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.
READER COMMENTS
Andy Weintraub
Aug 17 2022 at 10:28pm
As a practical matter – not politically practical, but economically practical – I still favor Milton Friedman’s rule requiring the money supply to grow at a fixed rate year in and year out, unless a large majority in Congress votes to change the rate of growth. Let the economy adjust to that.
Scott Sumner
Aug 18 2022 at 1:37am
It is much better to target NGDP than M2, due to fluctuations in velocity.
Mayank
Aug 17 2022 at 10:29pm
This is your best post in the 3+ years I’ve been reading.
Anyone have pointers to attempts at answering what is “the optimal monetary system?”
Vitalik’s site comes close but stops at the construction of money without extending all the way into the second order consequences like this post considers for gold (inflation due to less use of money? Great insight!).
Scott Sumner
Aug 18 2022 at 1:36am
Mayank, I have a new book entitled “The Money Illusion”, which explains why NGDP targeting is the best monetary policy.
robc
Aug 18 2022 at 12:38pm
Ignoring the “how to get there from here” problem, how is that the best?
Surely, a pure free market banking system would be better.
Scott Sumner
Aug 18 2022 at 9:23pm
Yes, I support a pure free market banking system. Monetary policy has nothing to do with the banking system.
BC
Aug 18 2022 at 1:38am
Re: the value of gold and Bitcoin being too unstable. The value of a broad basket of consumer goods (CPI or PCE) or even all goods in the economy (GDP deflator) seems very stable. Relative price changes in one good are offset by relative price changes in other good(s), by definition. So, it seems like defining the value of a dollar as 2% less of the basket than last year yields a very stable medium of account.
Maybe, if we started calling that the “PCE standard” rather than “fiat money”, then more libertarians would get on board with it. True, the Fed doesn’t hold consumer goods in its vaults to exchange with anyone that presents dollar notes. Many consumer goods are perishable after all! But, it does hold other assets that it trades for dollar notes, and those other assets are valuable enough that they can be traded for consumer goods. Also, the federal government has taxing power, “confiscation” powers by some libertarian accounts, so that if the Fed ever runs out of valuable assets to trade for dollar notes, the federal government can replenish it by confiscating Other People’s assets. Since libertarians generally think that government’s taxing powers are too strong, they should actually find a government currency ultimately backed by such taxing power to be very valuable. Fiat money, far from being “backed by nothing”, is actually a government promise to pay its liability to you by taking your neighbor’s assets, if necessary.
Arqiduka
Aug 18 2022 at 4:48am
I agree that NGDP (or better yet, VAT base) targeting would outdoo known standards but I am obliged to steelman the case for freezing the base, or going for a fixed increase, to be reviewed every so often.
The argument is that velocity shocks are at least partially (and some claim moslty) influenced by the knowlege that the Fed can and does adjust the base, and credibly fixing it to some growth rate would cause the market to get the message and husband the base. A heroic assumption maybe, but the gold standard wasn’t all that bad (though kot ideal).
Again, not advocating for this, just putting forth the best argument.
Scott Sumner
Aug 18 2022 at 11:38am
Under the gold standard, interest rates rarely fell to zero. When they did (1932) the results were bad. If we freeze the base, interest rates would always be stuck at zero.
Eric Charles
Aug 18 2022 at 9:17am
“Here’s what makes money so tough for libertarians. The US dollar is already deeply embedded in our economy.”
I don’t think this issue is uniquely “tough” though. Legalizing all drugs now would be extremely messy. Ditto for ending social security, Medicare/Medicaid, public schools, privatizing courts/police/military (if you’re an anarcho libertarian), etc., that might require decades worth of unravelling and transitioning to avoid social unrest. But that doesn’t mean that the status quo should remain if you’re a libertarian who is fundamentally against coercive monopolies. On the other hand, if you’re a utilitarian with libertarian tendencies, then adjusting (but not eliminating) many of the items I listed above makes sense. E.g. Legalize marijuana but not heroine and meth, raise the retirement age for social security but don’t end it, etc.
Scott Sumner
Aug 18 2022 at 11:40am
I disagree. There’s no problem with legalizing all drugs. You do not need to come up with an alternative policy—just stop arresting people for drug crimes.
But you are right about Social Security; the transition would have to be carefully thought out.
Eric Charles
Aug 18 2022 at 12:37pm
How would North Korea transition to a liberalized democracy? Interesting question but I don’t see the point of framing this as a problem or weakness of liberal democracy.
Taking the transition pains out of the picture, a much more interesting question is how monetary policy should work post coercive monopoly transition when everything consists of private firms. Would a NGDP work absent statism? There’s the interesting discussion! 🙂
Scott Sumner
Aug 18 2022 at 9:26pm
Would a NGDP work absent statism? There’s the interesting discussion!”
That’s like asking whether ice cream shops could serve both vanilla and chocolate absent statist. It’s just a totally nonsensical comment. Monetary policy has nothing to do with statism.
eric charles
Aug 19 2022 at 8:28am
Fair, I meant which monetary regime should be adopted absent statism? Btw, the forums here suck without an ability to preview your message before sending or the ability to modify once you send it. Boo!
Mark Brophy
Aug 21 2022 at 10:34am
Ending Social Security and switching to a gold standard would be difficult but we’d suffer less than maintaining the Social Security and fiat money systems that are destroying the economy. It’s like a fat person losing 50 pounds; it’s not easy but it’s worth the trouble. Without a gold standard, the government prints money and expands government. Keeping Social Security ruins savings and supports excessive government.
Garrett
Aug 18 2022 at 9:22am
Here’s a (probably dumb) idea: what if the US government IPO’d the Federal Reserve? The Fed profits from seigniorage, so its value as a publicly traded company I assume would be quite high. The government could distribute the proceeds to citizens. Then the Fed would be a standalone entity with a profit motive, which would incentivize it to manage the US Dollar in the most profitable way possible in perpetuity. The most profitable way to manage the currency would be to make it as popular as possible by keeping inflation low and stable.
Don Geddis
Aug 18 2022 at 11:30am
What does “profit” mean, to an entity that can create money by fiat? What in the world is a “profitable way” to “manage the US dollar”? What makes one management path of the dollar more “profitable” than another?
If I were “CEO” of this new “private Fed”, and my goal was to maximize “profits” … why wouldn’t I just create infinite money and buy up all assets in the whole country (or maybe world)? Sure, the unlimited money printing would cause the dollar to enter hyperinflation and then be abandoned. But before that happened … I’d own most of the assets in the entire world! How’s that for a “profitable company”!
“Profit” is a meaningless concept for a fiat currency central bank.
Garrett
Aug 18 2022 at 9:18pm
Would the value the private central bank could take from hyperinflating today be higher than the value of being the most popular currency in the world for the next hundred years?
Scott Sumner
Aug 18 2022 at 11:42am
Actually, the profit maximizing rate of inflation is extremely high. Numerous studies suggest that seignorage is maximized at very high inflation rates.
Garrett
Aug 18 2022 at 9:15pm
But without the backing of the US government, high inflation would incentivize people to move to another currency. So even if high inflation is good for a private central bank’s profits in the short term, in the long term it reduces the demand for their product.
Scott Sumner
Aug 18 2022 at 9:29pm
Unfortunately, people will stick with even highly inflating currencies due to network effects. Thus the revenue maximizing inflation rate is quite high. I forget the exact number, but I believe it’s triple digits (or at least high double digits), even in the long run.
Only when it gets to extreme levels do people completely abandon a currency.
Spencer Bradley Hall
Aug 18 2022 at 10:04am
A Central bank digital currency is aimed at the underground economy.
robc
Aug 18 2022 at 12:37pm
First, shoot the tiger dead. Then let go.
Or, you know, just accept the chaos. And enjoy it.
I think the choices are chaotic but smart or orderly by dumb.
We have orderly by dumb now. Orderly but smart is not possible.
Chaotic but dumb is possible and we need to avoid that, but if we choose a good end point, we can get chaotic but smart.
Yes, some of the suggestion would lead to a generation of chaos while everything shook out, but if it makes the world better for my great grand-children, then I am good with it.
Michael Sandifer
Aug 18 2022 at 5:12pm
I’ve long favored setting up a new parallel bank charter that allows banks to operate freely, absent Fed or OCC regulation, and that also has no FDIC insurance and explicitly is ineligible for bailouts. This would not require replacement of the Dollar, but would presumably allow for much more competition and innovation in the banking sector. It would be an interesting experiment, which I acknowledge might have trouble getting off the ground, as many customers might be too afraid to put their money into non-FDIC insured accounts.
Jose Pablo
Aug 18 2022 at 9:18pm
“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”
Right now? … The US$ has lost more than 96% of its purchasing power since the creation of the FED in 1913. That makes “not doing a great job” an understatement and the “now” in “right now” loosing its most common meaning.
Of course, you can always argue that after the first 100 years of Federal Reserve actions the continuous loosing of value certainly has become “predictable”. Indeed!
Scott Sumner
Aug 18 2022 at 9:35pm
The value of the dollar was relatively predictable from 1991-2021, wouldn’t you say? It fell by about 2%/year.
Jose Pablo
Aug 18 2022 at 10:32pm
This “relatively predictability” from 1991 to 2021, meant that the dollar lost half of its value during that period.
Calling this “some sort of stability” is a little misleading, don’t you think?
Although certainly is not that bad by the US government’s standards. For instance, only 50% of murders get cleared (and this is also a quite predictable rate), but I don’t know …
Scott Sumner
Aug 19 2022 at 2:17pm
“Calling this “some sort of stability” is a little misleading, don’t you think?”
Not at all, and I suspect most economists agree with me.
Thirty years is a long time. I don’t hold cash long enough to worry about $20 bills losing purchasing power.
Bitcoin just lost half its value in a few weeks.
murmur
Aug 19 2022 at 2:50am
I believe the free market can provide the best monetary system through competition. Under such a system different private currencies will exist; some based on the gold standard, some based on a commodity basket, or even fiat money based on nothing. The market will soon figure out the best one by trial and error (or different currencies may be more suitable for different use cases). The argument between inflation targeting vs. NGDP targeting has been completely theoretical till now. Free market based experimentation would have solved this debate long ago.
In all areas of the economy the free market performs far better than any government monopoly. Why should currencies be an exception?
eric charles
Aug 19 2022 at 8:34am
My take is that Sumner might even agree with that in theory but his question pertains more towards someone like Ron Paul who would support legislation to end the fed immediately and how dangerous that would be to do given what we have.
Spencer Bradley Hall
Aug 19 2022 at 11:42am
re: “I believe the free market can provide the best monetary system through competition”
The 12 District Reserve Banks used to be operated independently, not coordinated. We now actually have a central bank. It is called the Federal Reserve Bank of New York. An amendment to the Federal Reserve Act in 1933 established The Federal Open-Market Committee and gave it the power to control Total Reserve Bank Credit. The Fed can now buy an unlimited volume of earning assets.
Before 1933, one FRB could be conducting operations of the buying type — expanding credit, creating bank legal reserves and laying the foundation for a multiple expansion of money, while another FRB was doing the opposite, — conducting open market operations of the selling type)
Scott Sumner
Aug 20 2022 at 1:56pm
What about all of the Treasury bonds? How do they get repaid?
Philippe Bélanger
Aug 19 2022 at 12:30pm
“With a fixed base, QE would be impossible during a financial crisis.”
Even if the base is fixed, the government could issue a large amount of short-term T-bills, which would reduce the demand for money. The Treasury Department could run a kind of “monetary policy” by adjusting the quantity of Treasuries instead of reserves. (I’m not sure libertarians would see this as an improvement on the current situation, though.)
Philippe Bélanger
Aug 19 2022 at 4:58pm
To be clear, in order for this to work, the government would have use the revenue it generated from bond sales to buy relatively risky assets like mortgages or corporate bonds. The net effect would be an increase in the quantity of liquid assets held by the private sector, which is what happens under QE.
Scott Sumner
Aug 20 2022 at 1:55pm
That might or might not address the problem (suppose it were an increased demand for cash). In any case, libertarians that oppose expanding the base would probably oppose that option even more strongly.
Philippe Bélanger
Aug 22 2022 at 1:19pm
Maybe libertarians would be less inclined to abolish the Fed if they realized that without a Fed, there would be a lot of political pressure on the federal government to undertake actions similar to those which are normally carried out by the central bank. The result would be a much more interventionist fiscal policy, especially during financial crises.
On the issue of demand for cash, even if the fiscal authority can’t print out money, they could nonetheless issue very short-term debt like repurchase agreements that banks would consider to be almost equivalent to cash.
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