In Defense of a Flexible Monetary Policy

Gerald O’Driscoll has written a provocative essay on the history of central banking and the advantages of moving toward a free banking regime. There is much I agree with in the essay. Free banking offers many advantages, and banking problems in earlier centuries were often caused by perverse regulations, not laissez-faire. The creation of central banking probably did more harm than good; indeed I believe O’Driscoll actually understates the damage:

While I have pointed out that central banks are unnecessary in a classical gold standard, they probably did not do a great deal of harm. They were constrained in their discretion. They did “sterilize” reserves, which means they resisted letting the domestic money supply respond automatically to changes in gold reserves. Central banks could not do so for prolonged periods, however.

In my view the sterilization of gold reserves by the major central banks was the primary cause of the Great Depression, and hence World War II.

I will focus on a few areas of disagreement.

  1. I believe O’Driscoll is overly pessimistic about the prospects for an improved fiat money regime. For instance I do not believe the “Great Inflation” of 1965 – 81 was caused by the monetization of fiscal deficits. The deficits were relatively modest during that period, and the national debt was falling as a share of GDP. Deficits became a much bigger problem beginning in 1982, but that’s exactly when inflation fell to much lower levels.  Instead the Great Inflation was probably caused by a mixture of honest policy errors and politics.
  2. I believe O’Driscoll is overly optimistic about the effectiveness of gold standard regimes. In addition, I would argue that we should avoid policy regimes that are “tamper-proof.” We don’t know what sort of policy regime is best. Therefore we should have policy regimes that are easy to alter in a situation where they appear to be causing grievous economic harm.

In the late 1970s and early 1980s it was widely believed that fiat money regimes had an inflationary bias due to political pressure. I have doubts about whether this was the primary cause of the Great Inflation; it seems plausible that central bankers also had a flawed model of the economy. After all most academic economists (presumably free of political pressure) were making the same sorts of mistakes during the 1960s and 1970s.

During the 1980s and 1990s two things happened. Academic economists finally understood that central banks determine the trend rate of inflation, and central banks were given greater independence, either tacitly or officially. Under this new fiat money regime the inflation rate became well-anchored, and central banks no longer seemed swayed by political pressures. Indeed it’s remarkable that inflation in both the United States and the eurozone is running below the 2% target, despite high unemployment and significant debt problems.

Nor does this seem likely to change in the near future, as investors forecast low inflation for years to come. Once modern central bankers figured out the “Taylor Principle,” the so-called inflationary bias of fiat money seemed to mysteriously vanish. There are still plenty of problems with our monetary regime, but high inflation does not seem to be one of them.

O’Driscoll briefly discusses the possibility of combining fiat money and free banking. He ends up concluding that this sort of regime would be too susceptible to political tampering. In my view that’s a powerful advantage of a fiat money regime. Throughout history there are many examples of rigid monetary regimes that went seriously awry and caused great damage before they collapsed. In the early 1930s prices fell sharply under an international gold standard regime. Countries did not begin recovering from the Depression until they abandoned the regime. Argentina suffered from falling prices and nominal GDP in the late 1990s and early 2000s under a rigid “tamper-proof” currency board.

In the end both the United States and Argentina abandoned their highly flawed monetary regimes and recovered from their depressions. But in each case the depression was wrongly blamed on free-market capitalism and the political system reacted by enacting highly counterproductive statist policies.

In many respects the eurozone of today is an even more “tamper-proof” monetary regime than a gold standard or currency board regime. It is extremely difficult for an individual country to exit the euro without triggering a collapse of their banking system. The euro is much more than a fixed exchange rate regime. The peripheral economies of the eurozone certainly would have sharply devalued their currencies if they had been able to do so.

None of this is to deny that these historical examples are highly complex. Monetary policy wasn’t the only problem, other policy errors occurred.  Interwar policymakers looked back at the hyperinflation of the early 1920s and the Argentine policymakers looked back at the hyperinflation they experienced under floating exchange rates during the 1980s. Both had good reasons to want to avoid devaluation.

So then it becomes a judgment call. How bad are the future mistakes under fiat money likely to be? And how bad might things end up under a rigid monetary regime such as a gold standard?  In my view the downside risks from a return to a gold standard, however constituted, are far greater than the risks of persevering with fiat money and trying to make incremental improvements.

It has been argued that a gold standard regime combined with free banking would tend to produce a relatively stable monetary environment, usually defined as either stable prices or low but stable growth in nominal GDP. I do not share this optimism. I would point to research on the “Gibson Paradox” of the classical gold standard. Studies have shown that fluctuations in the real interest rate led to changes in the real demand for gold that largely account for fluctuations in the price level. When real interest rates fall the demand for gold rises, as the opportunity cost of holding gold decreases. Because the supply of gold grows at a relatively slow and stable rate, fluctuations in the demand for gold largely explain price level fluctuations in the period up until 1940.

The basic problem is this; neither individuals nor banks have an incentive to adjust their demand for gold in a way that would stabilize prices or nominal GDP. Assume global real interest rates fell close to zero due to an investment bust. That would sharply increase the demand for gold. Suppose that at the same time rapid economic growth in a continent with 60% of the world’s population (and a strong cultural affinity for gold) led to soaring nonmonetary demand for gold. If both of those things happened at the same time the real value of gold would soar dramatically higher. Any country with a currency fixed to gold would suffer severe deflation, as the price level is inversely related to the value of money.

Of course this hypothetical is exactly what happened in the past decade. And there is nothing about free banking that would prevent that sort of disturbance in the global gold market from causing severe price level fluctuations.  Even worse, wages and prices are much stickier than in the 19th century, meaning that even mild deflation can now cause a severe recession.

The counterargument is that fiat money regimes also performed relatively poorly in recent years. Interestingly, this poor performance did not show up in the metrics that fans of the gold standard might have expected. Inflation remained relatively well anchored, certainly compared to earlier decades. So then what lessons can we take from the recent failure of monetary policy?

The inflation targeting regimes of the so-called “Great Moderation” represented a significant improvement over both the gold standard and the unconstrained fiat money regime of the 1960s and 1970s. Progress is being made. Just as we learned useful lessons from the mistakes of the 1930s in the 1970s, I believe the policy errors of the last decade will lead to a further improvement in fiat money. There is rapidly growing interest among academics and even a few central bankers in nominal GDP targeting. If we had been following a policy of nominal GDP targeting (level targeting) in 2008, the recent recession would have been much milder.

Many libertarians are distrustful of fiat money regimes managed by bureaucrats. I share their distrust. But the solution is not to go back to a gold standard regime that might work, but that might also fail catastrophically, discrediting free market capitalism. Instead we should move toward a fiat money system where market forces determine the quantity of money and interest rates. For instance one promising free banking proposal by William Woolsey would have currency redeemable into nominal GDP futures contracts at a fixed price (equal to the policy target).  Government would define the dollar and leave everything else to the private sector.  With stable NGDP growth, there is less demand for fiscal “stimulus” to boost demand, or to give bailouts to failing companies.

Also from This Issue

Lead Essay

  • The Fed at 100 by Gerald P. O'Driscoll Jr.

    Gerald P. O’Driscoll reviews the history of central banking. He argues decentralized banking is possible, but getting there will be difficult. Under a commodity money regime, central banks are neither necessary nor particularly dangerous, while under a fiat money regime, central banks are capable of exerting substantial influence on monetary policy. The Fed’s use of that influence has been, in O’Driscoll’s words, “unenviable.” Governments have come to depend on central banks to run deficits and spend more than they otherwise could. To do without central banking, however, we will first have to shrink the federal budget itself, and this will be no easy task.

Response Essays

  • The Fed’s Track Record by Lawrence H. White

    Lawrence H. White explains that the Federal Reserve has “dramatically increased secular inflation.” Additionally, it has increased price level uncertainty, while failing either to tame the business cycle or to reduce unemployment. Instead, throughout its history, it has bowed to political pressures and expanded the money supply again and again.

  • Who Will Guard the Monetary Guardians? by Jerry L. Jordan

    Jerry L. Jordan argues that legislative restraints on monetary policy tend to fail; in this area, we just can’t trust government to watch itself. Standards intended to preserve the value of the currency have all fallen, as legislatures simply find it too convenient to siphon away value through inflation. Jordan is skeptical even of a balanced budget amendment, noting that state governments with such amendments have still come to fiscal grief. One of his most important concerns is that the public right now is dangerously apathetic about this underappreciated issue.

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