A tiger by the tail
Comments after my post asking for libertarian monetary ideas mostly focused on the question of what it means to abolish the Fed.
1. Some regard the phrase as not being literal, rather a call for the Fed to stop exceeding its mandate when intervening in the economy. According to this view, the Fed could still do something like inflation or NGDP targeting, but would stop doing things like bailouts.
2. Some insisted on the Fed doing something even less discretionary, such as rule freezing the monetary base. The Treasury could handle that.
3. Some suggested having the US government replace currency with gold as the medium of account. Again, no Fed would be required.
4. Some suggested just getting government entirely out of money and seeing what the market comes up with. Perhaps something like Bitcoin might win the competition.
Here’s what makes money so tough for libertarians. The US dollar is already deeply embedded in our economy. All sorts of contracts are denominated in dollars, and many of those contracts commit to dollar transactions decades out in the future. That means the US government has an obligation to insure some sort of stability or at least predictability to the value of the dollar over time. Right now they are not doing a great job, but things could be far worse.
It’s sort of like holding a tiger by the tail. You might wish that the US government had never created the fiat dollar, but now that it has it’s hard to let go.
That doesn’t mean it’s impossible, but you need to insure there is some sort of asset called “US dollars” for the foreseeable future, if only to prevent a collapse in our financial system.
That doesn’t mean that we must have a Fed. Commenters pointed out that we had US dollars before the Fed was created in 1913. However, even before 1913 the federal government had a monetary policy. That policy had two components:
1. A definition of the dollar as a specified quantity of gold.
2. Substantial government gold holdings, which changed over time. This influenced the value (purchasing power) of gold.
So it wasn’t pure laissez faire.
Many people wondered why options #2, #3 and #4 are such a bad idea. After all, we had a gold standard back in 1900. Why not return to that system?
I’d make two points here:
1. The gold standard was quite not as successful as advertised by its proponents.
2. Abolishing the Fed would not recreate the historical gold standard. That system is likely gone forever, much like the Holy Roman Empire.
A fixed monetary base, gold, and Bitcoin all share the same problem, which makes them unsuited to be the medium of account. In each case the quantity of the medium of account is fixed, or at least highly inelastic in the short run, and in each case the value (purchasing power) of the medium of account is likely to be highly volatile.
It’s not enough to say the market will choose a money that produces price stability. The value of Bitcoin has been extremely unstable, and yet the market chose Bitcoin over other cryptocurrencies that have a much more stable purchasing power.
The market price of gold has also been highly volatile in recent decades, much more volatile than back in the 1800s. If the US adopted the gold standard it would make the value of gold slightly less volatile, but still nowhere near stable enough to serve as medium of account. The US government isn’t influential enough, by itself, to recreate the sort of stability in the value of gold that we saw in the late 1800s and early 1900s. That would require a level of international cooperation that is unthinkable today. It would look more like the gold standard of 1918-33—in other words, a mess.
In addition, if the changeover occurred at something close to the current market price of gold, then long run inflation expectations would fall from 2% to roughly zero. This would lead to a massive transfer of wealth from borrowers to creditors. In the case of Treasury bonds, we’d need a tax increase to finance the enormous transfer of wealth to T-bond owners. Try selling that idea to voters!
A fixed monetary base has the same problem. The value of base money would be affected by changes in nominal interest rates and financial stability. If nominal interest rates fell to zero and/or if there were a financial crisis, the demand for base money would soar, creating severe deflation. With a fixed base, QE would be impossible during a financial crisis. In contrast, technological innovation that made the financial system more efficient might reduce the demand for base money, creating inflation.
As a practical matter, the amount of base money within the US would decline rapidly over time, as something on the order of $100 billion in currency flows overseas each year, hoarded by people in other countries. So freezing the total monetary base would be equivalent to rapidly reducing the stock of base money remaining in the US. That could cause a banking crisis.
I think it’s a mistake to start from the premise “we need to get rid of the Fed.” Perhaps the optimal monetary system would not involve a Federal Reserve. But the reasoning process should begin with a search for the optimal monetary system. (And when doing so, don’t assume that other countries will join us in abandoning fiat money.) The second step is figuring out how to get from here to the optimal system.
Right now we have a tiger by the tail. It’s not enough to say, “let go of the tiger”, you need a plan as to what to do next.