Friday, February 11, 2011

Ron Paul and the Austrians

Ron Paul, who now heads the House Financial Services Committee's subcommittee on monetary policy, has an important job. The Fed also has an important job, and a lot of power, and we want to know that we can trust them. Paul's job is to aid Congress in overseeing the Fed, in part by finding good expert witnesses to speak and answer questions in hearings, in order to shed light on what the Fed does and whether it is performing well.

Ron Paul is of course no friend of central bankers, and has written about putting the Fed out of business. Why? Paul is a libertarian, and is a follower of the "Austrian School," an essentially libertarian branch of economic thought, whose most prominent members were Ludwig von Mises and Freidrich Hayek. The Austrian School lives on as a fringe movement in the profession.

I don't know a lot about the Austrian School, but I have run across Hayek's ideas from time to time. The ideas are extreme, but not crazy. For example, Hayek's Denationalisation of Money, is a coherent argument for a monetary system with private money issue. Conventional economic wisdom is that, if we allow the private sector to issue money, then there is a market failure. Even Milton Friedman - an advocate of laissez faire in most respects - argued in A Program for Monetary Stability that the issue and control of the stock of money was the province of the government, so clearly Hayek's views were unusual.

However, what Hayek was advocating had in fact been put in practice historically in more than one instance. There was free banking (with currency issue by private banks) in Scotland in the early 19th century. The United States had private currency issue from 1837-1863 by state-chartered banks, and Canada had a system of private money before 1935. While the US free banking era (1837-1863) appears to have been quite chaotic (more so in some states than others) the experience with private money issue in Scotland and Canada appears to have been quite good. Canada, for example, went through the early part of the Great Depression with no bank failures, in spite of the fact that there was no central bank to act as lender of last resort.

There are legitimate questions economists should ask, and have asked, about the fundamental role of the central bank, and whether the issue of "money" should be essentially a government monopoly. Gary Gorton, Warren Weber, and Arthur Rolnick, for example, have studied the free banking era in the United States, and there is work in monetary theory, for example by Ricardo Cavalcanti and Neil Wallace, among others, on the role of private money in efficient monetary arrangements. Thus, some of the questions Hayek was interested in have been studied in rigorous economic frameworks.

Thus, the Austrians were libertarian, but not kooky, so the fact that Ron Paul is interested in Austrian economics does not make him a kook. But Ron Paul is also interested in the gold standard. I'm not sure where the Austrians stood on that, but the gold standard has certainly drawn its share of kooks. The gold standard was part of the natural evolution of monetary systems from exchange with pure commodity money to fiat standards. Commodity money is wasteful, in that it is costly to dig gold out of the ground for use as money, and gold has other uses, from which it has to be diverted if it is used in exchange. Gold is also heavy, and therefore costly to carry around in large quantities. If we are able to solve the counterfeiting problem inherent in exchange using paper currency, then we can save the costs of carrying gold around by backing the paper currency one-for-one with gold, with gold exchanging for currency at a fixed rate. We can go even further in resource savings with fractional backing of the currency by gold. Why not go even further and eliminate the backing altogether, and just trust the government to regulate the quantity of money in circulation? That's where our modern fiat money systems come from.

What case do gold bugs make for a return to the good old days of the gold standard? They argue that the government cannot be trusted. Governments, as they argue, will be tempted to use the printing press to finance government deficits, and the cost will be high inflation. The gold standard, whereby a government agency stands ready to buy and sell gold at a fixed price will, they argue, give us price stability. What's the problem with that? First there has to be a resource cost associated with this. In order to maintain a fixed price of gold in terms of central bank liabilities, the government would have to hold a reserve stock of the stuff. The relative price of gold would be higher than it would be otherwise, causing people to economize on it in alternative uses, and causing more of it to be dug out of the ground. Just as was the case historically, there would be waste, but perhaps this would be small. But the principal defect in the gold standard is that the relative price of gold fluctuates substantially, and would continue to fluctuate substantially under a gold standard. These fluctuations occur because of changes in mining technology, changes in the demand for gold in industrial and other uses, and because of the fact that gold is a store of wealth. It seems clear that the gold standard would give us more variability in prices, not less. Further, as was the case historically, a gold standard does not imply that the government is necessarily committed to anything. The government can always decide to change the price at which it buys or sells gold.

So, what has Ron Paul been up to in his role in leading the subcommittee on monetary policy? Well, not much good apparently. The subcommittee recently invited three economists to come to Washington to talk to them: Thomas DiLorenzo, Richard Vedder, and Josh Bivens. The first two are Austrian School types, and DiLorenzo is clearly a quack. Bivens writes pieces for the Economic Policy Institute on the state of the macroeconomy. This is certainly an undistinguished lot, and not the first names that come to my mind as experts on monetary policy.

To repeat, Ron Paul has an important job. We have been through some unusual experiences on the monetary and financial front. Our central bank has made the choice to engage in some unusual practices. The Fed's decisions need to be reviewed and analyzed, and Congress needs to determine whether the Fed did the right things, whether it did the wrong things but should be forgiven, or whether some additional constraints need to be placed on the Fed's behavior.

Currently, the Fed operates under a dual mandate set out in the Humphrey Hawkins Act, which contains vague language about how the Fed should view its influence over real activity and inflation. In some other countries, central banks don't operate that way, but instead negotiate an explicit inflation-targeting arrangement with the legislative branch. Why don't we do that? In any case, these issues should be discussed and debated in Paul's Committee.

But Ron Paul cannot make any headway on these important issues if his agenda is quack economics. My advice would be to ditch DiLorenzo and company and talk to some of these people (I'm assuming Bernanke is the only Fed person who can speak directly to Congress):

Mike Woodford, Columbia University
John Cochrane, University of Chicago
Mark Gertler, NYU
Gary Gorton, Yale
Arthur Rolnick, formerly Minneapolis Fed
Robert Lucas, University of Chicago

Inviting these people to speak to the subcommittee would at least capture the important ideas on monetary policy that are taken seriously at top research institutions in the profession.


  1. I notice a lot of name calling here. Maybe DiLorenzo or whoever is a "kook" or a "quack" (whatever that means) but what matters is whether his claims are true or false.

    I like the economists you list, but you have to understand why Paul wouldn't seek them out on this. For Paul, the pertinent question is "Should the interest rate, the quantity of base money and bank lending practices be partly subject to central planning or left entirely to market forces?" The economists you name have mostly devoted their efforts to the question of "Given that there should be some central planning, what should the central planner do?"

    For what it's worth, the Austrian view is that the vector of relative prices (p) is the only real guide that investors have to decide which projects to pursue. Some of those investments take a long time from the initial outlays of capital to the sale of the final product and if p changes a lot during the period of production, many of those investments will turn out to be unprofitable. (So far, this is not just an Austrian view.) The distinctly Austrian position is that in the absence of monetary intervention, p will change only in response to changes in real variables like preferences, supply shocks and technology. Sometimes p will be be a poor guide to the profitability of different ventures, but it could be worse.
    When the central bank gets involved, p will also be subject to changes in monetary variables. When that happens, p becomes a much poorer guide to the profitability of different investments. Because most actions by the central bank are conducive to inflation and lower rates rather than deflation and higher rates, a lot of very long term projects will initially appear profitable and it will take a long time for p to return to reflecting only real factors. As a result, there will be many unsustainable booms where resources are invested in long term projects, that turn out to be unprofitable, e.g. a housing boom.

    This is all just theory, but there is some decent empirical support in terms of stylized facts that most other macroeconomic model fail to capture. E.g. the clustering of bankruptcies both in time and within specific sectors of the economy, the fact that nearly all macroeconomically harmful bubbles have been in industries where the output took a long time and a lot of capital investment to produce and the fact that inflation doesn't appear in all goods at the same time when the Fed increases the money supply.

    So far as I understand, other types of macroeconomic thinking rely on models where the vector of relative prices is at most two elements, all goods take equally long to produce, and the money is assumed to have the same effect on every nominal price and no effect on the vector of prices. Maybe you know of a mainstream mathematical approach to modelling such an economy? I don't really follow current macro literature but I'd love to see a paper which considers the implications of varying build times across billions of different SKUs.

    By the way, I'd be remiss if I didn't bother to thank you for your very excellent macroeconomics text which I learned from some years ago. As you might guess, I didn't quite internalize the business cycle model that you endorse, but your book was still an excellent comparative presentation of mainstream ideas in macroeconomics.

  2. Very nice post. The "Monetary Theory II" course I had in graduate school was nearly 100% devoted to the history of free banking (mostly) in the US. The amount of "theory" in that course could have been placed in a set of measure zero. The continuous mantra was as follows. "See, free banking did not necessarily cause chaos in the banking system; government intervention was responsible for all that mess. Thus, it's revisionist history to argue that there was any 'need' for creation of a central bank in the US." Not much more was required to get an "A" on the final exam. I was lucky that the "Monetary Theory I" course was not so glib.

    While I'd be delighted to have my forecast proven wrong, my hunch is that Representative Paul will not be spending much time pursing non-quack issues as chair of this subcommittee.

  3. There is a division in the Austrian School about the gold standard. Many free bankers (more or less those who follow Hayek today) believe that a free market in banking would use gold in conjunction with fractional reserves. This mirrors what Scotland did.

    Ron Paul more frequently allies himself with the followers of Murray Rothbard. Some examples would be DiLorenzo, Joe Salerno, Jesus Heurta de Soto, and Guido Hulsmann. This school emphasizes a commodity standard with 100% reserves because they believe that any money unconnected with commodities is inherently destabilizing.

    It is debated which of these Mises actually believed in. Hayek, in his debates at the LSE, unambiguously favored a policy of "keep MV constant."

    I've raised concerns to huge Paul supporters that he will try to institute Rothbardian economic policies that might make things much worse. The response that I got was that Paul is not an idiot and understands what is going on in the background here. Perhaps Paul understands that DiLorenzo is an ideologue, but is bringing him in because he is good at rhetoric and communication (demonstrated by his popular publication history).

    The Austrians I would prefer to see instead of those Paul chose are Lawrence White, George Selgin, Steve Horwitz, and Roger Garrison.

  4. James,

    The names I gave above are, as you point out, people who take as given that we should have a central bank, and then the only question is how we should run it. In this context, I think that should be our starting point. Every serious developed country has adopted some form of central banking, and it is foolhardy given what we know to embark on an experiment that ties the hands of the central bank in the way that Paul appears to suggest in his writings. By the way, your discussion of relative prices makes no sense at all.


    There is a group of Minnesota people who thought a lot about free banking. Rolnick and Weber did empirical work in the 1980s, and then Neil Wallace and some of his students got interested in banking theory and how it related to the free banking experience. It's very useful to look at how the different systems worked. In the US, for example, the Suffolk banking system (pre-Civil War) seemed to have good incentive properties. The lessons are useful, even if we conclude that central banking is the way to go.


    Thanks for the information. The Rothbard people then support something that looks like gold standard plus narrow banking - essentially a 100% reserve requirement. This has additional efficiency losses due to the fact that you are destroying some useful financial intermediation. Part of the role banks and other intermediaries play is that they issue liabilties that can be traded and that act as a channel for funneling savings into investment. Narrow banking also seems odd as a proposal coming from these guys. It's a very severe regulation, and quite un-libertarian.

  5. I don't want to spend too much time defending Rothbardians, because I am not one, but they deny that there are any efficiency gains to be had from fractional reserves. To them, it screws up intertemporal subsitution since titles to the same wealth are traded more than once. They believe that everything gets worked out through the price system and stickiness is a non-issue.

    Rothbard, who is the source of all this, was known to be "Mr. Libertarian." His rationale is that the use of the 100% commodity standard was what developed historically on the free market and it is only intervention that gave us fractional reserves. Here is a monograph on the issue:

    On another note, the Hayekian free bankers I mentioned do not believe that United States banking in that time period was in any sense free. There wasn't much control from the federal government, but the banks were fiercely regulated by the states. And to the extent that they were less regulated in a given state (such as Suffolk) the better they behaved.

  6. Hayek's proposal (which I find interesting) is arguably more radical than the free-bankers. Most of them assume that these private banks will issue currency redeemable for something like gold (likely only having a fraction of the issued value in reserves). Hayek thought you could have privately issued fiat currency, possibly denominated as the minimum of some basket of other currencies or goods.

    There used to be regular arguments about FRB and what Mises' view was at The Austrian Economists blog (now at, but that seems to have died down recently.

  7. Interesting discussion. What's missing however is the understanding that Austrians oppose the role of a Central Bank in controlling the supply of money - or for that matter seeking to regulate the unadulterated functioning of the free market. Ron Paul's philosophical opposition to the Fed - and in fact his argument to End the Fed - is based on the the Austrian believe that the economy is a complex system and seeking to manage a complex system is fraught with dangerous consequences - as we experienced in 2008 and will likely again experience.
    Having said that Austrians had and have a very 19th century understanding of money as specie rather than the credit money that our sophisticated global monetary system operates under and one should be looking to Post-Keynesians and other non mainstream economic thinkers to advance Austrian principles of letting the free market set interest rates within a highly complex global monetary system.

  8. "It seems clear that the gold standard would give us more variability in prices, not less"

    Is it? Seriously - I got the impression that the pre-20th century inflation figures seem to be rooted in commodity basket rather than real CPI; the commodity basket seems to be very unstable even today - so we just don't know if there was or wasn't more variability.

    There was a price revolution in the 16th century in Europe; huge imports of precious metals from america. Prices doubled or tripled... gues what - the inflation was less then 2% a year.

    Until 1970's the price of oil was pretty stable. The variability that came after 1970's seems quite unprecendented.

    There's a lot more to having gold standard than just recomputing all todays prices relative to oil. How can you just say 'it seems clear'? What's "clear" on a system where the whole financial system depends on gold? It definitely isn't clear to me....


  9. oops.. There's a lot more to having gold standard than just recomputing all todays prices relative to GOLD..


  10. Steve, I would have added George Selgin to that list of names. I'm rather surprised that Ron Paul did not call on him, since George is one of the few that could have made a coherent case in support of Paul's main policy objectives.

  11. increasingmu,

    1. The Rothbardians would have big problems, then, with financial systems in Canada and New Zealand, for example, where there are no reserve requirements. Indeed, my view would be that the reserve requirement is just another distortion that we could do without, and the Fed now has the power to eliminate it. It all gets worked out in the price system, but with 100% reserves you get the wrong prices.

    2. Yes, as Warren Weber reminded me yesterday, the "free" banks, pre-Civil War, were only free in the sense that there was (sometimes) free entry into banking. A bank that must back its circulating notes with state bonds is not free in the Hayekian sense. The Canadian banks, pre-1935, were also restricted. There, entry was severely limited, and the banks could not issue small-denomination notes. However the Canadian banks had more freedom about how to choose their asset portfolios.

  12. Normally I would say that these kooks are irrelevant, but Paul is giving them a platform which implies that they are representative of the expert opinions of the profession. If that happens, we're all sunk.

  13. How about some insight from Robert Mundell on the single mission of the Federal Reserve being the maintenance of a stable price level and nothing else.

    Sound money that holds its value is the objective isn't it?

  14. A couple remarks. First, Steve writes that "the relative price of gold fluctuates substantially, and would continue to fluctuate substantially under a gold standard."

    Those "substantiallys" are without historical foundation. Even during the so-called "price revolution" of the 16th century, when all that gold and silver came flooding into Europe from the New World, the annual rate of inflation--well, let's just say that Ben Bernanke would have been worried about getting too close to the zero bound! (The price-level effects of the California discovery was equally ho-hum.) I don't count myself a gold-bug, or an "Austrian" for that matter. Still I hate seeing empirically lousy arguments raised against it.

    Second, although I'm glad that Steve agrees that free banking shouldn't be dismissed as a crazy notion, and that he correctly points to the Scottish (and Canadian) systems as examples that came closest to the ideal it represents, I wonder why in referring to people who have written on the subject he leaves out Larry White, who alone has written at length about the Scottish case, and instead cites persons who have never written a line referring to what happened in Scotland, or even referring at all to "free banking" except in the bastardized U.S. sense, which (as one commentator has already noted, was a far cry from what Hayek had in mind.

  15. george selgin and larry white would be far better choices.

    btw, milton friedman was once regarded as the wild-man in the wings.

  16. Stephen,

    Friedman and Schwartz reviewed the arguments of Milton Friedman in A Program for Monetary Stability, 1959, about the need for a government monopoly over money in “Has government any role in money?” Journal of Monetary Economics, 1986.

    The 1986 conclusions of Friedman and Schwartz are more ambiguous:

    • “A major aim of our Monetary History was precisely to investigate this question for the U.S. for the period after the Civil War. The evidence we assembled strongly suggests, indeed we believe demonstrates, that government intervention was at least as often a source of instability and inefficiency as the reverse, and that the major “reform” during the period, the establishment of the Federal Reserve System, in practice did more harm than good.


    • “Our own conclusion - like that of Walter Bagehot and Vera Smith - is that leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through governmental involvement. Nevertheless, we also believe that the same forces that prevented that outcome in the past will continue to prevent it in the future."

  17. George,

    1. Pick your favorite time series for the price of gold, tell me where to find it, and I'll show you why the gold standard is a bad idea.
    2. Yes, I read Larry White's book on free banking in Britain, and have it on my shelf. I certainly found it interesting. Not sure what he has been doing lately.


    Thanks for the Friedman reference. I forgot about the JME paper. Of course Friedman wanted to make the case for the policy prescription from his 1968 Presidential address. The prescription didn't work, and was abandoned.

  18. Stephen,

    Are you suggesting the prevalence of central banks in developed economies is an argument in their favor? This is surely a fallacy. More to the point, let's say that a central bank ought to adhere to the "Williamson Doctrine," e.g. whatever you think a central bank should do. Historically, how often have central banks actually adhered to such a program? If, as I suspect, the answer is never, the choice is between a central bank that does the wrong things, or no central bank. Which is worse?

    I'm sorry that you are unable to understand the importance of relative prices for investors making business decisions.

    Maybe an example will help: Suppose a cow can produce X gallons of milk today and that milk can be converted to cheese at a lag of one month provided that there is a cellar in which to age the cheese. In order to decide whether or not to invest in a cellar for aging cheese, an investor needs to know the relative prices of milk, cows, hay, a cellar, and the cost to finance the production of a cellar.

    If a central bank expands the money supply for some reason, the nominal prices of all of those will increase from by different percentages, distorting relative prices. This makes it harder to identify the more profitable investment and raises the risk that resources will be wasted on value destroying projects.


  19. Article 1, sections 8 & 10 of the US Constitution give the federal government a monopoly wrt currency issuance.

    When the government issues currency into the economy through expenditure it does so by increasing bank accounts. Because there is no corresponding nongovernment liability this increases nongovernment financial assets. When government taxes, it withdraws financial assets from nongovernment by decreasing bank accounts.

    A budgetary deficit increases nongovernment net financial assets and a budgetary surplus decreases nongovernment net financial assets. Nongovernment net financial assets are saved in the form of tsy issuance corresponding to net currency issuance as a politically imposed requirement.

    Bank credit cannot increase nongovernment net financial assets since it nets to zero.

    With only private bank credit creating endogenous money netting to zero, there is no lender of last resort and no mechanism for adjusting sectoral balances in the event of demand leakage through private saving and trade deficits. In the event of leakage either private dissaving increases or the economy contracts and employment increases, with no countervailing mechanism.

    Assuming private bank credit creation controlled by a convertible fixed rate monetary system, the result is going to be deflationary, risking the dreaded death spiral in the event of debt-deflation (see Irving Fisher, "The Debt-Deflation Theory of Depression"), which is the inevitable result of financial instability as described in the work of Hyman Minsky.

    Have the advocates of exclusively private banking thought this through?

  20. James,

    "If a central bank expands the money supply for some reason, the nominal prices of all of those will increase from by different percentages, distorting relative prices."

    Are you trying to say that growth in the money stock causes inflation, which in turn causes intertemporal distortions. If so, that was a pretty roundabout way to try to get that across. Understand?

  21. If the gold standard and free banking were optimal institutional arrangements for furthering the goals of human actors, they would have survived. They failed because they did not fit their environment.


  22. Stephen,

    If I were only pointing out that there are intertemporal distortions, my explanation would have been way too roundabout. My point was about cross-sectional distortions across the prices of goods, hence my words "by different percentages." Maybe even this is trivial, but that's kind of the point. Any economist should be able to see that the price effects of monetary expansion increase the difficulty of deciding which investments are worth undertaking, thereby increasing the risk of business failures, layoffs, and the like. And yet whenever lots of firms start failing and unemployment gets out of hand, even the most sophisticated economists begin to recommend monetary expansion, as though the resulting price distortions will somehow make things better.

    Most Austrians would say that this mistaken optimism about monetary expansion comes from the fact that mainstream economists rely on models in which there is only one consumption good and investors somehow just know the right amount to produce. I have no idea if that is an accurate description of mainstream macro today. If you know of some paper by a mainstream macroeconomist which assumes multiple goods with varying production times, non-neutrality of money, etc. and still implies that monetary expansion is potentially good for the economy, please share.

    Anyway, I wish you had addressed my other question which is really a lot more important: If the history of the world's central banks is a valid sample, it's really unlikely that a central bank is going to implement the policies you'd favor. Knowing that, the choice is between a bad central bank and no central bank. Which is worse?

  23. Steve, I presume that by "time series on the price of gold" you mean the relative price of gold when the gold standard was in effect: after all, the very presence of fiat money has destabilized gold, by giving rise to periods (like today) of high demand for it as a hedge against inflation.

    So, with that caveat in mind, consider the standard (Officer) U.S. CPI series, which goes back to 1774. As the U.S. was on a de facto silver standard until the Civil War, was on a fiat standard during the war, and imposed a gold embargo in 1916 (I think), the most relevant period is from the 1870s through 1915. The tendency there is one of mild deflation, not greatly exceeding the rate of TFP growth (and therefore not particularly problematic). Prices start rising in the 1890s owing to the discoveries in Alaska and Australia, but again (as in the 16th c.) the rise is very modest, and less than the current rate. U.S. financial crises of the period did of course involve short-run price-level shocks--though nothing like those all too commonly seen under fiat standards. But those shouldn't be blamed on the gold standard: they were related the our peculiar financial arrangements. (Canada experienced none of these crises despite sharing our monetary standard.)

    The interwar gold exchange standard, I hasten to say, was exceedingly unstable. But that house-of-cards arrangement hardly deserves to be considered as representative of "the gold standard." It was a jury-rigged arrangement among world central bankers to try to mimic the real (pre-WWI) gold standard despite not having the gold to do so according to former rules given money stocks and price levels that had been greatly enhanced during WWI. When France stopped practicing the forbearance needed to keep the whole rickety thing together, it came crashing down. For this we should blame, not gold, but the machinations of central bankers.

    Larry is at GMU, where he's just finished a book on 20th-century history of macroeconomic thought, which is forthcoming from Cambridge.

  24. A couple more thoughts, if I may: My original remarks about gold were to the effect, not that it avoided significant price-level fluctuations altogether (although I believe this was in fact the case w.r.t. the classical gold standard), but that the empirical record supplies no evidence of its having given rise to such on account of new gold discoveries.

    Also, in assessing the performance of any standard we must compare it, not to some hypothetical ideal, but to actual alternatives. Of course an ideally managed fiat standard can do a better job stabilizing the price level than even the classical gold standard did. The _actual_ price-stability record of fiat money has, nonetheless, been far inferior to that of the classical gold standard.

    Finally, I said earlier than I don't count myself a gold bug. To explain: had I, or anyone else, a magic wand capable of restoring the classical arrangement, I wouldn't hesitate to use it or to implore whoever had it to do so. But I don't have such a wand, and neither does anyone else. So far as I can see, the only sort of gold standard that might conceivably be reinstated would be one both introduced and managed by central banks, and therefore no less credible or stable than the interwar version. I believe that sort of gold standard would be no less disastrous than its predecessor. Consequently, I consider proposals aimed at reforming the present fiat standard by means of some sort of monetary base growth rule as the less-risky alternatives. At the same time, however, I oppose legal tender laws that serve to restrict people's freedom to make payments in whatever medium they like.

  25. Trouble is, anyone who believes in rational expectations, real business cycle theory, strong EMH etc. is actually "kooky" themselves. These things are far more disconnected from reality than anything the Austrians came up with.

    So much for your proposed list of names.

  26. George,

    If it would be more convincing, I think I could write down a model where fiat money, optimally managed, would clearly dominate a gold standard. Some people seem to think that the gold standard gives you some commitment properties that the fiat standard does not have, but as I think you agree there is no more commitment in one case than in the other. At some point, you have to trust the central bank, though as I hope seems clear, I think we need to shout at the central bank sometimes to get its attention. An important point to note is that legal tender laws only specify that the government-issued currency must be accepted in discharging debts. A legal tender law doesn't constrain what people use as means of payment. Federal Reserve notes are legal tender, but I have discharged my debts in Bank of America liabilities many times. Sometimes I have traded lunch today for lunch tomorrow, and no one ever complained.

  27. Steve, you say: "I think I could write down a model where fiat money, optimally managed, would clearly dominate a gold standard."ed the point in my post above.

    No need, Steve: I've already conceded the point in my earlier post.

    You also observe that "Some people seem to think that the gold standard gives you some commitment properties that the fiat standard does not have, but as I think you agree there is no more commitment in one case than in the other. At some point, you have to trust the central bank." Here also, I don;t disagree: central banks aren't good at making credible commitments. That's why I favor a system without them. On the relatively more credible commitments of private banks, see my and Larry's _Constitutional Political Economy_ paper, "Credible Commitments: A Constitutional Perspective."

  28. George,

    Interesting. In the private banking system without a central bank you envision, what is the government allowed to do? Do you restrict it to issuing large-denomination debt? Do you do away with a government role in payments (i.e. Fedwire or related payments systems operated by central banks)?

  29. I would not prevent the government from issuing debt of any denomination. However I wouldn't allow it a monopoly of paper currency (circulating small denomination non-interest-bearing debt, if you like). If there's an established fiat base--that is, non-redeemable non-interest-bearing currency, itself presumably issued by a government authority--I would favor a strict rule limiting its supply. (Nothing original about that, of course.)

    Finally, yes, I would do away with Fedwire and other CB-operated payments systems: there's no form of either wholesale or retail payments, paper or electronic, that can't be (or hasn't at some time or place) been effectively supplied and administered by the private sector. Concerning wholesale payments in particular I have a paper, "Wholesale Payments: Questioning the Market-Failure Hypothesis," in the Review of Law and Economics, that (as the title suggests) disputes the claim that traditional net-settlement type private wholesale payments systems (think early CHIPS) were beset by externalities that called for their replacement by RTGS-type arrangements.

  30. If you let the Treasury issue a range of debt instruments of different maturities then the issue would be where you draw the line between what is money and what is not. And I think that one cannot actually draw the line, so it is hard to prevent the Treasury from engaging in central-bank-like activities, i.e. swapping one kind of debt for another. I suppose then the argument would be that you allow enough private competition in debt issue that you effectively discipline the government. I think we're not far apart. I'm not convinced about central banking at all. I don't think we're ready yet to advocate something as radical as doing away with the Fed - that's too risky an experiment, and a lot could go wrong along the way - but we need to seriously analyze all the issues you are thinking about.

  31. Indeed, not far apart: once it's no longer a matter of switching to a commodity standard but of reforming the fiat standard, the question whether reform amounts to "doing away with the Fed" becomes a matter of semantics. Would a frozen base, for instance, "do away with the Fed"? Would a computer programed to make B (or M1 or something else) grow at a steady rate of x% do so?

    In my own view, freeing the private sector to do what it might do better than the Fed, while also eliminating guarantees that create moral hazard in that sector, is more important than doing away with the Fed, though I think it is also crucially important to subject that public monetary authority to much stricter discipline than that to which it has been held thus far.

  32. George,

    Charles Plosser has talked about a "new accord." What he has in mind might not be as radical as what you are thinking about, but he favors a more disciplined approach. I certainly agree that guarantees, implicit or explicit, and moral hazard amount to a big deal.

  33. Again, we agree: guarantees and the hazard they create are the Big Problem in the payments system today. A shame, really: had interstate branching been introduced in '34 instead of deposit insurance (as some had urged, but in the teeth of opposition from the very sort of under-diversified local banks that failed in droves), we might have a much sounder system today, and so might many other countries that ended up following the bad example we set.

  34. I didn't know that interstate branching was on the table in 1934. Too bad about that. Not only have we had under-diversified local banks failing in droves, but the branching restrictions (and the structure that persisted even in their absence) were in part responsible for the niche that Fannie Mae and Freddie Mac grew into, the huge growth in securitization, and the ensuing incentive problems.

  35. Stephen:

    "Why not go even further and eliminate the backing altogether, and just trust the government to regulate the quantity of money in circulation? That's where our modern fiat money systems come from."

    Your statement here underpins most of modern monetary theory, but it could easily be wrong. First of all, modern monetary theory does imply, as you say, that we could eliminate the backing altogether. If that's true, we should see some central banks that actually hold no assets against the money they issue. But we actually see no such banks. They all hold backing against their money, whether in the form of gold, bonds, or the 'taxes receivable' of their issuing government.

    Economists observe that the dollar is inconvertible into gold, and they conclude that it is unbacked. The most remarkable thing about this simple non-sequitur is that it has survived virtually unchallenged for centuries.

    Also, an alleged fiat money would give a free lunch to its issuer, and other money issuers would be able to get a piece of that free lunch by issuing rival moneys until the value of the original money was competed down to zero.

    There is no such thing as fiat money. All money is backed by the assets of its issuer.

  36. Silver $36 ...dollar is toast...All you experts will be explaining why we need SDR's in 2 or 3 years.