his entire career that opponents of discretion ought to favor the quantity rule that he favored instead of continuing to support a restoration of the gold standard. However, Friedman was badly mistaken in assuming that his modified quantity rule eliminated discretion in the manner that Simons had wanted, because his quantity rule was defined in terms of a magnitude, the total money stock in the hands of the public, which was a target, not, as he insisted, an instrument, the quantity of money held by the public being dependent on choices made by the public, not just on choices made by the monetary authority.

So my criticism of quantity rules can be read as at least a partial defense of the gold standard against the attacks of those who criticized the gold standard for being insufficiently rigorous in controlling the conduct of central banks.

Let me now respond to some of Larry’s specific comments and criticisms of my post.

[Glasner] suggests that perhaps the earliest monetary rule, in the general sense of a binding pre-commitment for a money issuer, can be seen in the redemption obligations attached to banknotes. The obligation was contractual: A typical banknote pledged that the bank “will pay the bearer on demand” in specie. . . .  He rightly remarks that “convertibility was not originally undertaken as a policy rule; it was undertaken simply as a business expedient” without which the public would not have accepted demand deposits or banknotes.

I wouldn’t characterize the contract in quite the way Glasner does, however, as a “monetary rule to govern the operation of a monetary system.” In a system with many banks of issue, the redemption contract on any one bank’s notes was a commitment from that bank to the holders of those notes only, without anyone intending it as a device to govern the operation of the entire system. The commitment that governs a single bank ipso facto governs an entire monetary system only when that single bank is a central bank, the only bank allowed to issue currency and the repository of the gold reserves of ordinary commercial banks.

It’s hard to write a short description of a system that covers all possible permutations in the system. While I think Larry is correct in noting the difference between the commitment made by any single bank to convert – on demand — its obligations into gold and the legal commitment imposed on an entire system to maintain convertibility into gold, the historical process was rather complicated, because both silver and gold coins circulating in Britain. So the historical fact that British banks were making their obligations convertible into gold was the result of prior decisions that had been made about the legal exchange rate between gold and silver coins, decisions which overvalued gold and undervalued silver, causing full bodied silver coins to disappear from circulation. Given a monetary framework shaped by the legal gold/silver parity established by the British mint, it was inevitable that British banks operating within that framework would make their banknotes convertible into gold not silver.

Under a gold standard with competitive plural note-issuers (a free banking system) holding their own reserves, by contrast, the operation of the monetary system is governed by impersonal market forces rather than by any single agent. This is an important distinction between the properties of a gold standard with free banking and the properties of a gold standard managed by a central bank. The distinction is especially important when it comes to judging whether historical monetary crises and depressions can be accurately described as instances where “the gold standard failed” or instead where “central bank management of the monetary system failed.”

I agree that introducing a central bank into the picture creates the possibility that the actions of the central bank will have a destabilizing effect. But that does not necessarily mean that the actions of the central bank could not also have a stabilizing effect compared to how a pure free-banking system would operate under a gold standard.

As the author of Free Banking and Monetary Reform, Glasner of course knows the distinction well. So I am not here telling him anything he doesn’t know. I am only alerting readers to keep the distinction in mind when they hear or read “the gold standard” being blamed for financial instability. I wish that Glasner had made it more explicit that he is talking about a system run by the Bank of England, not the more automatic type of gold standard with free banking.

But in my book, I did acknowledge that there inherent instabilities associated with a gold standard. That’s why I proposed a system that would aim at stabilizing the average wage level. Almost thirty years on, I have to admit to having my doubts whether that would be the right target to aim for. And those doubts make me more skeptical than I once was about adopting any rigid monetary rule. When it comes to monetary rules, I fear that the best is the enemy of the good.

Glasner highlights the British Parliament’s legislative decision “to restore the convertibility of banknotes issued by the Bank of England into a fixed weight of gold” after a decades-long suspension that began during the Napoleonic wars. He comments:

However, the widely held expectations that the restoration of convertibility of banknotes issued by the Bank of England into gold would produce a stable monetary regime and a stable economy were quickly disappointed, financial crises and depressions occurring in 1825 and again in 1836.

Left unexplained is why the expectations were disappointed, why the monetary regime remained unstable. A reader who hasn’t read Glasner’s other blog entries on the gold standard might think that he is blaming the gold standard as such.

Actually I didn’t mean to blame anyone for the crises of 1825 and 1836. All I meant to do was a) blame the Currency School for agitating for a strict quantitative rule governing the total quantity of banknotes in circulation to be imposed on top of the gold standard, b) point out that the rule that was enacted when Parliament passed the Bank Charter Act of 1844 failed to prevent subsequent crises in 1847, 1857 and 1866, and c) that the crises ended only after the provisions of the Bank Charter Act limiting the issue of banknotes by the Bank of England had been suspended.

My own view is that, because the monopoly Bank of England’s monopoly was not broken up, even with convertibility acting as a long-run constraint, the Bank had the power to create cyclical monetary instability and occasionally did so by (unintentionally) over-issuing and then having to contract suddenly as gold flowed out of its vault — as happened in 1825 and again in 1836. Because the London note-issue was not decentralized, the Bank of England did not experience prompt loss of reserves to rival banks (adverse clearings) as soon as it over-issued. Regulation via the price-specie-flow mechanism (external drain) allowed over-issue to persist longer and grow larger. Correction came only with a delay, and came more harshly than continuous intra-London correction through adverse clearings would have. Bank of England mistakes boggled the entire financial system. It was central bank errors and not the gold standard that disrupted monetary stability after 1821.

Here, I think, we do arrive at a basic theoretical disagreement, because I don’t accept that the price-specie-flow mechanism played any significant role in the international adjustment process. National price levels under the gold standard were positively correlated to a high degree, not negatively correlated, as implied by the price-specie-flow mechanism. Moreover, the Bank Charter Act imposed a fixed quantitative limit on the note issue of all British banks and the Bank of England in particular, so the overissue of banknotes by the Bank of England could not have been the cause of the post-1844 financial crises. If there was excessive credit expansion, it was happening through deposit creation by a great number of competing deposit-creating banks, not the overissue of banknotes by the Bank of England.

This hypothesis about the source of England’s cyclical instability is far from original with me. It was offered during the 1821-1850 period by a number of writers. Some, like Robert Torrens, were members of the Currency School and offered the Currency Principle as a remedy. Others, like James William Gilbart, are better classified as members of the Free Banking School because they argued that competition and adverse clearings would effectively constrain the Bank of England once rival note issuers were allowed in London. Although they offered different remedies, these writers shared the judgment that the Bank of England had over-issued, stimulating an unsustainable boom, then was eventually forced by gold reserve losses to reverse course, instituting a credit crunch. Because Glasner elides the distinction between free banking and central banking in his talk and blog post, he naturally omits the third side in the Currency School-Banking School-Free Banking School debate.

And my view is that Free Bankers like Larry White overestimate the importance of note issue in a banking system in which deposits were rapidly overtaking banknotes as the primary means by which banks extended credit. As Henry Simons, himself, recognized this shift from banknotes to bank deposits was itself stimulated, at least in part, by the Bank Charter Act, which made the extension of credit via banknotes prohibitively costly relative to expansion by deposit creation.

Later in his blog post, Glasner fairly summarizes how a gold standard works when a central bank does not subvert or over-ride its automatic operation:

Given the convertibility commitment, the actual quantity of the monetary instrument that is issued is whatever quantity the public wishes to hold.

But he then immediately remarks:

That, at any rate, was the theory of the gold standard. There were — and are – at least two basic problems with that theory. First, making the value of money equal to the value of gold does not imply that the value of money will be stable unless the value of gold is stable, and there is no necessary reason why the value of gold should be stable. Second, the behavior of a banking system may be such that the banking system will itself destabilize the value of gold, e.g., in periods of distress when the public loses confidence in the solvency of banks and banks simultaneously increase their demands for gold. The resulting increase in the monetary demand for gold drives up the value of gold, triggering a vicious cycle in which the attempt by each to increase his own liquidity impairs the solvency of all.

These two purported “basic problems” prompt me to make two sets of comments:

1 While it is true that the purchasing power of gold was not perfectly stable under the classical gold standard, perfection is not the relevant benchmark. The purchasing power of money was more stable under the classical gold standard than it has been under fiat money standards since the Second World War. Average inflation rates were closer to zero, and the price level was more predictable at medium to long horizons. Whatever Glasner may have meant by “necessary reason,” there certainly is a theoretical reason for this performance: the economics of gold mining make the purchasing power of gold (ppg) mean-reverting in the face of monetary demand and supply shocks. An unusually high ppg encourages additional gold mining, until the ppg declines to the normal long-run value determined by the flow supply and demand for gold. An unusually low ppg discourages mining, until the normal long-run ppg is restored. It is true that permanent changes in the gold mining cost conditions can have a permanent impact on the long-run level of the ppg, but empirically such shocks were smaller than the money supply variations that central banks have produced.

2 The behavior of the banking system is indeed critically important for short-run stability. Instability wasn’t a problem in all countries, so we need to ask why some banking systems were unstable or panic-prone, while others were stable. The US banking system was panic prone in the late 19th century while the Canadian system was not. The English system was panic-prone while the Scottish system was not. The behavioral differences were not random or mere facts of nature, but grew directly from differences in the legal restrictions constraining the banks. The Canadian and Scottish systems, unlike the US and English systems, allowed their banks to adequately diversify, and to respond to peak currency demands, thus allowed banks to be more solvent and more liquid, and thus avoided loss of confidence in the banks. The problem in the US and England was not the gold standard, or a flaw in “the theory of the gold standard,” but ill-conceived legal restrictions that weakened the banking systems.

Larry makes two good points, but I doubt that they are very important in practice. The problem with the value of gold is that there is a very long time lag before the adjustment in the rate of output of new gold will cause the value of gold to revert back to its normal level. The annual output of gold is only about 3 percent of the total stock of gold. If the monetary demand for gold is large relative to the total stock and that demand is unstable, the swing in the overall demand for gold can easily dominate the small resulting change in the annual rate of output. So I do not have much confidence that the mean-reversion characteristic of the purchasing power of gold to be of much help in the short or even the medium term. I also agree with Larry that the Canadian and Scottish banking systems exhibited a lot more stability than the neighboring US and English banking systems. That is an important point, but I don’t think it is decisive. It’s true that there were no bank failures in Canada in the Great Depression. But the absence of bank failures, while certainly a great benefit, did not prevent Canada from suffering a downturn of about the same depth and duration as the US did between 1929 and 1933. The main cause of the Great Depression was the deflation caused by the appreciation of the value of gold. The deflation caused bank failures when banks were small and unstable and did not cause bank failures when banks were large and diversified. But the deflation  was still wreaking havoc on the rest of the economy even though banks weren’t failing.

What’s Wrong with Monetarism?

UPDATE: (05/06): In an email Richard Lipsey has chided me for seeming to endorse the notion that 1970s stagflation refuted Keynesian economics. Lipsey rightly points out that by introducing inflation expectations into the Phillips Curve or the Aggregate Supply Curve, a standard Keynesian model is perfectly capable of explaining stagflation, so that it is simply wrong to suggest that 1970s stagflation constituted an empirical refutation of Keynesian theory. So my statement in the penultimate paragraph that the k-percent rule

was empirically demolished in the 1980s in a failure even more embarrassing than the stagflation failure of Keynesian economics.

should be amended to read “the supposed stagflation failure of Keynesian economics.”

Brad DeLong recently did a post (“The Disappearance of Monetarism”) referencing an old (apparently unpublished) paper of his following up his 2000 article (“The Triumph of Monetarism”) in the Journal of Economic Perspectives. Paul Krugman added his own gloss on DeLong on Friedman in a post called “Why Monetarism Failed.” In the JEP paper, DeLong argued that the New Keynesian policy consensus of the 1990s was built on the foundation of what DeLong called “classic monetarism,” the analytical core of the doctrine developed by Friedman in the 1950s and 1960s, a core that survived the demise of what he called “political monetarism,” the set of factual assumptions and policy preferences required to justify Friedman’s k-percent rule as the holy grail of monetary policy.

In his follow-up paper, DeLong balanced his enthusiasm for Friedman with a bow toward Keynes, noting the influence of Keynes on both classic and political monetarism, arguing that, unlike earlier adherents of the quantity theory, Friedman believed that a passive monetary policy was not the appropriate policy stance during the Great Depression; Friedman famously held the Fed responsible for the depth and duration of what he called the Great Contraction, because it had allowed the US money supply to drop by a third between 1929 and 1933. This was in sharp contrast to hard-core laissez-faire opponents of Fed policy, who regarded even the mild and largely ineffectual steps taken by the Fed – increasing the monetary base by 15% – as illegitimate interventionism to obstruct the salutary liquidation of bad investments, thereby postponing the necessary reallocation of real resources to more valuable uses. So, according to DeLong, Friedman, no less than Keynes, was battling against the hard-core laissez-faire opponents of any positive action to speed recovery from the Depression. While Keynes believed that in a deep depression only fiscal policy would be effective, Friedman believed that, even in a deep depression, monetary policy would be effective. But both agreed that there was no structural reason why stimulus would necessarily counterproductive; both rejected the idea that only if the increased output generated during the recovery was of a particular composition would recovery be sustainable.

Indeed, that’s why Friedman has always been regarded with suspicion by laissez-faire dogmatists who correctly judged him to be soft in his criticism of Keynesian doctrines, never having disputed the possibility that “artificially” increasing demand – either by government spending or by money creation — in a deep depression could lead to sustainable economic growth. From the point of view of laissez-faire dogmatists that concession to Keynesianism constituted a total sellout of fundamental free-market principles.

Friedman parried such attacks on the purity of his free-market dogmatism with a counterattack against his free-market dogmatist opponents, arguing that the gold standard to which they were attached so fervently was itself inconsistent with free-market principles, because, in virtually all historical instances of the gold standard, the monetary authorities charged with overseeing or administering the gold standard retained discretionary authority allowing them to set interest rates and exercise control over the quantity of money. Because monetary authorities retained substantial discretionary latitude under the gold standard, Friedman argued that a gold standard was institutionally inadequate and incapable of constraining the behavior of the monetary authorities responsible for its operation.

The point of a gold standard, in Friedman’s view, was that it makes it costly to increase the quantity of money. That might once have been true, but advances in banking technology eventually made it easy for banks to increase the quantity of money without any increase in the quantity of gold, making inflation possible even under a gold standard. True, eventually the inflation would have to be reversed to maintain the gold standard, but that simply made alternative periods of boom and bust inevitable. Thus, the gold standard, i.e., a mere obligation to convert banknotes or deposits into gold, was an inadequate constraint on the quantity of money, and an inadequate systemic assurance of stability.

In other words, if the point of a gold standard is to prevent the quantity of money from growing excessively, then, why not just eliminate the middleman, and simply establish a monetary rule constraining the growth in the quantity of money. That was why Friedman believed that his k-percent rule – please pardon the expression – trumped the gold standard, accomplishing directly what the gold standard could not accomplish, even indirectly: a gradual steady increase in the quantity of money that would prevent monetary-induced booms and busts.

Moreover, the k-percent rule made the monetary authority responsible for one thing, and one thing alone, imposing a rule on the monetary authority prescribing the time path of a targeted instrument – the quantity of money – over which the monetary authority has direct control: the quantity of money. The belief that the monetary authority in a modern banking system has direct control over the quantity of money was, of course, an obvious mistake. That the mistake could have persisted as long as it did was the result of the analytical distraction of the money multiplier: one of the leading fallacies of twentieth-century monetary thought, a fallacy that introductory textbooks unfortunately continue even now to foist upon unsuspecting students.

The money multiplier is not a structural supply-side variable, it is a reduced-form variable incorporating both supply-side and demand-side parameters, but Friedman and other Monetarists insisted on treating it as if it were a structural — and a deep structural variable at that – supply variable, so that it no less vulnerable to the Lucas Critique than, say, the Phillips Curve. Nevertheless, for at least a decade and a half after his refutation of the structural Phillips Curve, demonstrating its dangers as a guide to policy making, Friedman continued treating the money multiplier as if it were a deep structural variable, leading to the Monetarist forecasting debacle of the 1980s when Friedman and his acolytes were confidently predicting – over and over again — the return of double-digit inflation because the quantity of money was increasing for most of the 1980s at double-digit rates.

So once the k-percent rule collapsed under an avalanche of contradictory evidence, the Monetarist alternative to the gold standard that Friedman had persuasively, though fallaciously, argued was, on strictly libertarian grounds, preferable to the gold standard, the gold standard once again became the default position of laissez-faire dogmatists. There was to be sure some consideration given to free banking as an alternative to the gold standard. In his old age, after winning the Nobel Prize, F. A. Hayek introduced a proposal for direct currency competition — the elimination of legal tender laws and the like – which he later developed into a proposal for the denationalization of money. Hayek’s proposals suggested that convertibility into a real commodity was not necessary for a non-legal tender currency to have value – a proposition which I have argued is fallacious. So Hayek can be regarded as the grandfather of crypto currencies like the bitcoin. On the other hand, advocates of free banking, with a few exceptions like Earl Thompson and me, have generally gravitated back to the gold standard.

So while I agree with DeLong and Krugman (and for that matter with his many laissez-faire dogmatist critics) that Friedman had Keynesian inclinations which, depending on his audience, he sometimes emphasized, and sometimes suppressed, the most important reason that he was unable to retain his hold on right-wing monetary-economics thinking is that his key monetary-policy proposal – the k-percent rule – was empirically demolished in a failure even more embarrassing than the stagflation failure of Keynesian economics. With the k-percent rule no longer available as an alternative, what’s a right-wing ideologue to do?

Anyone for nominal gross domestic product level targeting (or NGDPLT for short)?

Hayek, Free Banking and Tax Payments

Among the many interesting comments on my previous post about free banking was one by Philippe which provoked an extended (and perhaps still ongoing) exchange between Philippe and George Selgin. Referring to this assertion of mine,

if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies

Philippe made the following comment:

In “The Denationalization of Money” Hayek argued that you should be able to pay taxes with privately-issued currencies. However, this would in effect turn those ‘private currencies into’ de facto state currencies, or forms of government ‘fiat money’. For some reason Hayek chose to ignore this massive contradiction in his argument. Essentially, what he was actually arguing was that private corporations should be granted special state powers, i.e. the power to issue money backed by the state’s legal powers of taxation.

I thought that this was a very insightful observation by Philippe, though its significance for me may be somewhat different from its significance for Philippe. In my criticisms of Hayek’s free-banking position – I call it a free-banking position even though free banking may be a misnomer inasmuch as Hayek advocated banks’ creating new currency units not just allowing banks freedom to create a complete menu of liabilities denominated in existing currency units – my argument was that newly created currency units would be worthless unless the banks made them convertible into some outside asset not under their control. Or in Nick Rowe’s helpful terminology, Hayek advocated free-alpha-banking, while conventional free bankers advocate free-beta-banking. The reasoning behind my argument is that the value of a pure medium of exchange depends entirely on its expected value in exchange, so if a currency unit is not defined in terms of a commodity providing a real, valuable, service apart from being used as money, people will eventually realize that its value must go to zero. Any positive value that it may temporarily have is just a bubble, and, like every bubble, it will burst.

However, unlike the private issuer of a currency unit, a sovereign issuer can impart a real value to a fiat currency by making the currency acceptable for discharging tax liabilities, creating a real demand for the currency distinct from its use as a medium of exchange. Using this argument, I have suggested that bitcoins are a bubble, though it is possible that are some techie reasons that I don’t understand why bitcoins could provide real services that would allow them retain a positive value. At any rate, the point made by Philippe — that if governments were to accept newly created private currency units in payment of taxes – they could retain their value just as fiat currencies issued by governments do – is a point that had escaped me in my criticisms of Hayek. So, well done, Philippe.

However, Philippe seems to carry this valid point a bit too far, accusing Hayek of a massive contradiction in arguing that private corporations be granted special state powers. The problem with that argument is that it begs the question what is special about money that confers the sole power to issue money to the state. I actually once wrote a paper trying to answer that question (once again relying on an argument that I heard from Earl Thompson) published in a volume called Money and the Nation State. I summarized the argument in chapter 2 of Free Banking and Monetary Reform.

The short answer is that currency debasement may be necessary as a means of emergency taxation when a sovereign is faced with a hostile military force threatening its survival. To profitably debase a currency, you have to be the monopoly supplier. Ergo, sovereigns that monopolize the mint or the supply of currency have a better chance of surviving than sovereigns that don’t. Hayek was a staunch anti-communist, cold warrior, so the defense argument, at least on some level, would have appealed to him. But otherwise, it’s not clear to me why Hayek could not have said that, apart from certain national-defense functions, there really are no government services that may not be provided by private enterprise. After all, we do allow various services that were once exclusively provided by the government to be provided by private enterprise. I don’t say that this is always a good thing, but it doesn’t seem to me inherently unreasonable to believe that the burden of proof is on the one claiming that the state has an exclusive right to discharge a particular service, not on the one who questions that such an exclusive right exists.

Having said that, I will also say that it also seems perfectly reasonable for a government to say that a tax obligation that it legitimately imposes – I freely admit that I am now begging the question where this legitimate power comes from, but only libertarian fanatics dispute that power – can only be discharged in terms of a currency unit that the government itself specifies. And implicitly or explicitly, George Selgin and other free bankers — i.e., free-beta-bankers — seem to be perfectly OK with the government specifying the currency unit in terms of which tax obligations may be discharged. In other words, the government may impose a tax obligation on me that is specified in dollar terms. To discharge it, I have no choice but to pay the government the requisite number of dollars, either delivering the government’s own currency or delivering a private (beta-bank) money denominated in dollar terms.

The peculiarity in Hayek’s argument is that he was proposing that governments impose a tax liability in, say, dollar terms, and then accept payment in some other currency unit without specifying any method by which an obligation specified in dollars would be discharged in terms of another currency unit. Any creditor is free to specify at the time an obligation is created the terms on which the debt will be discharged (subject of course to legal tender laws, but for purposes of this discussion I am ignoring legal tender laws which are not the same as tax acceptance). The government is not just any creditor, but there doesn’t seem to me to be any compelling reason why a government should not be entitled to say we have created this obligation in terms of dollars and it must be discharged in terms of dollars. And, if I am right in asserting that acceptability in payment of taxes is a necessary condition for an inconvertible fiat money to retain value, there does seem to be something funny about Hayek’s argument for the creation of private fiat moneys, even if it is not a flat-out contradiction as Philippe claims.

What is funny is the degree to which the viability of a Hayekian private fiat currency is dependent on its being accepted by the state as payment for taxes. Moreover, Hayek’s argument was that there would be a discovery process in which many competing currencies would vie for acceptance with the market eventually choosing one or a few currency units as somehow being the most desirable. Hayek thought that the currency unit with the most stable value would eventually capture the largest market share. There are lots of problems with the argument, especially that it ignores the network effects that tend to produce an entrenched monopoly, and the extreme path dependence of such outcomes, but on a practical level, it seems almost unimaginable that a government would, or could, allow any number of distinct competing currency units to be simultaneously acceptable in payment of taxes.

I do not mean to be overly critical of Hayek, for whom I always have had the greatest admiration, but he had an unfortunate tendency to get carried away with certain utopian ideas and proposals, for example his idea of separating the law-making power from the governing function of parliaments into two distinct bodies, going so far as to propose a method for selecting members of the law-making body under which people at the age of 35 would each year elect a number of their contemporaries to serve a 15-year term in the law-making body, the law-making body being composed entirely of people between the ages of 35 and 50. He presents the idea in volume 3 of Law, Legislation and Liberty, a wonderful book of great philosophical depth and erudition. But it is amazing that Hayek felt that such an idea could ever be implemented. I don’t like to think so, but it occurs to me that his toleration for certain dictators might have had something to do with his imagining that they could be persuaded to implement his ideas for political and constitutional reform. His Denationalization of Money was a similar flight of fancy, based on some profound insights, but used as the basis for practical proposals that were fantastically unrealistic.

 

What Is Free Banking All About?

I notice that there has been a bit of a dustup lately about free banking, triggered by two posts by Izabella Kaminska, first on FTAlphaville followed by another on her own blog. I don’t want to get too deeply into the specifics of Kaminska’s posts, save to correct a couple of factual misstatements and conceptual misunderstandings (see below). At any rate, George Selgin has a detailed reply to Kaminska’s errors with which I mostly agree, and Scott Sumner has scolded her for not distinguishing between sensible free bankers, e.g., Larry White, George Selgin, Kevin Dowd, and Bill Woolsey, and the anti-Fed, gold-bug nutcases who, following in the footsteps of Ron Paul, have adopted free banking as a slogan with which to pursue their anti-Fed crusade.

Now it just so happens that, as some readers may know, I wrote a book about free banking, which I began writing almost 30 years ago. The point of the book was not to call for a revolutionary change in our monetary system, but to show that financial innovations and market forces were causing our modern monetary system to evolve into something like the theoretical model of a free banking system that had been worked out in a general sort of way by some classical monetary theorists, starting with Adam Smith, who believed that a system of private banks operating under a gold standard would supply as much money as, but no more money than, the public wanted to hold. In other words, the quantity of money produced by a system of competing banks, operating under convertibility, could be left to take care of itself, with no centralized quantitative control over either the quantity of bank liabilities or the amount of reserves held by the banking system.

So I especially liked the following comment by J. V. Dubois to Scott’s post

[M]y thing against free banking is that we actually already have it. We already have private banks issuing their own monies directly used for transactions – they are called bank accounts and debit/credit cards. There are countries like Sweden where there are now shops that do not accept physical cash (only bank monies) – a policy actively promoted government, if you can believe it.

There are now even financial products like Xapo Debit Card that automatically converts all payments received on your account into non-monetary assets (with Xapo it is bitcoins) and back into monies when you use the card for payment. There is a very healthy international bank money market so no matter what money you personally use, you can travel all around the world and pay comfortably without ever seeing or touching official local government currency.

In opposition to the Smithian school of thought, there was the view of Smith’s close friend David Hume, who famously articulated what became known as the Price-Specie-Flow Mechanism, a mechanism that Smith wisely omitted from his discussion of international monetary adjustment in the Wealth of Nations, despite having relied on PSFM with due acknowledgment of Hume, in his Lectures on Jurisprudence. In contrast to Smith’s belief that there is a market mechanism limiting the competitive issue of convertible bank liabilities (notes and deposits) to the amount demanded by the public, Hume argued that banks were inherently predisposed to overissue their liabilities, the liabilities being issuable at almost no cost, so that private banks, seeking to profit from the divergence between the face value of their liabilities and the cost of issuing them, were veritable engines of inflation.

These two opposing views of banks later morphed into what became known almost 70 years later as the Banking and Currency Schools. Taking the Humean position, the Currency School argued that without quantitative control over the quantity of banknotes issued, the banking system would inevitably issue an excess of banknotes, causing overtrading, speculation, inflation, a drain on the gold reserves of the banking system, culminating in financial crises. To prevent recurring financial crises, the Currency School proposed a legal limit on the total quantity of banknotes beyond which limit, additional banknotes could be only be issued (by the Bank of England) in exchange for an equivalent amount of gold at the legal gold parity. Taking the Smithian position, the Banking School argued that there were market mechanisms by which any excess liabilities created by the banking system would automatically be returned to the banking system — the law of reflux. Thus, as long as convertibility obtained (i.e., the bank notes were exchangeable for gold at the legal gold parity), any overissue would be self-correcting, so that a legal limit on the quantity of banknotes was, at best, superfluous, and, at worst, would itself trigger a financial crisis.

As it turned out, the legal limit on the quantity of banknotes proposed by the Currency School was enacted in the Bank Charter Act of 1844, and, just as the Banking School predicted, led to a financial crisis in 1847, when, as soon as the total quantity of banknotes approached the legal limit, a sudden precautionary demand for banknotes led to a financial panic that was subdued only after the government announced that the Bank of England would incur no legal liability for issuing banknotes beyond the legal limit. Similar financial panics ensued in 1857 and 1866, and they were also subdued by suspending the relevant statutory limits on the quantity of banknotes. There were no further financial crises in Great Britain in the nineteenth century (except possibly for a minicrisis in 1890), because bank deposits increasingly displaced banknotes as the preferred medium of exchange, the quantity of bank deposits being subject to no statutory limit, and because the market anticipated that, in a crisis, the statutory limit on the quantity of banknotes would be suspended, so that a sudden precautionary demand for banknotes never materialized in the first place.

Let me pause here to comment on the factual and conceptual misunderstandings in Kaminska’s first post. Discussing the role of the Bank of England in the British monetary system in the first half of the nineteenth century, she writes:

But with great money-issuance power comes great responsibility, and more specifically the great temptation to abuse that power via the means of imprudent money-printing. This fate befell the BoE — as it does most banks — not helped by the fact that the BoE still had to compete with a whole bunch of private banks who were just as keen as it to issue money to an equally imprudent degree.

And so it was that by the 1840s — and a number of Napoleonic Wars later — a terrible inflation had begun to grip the land.

So Kaminska seems to have fallen for the Humean notion that banks are inherently predisposed to overissue and, without some quantitative restraint on their issue of liabilities, are engines of inflation. But, as the law of reflux teaches us, this is not true, especially when banks, as they inevitably must, make their liabilities convertible on demand into some outside asset whose supply is not under their control. After 1821, the gold standard having been officially restored in England, the outside asset was gold. So what was happening to the British price level after 1821 was determined not by the actions of the banking system (at least to a first approximation), but by the value of gold which was determined internationally. That’s the conceptual misunderstanding that I want to correct.

Now for the factual misunderstanding. The chart below shows the British Retail Price Index between 1825 and 1850. The British price level was clearly falling for most of the period. After falling steadily from 1825 to about 1835, the price level rebounded till 1839, but it prices again started to fall reaching a low point in 1844, before starting another brief rebound and rising sharply in 1847 until the panic when prices again started falling rapidly.

uk_rpi_1825-50

From a historical perspective, the outcome of the implicit Smith-Hume disagreement, which developed into the explicit dispute over the Bank Charter Act of 1844 between the Banking and Currency Schools, was highly unsatisfactory. Not only was the dysfunctional Bank Charter Act enacted, but the orthodox view of how the gold standard operates was defined by the Humean price-specie-flow mechanism and the Humean fallacy that banks are engines of inflation, which made it appear that, for the gold standard to function, the quantity of money had to be tied rigidly to the gold reserve, thereby placing the burden of adjustment primarily on countries losing gold, so that inflationary excesses would be avoided. (Fortunately, for the world economy, gold supplies increased fairly rapidly during the nineteenth century, the spread of the gold standard meant that the monetary demand for gold was increasing faster than the supply of gold, causing gold to appreciate for most of the nineteenth century.)

When I set out to write my book on free banking, my intention was to clear up the historical misunderstandings, largely attributable to David Hume, surrounding the operation of the gold standard and the behavior of competitive banks. In contrast to the Humean view that banks are inherently inflationary — a view endorsed by quantity theorists of all stripes and enshrined in the money-multiplier analysis found in every economics textbook — that the price level would go to infinity if banks were not constrained by a legal reserve requirement on their creation of liabilities, there was an alternative view that the creation of liabilities by the banking system is characterized by the same sort of revenue and cost considerations governing other profit-making enterprises, and that the equilibrium of a private banking system is not that value of money is driven down to zero, as Milton Friedman, for example, claimed in his Program for Monetary Stability.

The modern discovery (or rediscovery) that banks are not inherently disposed to debase their liabilities was made by James Tobin in his classic paper “Commercial Banks and Creators of Money.” Tobin’s analysis was extended by others (notably Ben Klein, Earl Thompson, and Fischer Black) to show that the standard arguments for imposing quantitative limits on the creation of bank liabilities were unfounded, because, even with no legal constraints, there are economic forces limiting their creation of liabilities. A few years after these contributions, F. A. Hayek also figured out that there are competitive forces constraining the creation of liabilities by the banking system. He further developed the idea in a short book Denationalization of Money which did much to raise the profile of the idea of free banking, at least in some circles.

If there is an economic constraint on the creation of bank liabilities, and if, accordingly, the creation of bank liabilities was responsive to the demands of individuals to hold those liabilities, the Friedman/Monetarist idea that the goal of monetary policy should be to manage the total quantity of bank liabilities so that it would grow continuously at a fixed rate was really dumb. It was tried unsuccessfully by Paul Volcker in the early 1980s, in his struggle to bring inflation under control. It failed for precisely the reason that the Bank Charter Act had to be suspended periodically in the nineteenth century: the quantitative limit on the growth of the money supply itself triggered a precautionary demand to hold money that led to a financial crisis. In order to avoid a financial crisis, the Volcker Fed constantly allowed the monetary aggregates to exceed their growth targets, but until Volcker announced in the summer of 1982 that the Fed would stop paying attention to the aggregates, the economy was teetering on the verge of a financial crisis, undergoing the deepest recession since the Great Depression. After the threat of a Friedman/Monetarist financial crisis was lifted, the US economy almost immediately began one of the fastest expansions of the post-war period.

Nevertheless, for years afterwards, Friedman and his fellow Monetarists kept warning that rapid growth of the monetary aggregates meant that the double-digit inflation of the late 1970s and early 1980s would soon return. So one of my aims in my book was to use free-banking theory – the idea that there are economic forces constraining the issue of bank liabilities and that banks are not inherently engines of inflation – to refute the Monetarist notion that the key to economic stability is to make the money stock grow at a constant 3% annual rate of growth.

Another goal was to explain that competitive banks necessarily have to select some outside asset into which to make their liabilities convertible. Otherwise those liabilities would have no value, or at least so I argued, and still believe. The existence of what we now call network effects forces banks to converge on whatever assets are already serving as money in whatever geographic location they are trying to draw customers from. Thus, free banking is entirely consistent with an already existing fiat currency, so that there is no necessary link between free banking and a gold (or other commodity) standard. Moreover, if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies.

My final goal was to suggest a new way of conducting monetary policy that would enhance the stability of a free banking system, proposing a monetary regime that would ensure the optimum behavior of prices over time. When I wrote the book, I had been convinced by Earl Thompson that the optimum behavior of the price level over time would be achieved if an index of nominal wages was stabilized. He proposed accomplishing this objective by way of indirect convertibility of the dollar into an index of nominal wages by way of a modified form of Irving Fisher’s compensated dollar plan. I won’t discuss how or why that goal could be achieved, but I am no longer convinced of the optimality of stabilizing an index of nominal wages. So I am now more inclined toward nominal GDP level targeting as a monetary policy regime than the system I proposed in my book.

But let me come back to the point that I think J. V. Dubois was getting at in his comment. Historically, idea of free banking meant that private banks should be allowed to issue bank notes of their own (with the issuing bank clearly identified) without unreasonable regulations, restrictions or burdens not generally applied to other institutions. During the period when private banknotes were widely circulating, banknotes were a more prevalent form of money than bank deposits. So in the 21st century, the right of banks to issue hand to hand circulating banknotes is hardly a crucial issue for monetary policy. What really matters is the overall legal and regulatory framework under which banks operate.

The term “free banking” does very little to shed light on most of these issues. For example, what kind of functions should banks perform? Should commercial banks also engage in investment banking? Should commercial bank liabilities be ensured by the government, and if so under what terms, and up to what limits? There are just a couple of issues; there are many others. And they aren’t necessarily easily resolved by invoking the free-banking slogan. When I was writing, I meant by “free banking” a system in which the market determined the total quantity of bank liabilities. I am still willing to use “free banking” in that sense, but there are all kinds of issues concerning the asset side of bank balance sheets that also need to be addressed, and I don’t find it helpful to use the term free banking to address those issues.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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