Keeping the Money Stream Stable: Essays on Money, Monetary Rules and Free Banking
Casey Pender
Thesis presented for the PPE Master of Arts Program
Submitted April 20th, 2018
Thesis Advisor: Professor Pavel Potužák
Abstract
This thesis aims to analyse the effects and implications of a monetary economy. Inspired by the analysis of networks and connectivity, the first two parts of this thesis aim to differentiate the causes of price level movements and their respective economic effects. A hub-and-spoke framework is laid out to show that the general price level of goods and services can move in ways which are productive but also which are harmful. Part three then proposes central bank rules which could aid in the avoidance of harmful inflations and deflations. To do this, I first assume most central banks follow New-Keynesian theory and Taylor like rules, and then build of this by adding Hayekian insights. This concludes with a future looking stable NGDP level target. Finally, Part four looks to free banking as an alternative way to stabilize NGDP without any central bank or monopolization of money supply creation. By building a graphical free banking model, I find that while free banking does a reasonable job of this, it would likely cause more inflation than is optimal (based on the hub-and-spoke framework from Parts one and two) and more inflation that many free bank advocates have previously stated.
JEL codes: B13, B22, B25, B53, E14, E31, E41, E43, E58 Keywords: Hub-and-Spoke, Hayek, Inflation, Price-level, Natural Rate of Interest, Monetary Rules, Taylor Rule, Neutral Rate of Inflation, Inflation Gap, Free Banking
Page 2 of 144
Acknowledgements
I have received an immense amount of help and support in completing this thesis for which I am very grateful. I would like to thank all my professors at the Cevro Institute, specifically Professor Josef Sima and Pavel Potužák for their help over the past year and a half. I also have to thank all of my fellow Cevro students for great conversations which helped shape my views put forth here. As well, to the Professors and students at Texas Tech’s Free Market Institute, who all gave me a ton of help and great feedback during my stay in Texas.
I cannot thank my fiancé Mallory Kardish enough for her tireless help with editing earlier drafts, as well as her overall patience with me during this crazy two years of being a student again. Finally, my parents, Tom and Jan Pender, deserve an insane amount of thanks for all their support.
It goes without saying, but I’ll say it anyway; all mistakes are my own.
Page 3 of 144
Table of Contents
Introduction ...... 6 Review and Contributions ...... 11 An Interdisciplinary Approach ...... 12 Part I - The Pattern of Trade ...... 14 Monetary Evolution as Preferential Attachment ...... 17 Money as a Hub ...... 21 The Importance of Transaction Costs ...... 23 Fragility in the Network ...... 25 Part II - Monetary Disequilibrium and Monetary Neutrality: Different Mechanisms for Moving the Price Level ...... 29 Hub Deflation ...... 30 Spoke Deflation ...... 38 The Two Inflations ...... 41 Implications from Hub-and-Spoke Price Level Movements ...... 44 Part III: Rules and Mechanisms to Stabilize the Money Stream ...... 46 Stable Prices and the Natural Rate of Interest ...... 49 The Taylor Rule ...... 52 Price Stability versus Hub Stability ...... 57 The Neutral Rate of Inflation ...... 61 Neutral Monetary Rules ...... 63 The Knowledge Problem ...... 65 Dynamic Efficiency and the Zero Lower Bound ...... 67 Level Targeting ...... 71 Forward Looking Rules ...... 74 Further Public Choice Concerns ...... 78 Part IV - A Graphical Representation of Free Banking ...... 82 Money Market with Single Monetary Good...... 84 Response to a Demand Shift with a Single Monetary Good ...... 87 Fractional Reserve Free Banking ...... 89 Free Banking: Graphical Representation...... 92
Page 4 of 144
Free Banking in Response to a Velocity Shock ...... 96 Free Banking in a Response to a Supply Shock ...... 100 Summary of the Free Banking Model ...... 103 A “k Percent Rule” on Base Money ...... 104 Conclusion ...... 109
Evidence for Monetary Equilibrium with Free Banking: A look at Canadian Banking, 1870-1914 ...... 113 The Beginning of Canada and its Banking ...... 113 Note Issue and Reserve Requirements ...... 117 Branching ...... 119 Bank Failures ...... 120 Canadian Banking in Response to a Velocity Shock...... 122 Canadian Banking in Response to a Supply shock ...... 125 The End of Free Banking in Canada ...... 128
BIBLOGRAPHY ...... 131
Page 5 of 144
Introduction
It has now been a decade since the 2008 American and European financial crises.
In the US, employment is finally back to a level considered “full”1 however, at the time of this writing, total US output remains 15 percentage points below the pre-crisis growth trend, and it appears the gap is widening (Mason 2017, p.18).2 There are similar problems in the European Union. At its worst, Eurozone average unemployment was at
12 percent, with some regions, such as Greece, being above 20 percent (Beckworth 2016; p.3: O'Rourke and Taylor p.167). In 2017, the EU projected a respectable growth rate of
1.6 percent after years of performing below trend (Rohac and Christensen 2017 p.16).
However, countries such as Greece, Portugal, and Spain remain immersed in disappointing economic numbers (Blanchard et al. 2016, p.104). Furthermore, both regions are currently holding unprecedented amounts of debt, while central banks remain pushed up against the zero lower bound of nominal interest rates (Rogoff
2017).
While it is not easy to point to a single cause of the crisis and the weak recovery, it is clear that the policies conducted by the major central banks of the world were largely ineffective for either prevention or a swift recovery. Many economists claim that modern financial systems are inherently unstable, and therefore monetary policy – while perhaps still important for inflation management – cannot, on its own, influence the
1 Dantas and Wray (2017) argue that common wisdom believes the US is back to full employment, but this is overly optimistic, and employment is still actually below potential. 2 To understand the severity of a 15 percent divergence from trend, Mason notes: “There is no precedent for GDP’s current divergence from trend in postwar U.S. history” (Mason 2017, p.18). In other words, not since World War II has GDP growth deviated so much and for so long. Page 6 of 144 business cycle (Blanchard et al. 2010, Kashyap et al. 2011). Alternatively, others have pointed out that monetary policy may have been able to prevent such a severe downturn, had central banks responded differently (Sumner 2012; Hanke 2013). A third group takes this second opinion even further, claiming that monetary policy may have had an active role in creating financial instability, which in turn led to a near-global economic crisis (Beckworth 2016; Selgin et al. 2015; Young 2015; Horwitz and Luther
2010).
The conclusions drawn in this thesis fall in line with the second and third group of economists – that monetary policy bears some, if not all, of the blame for the recession and the “lingering economic malaise” (Salter 2017, p.443). Following W.
White (2006), I choose to contrast modern mainstream thinking with that of earlier economists such as Carl Menger (2009 [1892]) and F. A. Hayek (1984 [1928], 1935,
1960), and to complement this with the work of more modern economists (L. White
1984, 1989, 1999; Selgin 1988, 1990, 1994, 1997; Sumner 2012, 2013; Beckworth 2008,
2014, 2016; Potužák 2015, 2016, 2017). In doing so, I attempt to systematically lay out the ways in which modern policy norms can both create economic distortions and fail to help during the following recession. While intentionally staying more general, I do not attempt here to look specifically at one crisis or one region, but instead to think of the ways in which money can be universally mismanaged, and its broad consequences.
Therefore, in this manner, I look to add to the literature rethinking inflation targets as the optimal monetary policy and to propose ways in which current practices in central banking could be improved. To do this, a greater examination of the nature of money is needed as the money supply is what central banks ultimately try to control to some extent.
Page 7 of 144
Part I outlines what I perceive to be the most cogent theory of the emergence of money. It follows the Mengerian conjectural history of how a medium of exchange will logically arise as a solution to the high transaction costs involved in trade. While telling this story, I look through the lens of modern network theory, seeing trade as a pattern of human interaction. Thus, I show how as money comes about, it sets off certain feedback mechanisms which organize the economy into a hub-and-spoke network. This part also digs into the concept of neutral money. I argue that far from a necessary feature of money, money can only be neutral with respect to the rest of the economy under very special conditions, meaning that non-neutrality, if it comes about, is a possible downside of using money. As Borio (2012, p.11) puts it “while [money] acts as oil for the economic machine, it can, in the process, open the door to instability.”
Part II looks at the implications of such a trade network, and how this can influence overall prices within the economy. More specifically, I isolate four different price level movements, two from the hub and two from the spokes. Here the link between the price level and the money market is drawn, showing the connection between monetary disequilibrium and the price level. I argue that while both hub movements are harmful due to the economic discoordination they create, both spoke movements are beneficial because of the market signals they emit. This brings up a rather simple normative conclusion: all else equal, an economy would want to avoid harmful price level movement but encourage the beneficial.
Part III is the first half of the heart of this thesis. It takes the normative conclusion of Part II and applies it to modern central banking. Here I start off by first looking at current policy, which I argue is based on the Wicksellian – and now New
Keynesian – idea of price level stabilization, manifested by the Taylor Rule. Starting
Page 8 of 144 with the work of Hayek (1928, 1933) and Potužák (2017), I then look at potential rules which better stabilize the hub of trade. Those rules, which amount to stable NGDP targets, have the added benefit over the Taylor rule of requiring less real-time input data to execute. These NGDP targets are then modified to target an indexed NGDP level instead of targeting a growth rate, and it is argued how this will help anchor expectations and reduce future uncertainty for people entering long term contracts.
Furthermore, the idea of targeting the future and NGDP futures markets are discussed to incorporate a more forward-looking monetary rule. That leads to a simple and easy- to-follow central bank rule, which could be implemented with little-to-no regime change, and could vastly improve macroeconomic outcomes, based on the conclusions of Part II. However, it must be admitted that, while such a rule could improve central banking in theory, in practice central banks may not have the proper incentive to follow such a rule. As such, Part III concludes with a discussion of the Public Choice issues facing discretionary central bankers. That leads into Part IV which explores what money creation and macro-stabilization could look like absent government intervention.
Beginning with Lawrence White’s seminal book “Free Banking in Britain: Theory,
Experience and Debate, 1800-1845” (1984), an entirely new field of money and banking was created. Along with follow-up books shortly after by Selgin (1988) and Horwitz
(1992), the theory of free banking was developed. Part IV is the second half of the thesis’ heart. Acknowledging that there may be inherent problems with central banking, this section aims to build up a simple graphical explanation of how we could expect free banking to work in theory, based primarily on those initial authors in the field. It tries to answer the question: what would an economy look like if government had no special role in money creation or banking?
Page 9 of 144
To do so, I start where the Mengerian story in Part I left off and see how an economy with only a single good acting as the medium of exchange would react to various shocks. From there fractional reserve banking, with an outside and inside money market, is added. Looking at both supply and demand shocks, it’s shown how fractional reserve banking has an inherent stabilizing mechanism which – although created by profit-maximizing banks – creates large social welfare gains. It is noted however, that in a growing economy, free banking may not have as much beneficial deflation as would be ideal (based on theory put forth in Parts II and III), and not as much deflation as put forth by some free banking advocates (for example, Sechrest
1993; Horwitz 2000). This is a surprising result, which means that free banking may be closer to mimicking New Keynesian monetary policy instead of a Hayekian one. This
Part concludes with a proposal to freeze the base money supply. Given that a return to a commodity money standard is unlikely in any modern economy any time soon, a base money freeze is offered as a way to achieve free banking-like conditions, while also addressing some of the concerns associated with complete free banking and monetary increases.
Finally, I conclude the thesis with a case study on Canadian banking from 1867-
1914. As an approximation of free banking, this period is used to test the theory laid out in Part IV. After laying out the general conditions of the time, I analyze the same supply and demand shocks as in Part IV and find the data fits well with the theory.
Page 10 of 144
Review and Contributions
While this thesis is primarily intended to bring existing ideas of great thinkers together in a unique way, I believe there are some original contributions beyond mere literature review.3 For instance, I believe that the way in which Part I incorporates network theory creates a unique lens to look at the creation of a medium of exchange.
While I am not the first to use the notion of a hub-and-spoke network when referring to trade (see Selgin 1988 and Rowe 2009), I believe that Parts I and II explore this metaphor in more detail than other previous works. Part III reviews much of the literature on monetary rules, but along the way introduces the concepts of the neutral rate of inflation and the inflation gap. While these two concepts are most certainly implied in other works (see Potužák forthcoming), I believe I am the first to explicitly define these terms which better allow for meaningful comparisons to alternative views on inflation. Part IV, to my knowledge, is the first work in free banking to look at a disaggregated money market graphically – that is to visualize the interaction between base money and broad money simultaneously in a free market system. Finally, my
Canadian case study is an original contribution in that it goes into more detail than most modern works (see Schuler 1992; Selgin 2017) and uses my concept of the inflation gap to look at monetary equilibrium during this free banking period.
3 Although here it must be noted that even my goal of a full literature review must be restricted somewhat. Given the vast, almost infinite, literature on money and banking, it would be impossible to review this fully. Nonetheless, I feel this thesis gives a nice overview of the general thinking within Austrian, Monetarist, and New Keynesian lines of thought. Page 11 of 144
An Interdisciplinary Approach
To be sure, the primary focus of this thesis is economics, however, I feel it branches into other complementary disciplines as well. For example, Parts I and II have a philosophical twist; Part I attempts to build a monetary epistemology, and Part II being an ontology of the various ways in which prices can move. These sections go beyond economics and ask more fundamental and abstract questions such as “what is money?” and “what is the underlying nature of inflation?” Part III is much more political and focused on public policy. Instead of doing economics in a vacuum, this Part attempts to make pragmatic policy prescriptions for a government or central bank in ways which could improve macro-stability on the margin, but also can be seen as reasonably plausible given the way the world operates today. Part IV is the closest section to pure economics. It builds a simple graphical model to explain how banking likely would look absent intervention into the market. And this section also concludes with a more idealistic policy prescription. Although Part IV’s recommendation is what I feel to be the best solution to monetary policy, this of course is traded off by the fact that it is much less likely to ever come to fruition. Finally, the appended case study is an exercise in economic history; it explains how free banking has been born out in practice, and the beneficial effects it had. I use sources from the time period instead of merely relying on modern second or third hand accounts, and I use historical data estimates to run my regressions.
The conclusion then swings back to philosophy, looking at the importance of a stable money from a classical liberal perspective. It is argued that avoiding large swings in the trade cycle – which this thesis proposes to aid in – helps avoid public calls for Page 12 of 144 bigger government. It is all too easy to confuse the effects of money mismanagement with market failure, and therefore sound money can help gain public support and understanding of well-functioning markets. Thus, it is argued that the implications of this thesis should be of interest to anyone who is interested in prosperous societies with minimal government intervention; not merely macroeconomists.
Page 13 of 144
Part I - The Pattern of Trade
In 1999, Albert-Laszlo Barabasi and Reka Albert published a paper in Science that showed the ways in which websites connect to each other. They noted some interesting properties in these internet connections which are also found in biological and other networks, but not found in purely randomly connected networks. Unlike with randomly connected networks, they reported to find within these website connections a
“high degree of self-organization characterizing the large scale properties of complex networks” (Barabasi and Albert 1999, p.509).
This in part built off of the observations by Derek de Solla Price (1976), who famously showed that a small minority of academic works get cited vastly more often than all others, creating a long tailed distribution. Price showed how these long-tailed distributions had been known to evolve naturally and have been studied for quite some time, however, their “full elegance”, especially when related to social phenomena, was widely underappreciated (Price 1976, p.292). What Price dubbed “the cumulative advantage principle”– what he highlighted and formalized in his paper – he nicely sums up as: in many diverse social phenomena, “success seems to breed success” (ibid).
Barabasi and Albert give two necessary requirements for “success” to be self- reinforcing within a network: “(i) networks expand continuously by the addition of new vertices, and (ii) new vertices attach preferentially to sites that are already well connected” (Barabasi and Albert 1999, p.509). This cumulative advantage method of organization has also come to be known as “preferential attachment” (ibid p.510). It creates a frequency distribution much different than the standard Gaussian bell curve
Page 14 of 144 distribution that we observe in random samples. The bias toward linking with that which is already linked, creates a relationship such that number of nodes with degree k is proportional to 1/k2. In mathematics this is called a power law distribution or a “scale free” model, because in its idealized mathematical form, the shape of the curve will be identical at any scale you pick (ibid). What Price, and later Barabasi and Albert, have shown is that preferential attachment can be found scattered through everyday life in things like the World Wide Web and academic citations.
Figure 1 Power Law Distribution vs Normal Distribution
Figure 1 shows two frequency tables. On the right is the standard idealized distribution we assume if connectivity was chosen at random. To the left is shown the non-random scale free distribution caused by preferential attachment.
One of the most obvious example these days is perhaps the way airlines and delivery companies have set up “hub-and-spoke” systems. While they may lack some of the evolutionary traits of naturally evolving networks, the result is the same – only a few ports or “nodes” are highly connected, while most nodes have significantly fewer connections. Hub-and-spoke has become a colloquial term used when discussing the success of companies like FedEx, but at their roots these transportation networks fit
Page 15 of 144 quite close to power law distributions (Barabasi and Albert 1999, p.511). Price concludes his paper by noting the following:
What intrigues me most is that this new underlying theory which seems to pull together so many diverse phenomena and qualitative laws into good quantitative predictability does so in a way that has an element of causal asymmetry. (Price 1976, p.304)
In what follows, I present the theory of monetary evolution as one such diverse phenomena which displays this causal asymmetry. Money can be seen like a popular website or citation, a node on the far tail of the frequency distribution which fits the
Price, Barabasi and Albert story. A highly marketable, or liquid, commodity will naturally be favoured in indirect exchange as there is a higher probability it can be again traded on the way to one's ultimate desired good. This process is self-reinforcing, for the more a good is used in indirect trade, the more people are willing to accept it and the more liquid it becomes. Eventually one good emerges as the money of the society. What evolves is a hub-and-spoke network.
After establishing money’s position in the trade network, I will conclude Part I by looking at the pros and cons of such a system, concluding that, while immensely beneficial, it does have some weaknesses. I explore the concept of network attack and failure, and how contagion can rapidly disseminate through a highly connected network, and in doing so, the concept of neutral money will be analysed within this framework.
The implications for the effects on money are then expanded upon in Part II.
Page 16 of 144
Monetary Evolution as Preferential Attachment
At first glance, the way we conduct trade in the modern world may seem rather peculiar to some. People offer their labour, their goods, and their services in exchange for bits of metal or paper which, on their own, seem rather useless. Of course, this puzzle as to why these “useless” objects are so readily accepted, is answered as soon as one understands the concept of indirect trade. The reason we are so willing to trade paper for labour or goods is because we are confident that other people will trade us what we ultimately desire for this paper at some point in the future. What has become to be known as money, acts as a middleman for us to get the goods we truly want. But this leads to another interesting puzzle, how did such a system come into existence?
There was once a popular view within the economic community that money had been intentionally invented by people as a convenience to help make trading easier with one another. Either a really smart monarch or a government devised the original monetary system so that everyone could have access to this “middleman.” However, by at least the 1920’s, and possibly earlier, this view had fallen out of fashion due to the growing understanding of the evolution of institutions. At the time, the prominent
American economist Allyn Young summed up this view in a layman's encyclopaedia titled “The Book of Popular Science”:
This view of things, that men invented money in order to rid themselves of the difficulties and inconveniences of barter, belongs... on the scrap-heap of discredited ideas… The use of money, like other human institutions, grew or evolved. (Young 1929 p.266)
Page 17 of 144
The reason Young was able to be so confident that money was not consciously invented, and instead evolved in an unplanned manner like any other institution, was largely due to the work of Carl Menger.4
Although writing nearly a century earlier than Price, Barabasi and Albert, it appears Carl Menger understood the concepts underlying preferential attachment quite well. In “On the Origins of Money” (1892), Menger argued that when trading goods, patterns emerge where a few goods are highly connected, while the vast majority of goods are not. This process of spontaneous self-organization explains how money can become both a good valued like any other in an economy, but also have some special properties which no other good has.
Menger begins this story with a society that only knows trade as a system of direct exchange. This is a picture of primitive world where people only barter for goods which they want to keep or consume directly for personal use. In such a system of trade, it would be difficult to have an economy grow or to show any considerable amount of complexity. This is because of the well-known problems of the double coincidence of wants. Specialization and division of labour will not occur to any significant extent because stockpiling one good is unwise if trading partners for that good are hard to come by (Mises 1953 [1912], p 31).
As barter continues, some particularly astute traders may realize that they can accept goods they do not want to consume themselves, so long as they can trade away these newly accepted goods for something else they truly desire in the future (Menger
2009 [1892], p.12). This is a large improvement as it allows people to begin to specialize
4And then expanded upon by Simmel (1907), Wieser (1909), and Mises (1912). Page 18 of 144 and bring up their inventory of a particular good. Indirect exchange is necessary if division of labour is to increase and become more refined. But the uncertainty from an unknowable future makes indirect exchange difficult as well. It would not be beneficial to be stuck holding a good which you traded for and you yourself do not want, but that you cannot trade away either in the future.
It is this uncertainty which leads goods to be sought out with the lowest “bid-ask spread”, or what Menger (2007 [1892], p.27) called a “saleable” good. For some goods it takes time to find the right buyer, or perhaps any buyer at all. Basic staples such as foodstuffs and textiles, are likely much easier to find people willing to trade for than goods such as artwork or specialty items. Goods that are more readily accepted will likely have a more standard price, whereas goods which sales are rarer may take a considerable amount of bargaining to determine its final sale value. Therefore, what is predicted by Menger is that as indirect exchange is discovered, traders will seek out goods with the lowest bid-ask spread, or the most saleable good, in order to minimize the uncertainty costs of indirect trade. Traders doing so will increase “the prospect of accomplishing his purpose more surely and economically than if he had confined himself to direct exchange” (Menger 2009 [1892] p.34). As Menger explains further:
Under these circumstances, when any one has brought goods not highly saleable to market, the idea uppermost in his mind is to exchange them, not only for such as he happens to be in need of, but, if this cannot be effected directly, for other goods also, which, while he did not want them himself, were nevertheless more saleable than his own (ibid).
Furthermore, Menger notes that those who are successful at such a strategy of trading for more liquid goods, will be imitated by other market participants who are also looking to minimize costs (ibid p.36). With this convergence on demand for liquid
Page 19 of 144 goods, there will be a feedback loop – the more acceptable these goods with low bid-ask spreads become, the smaller the spread will be.
Many more formal models have been built in the time since the logical progression of money was laid out and refined by Menger and the early Austrian economists. Kiyotaki and Wright (1989) for example, famously put forth their search- theoretic model which, inspired by Menger, shows that under certain conditions profit maximizing agents (randomly paired to trade) will allow certain goods to emerge endogenously as a media of exchange (Kiyotaki and Wright 1989, p.950). Many people have since built upon the search-theoretic framework and expanded the ways money can spontaneously evolve. For example Moran et al. (2013) have independently come up with the search-theoretic results using more complex agent-based modeling software, and Duffy and Ochs (1999), have come up with similar results using real subjects in a lab.
Perhaps the evolution of money model which most closely fits into the preferential attachment framework, is the monetary dynamics model of Klein and Selgin
(2000). Klein and Selgin lay out their model by viewing the adoption of a particular commodity as money as the solution to “a pure coordination game” (Klein and Selgin
2000, p.218). They set up their computer model to simulate agents, each endowed with a unique good, who meet “daily” at the marketplace and are paired up for potential trade at random (ibid p.219). Each good is given a different bid-ask spread, however the agents do not have perfect knowledge of these spreads (and therefore of the transaction costs) but can learn this from “sampling the market” (ibid p.220). Trades take place if agents are paired with another who has either a consumption good they desire directly, or if their trading partner has a good which they believe has a lower bid-ask spread than
Page 20 of 144 their endowment good (ibid). The model also allows for the bid-ask spread of a given good to shrink as it becomes more widely accepted. After running their simulations with various parameters, the results came back conclusively that after a period of time, the economy will “converge to a monetary steady-state” (ibid p.222).5
What these models show is that if trade has transaction costs, and if the bid-ask spread of a good diminishes with greater acceptability, than a universally accepted exchange medium will evolve as the spontaneous outcome of human action, but not of intentional human design (ibid p.232).
We can now see that in the same way certain academic papers rise to the top of the citation list, eventually one good will rise to the top of demanded goods in trade, a perfectly liquid good we call money. Hence, a commonly accepted medium comes about as “the spontaneous outcome, the unpremeditated resultant, of particular, individual efforts of the members of a society, who have little by little worked their way to a discrimination of the different degrees of saleableness in commodities” (Menger 2009
[1982] p.38), an insight strikingly similar to Barabasi and Albert’s.
Money as a Hub
Once a commodity has evolved into the role of a universally accepted medium of exchange, the economy becomes a specific system of indirect trade in which the number of trades to get from any good to any other good that one ultimately desires, is never
5Interestingly, they also found that “a universally accepted medium of exchange can emerge even when all goods are initially equally marketable” (Klein and Selgin 2002, p.228). The feedback process alone appears to be enough to have a market converge on a single money.
Page 21 of 144 more than two. In a world with high transaction costs, it is impossible to make trade happen when the average path length between desired goods is too long. Only with money as a hub, can an actor go directly from any good A, to money, to any good B (See
Figure 2).
Figure 2 Connectivity of Goods in a Trade Network
Figure 2 shows the trade pattern for a representative sample of goods. Of course, the number of goods here is kept small for purpose of illustration, however in reality all economic goods are ‘spoked’ out around money.
Modern trade patterns fulfill Barabasi and Albert’s two requirements for long tailed distribution; new goods are constantly coming to market and being added to the network, and these sell for, or “attach” to, goods which are already well connected in trade. Like Price’s citations, there is a path dependence or a bias, where we end up with the form indirect trade that we see in modern economies – liquidity begets more
Page 22 of 144 liquidity. What we call “money” then, can be defined as the good which forms the hub, and all other goods are out on the spokes. In other words, the end result of this preferential attachment mechanism is that money becomes one half of every exchange.
The Importance of Transaction Costs
Upon reflation then, it is not general indirect trade which allows for economic growth, but only a very specific type of indirect trade via preferential attachment, where the connection of goods falls into a power law distribution. To better see why this is so, imagine the feedback-loop of cumulative advantage which creates the long-tailed distribution of indirect trade, was nonexistent such that it did not look how it represented in Figure 2. If that were the case, we could easily think up an example where the chain of goods being traded becomes longer than two (trade a for b, b for c, c for d…. y for z). This would be what would happen if trade networks look more like a lattice. Absent transaction costs, this could also be an effective way to maximize the gains from trades. When transaction costs become high relative to the potential gain from trade however, this long chained indirect trade system will likely become impossible to execute as the cost of the multiple trips between nodes quickly becomes prohibitively high (Clower 1977, p.208).
The uncertainty from an unknowable future makes indirect exchange difficult and we can’t assume the exact lattice structure would be known to the traders ex ante.
Furthermore, because time is scarce, search and bargain costs at each node matters, and the more steps between an initial good and final desired goods, the higher the cost.
Page 23 of 144
Figure 3 Lattice vs. Hub-and-Spoke Networks
Figure 3 compares two idealized form of connectivity. The left hand side shows that as a network grows from A to B, the average distance between any two nodes chosen at random must grow. On the right hand side, we see that growth from C to D entails no growth in average path length.
Minimizing trips between nodes is therefore very important to minimize costs. In a lattice type network, the more nodes (goods) added to the network the larger the average path length between any two nodes becomes. The path length increase has no limit – if the nodes are infinitely increasing then so is the average path length (see figure
3). With hub-and-spoke style systems, an increase in the total number of nodes will never have an average path length exceeding two. Therefore, it is not just any form of indirect trade which allows for specialization and increased division of labour, but only indirect trade in a long-tailed network structure (i.e. the structure where money is the hub). This network structure brings the cost of trade down enough to allow it to happen at a much larger scale, and this further helps explain why barter economies cannot grow beyond small communities (Horwitz 2000, p.66). In fact, barter would be so costly to engage in that it could “hardly be expected to exist outside of the economist’s
Page 24 of 144 imagination, except in the extremely primitive (at least in material terms) societies”
(Laidler 1990, p.6).
This framework highlights the importance not only of indirect exchange in general, but of a specific trade network – the hub-and-spoke model. This draws importance of the bargaining and search cost of trade and confirms the work of many economists such as Jürg Niehans, whose model of money concludes that “for a commodity to emerge as the universal means of payment, it is sufficient that its transactions costs are sufficiently low relative to the transaction costs for other commodities” (Niehans 1969, p.717).
In a world of zero transactions costs, indirect exchange in a lattice network is unproblematic, when transactions costs play a crucial role, hub-and-spoke models best explain how indirect trade can allow for market growth and diversity. This model shows how people interacting in a market place can make gains from trade at much lower cost than otherwise possible. If transition costs are the friction in the economy, then money is the “lubricant” that makes benefiting from trade smoother and easier (Nash 2002, p.5).
Fragility in the Network
This evolutionary story of money gave a plausible alternative to the idea that money was consciously and purposefully invented and helps us understand why people accept money in trade. But this understanding of why money exists can also help explain how this network of trade can be maintained and what can cause it to destabilize.
Page 25 of 144
As has already been stressed, hub-and-spoke networks dramatically lower costs and allow the trade network to grow to sizes not possible from barter or long-chain indirect exchange of lattice networks. Without the evolution of a medium of exchange at the hub of trade, complex societies and all their wealth would not exist.
Just like a major and well-functioning airport, if money is stable, it acts merely as a joint or a connection of trade. As shown, it lowers the transaction costs of exchange, while maintaining a completely neutral relationship to the relative price of goods. When the hub is stable we can then say that money is neutral; the state of affairs such that a monetary economy is behaving as if it were a barter economy (in a frictionless economy i.e. with zero transaction costs) (Negishi 1964, p.147). As Horwitz (2016, p.71) sums up
F. A. Hayek’s view of neutral money: “for Hayek, neutrality means no monetary interference with the process by which real factors determine prices.” Or as Koopmans states: “money is neutral if, and only if, the properties of a monetary economy correspond to the ideal type of a pure exchange economy, according to the laws of equilibrium theory (as quoted and translated by Patinkin and Steiger 1989, p.134. Italics reported in original).6 That is, when money is neutral, all demand for goods is satisfied with the existing supply and money simply acts as a transactions cost reducer.
However, although this system is immeasurably beneficial, it creates a special importance and role for money that it does not share with other goods. As Friedman quotes J.S. Mill “[Money] is a machine… and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order” but
6 Interestingly, according to Patinkin and Steiger (1989, p.132) Hayek was the first economist to actually use the term “neutral money” and Hayek himself attributed the term to Knut Wicksell (1935, p.129). Wicksell, particularly his views on interest rates and neutral money, will be discussed in detail here in Part III. Page 26 of 144
Friedman wisely caveats Mill, noting “money has one feature that these other machines do not share. Because it is so pervasive, when it gets out of order, it throws a monkey wrench into the operation of all other machines.” (Friedman 2007 [1969], p.105).
Money neutrality should therefore be seen as special case which is only achieved when the hub is stable. Unfortunately, this is not a guarantee.7 Since all transactions must go through the hub, if the hub is altered, everything is altered (Rowe 2009).
All long-tailed networks are incredibly robust to random node failure, much more so than randomly distributed networks. It is easy to see why with a quick example. If a single website selling fishing lures goes down, it would be frustrating for some, but it will not disrupt the internet in the same way as Google or Facebook going down would.
Likewise, disequilibrium in the whole fishing lure market will be bad for many, but it will not have a large pervasive impact on the overall patterns of trade in the economy.
When the clear majority of nodes have low connectivity, a random failure will most probably be within one of these low connected nodes, and the odds of random failure at a hub is increasingly small as the size of the network grows.
Where this robustness is limited is when node “attack” is non-random, or targeted. If hackers want to disrupt the most internet traffic, they won’t just target websites at random, but target the ones with the most connections. If a highly connected node is disrupted, then the whole network is disrupted via its massive connectivity through the network. If money is disrupted, it makes our whole network of trade
7 It should be noted that while I argue that neutral money is a special case throughout this Thesis, this view point is not uncontested. As Horwitz (2016, p.71) notes, for many economist’s neutrality implies that changes in the money supply “do not affect real variables because all that they do, at least in the long run, is to raise every price equiproportionately… For these writers, neutrality is not about monetary policy, but a feature of a general equilibrium model that meets those conditions.” Page 27 of 144 distorted. Disequilibrium in the money market affects all the goods markets which money is a part of. The low bid-ask spread which caused a bias towards a single money in the first place is altered. Going again to the hub-and-spoke model and the similarity to air travel, Rowe (2009) makes the following analogy: “If Peoria is a spoke, and Peoria is closed, nobody can fly to or from Peoria. If Atlanta is the hub, and Atlanta is closed, nobody can fly anywhere. Money is like Atlanta; every other good is like Peoria.”
In what follows, Part II, I will analyze what it means for money to be stable and what it means to be disrupted. I will also explain the different causes of price level movement; when it is good and when it is bad. To do so, I will explore the concepts of inflation and deflation under this long-tailed framework established here in Part I. It will be argued that under certain conditions, inflation and deflation can be symptoms of
“attacks”, or at least disruptions, at the hub of trade which have harmful, pervasive, effects. In other words, can money become non-neutral when there is too much of it
(people demand more real goods and services than exist) or if there is too little of it
(supply of goods and services exceeds demand) (Potužák 2015, p.404). However, as will be shown, not all movements in the general price level are a symptom of monetary disequilibrium.
Page 28 of 144
Part II - Monetary Disequilibrium and Monetary Neutrality:
Different Mechanisms for Moving the Price Level
No one would claim markets are perfect. It is commonly assumed least some frictional unemployment will be present, and some industries will inevitably be in decline. However, to have systemic disruptions across all sectors, to have large swings in unemployment and to see mass misallocation of resources, requires signals (or lack thereof) across all industries, and only one economic good is that pervasive. Shocks across an entire economy can only be a monetary phenomenon. What I have hope to have shown in Part I using a hub-and-spoke framework, is that money’s special status as the hub of trade leaves the system susceptible to certain fragilities – namely that if money goes wrong, it cascades into all markets going wrong. Given that much of my work here is largely an echo of George Selgin’s work, it is worth quoting him at length:
One can think of the market as being like a wheel, with money as the hub, prices as the spokes, and other goods as the rim. A change in the relation of one good to the rest is like a tightening or loosening of a single spoke: it has a great effect on one small part of the wheel, but much less effect on the rest of the wheel. A change in the relation of money to other goods is like moving the hub: it has a great effect on all parts of the wheel, because it moves all the spokes at once. Adjust a spoke—a particular price—improperly, and you make one small part of the wheel wobble; adjust the hub—money—improperly, and you bend the whole wheel out of shape.” (Selgin 1988, p.80)
The remainder of this section can largely be seen as an expansion and elaboration of this quote. I will argue that what it means for “money to go wrong” is for the supply and demand for money to be out of sync with one another.
I will first examine where I think conventional fears of deflation are by in large correct. I call this “hub deflation”, as is stems from a disequilibrium at the hub of trade.
Page 29 of 144
More time will be spent on this than any of the other forms of price level movements, as many of the underlying mechanisms and explanations will be the same throughout.
Next, I will argue that while deflation indeed can be worrisome, it need not always be, and in fact, given the right cause, can be economically beneficial; when it comes from the spokes – “spoke deflation”. Throughout the beginning of this section I will be restricting my analysis mainly to that of deflation for the sake of brevity and to avoid redundancies, however I will also touch on inflation toward the end to explain any important differences between the two directions of price level movement. I will layout the underlying mechanisms of hub inflation, where it comes from, and its effects on the macro economy. Then I will analyse spoke inflation, its origins, and its effect on the macro economy, and it will be shown how this is economically desirable phenomenon.8
Hub Deflation
Generally, barring external intervention (i.e. price controls), the price of any good in a competitive market is not fixed but relative to supply and demand. Therefore, if supply and demand schedules are shifting through time – which likely is happening
8 Here I am using the terms “inflation” and “deflation” by their modern definitions, “an increase or a decrease in the general price level” respectively. However, given the Austrian influence of this thesis, it may be interesting to note that this is not the definition used by Austrian economists such a Mises (1953 [1912], p.240), who defines the terms as follows:
Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur. Again, Deflation (or Restriction, or Contraction) signifies: a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange-value of money must occur.
Reconciling my terms with this; hub inflation and deflation would be equivalent to inflation and deflation general as defined by Mises, but spoke inflation and deflation, would not be seen as inflation or deflation at all to him. Page 30 of 144 constantly in the real world – an equilibrium price at one time will be a disequilibrium price at another (Yeager 1956, p.7). However, a dynamic economy constantly in flux is generally unproblematic. When typical spoke goods, say apples, get out of equilibrium
(if S
In economics we are often taught that the money supplied equals the money demanded (Ms=Md), but it is important remember that this is an identity which holds only in equilibrium, it is not a requirement, and certainly not a given (ibid). The money market can of course be in equilibrium, but there is no reason to assume this is always, under all circumstances, the case. Furthermore, money doesn’t work like apples. Apples have a single “apple market” in which to clear, but “the money market” is merely a mental construct as money is pervasive in all markets, as laid out in Part I. Yeager makes this point vividly clear:
No actual "money market" exists on which price or quantity adjusts or from which frustrated demanders turn away and move to other markets. The medium of exchange has neither its own specific market nor a specific price of its own that could adjust to correct excess demand or supply. It is "fixed in value in terms of the unit of account"; a $10 bill or $100 demand deposit is worth just 10 or 100 dollars (Yeager 1978, p.127).
Figure 4 is given to better visualize this.9 Assuming an increase in demand from
Md1 to Md2, we ought to (eventually) observe a move from A to C, meaning 1/P goes up, and hence P must go down – we should see price deflation.
9To analyze the price of money (on the vertical axis of Figure 4) we must look at the ratios of exchange between money on one hand and all other goods and services on the other (Mises 1949, p.398). It is for this reason that the “price” of money should be viewed as 1/P (the inverse of the general price level). Page 31 of 144
Figure 4 Money Market through Time
Imagine the money market is in equilibrium at point A, at time t. If money demand shifts to Md2 at t+1, then initially we should see demand exceed supply at point
B. As the price adjusts, the market should eventually equilibrate at time t+a, at point C.
However, as noted, because the nominal value of money cannot change, this means that all other goods must change their price for the adjustment to take place. This give us reason to believe that 1≠a and that a>1, such that there will be a length of time where the money market (and therefore all markets) are in disequilibrium. If the move from A to B to C was instantaneous, then there would be no problem with this price deflation because we would have no time spent out of an equilibrium and neutrality would hold.
All goods would simply instantly change price all at the same time and at the same ratio, to equilibrate money and preserve relative prices.
Unfortunately, as I will be expanding upon in detail, we cannot expect this to be a realistic outcome, for there are many reasons to assume prices are sticky. As Laidler notes:
Page 32 of 144
It is a commonplace that price stickiness can arise, quite mechanically, from inertia in expectations, from the existence of nominal contracts of significant length, or indeed from price-setting agents facing non-trivial costs of changing them (Laidler 1990, p.10)
At least temporarily then, this operates as a de facto price control (in this case a price ceiling). For a non-trivial amount of time, money demand will exceed money supply. If people on the whole are trying to add more money to their total cash balances than exists given the total money stock, then they are on average trying to sell more goods and labour than are being bought (Yeager 1956, p.5).10It is important to note here that the decreasing price level is a symptom of falling demand for non-monetary goods
(Ryska 2017, p.4). Therefore, it is not the deflation that is the cause of the depression per se, but the slow and uneven way in which it occurs (Yeager 1956, p.10).
To see the broader effect of this disturbance at the hub, let me represent this in terms of AS-AD space. Why people in aggregate might suddenly wish to shift their wealth portfolio to holding more money could come from numerous sources. Whether this stems from a decrease in consumption (C), investment (I), Government purchase
(or higher taxes) (G and T), or net exports (NX), the result is a fall in nominal aggregate spending (either a fall in M or a fall in V) and therefore we can say a shift in aggregate demand (see Figure 5).11
10In figure 4 I have depicted an increase in money demand, however, it is important to note that a decrease in supply (while holding demand constant) would have the same effect. A similar graph depicting this hub inflation from an increase in the money supply can be found in Horwitz (2000, p.68). 11Figures 5 and 6 are recreations of Beckworth (2008, p.367). Stylistically I have drawn the AD curve as linear, however, as per Beckworth’s original depiction, a unit elastic curve would actually be more appropriate (a rectangular hyperbola) and it more accurately represents the trade-off moving along the AD curve from Y and P. Page 33 of 144
Figure 5
Figure 5 shows an inward shift of the AD curve due to a decrease in spending. In the short run, assuming some stickiness in prices, the price level will fall from P1 to P2 and output will fall as well, from Y1 to Y2.
Given Figure 5, we can assume eventually we will end with lower prices, back out the original output path of the LRAS, at point C. However, as has already been stressed, this takes time, and it is a time of painful adjustment, represented by point B. Before the long run equilibrium is achieved, we should expect excess inventories and slack in business, which will put downward pressure on prices of goods, services and wages.12
Not only do prices stick, there seems no reason to believe that price stickiness is uniform across all the spokes, and so prices are likely to adjust to the new long run equilibrium each at different rates (Yeager 1956, p.11). Relative prices will be distorted, sending money and resources away from their best uses (Woolsey 2015, p.128). To this
12 This may seem rather “un-Austrian” to talk of aggregate demand falls, but interestingly Hayek himself at times discussed deflation like this: “Unemployment may itself become the cause of an absolute shrinkage of aggregate demand which in turn may bring about a further increase of unemployment feeds on unemployment.” (Hayek 1975, p.44). Page 34 of 144 point, Yeager particularly draws attention to wages, which can be stickier than good prices due do things like contracts, unions or even psychological reasons.13 Goods adjusting faster than wages will “distort the structure of relative prices and so transitionally worsen maladjustments in production and trade” (Yeager 1956, p.11).
This short run uneven price stickiness can also be because entrepreneurs cannot be expected to instantly have the knowledge of the cause or the duration of their new lack of revenues. Entrepreneurs cannot discern whether the sudden lack of business is because customers’ genuine preferences have been altered, or if there is a lack of money in the economy. Therefore, when faced with a new and unexpected of lack of revenue some businesses may choose to “ride it out” thinking the lack of spending is only temporary, while others may overreact and layoff too many workers, or close up shop altogether. Plans of entrepreneurs can be altered in many ways which may not be the optimal choice to achieve the new long run equilibrium where the price level is lowered. Perhaps the new equilibrium could be achieved sooner had people understood the reason and duration of this lack of revenue that monetary deflation causes, allowing faster and smoother coordination to the new monetary equilibrium. However, this is not the type of knowledge that prices can be expected to convey. Again, as Yeager has pointed out:
One cannot consistently both suppose that the price system is a communication mechanism— a device for mobilizing and coordinating knowledge dispersed in millions of separate minds—and also suppose that people already have the knowledge that the system is working to convey. Businessmen do not have a quick and easy shortcut to the results of the market process (Yeager 1986, p.375).
13Bordo et al (2000) used data from 1718 firms during the great depression and found this empirically to be case, wages indeed adjusted slower than other prices. There is good reason to this is even more of a problem today. As Sumner (2012, p.7) points out wages fell sharply during the great depression, but in the great recession wages never fell, only their rate of growth fell. Page 35 of 144
Yet even if we assume some especially attuned entrepreneurs have the knowledge and foresight to understand that an excess demand for money is causing this new lack of spending, there would still be what Yeager describes as the “who-goes-first” problem
(ibid p.374-375). This occurs when there is downward pressure on prices and firms therefore need to lower their prices to clear the market, but it is economically disadvantageous for any firm to be the first to do so.14 In a competitive market, it would not be profitable to lower prices unless costs are lowered first (because, if lowering prices without an accompanying lowering of cost was profitable, competition should have pushed this to happen already). Labourers do not want to accept a lower wage until goods are cheaper, but it is difficult to make goods cheaper without first lower wages
(assuming no change in productivity).
Furthermore, if the lack of spending is primarily on consumption goods, then the sellers of these goods will want the sellers of intermediate goods to first lower their prices as well. What happens is that everyone is waiting for everyone else to lower its price, in order to try and hold profit constant. This who-goes-first problem is essentially one of coordination, which results in excess inventory sitting on shelves and, if severe enough, unemployment.15 In other words, if a business owner lowers the price of the goods he produces without first having a reduction in the cost of the factors of
14 Yeager’s who-goes-first problem is often restated in later in New Keynesian literature as simply “coordination failure.” For example, Cooper and John (1988, p.442-443) say, in very similar language to Yeager, that “mutual gains from an all-around change in strategies may not be realized because no individual player has an incentive to deviate from the initial equilibrium.” 15According to at least one study, this coordination problem has been empirically shown to be the number one cause of price stickiness. Alan Blinder surveyed real businesses and asked them why they are slow to change prices, the number one answer given was “coordination failure” where “firms hold back on price changes, waiting for other firms to go first” (Blinder 1994, p.124). Page 36 of 144 production (as will be shown with spoke deflation) there will be a “price-cost squeeze”
(Horwitz 2000, p.145).
The knowledge problem and the who-goes-first problem, can largely explain what causes the hub adjustment to be slow and painful. Businesses which have an equilibrium price initially, must “distinguish between random fluctuations in sales and those which signal a lasting shift in demand, and respond only to the latter”, however “it takes time to solve signal extraction problems before prices are changed” (Laidler 1990, p.9). But furthermore, expectations and nominal contracts can exacerbate this as well. People set up long term contracts under the assumption of certain trends. For example, the honest person who receives a twenty-year mortgage, presumably has predicted a steady stream of income to make the necessary payments over time. Unplanned income decrease and unemployment will disrupt these plans. If these disturbances are systematic and fixed long-term contracts are seen to some extent throughout the economy, this unplanned lack of income can lead to many debts (which would have been payable in the previous money price equilibrium) being now difficult to pay off. As Irving Fisher noted long ago, under this type of deflationary pressure “each dollar of debt still unpaid becomes a bigger dollar” (Fisher 1933, p.344), and this will cause delinquencies and defaults to excessively rise (Sumner 2012, p.14).16 In other words, anyone making payments on a
16 This is the well-known idea of debt deflation and is still recognized by some economists today as the number one cause of the great depression of the 1930’s, in which there was a large fall in nominal prices and wages, but most debt obligations were fixed in constant US dollars (Calvo 2013 p.11). Calvo (ibid p.13) also states debt deflation as a major factor in the more recent euro- crises. Page 37 of 144 fixed nominal contract is exposed to financial stress “whenever nominal income flows deteriorate relative to expectations” (Koening 2013, p.58).17
What will be discussed later in Part III is if and how this money market disequilibrium can be avoided, but first I will discuss the other way in which prices can move, starting with spoke deflation.
Spoke Deflation
I have gone into detail thus far about how dangerous economically deflation can be, but this must not always be the case. Goods-induced, “spoke”, deflation (depicted in
Figure 6) is caused by positive aggregate supply shocks which are not achieved by an increase in the money supply (Beckworth 2008, p.366). More precisely, if it is given that
SRAS = Y*+a(P-Pe),18 and it is assumed P-Pe=0, then aggregate supply can only shift outward with an increase in the natural rate of output.19 This would mean new technology and innovation or growth in the capital or labour supply, would lower “per unit costs of production” and drive down the price in a competitive market (Beckworth
2008, p.367). In this scenario, the lower price level simply reflects the new arrangement of relative prices, which signal that goods are less scarce than previous. When this occur without being accompanied by hub movements, what Hayek called the “money
17 It should be noted that Koening (2013, p.75) see’s Fisher's view as incomplete, as Fisher only looked at price level, but did not look at NGDP. In Koening’s view it is therefore hub deflation which causes debt deflation, not spoke deflation. 18Where “P” is the actual price level, “Pe” is the expected price level, and “a” is a parameter used to show the extent of the effect on SRAS during a P and Pe deviation. 19It could be said that non-monetary supply shocks are increases in total factor productivity, where Y* is a function of A;K;L (“A” = technology, “K” = Capital, and “L” = labour).
Page 38 of 144 stream”20 (MV in the equation of exchange) is held constant (Hayek 1935, p.131). In other words, when the quantity of a good produced is increased (all else equal), the consequence will be a fall in price (Mises 2007 [1949], p.431).
This form of deflation, which is just a fall in specific goods prices, necessarily improves the lives of people who demand such a good, for they can now get more for less, as there is greater per unit output for each input (ibid p.490). For these reasons, economists such as Bordo and Redish have labelled this type of price level decrease as
“good” deflation (Bordo and Redish 2003, p.2), George Selgin has coined it
“meaningful” deflation (Selgin 1997, p.24) and William White and David Beckworth has labelled it “benign” deflation (W. White 2006, p.4; Beckworth 2008, p.367). But, as
Hayek explains, this type deflation is not only benign or “merely not detrimental” but is actually beneficial or “even necessary if disturbances of equilibrium are to be avoided”
(Hayek 1984 [1928], p.100).21
One way to look at spoke deflation is to notice that it is not a uniform fall across all goods counted in the general price level, but merely a statistical artifact achieved through arbitrary aggregation. This means that the “groping toward a coordinated pattern of market-clearing prices” through “piecemeal, sequential, trial-and-error” which is the hallmark of hub deflation (Yeager 1986, p.226), is not a factor in this case.
There is no who-goes-first problem or knowledge problem, as what we observe here is profit maximizing firms lowering their prices as their input costs are lowered.
20 According to Hayek (1933, p.92) the money stream “does not mean merely the quantity of money in circulation but the… the effective circulation (in the usual terminology — quantity [of money, “M”] times velocity [V] of circulation)” (emphasis in original). 21 Seconding Hayek’s opinion, W. White, after dubbing this deflation “benign”, notes shortly afterword’s that “good” is perhaps the more accurate term (W. White 2006, p.4). Page 39 of 144
Figure 6
Figure 6 shows both supply curves shifting outward due to an increase of total factor productivity. Assuming a constant schedule of AD, the price level will fall from P1 to P2, but output will rise from Y1 to Y2
As an example, assume China’s economy continues to liberalize its market, and new and cheaper imports of car parts begin flowing into the Czech Republic. This would allow car manufacturers such as Skoda, to sell cars for a lower price than they did previously, without a price-cost squeeze or a reduction in wages. Even if car prices were the only good in the Czech market to drop in price, then by statistical design, the aggregate Czech price level would also drop. The composition of spending in the economy changes, but the total spending does not (Beckworth 2017, p.5). Unlike hub deflation, here the fall in the general price level is just representing productivity gains to individual firms or markets and not truly showing a pervasive macro phenomenon, as the name “a fall in the general price level” may suggest.22 William White (2006, p.4),
22 To bolster this hypothesis, Ryska and Sklenář (2017) have analysed sectorial data from the Czech Republic and indeed find strong negative correlation between output and prices, meaning Page 40 of 144 among others, has pointed out that this type of positive supply shocks seem to appear with relative regularity in the United States before World War I, noting that under these circumstances: “Lower prices contributed to higher real wages, while higher productivity allowed the share of profits in factor incomes to be maintained or even increased. In this environment, asset prices also remained strong and monetary and credit aggregates tended to rise as well.”23
Here I hope to have made clear that price deflation can have dramatically different effects on the economy depending on what causes it. New technologies and production techniques in a competitive market should drive down prices without any unpleasant money market distortions. On the other hand, excess demand for money will drive down prices, slowly and unevenly, with harmful economic effects.
The Two Inflations
For the most part the effects of inflation can just be seen the reverse of deflation.
However, at this point, it may be worth highlighting some important facts about the respective inflations, to paint a fuller picture of which price level movements are harmful and which are not.
Hub Inflation also stems from the money market being in disequilibrium, but in the opposing direction. Again, as Yeager points out:
If people on the whole are unwilling to add as much money to their total cash balances as is being added to the total money stock (or are trying to reduce their that the industries which are growing can be expected to have a price for their goods which is falling. 23 For more historical examples of the benefits of hub deflation see Bordo and Redish (2003), Bordo and Filardo (2005), and the appended case study attached to this thesis. Page 41 of 144
cash balances when the money stock is not shrinking), they are trying to buy more goods and labor than are being offered. (Yeager 1956, p.5).
This causes prices to rise as money becomes less valuable. But like hub deflation, there is no reason to assume prices will change smoothly and evenly. Barro (1972) showed that firms do not tend to move their prices upward in a smooth analog pattern, instead they periodically raise their price in discrete jumps.24 This mean that firms will be changing their output prices and they will also be facing jumps in their input costs, but there is no mechanism in this system that would ensure these output/input jumps to be in sync, in fact they most likely would not be (Laidler 1990, p.52). The typical coordination problems apply, and furthermore, if it stems from the creation of new money (as opposed to a fall in demand) then this new money will not be equally endowed to all market participants at once but will enter the economy in a particular time and place (Hayek 1935, p.8-9), further distorting relative prices.25
This hub inflation fits with the well-known Austrian business cycle theory, and so will not be told in too much detail here.26 But in short, an increase in the supply of money beyond the demand to hold money, will cause the market rate of interest to fall below the natural rate of interest (the rate which would prevail when the money market and the loanable funds market are both in equilibrium).27 This lower interest rate signals to entrepreneurs to take on and invest in more long term projects. However, the low interest rate does not actually reflect the time preferences of savers but is only the
24Also see Hayek (1935, p.6), where he discusses these discrete jumps as “lags” which exist “between the changes of different prices.” 25 These distortionary effects of site specific monetary injection are known as “Cantillion effects”, named after Richard Cantillion (168? - 1734), who first (or at least best) detailed this type of phenomena (Cantillion 1755). 26 Horwitz contends that a story of deflation, much like the hub deflation discussed here, is the “mirror image” of the Austrian story of inflation (Horwitz 1996, p.291). 27This rate is discussed in more detail in Part III. Page 42 of 144 cause of the excess money which people are trying to rid themselves of. Eventually, prices will rise and interests rates will rise as the money market equilibrates, and many long term investments will not be able to come to fruition. 28 In AS-AD space, this means that not only is the economy’s output beyond the LRAS and thus likely to retract, it is also producing the wrong kind of output, which once adjusted for will shift the
LRAS to the left. Although Hub inflation is the other side of the coin to hub deflation, it is perhaps sneakier, in the sense that the harmful underlying effects are not immediately seen (Hayek 1960, p.330). Whereas a fall in AD will be quickly born out with unemployment, in contrast, a monetary driven rise in AD will at first seem like a boom, and will only later bear out its consequences when there is a bust, therefore, as Horwitz notes: “by the time most of the problems of [hub] inflation have become obvious, it is much too late to act” (Horwitz 1996, p.294).
Spoke Inflation on the other hand, is caused by a price increase of any good or goods, which is not located at the hub node. For example, suppose an oil embargo in the
Middle East reduces oil imports into the Czech Republic. With oil more scarce than previous, and given market forces, we should expect an increase in the price of oil. If all spoke node prices are then aggregated, we see an increase in the general price level, even though only the oil market has been affected. This spoke inflation should be seen, in a sense, as beneficial. It is not beneficial in the direct sense of bringing about improvements to standards of living (as was with spoke deflation), but because it signals new scarcities. Therefore, what we expect is that the rise in oil prices means that
28For a more detailed explanation of the Austrian business cycle theory, see Mises (1953 [1912], 2007 [1949]), Hayek (1935), or for a more modern summary see Horwitz (2000), Garrison (2001) or Potužák (2015). Page 43 of 144 entrepreneurs have a better understanding of what to use in the production process.
Given the underlying circumstances, people will benefit by the market allowing the price of oil to rise, for that is how people come to learn that oil is now scarcer than previous.29
Implications from Hub-and-Spoke Price Level Movements
The price level movements are summarized in Figure 7, with the main takeaway being that price level movement can be good or bad for economic activity depending on the cause.
The normative conclusion here seems rather straightforward, all else equal, an economy ought to avoid hub movements but allow spoke movement. Assuming we are in a world with central banks,30 they should aim to keep the money market in equilibrium while allowing for price changes at the spokes of the trade network.
Figure 7 Direction and Location of Price Level Movement
29 It is important to note that because less per unit output results in lower real wages, this effect is not simply an adjustment of relative prices, but a rise in the general price level as well. 30An assumption which will be relaxed in Part IV. Page 44 of 144
Again, using the equation of exchange MV=PY,31 the goal would then be to hold
MV stable through time (which in turn holds PY, constant). If velocity falls then the central bank ought to raise the money supply – ↑M↓V=PY, offsetting any potential hub movement. However, if the economy is becoming more productive over time, say new technologies are invented which lowers per unit costs and therefore raises output (Y), then holding MV constant would mean allowing a corresponding fall in the general price level - MV=↓P↑Y (Horwitz 2000, p.99).32 As Hayek (1960, p.326) further explains:
The rate at which money is spent should not fluctuate unduly. This means that when at any time people change their minds about how much cash they want to hold in proportion to the payments they make (or, as the economist calls it, they decide to be more or less liquid), the quantity of money should be changed correspondingly.
In this sense, to avoid bad price level movements, but allow good, a central bank should target a stable MV (Potužák 2016, p.4-7), or its equivalent, stable nominal GDP
(Murphy 2013, p.25). Such a system such as this – where prices are allowed to fall opposite to productivity growth – has been labelled as a “productivity norm” by Selgin
(1990, 1997). How a central bank could practically achieve such a norm, and how that differs from current practice, is the topic of Part III.
31Where “M” is the money supply, “V” is the velocity of money, “P” is the general price level, and “Y” is total economic output. 32 The assumption required here is that sufficiently competitive markets will lead to final prices completely reflecting productivity gains (Fernández 2005, p.64). Page 45 of 144
Part III: Rules and Mechanisms to Stabilize the Money Stream
The economist Knut Wicksell could perhaps rival anyone for the title of the most influential economist of the last 150 years. When James Buchanan gave his Nobel lecture (1987 [1986]), he lauded Wicksell for being the primary inspiration behind his own intellectual journey, which was a major contribution to the founding of Public
Choice economics. That praise on its own would be enough to cement Wicksell’s legacy, however, he is arguably even more well-known today for his contribution to monetary economics than for his work on public finance. Modern macroeconomics cannot get far without discussion of the natural rate of interest, popularly known as the “Wicksellian rate.”
The normative conclusion of Part II seems rather straight forward, all else equal, an economy ought to avoid hub movements but allow spoke movement. However, this gives no guidance as to how this goal ought to be achieved. This Part looks to give simple and pragmatic alterations to current monetary policy, which ought to push policy closer toward this goal.
To show this, first a look at current policy in necessary. Tracing forward from
Wicksell, I will argue that although the concept of the natural rate of interest is indeed valuable, Wicksell was mistaken as to how to spot the natural rate in the real world. This mistake lead himself, and his modern-day followers, to erroneously believe price- stability ought to be the most desired goal of monetary policy. This error was pointed out by Hayek (1928, 1931, 1933) who showed that in a growing economy, the natural rate of interest would be synonymous will a falling price level and so the price level
Page 46 of 144 should move inversely to real output. As put forth in the previous Part, instead of favouring a stable price-level, Hayek therefore favoured stable nominal income; what he referred to as the money stream.
Many modern central banks, and academics alike, now look to achieve
(something akin) to stable prices, often using interest rate targeting monetary policy rules such as the now famous Taylor Rule (Taylor 1993). However, given Hayek’s insights on the natural rate and on a stable money stream, here I find that the Taylor
Rule can be modified to better achieve intertemporal coordination and therefore a more stable macroeconomy. As will be shown in detail, what this amounts to is a special type of nominal GDP target, where NGDP is held stable through time. I then build on
Potužák’s Hayek-Taylor Rule (2017) by looking at modifications such as level and futures targeting.
This Part will go as follows; first I examine Wicksell’s formulation of the natural rate and what it implies for monetary policy. This begins by tracing the line of thought from Wicksell’s own work, through Keynes and into the work of the New Keynesians; specifically, how they understand stable prices to be a sign of bank rates being in concert with the natural rate. This section concludes with an exposition of the Taylor Rule, and how it fits within a Wicksellian framework.
A detailed survey of Hayek’s objection to price-stability will then be given which builds on the work of Parts I and II, but that adds emphasis on the role of interest rates.
I then offer the concept of the ‘neutral rate of inflation’ – a rate of price-level change which best holds money neutral towards the trade of goods and services. This section then concludes by deriving Potužák’s (2017) Hayek-Taylor Rule (HTR); a monetary rule which has central bank’s target interest rates, as in current practice, but corrects for
Page 47 of 144
Hayek’s insight into Wicksell’s misjudgment of when real and natural interest rates are aligned.
Next is a look at the issue of the zero lower bound and an analysis of its implications for the HTR. Here I argue that under some circumstances (i.e. when the economy is not dynamically efficient) the zero lower bound (ZLB) may make more traditional NGDP growth targets favourable over the Hayekian stable money steam.
However, it will be stressed that this is the best of a bad situation, and I highlight the non-neutral effects of growing NGDP. I then look at how the simplest version of the
HTR can be modified to accommodate both level targeting and futures targeting, which could further aid in stabilizing the money stream.
While some more radical proposals to stabilize the money stream may be more ideal in the abstract, this Part will follow James Buchanan (2015). Any exercise in how to get from “here to there” we ought to start in the world we are in and with the institutions that are currently in place (ibid p.54). Therefore, the HTR should be considered as a viable option for central bank implementation as it would require relatively minor adjustments from current practice. And that, while admittedly imperfect, the HTR should still be seen as favourable over the status quo. However, Part
III will conclude with a discussion of Public Choice issues that are inherent in central banking, and therefore this opens the door to Part IV which will look at a more radical proposal – free banking.
Page 48 of 144
Stable Prices and the Natural Rate of Interest
Wicksell (1898, 1935) seems to be one of the first economists to clearly and systematically draw a connection between the markets for money and the markets for capital. He noted that the equilibrium price in the loanable funds market would be the market clearing interest rate (Wicksell 1935, p.193). Such a rate ought to hold money neutral through time as people only borrow what others wish it save. It is this rate that provides intertemporal coordination, and which is now known as the natural rate.
Furthermore, Wicksell noted the relationship to the rate of interest charged by banks and the total money supply. As Horwitz (1996, p.300) further explains: “it is on the banks’ balance sheets that we see the intersection between the markets for time and money.” However, in the world we live in where new money is created through loans, changes in the money supply can mean changes in the lending interest rate that don’t necessarily conform to peoples underlying time preferences.
Wicksell understood that demand for credit, while linked with the demand for money, is not itself the same as demand for money. If new money is created without first new loan demand, then interest rates set by banks will fall as the supply of loanable funds shifts outwards. New loans are made, and as Wicksell (1935, p.190) pointed out, “he who borrows money at interest does not as a rule intend to keep it, but to exchange it at the first suitable opportunity for goods and services”. This newly created spending on goods and services – what we would now call an outward shift in aggregate demand – will cause the price level to rise; a sign bank rates are below the natural rate.
He concluded as a general rule that an increasing price level is always a signal that the actual rate of interest which banks are charging for loans is divergent from the natural Page 49 of 144 rate (ibid 1898, p.88), and thus the economy will experience monetary disequilibrium and inflation. Neutral money is thus established only with a stable price level and so “it is the obligation of the banks to maintain the rate of interest in agreement with the normal or real rate of interest” (ibid 1935, p.201).
John Maynard Keynes explicitly laid out an argument for price-level stability in his “Tract on Monetary Reform” (2013 [1923]), and by the time he published “A Treatise on Money” (1971 [1930]), Keynes seems to be clearly influenced by Wicksell. The latter work Keynes’ argues that a stable price level is the best way to insure “preservation of a balance between the rate of saving and the value of new investment” (Keynes 1971
[1930], p.220).
F.A. Hayek (whose thought also in many ways followed from Wicksell, as will be shown further in the next section) clearly noted the Wicksellian nature of the Keynes thought throughout this time period: “It is true that in this attempt to establish a direct connection between a divergence between I and S, or what amounts to the same thing, a divergence between the natural and the money rate of interest, and the changes in the price-level, Mr. Keynes is following the lead of Wicksell” (Hayek 1931, p.294).33
As Leijonhufvud (1981, p.160-164) has pointed out, in “Treatise” Keynes’ goal is to apply Wicksell’s natural rate of interest as an explanation for deflation (whereas
Wicksell himself only wrote about inflation).In the opposite scenario laid out by
Wicksell, if bank loans contract and thus shrink the total money supply without a corresponding change in demand for loans (i.e. an inward shift in aggregate demand), prices will have pressure to fall as there is less spending in the economy. Under this
33 The conclusion of Hayek’s thought here will be important for the following section: “… but it is just on this point that … Wicksell has claimed too much for his theory” (Hayek 1931, p.294). Page 50 of 144 scenario Keynes deduced the bank interest rate is above the natural rate. Thus, Keynes gave us a detailed explanation of the other side of the Wicksellian coin.
Growing out of the Wicksellian-Keynesian tradition, the general macroeconomic consensus now is that central banks should accommodate any change in money demand with newly created money supply. In other words, all forms of price-level movement tend to be seen as harmful, and the natural rate of interest has become synonymous with “the equilibrium real interest rate consistent with price stability” (Amato p.1).34
Therefore, assuming central banks are influencing interest rates,35 if the price level is increasing, the Wicksellian assumption is that the central bank has necessarily pushed interest rates below the natural level, whereas if prices are falling, the central bank is holding rates above the natural level. Only when prices are stable is the actual rate on par with the natural rate.
How this plays out is optimal monetary policy becomes “successfully stabilizing inflation around a low average level” (Svensson 2002. p.1). This currently held mainstream position, which is often called “New Keynesianism,”36 in many ways
34Leijonhufvud, writing in 1976 (1981, p.133), claimed that after Keynes’ “General Theory” (1936) the economic profession largely stopped concerning itself with Wicksell and the natural rate. However, by the 1990’s the Wicksellian line of thought can clearly be seen back in the midst of mainstream macroeconomics (i.e. Taylor 1993, Clarida et al. 1999; Woodford 2003) 35For a more detailed explanation of how central banks “control” interest rates – the transmission mechanism in which interest rates affect the money supply and the price level – see Mahadeva and Sinclair (2011), and Hummel (2017). 36 The name “New Keynesian” is given because the stress they place on nominal price rigidities as Keynes did, but at the same time base their analysis on “frameworks that incorporate the recent methodological advances in macroeconomic modeling (hence the term “New”)” (Clarida et al. 1999, p.1662). However, there is much overlap with Monetarist thinking in there as well such as the stress of only short run effects of money injections, and hence no long run Philips curve, so perhaps the term Friedman-Keynes Synthesis would be appropriate as well, or as Ball and Mankiw (1994, p.9) put it, New Keynesian’s “could just as easily be called “new Monetarists””. However, for our discussion here, the monetarist label does not fit our level of analysis, as classic monetarists such as Milton Friedman had little use for Wicksell’s concept of the natural rate. While it is true many monetarists believe that a stable price-level is the most desirable macro goal as well, their explanation as to why relies much more heavily on the Page 51 of 144 harmonious with the hub-and-spoke model put forth is Parts I and II. They recognize that sticky prices mean price level movements can lead to unemployment and an
“inefficient dispersion of relative prices” (Carney 2013, p.5). In fact, the core of the New
Keynesian policy position is said to be that “temporary nominal price rigidities provide the key friction that gives rise to non-neutral effects of monetary policy” (Clarida et al.
1999, p.1662). However, while there are similarities between these two viewpoints, there are also subtle but important differences. Differences which should become further apparent as this section continues.
The Taylor Rule
While some economists (for example Wray 2007) still contend that the authorities need full discretionary power over policy instruments, since Henry Simons’ famous 1936 paper, a growing body of argument suggests that central banks could best achieve their goals by being constrained to rules. Building off Simons (1936), economists have identified three problems facing any central bank which lead to a conclusion in favour of rules over discretion; the knowledge problem, the public choice problem and the dynamic inconsistency problem.
It was F.A Hayek (1945) who first outlined the insurmountable task of centralized knowledge collection in a decentralized system. A knowledge problem of this sort was famously put in context of monetary policy by Milton Friedman (1960, 1969), and more recently by Beckworth and Hendrickson (2016), and Beckworth (2017).
quantity theory of money, and less on the loanable funds market (as in Wicksell, Keynes and Hayek) and so their arguments will not be further discussed here. (For more on these lines of thought see Leijonhufvud 1981, Yeager 1991; De Long 2000). Page 52 of 144
Central banks inherently lack the real time data to discern the underlying features in the economy. Despite the technically sophisticated forecasting models available, long and variable lags still exist between the time and magnitude of real changes in the structure of the economy and the time the central bank can know and understand these changes.
This means that despite their best efforts, discretionary central banks may only be able to react when it is already too late, or worse, react in a way which is actively harmful for the economy.
Furthermore, as forcefully argued by Buchanan and Tullock (1999 [1962]), private interests of government officials, under certain institutional arrangements, can often misalign state goals with overall public welfare. Brennan and Buchanan (1981), and more recently Murphy (2013) and Salter (2017), have elaborated as to how this can apply to central banks. There can be pressures, institutional or otherwise, that influence central bankers to promote policy which is sub-optimal for overall macro-stability. As
Salter (2017, p.446) has made clear: “real-world monetary-policy decisions are made by imperfectly rational agents and imperfectly altruistic central bankers for an imperfectly rational public.”
In short, monetary theory can sometimes implicitly assume central bankers are
“benevolent and omniscient” philosopher kings (Sumner 2012, p.5), however this assumption operates outside of reality in important ways in which knowledge and public choice problems make difficult (if not dangerous) to ignore. But even if the benevolent and omniscient assumptions are not completely invalidated by knowledge problems and public choice concerns, expectations play a big role here in favouring rules over discretion as well. A large part of announcing simple rules “enables a skeptical public to monitor what the central bank is doing, and to evaluate whether it is fulfilling its
Page 53 of 144 proclaimed policy” (Frankel and Chinn 1995, p.319). In this way economic actors can plan and coordinate with a reasonable expectation of further central bank actions
(Taylor 1993, p.196). If, on the other hand, the policy itself is uncertain, then businesses must devote resources away from production and towards speculation on future monetary conditions (Simons 1936, p.3). And furthermore, absent explicit and binding rules, central banks preferred course of discretionary action may change overtime which in the long run can be self-defeating (Carlstrom and Fuerst 2002, p.2; Frankel and
Chinn 1995, p.319). Gains can be made therefore, from convincing firms and actors within the economy that because the central bank will not be able to deviate from its rules even if it wants to, the central bank is prevented from undermining its long-range goals for short-term results. This solves what is often referred to as the dynamic inconsistency problem, first outlined by Kydland and Prescott (1977) and expanded by
Barro and Gordon (1983).37
Today most central banks roughly follow a rule by restraining themselves to achieving certain goals – usually defined as low at stable inflation.38 How they attempt to achieve this goal varies from country to country, but it is largely assumed that most banks follow and track certain macro variables in a formulaic way, at least as a guide to policy, if not a fully mechanized rule (Taylor 1993, 2007). The policy instrument of
37 Beyond the authors cited directly in this section, Hendrickson and Salter (2015, p.2) also list and agree with a subset of literature by the likes of James Buchanan, Leland Yeager and others who endorse – and give further arguments for – rules over discretion. 38 For example, in practice the European Central Bank (ECB) currently targets “inflation rates of below, but close to, 2%” (European Central Bank 2016). The United States Federal Reserve System “judges that inflation at the rate of 2 percent… is most consistent over the longer run with the Federal Reserve's mandate for price stability” (Board of Governors of the Federal Reserve System 2015). And the Bank of Canada notes that is goal is “sustained economic growth, rising levels of employment and improved living standards,” and “the best way monetary policy can achieve this goal is by maintaining a low and stable inflation environment” (Bank of Canada 2014). Page 54 of 144 choice for New Keynesians and most current central banks is the short-term interest rate (ibid). When a central bank chooses to adopt a more expansionary monetary policy because, say, it predicts downward pressure on prices, it increases the monetary base through open-market purchases of securities until short term interest rates low enough to provide the amount of monetary stimulus which would hold the price level stable
(Sumner 2013, p.10).
Economist John Taylor (1993) proposed his now famous rule, not at first as a prescriptive rule, but as an approximation of what he thought the US central bank was following. Nonetheless, since 1993, this rule (or more generally, rules of this sort) have become a normative prescription as well, to be the specific rule which the “game” should be played under. The Taylor rule specifies a nominal short-term interest rate a central bank should target in response to observed or predicted values of inflation and the output gap (McCallum 2000, p.1). It was first outlined in Taylor (1993, p.202), and can generally be abstracted to the following formula:39
(1) iCB = r* + π + θπ(π − π*) + θY(Y − Y*)
The parameters (θπ and θY) should be chosen depending on the sensitivity of aggregate demand to interest rates (Taylor 1993, p.207). And (as Taylor did) it is generally assumed to be 0.5 for both (ibid p.202).
39 Where iCB = choice nominal interest rate, π*= the inflation target, π= actual inflation, r* = natural rate of Interest, Y = current real output and Y* = natural (potential) output. Where θπ and θY are parameters set to the responsiveness of the nominal interest rate to inflation and to output. Page 55 of 144
Implied by the term θπ (π − π*), is what is now known as the “Taylor principle”, which states that the central bank interest rate needs to respond to inflation in a more than a one-to-one ratio for monetary policy to be effective via the interest rate mechanism (i.e. θπ > 0). In other words, for central bank rates to have any effect on the real economy they have to more than passively adjust their rate to the sum of r* + π
(Clarida et al. 1999, p.1663; Svensson 2002 p.2; Sumner 2012, p.8). For example, if the central bank raises rates more than one-for-one with expected future inflation, this should depress spending in the economy in the short run, represented as a movement along the IS curve, and therefore slow down inflationary pressure as well according to the NK Phillips curve (Potužák 2017, p.3).
The Taylor rule remains the cornerstone of modern central bank policy
(Orphanides 2001; Svensson 2002; Beckworth and Hendrickson 2016). As Taylor himself (1993, p.200) put it, having a central bank target interest rates to achieve stable prices “seem to work well.”
However, this assumes two points of contention. First, following Wicksell, it presumes stable prices always means neutral money. This, given the various conclusions in Parts I and II, should be seen with great skepticism. But second, and more pragmatically, it supposes that any central bank following a Taylor rule is a “benevolent and omniscient philosopher king” (Sumner 2012, p.5). It assumes central bankers have no other goals or objectives aside from diligently following their rule, and it assumes they instantly and accurately have all the information (i.e. natural rate of interest, inflation rate, output gap) to do so. In what follows I will outline where Wicksell went wrong with thinking stable prices always mean neutral money, and along the way, the assumptions of benevolence and omniscience will be relaxed as well.
Page 56 of 144
Price Stability versus Hub Stability
While Wicksell and the New Keynesians have championed price stability,40 other economists have noted (Hayek 1933, 1935; Selgin 1988, 1991; L. White 1989; 1999;
Horwitz 1996, 2000, W. White 2006, for some examples) that this goal of stable prices - while adequately addressing hub movement – fails to fully allow for spoke movements.41 Hayek (1984 [1928], 1933, 1935) in particular, picking up on the
Wicksellian analysis, agreed that in some cases neutral money could mean a stable price level, noting that under certain circumstances the rate of interest which remains neutral in its effects on the prices of goods will tend neither to raise nor to lower them (Hayek
1935, p.24). However, where Hayek diverged from Wicksell was his observation that a stable price level would only hold money neutral in the special case of a static economy.
So long as annual output was unchanging the Wicksellian framework outlined above is correct, however, this does not hold in a growing economy.
More specifically, where the Taylor rule and New Keynesians in general appear in harmony with a Hayekian framework, is the view that price level should remain constant in the face of a velocity shock. In other words, changes in the Cambridge k – or what we could call “liquidity preference” – should not result in a change in P (Potužák
2016, p.2-3). If velocity is rightly defined as V = 1/k, then the proportion of income held as money is inverse to the speed at which money circulates through the economy.
40 In line with footnote 36, we see another similarity between the New Keynesians and Monetarists. While not a major part of the story told here, it should be noted again that stable prices were generally seen same light by the Monetarists as well. For examples, see Fisher (1933), Simons (1936), Friedman (1959, 1984) and Yeager (1986). 41 Selgin (1995) gives a fuller historical picture of the economists who have argued against stable prices. Page 57 of 144
Because it is a variable which affects money demand, all else equal, a change in k would lead to undesirable fluctuation in aggregate demand, resulting in unnecessary unemployment or distortionary inflation (depending on the direction), which means the real interest rate has diverged from the natural rate.
However, it would be erroneous to conclude here that because changes in k can move the price level, nothing else can cause the price level to move. In fact, as outlined in detail in Part II, when output is growing the price level can fall without any effect to aggregate demand. Wicksell and the New Keynesians have confused sufficiency with necessity; an interest rate gap is sufficient to move the price level (from where it otherwise would be), but it is not necessary. Hayek argued that this meant the alignment of actual and the natural rate of interest would only be truly consistent with a decreasing price level in a growing economy, as he noted:
Given a general expansion of production, the maintenance of equilibrium requires a corresponding reduction in prices, and in this case any failure of prices to fall must give rise to temporary disruptions of the equality between supply and demand. (Hayek 1984 [1928], p.74)
This is because the Cambridge k is not all that drives money demand, income also plays a role (Potužák 2016, p.2). If real money demand is described as:
(2) Md/P = k(i,x1,x2… xn)Y
Page 58 of 144
Then we can still see shifts in Md even when k (and therefore, V) is constant.42 If
P is to again remain stable as Wicksell and the Taylor Rule would prescribe, then there must be an increase in the money supply (assuming no change in velocity) even in the face of output growth (Y). But this monetary expansion would lower the actual rate of interest below the natural rate (ibid). Even though the price level may not rise in nominal terms, it will rise compared to what equilibrium would require. In this way an economy can experience the pain of hub inflation without a rise in the general price level.
This is important not only because of the reasons outlined in Part II, but also because only when the hub is stable, can spoke movements carry the information of underlying relative price signals through time. As Coulombe (1997, p.4) notes, “the price system does not play the same role as a vehicle of intertemporal information under different monetary regimes.” In a world absent hub distortions, the rise in the price of any given good must signal a relative increase. But if all prices are all increasing (even at a slow and steady rate) because of increases to the money supply, any intertemporal price comparisons “require a calculator and a knowledge of logarithmic or exponential functions” (ibid p.9). To put it another way, only when the markets for time and money are equilibrated, can price changes allow people use “money as an intertemporal unit of account” (ibid p.25). These signals are lost if policy is offsetting spoke movements with hub movements.
In other words, Wicksell and the New-Keynesians are correct in their concept of a
“natural rate of interest”, but they are incorrect in analyzing what would be the
42 Where i is the interest rate, x1 through xn are the many other variables which influence our portfolio decisions.
Page 59 of 144 economic conditions which would follow from a loanable funds market rate and the natural rate were in parity; their emphasis on stable prices means they believe the natural rate should be lower than it really is when output in growing. Hayek’s main contention with Wicksell thus boils down to how to tell if the actual rate banks are charging is in concert with the natural rate. Wicksell’s analysis implicitly assumes a static economy, but Hayek makes clear that economies are dynamic and often (we hope) growing as we learn new ways to get more from less. This means that when looking out in the real world for the natural rate, Hayekian will tend to look for a higher rate than
New Keynesians. As Hayek (1933, p.114) again explains:
The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price-level stable, is always lower than the rate which would keep the amount of available loan-capital equal to the amount simultaneously saved by the public.
To see why this is so we can revisit the Skoda example given earlier in Part II, where we imagine that new imports of car parts begin coming from China, allowing
Skoda to sell cars for a lower price than previous. Even if Skoda’s were the only good to drop in price, by aggregating all prices in the economy into the average price level, the price level would drop. To prevent this and hold the price level stable, the central bank would then want to lower interest rates to expand the money supply in order to offset this. But central banks cannot alter spoke node prices, they can only move the price level from where their tools allow: the money market. The new money will not just go into the car industry, it will instead flow into other sectors in the economy as well. Therefore, any attempts for a central bank to affect spoke movement, causes unnecessary hub movement (Hayek 1960, p.330). In general, when “excess or deficient supplies of money” exist, such as in this example, “the array of prices will be distorted, providing
Page 60 of 144 faulty information to entrepreneurs which will be manifested as malinvested capital”
(Horwitz 1996, p.297).
Furthermore, Koening (2013) uses both a two-period endowment model and a two-period competitive production model to conclude the debt deflation discussed in
Part II, occurs not with any deflation (as would be the worry for stable price advocates), but only with hub deflation, and therefore optimal policy ought to allow the price level to move opposite to output. Random fluctuation in prices is bad for debt risk and defaults, but systematic fluctuation in price levels – inverse to real output – helps spread risk between debtors and creditors, therefore reducing the risk of debt deflation
(Koening 2013, p.64).
Therefore, what we would need to keep money neutral is a stable MV – what
Hayek calls the money stream – such that a rise in Y precipitates a fully offsetting fall in
P (in other words, a productivity norm). In a growing economy, for money to remain neutral – and therefore for actual and natural interest rates to be aligned – we need to see price deflation (Potužák forthcoming, p.6). This is equivalent to allowing price level movement at the spokes.
The Neutral Rate of Inflation
Thus if the percent change in P must perfectly oppose the percent change in Y*, then it can be said that inflation rate which keeps the loanable funds market equilibrated and therefore money neutral, is the inverse of the growth rate in natural output, i.e. if GDP is growing at 3% per annum, then the “neutral inflation rate” is -3% per annum. For, as per Part II, if we treat aggregate demand as unit elastic (and assume
Page 61 of 144 no shift in AD), then a movement is the LRAS curve will push the price level and output in equal and opposite directions (Beckworth 2017, p.2).43
Given this, some further definitional work can be done; the “actual inflation rate” can be defined as just whatever inflation actually is, as observed by movements in the general price level. If inflation was measured as 2% last year, then the actual rate of inflation was 2%, as traditionally stated. But if natural GDP growth was 3% then, given what we know about the neutral rate, what could be called the “inflation gap” was 5%, as measured by deviation between the actual rate and the neutral rate. Thus, we now have two measures of inflation: the neutral and the actual, and when these two rates are not equal we can say there is an inflation gap.
The actual inflation rate seems to be the only one garnering any attention in contemporary academic literature as it is the rate placed into the Taylor rule. But the inflation gap matters too if we care about monetary neutrality, as this gap measures the economy’s deviation away from neutral money. To use Hayek’s terms, it measures how
“loose of a joint” we have (Hayek 1960 p.325); it quantifies the deviation away from a neutral money, or in other words, it measures disruptions at the hub of trade. And what this implies is that we could experience monetary disequilibrium (as measured by the inflation gap) even if the price level appears stable (i.e. if there was 2% GDP growth and
0% actual inflation).
To my knowledge, the neutral rate of inflation and the inflation gap have not been explicitly distinguished and named, yet a monetary policy which implicitly incorporates them certainly has many times been endorsed. In fact, that was one of Hayek’s main
43 See Figure 6 in Part II of this thesis (page 40)
Page 62 of 144 points in “Prices and Production” (1935), and it has since been pointed out again and elaborated upon by many, including Hutt (1979), Selgin (1988), Horwitz (2000),
Garrison (2001) and Potužák (2015). Implicit in all of these is the idea that monetary disturbances – a persistent inflation gap – is what drives instability, not necessarily actual inflation as current theory and policy would suggest (as in theory, actual inflation could equal neutral inflation, and this would mean there was no gap). A neutral monetary policy is thus one which targets the neutral rate of inflation and stabilizing the hub of trade, i.e. aims to have a 0% inflation gap. This is known as a Hayek’s MV rule
(Potužák 2016).
Wicksell is known for the natural rate of interest, or the “Wicksellian rate” which is currently built into the Taylor Rule. Given what has been explained thus far with price level movement, Hayek should be known for the neutral rate of inflation, the “Hayekian rate” and that too should be built into monetary rules if wish to minimize the effects of non-neutral money. This is the goal of the remainder of Part III.
Neutral Monetary Rules
Given what we know now of the neutral rate of inflation, what Potužák (2017) has done, is simply plug this rate into the Taylor rule. Many central banks seem to currently follow some version of a Taylor Rule; therefore, this seems the simplest, most pragmatic way to push monetary policy in a more neutral direction (ibid p.3). Recall that π* is the target inflation rate in the Taylor rule. As suggested above, the rate of inflation which holds money neutral is the opposite of economic growth. Potužák (ibid p.3) represents this
Hayekian rate as:
Page 63 of 144
(3) π*= –(yt* – yt-1*)
Where y* is the log of natural output, and assuming 0.5 for the parameters, as is common for Taylor rules, this leads Potužák to the following formula:
(4) iCBt = r* + πt + 0.5[πt + (yt* – yt-1*)] + 0.5(yt – yt*)
Which can further be simplified as:
(5) iCBt = r* + πt + 0.5[(yt + pt) – (yt-1 + pt-1)]
Given that p is the log of the price level, the term inside the parameter is the equivalent to the log of nominal GDP at time t, minus the log of nominal GDP in the previous period (Potužák 2017 p.5).44 Using the notation of McCallum (2000, p.6), (yt + pt) – (yt-1
+ pt-1) can be re-written as Δxt where McCallum uses “x” to be log of nominal GDP, and so Δxt represents its change from the previous period to the current period, i.e. it is the growth rate of nominal GDP:
(6) iCB = r* + π + 0.5(Δx)
44 In Potužák (2017), a number of algebraic manipulations are used to get to this final step. Therefore, readers are encouraged to look through all of Potužák (2017) for a fuller picture and explanation of how this formula was derived.
Page 64 of 144
This is what Potužák has dubbed the Hayek-Taylor Rule (HTR), which is a special case of a nominal GDP target, namely that the target rate of NGDP is 0%. This calls for any rate of change to nominal GDP other than 0% to affect the interest rate of the central bank. If NGDP is rising, that means inflation was not falling fast enough to offset economic growth – a signal that there is more money in the economy than is demanded to be held, and therefore the threat of inflation. Also note that because inflation is accounted for as its own term and “baked” into "x" as well, the Taylor requirement for the interest rate to change with inflation at a rate greater than one-to-one is preserved.
The Knowledge Problem
It is possible that many different models and rules could appear to lead to an outcome of neutral money, but if they assume perfect information on the part of the central bank, they may be fatally flawed. Therefore, failing to address the limits of a central bank's knowledge itself can lead to non-neutral money (Orphanides 2001;
Beckworth and Hendrickson 2016; Beckworth 2017).
With this in mind, as well as stabilizing the hub of trade, the HTR has additional benefits once we relax the assumption of omniscient central banks. One notable feature is that by relying on the variable x (NGDP) instead of its component variables of p and y, it requires less statistical data manipulation than otherwise. This may seem counterintuitive, as it may seem as though you first need to know inflation and real GDP to know nominal GDP, but in actuality is the reverse. NGDP is not built from p + y, but p
Page 65 of 144 and y are inferred from deconstructing NGDP.45 Another notable feature is that substituting the Hayekian rate of inflation into the Taylor rule removes the output gap from the formula (Potužák 2017, p.5). As Beckworth and Hendrickson explain (2016, p.7), the output gap is “the difference between the economy’s actual and potential level of output” and it is subject to “big measurement problems”. As, in reality, the current output gap for period t cannot be known with certainty until after the end of period t at best (McCallum 2000, p.4). This mean that any monetary rule which requires input information before it becomes available – such as the Taylor rule – may ultimately be non-operational (Orphanides 2001, p.965).
As Orphanides (2001) has shown, output gap measurements are being continually being revised, meaning even if a central bank can obtain output data in a reasonable time frame, it is likely incorrect, which would lead to unnecessary changes in short term interest rates. The HTR (and indeed, most nominal GDP target rules), being absent of real output and output gaps, means there is less room for central bank policy mistakes. Along these lines, if a central bank wanted to continue to target inflation, but simply ignore any good spoke movement, it’s not clear how it could get the real time data to know where the price movement was coming from (Beckworth 2017, p.2;
Murphy 2013, p.28), leaving such a potential policy ripe for error.
Targeting nominal GDP has another advantage over traditional inflation targets.
Inflation measures are highly subjective and tend to be highly inaccurate (Sumner 2012, p.15). A limited basket of goods does not accurately represent one half of every
45 As Beckworth and Hendrickson (2016, p.3) point out “It is wrong to think of nominal GDP growth as the sum of inflation and real GDP. Nominal GDP is a unique economic variable that is estimated independently of estimates or real GDP. In addition, it is the GDP deflator that is calculated as the implicit variable, not nominal GDP.” Page 66 of 144 exchange, i.e. the value of money. Therefore, movement in the CPI (or lack thereof) may not actually capture changes at the hub of trade (Fernández 2005, p.62-63).46 By contrast, as Sumner (2012, p.16) notes that although there are errors in the measurement of both inflation and NGDP growth:
NGDP is a more objectively measured concept. The revenue earned by a computer company (which is a part of NGDP) is a fairly objective concept, whereas the price increase over time in personal computers (which is a part of the CPI) is a highly subjective concept that involves judgments about quality differences in highly dissimilar products.
This is not to say these types of monetary rules are perfect, there are still variables that the central bank is required to know, such as that natural rate of interest
(Potužák 2017, p.5). However, by eliminating at least some unknowns from central bank calculation, on top of increasing monetary stability, it also reduces the burden of complete knowledge on the part of the central bank.
Dynamic Efficiency and the Zero Lower Bound
Now we have a pragmatic and operational central bank rule, the HTR, which is simply a Taylor rule calibrated for a Hayekian inflation target. However, given the
46 This is a subtle, but crucially important point. While we have claimed that money’s price is the reciprocal of the general price level, no actual price level indexes measure anything like “all prices”, usually they are restricted to a small basket of consumption goods (Fernández 2005, p.62). This means that the theoretical price level could fluctuate in ways unobserved by central banks metrics. For example, Rouanet (2017) tells the story of how from the Cantillon effects (the way in which new money enters the economy in a specific time and place), created by a positive inflation gap, can lead to asset bubbles that are not properly picked up in standard price-level measures. Some central bankers (Hampl and Havránek 2017) have argued to expand price indexes to include more assets, such as housing, however, in theory, to get a most accurate picture of money’s price, an index would need to include as many goods bought and sold for money as possible. Page 67 of 144 simplicity of this formula, one thing jumps out as abundantly clear. Assuming nominal
GDP growth is on target of 0% growth per annum, for the central bank's short-term rate to be positive, r* + π must be positive (Potužák 2017, p.4). And given that economic growth is the inverse of π, a growing economy calls for π to be negative (i.e. spoke deflation). This means that r*>g (where “g” represents real economic growth) in order for rates to be positive. If a monetary rule prescribes a central bank to set its short-term rate below zero, then we have the well-known problems of the zero lower bound (ZLB).
As negative inflation in an HTR would mean a generally lower central bank rate than a Taylor rule (Potužák 2017, p.6), demand shocks may push monetary policy closer to or onto the ZLB than otherwise. Given that the monetary rules in discussion use the short-term interest rate as their mechanism for affecting aggregate demand, interest rates are the tool for money supply expansion, then the Taylor principle is violated at the
ZLB because the rate can no longer move more than one-to-one with inflation (Potužák
2017, p.3).
This could be problematic for implementing the HTR, for as (then head of the
Bank of Canada) Mark Carney, pointed out (2013, p.13), in recent years the idea of the
ZLB has gone from a theoretical curiosity to a reality “with frightening speed.” And as
John William, chair of the Federal Reserve Bank of San Francisco has remarked (2017, p.5) “we are now living in a low r-star world.” Indeed, recent trends seem to indicate a steady fall in the natural rate of interest (Eggertsson et al. 2015; Williams 2017), which is often attributed to “secular stagnation” – the long and stable rises in the propensity to save, which are not matched by new investments (Summers 2013). With secular stagnation driving long term trends, a large enough demand shock could push the natural rate of interest dangerously low or even negative (Williams 2017).
Page 68 of 144
Therefore, it could be said that some form of built in inflation may be warranted in a monetary rule, as the best of a bad situation.47 If we are stuck in a secular stagnation world with a low r*, we may need to tolerate the distortionary effects of monetary injection to keep interest rates above zero. If this is truly the case, then we ought to set up an inflation gap target, not an actual rate target (as is currently standard practice),48 to keep monetary policy as close to neutral as possible, while remaining operational. But note that this simply collapses the HTR into a nominal GDP target; the inflation target turns into: x*-g. Where “x*” is the desired percent of inflation gap, chosen to cover variance of r* and g, plus perhaps a percentage point or two as a ZLB buffer, to satisfy our earlier condition such that now: r*+x*>g. To add this into the HTR we can first assume that implicit in the rule is the target of 0% NGDP growth, which can be made explicit:
(7) iCBt = r* + πt + 0.5(Δxt-0)
From here, it is now clear that raising the target above zero to some sufficient level, will buffer our rule from the zero lower bound, this simply means Δx* is the equivalent to the desired growth trend of NGDP.49 If we replace the zero and abstract to
47 However, as Potužák notes (2017, p.6), the type of demand shock which effects r* would have be far less likely to happen in the first place if NGDP was successfully held stable (i.e. not allowed to fall) and therefore had more countries had in place a HTR we may not live in this low r* world. Furthermore, along with Potužák, others (Taylor 2007; Selgin et at. 2015; Beckworth 2017) have noticed that negative demand shocks are usually preceded by above trend NGDP growth (in other words, a “boom”), further suggesting that a large exogenous demand shock is unlikely with stable NGDP, and therefore the ZLB ought to be much less of a worry under a HTR than an inflation target, even though interest rates may generally be lower in normal times. 48 See footnote 38. 49 Sumner (2013, p.9) suggests 3-5 percent growth in NGDP per year would be ideal. Page 69 of 144 let Δx* become the target NGDP growth rate, then the HTR becomes McCallum’s NGDP
Target (2000, p.7), which McCallum writes as follows:50
(8) iCBt = r* + 휋t +0.5(Δxt - Δx*)
Under this more generic rule, productivity shocks are still offset by an opposite change in the inflation rate (Sumner 2012, p.15), however now the economy will have to endure mild hub inflation, and its disruptive effects, in order to maintain a central bank rate above the ZLB. NGDP targets (where the target is > 0) have become increasingly popular lately, endorsed by McCallum (1987, 2000), Sumner (1989, 1995, 2012, 2013)
Beckworth (2008, 2014, 2016, 2017), Murphy (2013) and Koenig (2013), as well as Hall and Mankiw (1994).51 And as Beckworth has pointed out (2017, p.5), other prominent economists have recently endorsed NGDP targeting as well, such as Michael Woodford and Christina Romer. While it does have many improvements over standard price stability, and standard Taylor rules, it should be noted that, given the framework outlined here, any NGDP target greater than zero can only be “ideal” when the economy is not dynamically efficient, and otherwise the HTR should be preferred.
50 CB McCallum presents his NGDP target as: i t = r* + 휋t -0.5(Δx* - Δxt), however I have simply rearranged the end term to have the parameter be positive. This is simply to better match the format of the Taylor Rule and its positive parameters. 51 See Potužák (2017, p.2) for a more complete list of papers advocating nominal GDP targeting. Page 70 of 144
Level Targeting
The HTR is a simple and elegant way to incorporate a hub-and-spoke view of money into traditional New Keynesian monetary policy, while at the same time ridding the more traditional Taylor rule of the problems associated with output gap measurement. However, to further avoid monetary disequilibrium, the HTR can be adapted to target an NGDP level instead of a rate. To see why this would be beneficial recall Part II as to why prices were often sticky: fixed nominal contracts. In fact, Hayek
(1935, p.131) claimed that all long-term contracts would need to correctly anticipate future price movements for money to stay neutral over time. Hayek was skeptical that this was possible, and so he felt it unlikely that any monetary policy could truly be neutral. While he may ultimately be correct on this issue, level targeting should at least quell some Hayekian skepticism, at least regards to the issue of correct anticipation on long term contracts.
Targeting the growth rate of a particular variable – be it the price level (inflation),
NGDP or the money supply – means that the uncertainty of prices, output, or money, is increasing with time, and this uncertainty would rise without limit (Gaspar et al. 2007, p.8). With current inflation targets, (or even if a central bank was to implement an
NGDP rate target), past “misses” do not affect future central bank decisions. Carlstrom and Fuerst (2002, p.3) call this “base drift”52
52Gaspar et al. (2007, p.9) have measured the actual base drift of various regions throughout the 2000’s. While Canada, Sweden and the Euro Zone, are all relatively disciplined central banks, all have experienced substantial base drift, with Sweden seeing a drift of 4 base points, and Canada and the Euro between 2 and 3.
Page 71 of 144
The base-drift problem with inflation targeting leads to a great deal of uncertainty about what the price level 5, 10, or 30 years in the future will be. The central bank may miss its inflation target by a very small percentage in some years, but if these misses are not offset, they will accumulate and may become quite large after 30 years (ibid).
On the other hand, level targeting, if credible, is absent any long run base-drift because the central bank will have to make up for any short-term overshoots or shortfalls. This means much less uncertainty of long time horizons, which is crucial for financial planning with things such as home purchases, retirement savings, or other long-term commitments (Gaspar et al. 2007, p.10). In short, level targeting “essentially forces a central bank to do what it says it is trying to do” (Sumner 2012, p.11).
Some economists (for example, Clarida et al. 1999) have noted potential problems with level targeting, for the rather intuitive reason that while in the long run level targeting keeps stability, in the short run there could be very volatile swings in prices (ibid p.1700). The intuition is that level targeting could be metaphorically like running someone over with your car and then backing over them afterwards to try and undo the damage. If this is the case then letting bygones be bygones might actually be the better option (Gaspar et al. 2007, p.8). However, as Svensson (1999, p.11-14) has shown, if we accept a version of rational expectations, level targeting leads to less short run variation. Rational expectations act as “automatic stabilizers”, meaning that if economic actors expect corrections to level deviations to occur, they will anticipate the central bank's future actions, and therefore mitigate the initial impact of deviation (ibid p.15). In other words, believing that central bank “mistakes” will credibly be undone,
Page 72 of 144
“gives firms a reason to moderate the current adjustment of its own price” (Gaspar et al.
2007, p.18). This means that the coordination problems will be significantly reduced.
One of the benefits of NGDP targeting already discussed is that it requires a central bank to obtain less real time aggregate data. Along these lines, level targeting seems to have the added benefit performing well even in models with imperfect information. Aoki and Nikolov (2004, p.35-36), show that level targeting outperforms rate targeting when both the central bank and private sector are unsure (but can “learn”) the slopes of the IS and short run Phillips curve, and natural interest rate. This suggests that the benefits of a level target are further enhanced by introducing some uncertainty into the models (Gaspar et al. 2007, p.33).
Level targeting also helps avoid problems involving the zero lower bound (ZLB).
The stabilizing effect of rational expectations or adaptive expectations to a level target mean that nominal interest rates will not have to go through the same adjustments as would be predicted with a rate target. This means that the likelihood of hitting the ZLB is reduced (Gaspar et al. 2007, p.21). Therefore, with a level target it is likely that the target NGDP growth rate could be 0% or closer to 0%.
Thus, a NGDP level target in favour of a growth rate target, will work to better remove long run uncertainty, avoiding excessive market discoordination created by long term nominal contracts, as well as anchoring expectations and increasing central bank credibility. This can be written by replacing the growth rate, with an indexed level.
Simply fixing the nominal GDP at a base year to an index of 100 (represented as xL) and committing to maintain that level, instead of a growth rate, Potužák’s HTR can be turned into a level target:
Page 73 of 144
(9) iCBt = r* + 휋t +0.5[(XL*t - XLt-1)/XL*t]
Or simply:
(10) iCB = r* + 휋 +0.5(ΔXL/XL*)
Which looks the same as formula 6, however, now interest rates are responsive to changes in the absolute level, instead of being only responsive to deviation in rate of change, and we now use capital “X” as small “x” equals the natural logX. If the target
NGDP is indexed at 100 and in t-1 the NGDP level was, say, 102, then this would call for the short-term interest rate to rise by an additional 1%. As Sumner (2012, p.15) notes, such a rule would be excellent at “keeping ex post real rates closer to where they would have been if both lenders and borrowers had been equipped with perfect foresight.” This should be able to soften some Hayekian skepticism.
Forward Looking Rules
There is another problem with the central bank rules presented so far, again involving time. Imagine the economy is in a neutral equilibrium and faces a sudden demand shock, say, a change in velocity. Ideally the central bank would instantly react with a change in its short-term interest rate, however, given the speed at which knowledge of the change in velocity can be obtained by a central bank, and given our rule only reacts to variables in times t and t-1, instant reaction is not realistic. It is to be expected even if the rule is followed by a perfect central bank, exogenous shocks will still
Page 74 of 144 create short run hub movements from time to time. However, what if, while exogenous, the shock to V could be better predicted? If another term could be added the HTR level target to stem off undesired future movement, monetary disequilibrium could be further avoided. This could look as follow:
(11) iCBt = r* + 휋t +0.5(ΔXLt/XL*) +0.5[(XL*t - XLt+1)/XL*t]
Or again, using deltas, re-written as:
(12) iCBt = r* + 휋t +0.5(ΔXLt/XL*) +0.5(ΔXLt+1/XL*)
Such that XLt+1 is the NGDP level predicted to exhibit itself at one time period in the future. Under this iteration of the HTR the rule prescribes central banks to both adjust the short run interest rate to make up for past mistakes, and to adjust the short- term rate to avoid future mistakes.53 To understand the importance of incorporating future expectations into the rule, take the following example of the US Federal Reserve in 2008, from Sumner (2012, p.10):
A good example of the Fed’s failure to target the forecast occurred in the September 2008 Federal Open Markets Committee meeting, which occurred right after Lehman Brothers failed. The Fed decided not to cut interest rates,
53 It should again be noted here that the 0.5 parameters are chosen only to fit the original Taylor Rule. No judgment is given here in this thesis as to whether or not this is optimal. To represent the more abstract forward looking Hayek-Taylor level target, it could be written as:
CB L L L L i t = r* + 휋t +α(ΔX t/X *) +β(ΔX t+1/X *)
Further research, specifically to run simulations, would be instructive here to find the optimal alphas and betas. Page 75 of 144
keeping the federal funds target at 2 percent, where it had been since April. It cited equal risks of inflation and recession. It is easy to understand the recession worries; we had been in a recession since December 2008. But inflation? On the day of the meeting the five-year TIPS spread (a market indicator of inflation forecasts) had fallen to 1.23 percent, well below the Fed’s 2 percent inflation target. If these indicators called for easing, why did the Fed stand pat? It turns out that inflation over the previous 12 months had been well above the Fed’s 2 percent target. The Fed was responding to past data, not forecasts. It was like trying to steer a car while looking only in the rearview mirror.
This example clearly shows the importance of a forward looking monetary rule or at least the potential dangers of not doing so. Incorporating forecasts into the model circumvents the issue of lags in data collection, as in theory, new information could be brought into the model in real time. However, this brings about a new onus onto the central bank, for if their future forecasts prove inaccurate, such a rule could do more harm than good by unnecessarily fluctuating the central bank’s interest rate, such as was argued with the Taylor rule and the output gap.
Any given central bank could try and forecast internally, but they may lack the incentives to get it as accurate as possible. Markets perform best when the market participants have “skin in the game.” This means that one-dollar, one vote should produce better results than one person, one vote (Sumner 2013, p.11). To put it another way, as opposed to only a small group of central bankers to voting on the best policy, people who must “put their money where their mouth is”, are more likely to only bet when they have (what they perceive as) good information and pay a financial penalty if their information proves incorrect. Central bank economists to not face these corrective market feedbacks.
It is for this reason, Sumner (1989, 1995, 2013) has come up with the idea of an
NGDP futures market. While there exists market forecasts for inflation, currently there
Page 76 of 144 are no such markets for NGDP (Sumner 2013, p.10).54 Therefore a central bank (or any government agency), instead of forecasting themselves, could simply open up their own futures market, where they would “offer to buy or sell unlimited quantities of NGDP futures at a price equal to one plus the expected GDP growth rate… when the contracts mature a year from today, their value will equal the ratio of next year’s NGDP to current
NGDP” (ibid p.11). Under this situation if the economy was running hotter than expected, then those who took the long position would make money and those who took the short would lose, and if economic growth was slower than expected profits would be reversed (ibid). Thus, speculators would have an opportunity and an incentive to indirectly influence current monetary conditions based on their future predictions; market expectations would be helping to guide policy (Woolsey 2015, p.148). As Sumner
(2013, p.13) continues his story of the great recession:
By late 2008, it was obvious to market participants that NGDP growth during 2008–9 would be far lower than the Fed would have liked. Indeed, NGDP fell by 4 percent between mid-2008 and mid- 2009—the steepest decline since the Great Depression. Asset prices were falling sharply as investors reduced forecasts of future nominal growth and future asset prices. Yet, even though financial- market participants saw what was happening, investors had no way to profit from that information. Markets were unable to correct the Fed’s monetary policy errors
Sumner believes that such a futures market could eventually mostly replace the central bank altogether (which will be discussed in more detail below), but in the market's beginning, it could simply inform the central bank, giving real time data for the
54 As of the time of this writing, Sumner and Beckworth (2017) have just announced that the Mercatus Center at George Mason University will be sponsoring the development of an NGDP futures market through the UK-based predictions market, Hypermind. The market is currently operational, however there is no option yet to speculate with actual money. Page 77 of 144 final term of the future looking HTR (the last term of formula 12). Given the worry of error influenced rate changes, central banks could open the futures market and simply observe the results, compare to their own forecasts, and see which performs best over, ideally, over a significant period. After there is adequate data on the acceptable performance of the futures market, a central bank using an HTR, or any general NGDP target, could add the future looking parameter to their rule.
Further Public Choice Concerns
Given a world of rule following central banks, the HTR adjusted to level targeting and future targeting seems the best that can be achieved – assuming the goal is monetary equilibrium. I had to started with the assumption of central bankers who acted like benevolent and omniscient philosopher kings, and it was shown how the case for the HTR was further strengthened when the omniscient assumption was relaxed. But now it is time to tackle the benevolent assumption. As was discussed already, precommitment to a monetary rule can restrain self-interested political actors.
Following any monetary rule, such as the HTR, in a perfectly undeviating fashion would reduce the job of central banking almost exclusively to data collection, inputting the data into the formula, and influencing interest rates as per rule output (Svensson 2002 p.3). However, it seems in today’s world most, if not all, central banks prefer not to go this extreme to give themselves increased flexibility and restrained discretion to outperform strict rule following (i.e. “flexible” inflation targeting). Unfortunately, there is no guarantee the right incentives are in place for them to do so.
Page 78 of 144
In what has been discussed so far, the goal of being pragmatic in trying to come up with rules which would be put in place with relative ease in modern central banking, was given high priority. However, now in discussing a world with “misbehaving” central banks, this pragmatism must be abandoned for more conjectural theory. This is because it is unlikely current monetary authorities will be willing to give up their roles as experts.
As even the developer of many of these proposals to further end central bank discretion,
Scott Sumner, has pointed out (2013, p.5), given current institutions, is hard to even imagine modern governments giving up their active roles in determining monetary policy. Therefore, while the HTR (or any NGDP target) would be seen as an improvement, from a hub-and-spoke perspective, we cannot realistically expect central banks to replace their economists with HTR following computers. In reality, such things as government and private interests can possibly misalign central bank goals with the overall public’s welfare (Salter 2017, p.447).55
Keeping in mind that we are now theorizing of monetary regimes which are less likely to be born out given current monetary institutions, Sumner’s solution to this benevolence issue is take his future taking a step further. As he lays out, once a futures market has been established a rule following central bank could be dissolved in favour of a fully automated process. Instead of merely using futures markets as simply another metric for the central bank to consider, the futures market itself would set policy. The proposal would be for a government agency to the control supply of base (as central banks do now), but the base would contract or expand via open market operations
55 For a review of literature pointing to examples of public and private interests historically entering into monetary policy decisions see Murphy (2013, p.27) and Salter (2017, p.447). Page 79 of 144 automatically in concert with the sale and purchase of NGDP futures.56 As Sumner
(1989, p.158) lays out in more detail:
For instance, suppose the monetary authority wished to target next quarter’s GNP at 400 billion pounds. In that case the central bank would offer to buy or sell unlimited quantities of a futures contract linked to (one-one billionth of) next quarter’s GNP, at a price of 400 pounds. If market participants expected GNP to rise above target, then they would buy GNP futures. These purchases would represent open market sales, and would continue until the money supply was reduced enough to bring the expected future level of GNP back on target.
Such a proposal could be implemented by computers instead of employees, thus further eliminating the worry of non-benevolence – that is incentive problems – with central bankers.57 Economics gives the good rule of thumb that a profit a loss system will contain more accurate knowledge than any group of individuals. Or as Salter (2017, p.447) puts it: “it is unwise to believe that a small group of policy makers, however intelligent and well educated they may be, can outplan the market.” Thus, Sumner's proposal would forgo central bank committees in favour of a more open decision- making process, where any speculator in the word who wishing to put their money down, will help make monetary decisions (ibid p.457; Sumner 2013, p.13).
While Sumner’s proposal is intriguing and somewhat radical, other economists have looked in a different, perhaps even more radical direction to propose a monetary regime which stabilizes the money stream and is robust to both incentive and knowledge problems. In what follows in Part IV – following many works such as L. White (1984,
56For a more detailed explanation of such a regime see Sumner (1989, 2013) and Woolsey (2015). 57 Some economists such as Murphy (2013) and Salter (2017) have argued that any set of monetary institutions which are under government control cannot fully abate themselves of these public choice concerns. Thus, they remain somewhat skeptical of Sumner's proposal. Page 80 of 144
1989, 1999), Selgin (1988, 1990, 1994, 1997), Dowd (1992), Horwitz (1992, 2000),
Sechrest (1993) and more recently Salter (2013, 2017), Murphy (2013) and Cachanosky
(2014) – the theory of “Free Banking” will be outlined as a possible way for money to remain neutral absent government or central bank intervention. Specifically, Part IV will present a graphical representation of free banking, and how in theory it avoids price level movement at the hub while allowing for price level movement at the spokes.
Page 81 of 144
Part IV - A Graphical Representation of Free Banking
Until the 1970’s, virtually no creditable economist theorized about money being completely supplied and managed by the market process alone. Even the most ardent market advocates such as Milton Friedman (1960, 1969) argued that money is distinct from other goods, and left to market forces, would be mismanaged. Indeed, in Parts I and II, I have argued that money does have features unique from all other goods, and that its mismanagement has more cascading consequences than the mismanagement of non-monetary goods. Money’s uniqueness does not necessary imply, however, that its supply is best left to governments, or that it requires special regulations.
It was F.A. Hayek who really started questioning the assumptions of money management which were pervasive throughout the profession. He began his booklet,
“Denationalization of Money” (1976) with the following insight:
As soon as one succeeds in freeing oneself of the universally but tacitly accepted creed that a country must be supplied by its government with its own distinctive and exclusive currency, all sorts of interesting questions arise which have never been examined. (Hayek 1990 [1978], p.13)
Trying to answer some of these questions, Hayek imagined that firms would, if legally allowed, issue currencies that had freely floating exchange rates with other such private monies. And this competitive process would incentivize these firms, by their own self-interest, to control their supply in such a manner as to make it “most acceptable to their users” (ibid p.92). He further conjectured that governments would at first continue to issue their own money but wasn’t optimistic about government’s long-term ability to stay competitive with private firms, and figured, in the long run, government currencies would fall from circulation entirely. Page 82 of 144
Admittedly, “Denationalisation of Money” was not an instant success at altering academic opinion of how money should be supplied. However, as the 1980s began,
Hayek’s work started to influence a new generation of economists such as Lawrence
White and George Selgin. Starting with L. White’s “Free Banking in Britain” (1984) and followed by Selgin’s “The Theory of Free Banking” (1988), the concepts of privately issued money and free banking were more fully developed.
While Hayek had envisioned freely floating fiat currencies, White and Selgin theorized about private notes of issue, backed by a single base money (likely a commodity such as gold), that would trade on par with one another. Using historical examples of relatively free-market banking (such as in periods in Scotland and
Canada)58 along with rigorous theory, the free bankers showed not only that money could be provided on the free market (in a different manner than Hayek proposed) but that this would have many beneficial macro-level outcomes that governments could only hope to achieve.
In contrast to the central bank rules proposed in Part III, in this Part, I attempt to analyse free banking as a possible way to stabilize the money stream. While the Hayek-
Taylor Rule offered a pragmatic way to influence current policy in this direction, the previous section ended on a more skeptical note of such a rule staying in place for long due to public choice concerns. Therefore, using primarily the works of Selgin (1988;
1990; 1994), L. White (1989; 1999) and Sechrest (1993) this Part will attempt to build a simple graphical model of free banking. While this would require a major overhaul in current monetary regimes, free banking may still be favorable to a system to
58 The Case Study, appended at the end of this thesis, also looks at Canada’s period of near free banking in more detail. Page 83 of 144 government created money, because of the potential avoidance of the knowledge and incentive problems inherently built into central banking discussed in the previous section. It will be argued that free banking can closely, albeit imperfectly, hold MV stable and thus mimic the ideal monetary system which Hayek (1928, 1933, 1935) first proposed.
First, I will paint a picture of fractional reserve free banking, which could evolve naturally from the Mengerian story told in Part I. Next, I will analyze the effects of a change in k and then a change in Y, to see if the desired results discussed in Part II can be predicted. I conclude by theorizing that free banking would indeed offset changes in k, holding MV stable and thus money neutral. However, it is less clear that free banking would have inflation (or deflation) perfectly offset income growth in the long run and may therefore actually come somewhat closer to the Wicksellian ideal of stable prices.
Nonetheless, the system should allow for mild spoke deflation in the face of economic growth, and thus keep money closer to neutrality than a common price stability target while avoiding the public choice issues discussed in Part III.
Money Market with Single Monetary Good
Menger’s story of preferential attachment and monetary evolution was shown in
Part I. It was argued that certain goods would be valued not only for the utility they could provide in direct consumption, but also for the utility they provide in ‘saleability’ or liquidity. Some goods have more prospective buyers than others, and these goods are therefore easier to exchange for something you need more in a pinch. This desire for
Page 84 of 144 liquidity creates a feedback loop where one good ends up becoming a perfectly liquid good, which we now call the medium of exchange or simply, money.
Often it is assumed a metal would be the first money, due to its natural qualities of durability, fungibility, and rarity. The assumption that it would be gold was used in
Part I and will be used again here for simplicity.
In such a simple system with gold serving as money, it can be assumed gold would still maintain other uses beyond just being the medium of exchange – jewellery, dentistry, electronics, etc.59 Following Lawrence White’s depiction in “The Theory of
Monetary Institutions” (1999, p.29), Figure 8, illustrates the supply and demand to hold monetary gold to the right of the stock of non-monetary gold. The demand to hold monetary gold schedule is decreasing, because when the price of monetary gold is higher
(inversely, the general price level is lower), less is needed to trade for goods and services. Traditionally the money market is conceived with a vertical supply curve of the stock of money (as I have done in Part II), however, with gold able to move from other uses into monetary uses, the supply of the stock of monetary gold is better conceived as sloping upward. Therefore, as L. White (1999, p.30) explains, “a downward-sloping demand curve for non-monetary gold items (such as candlesticks and jewellery) implies an upward-sloping supply curve for monetary gold.”
59 As already discussed, this assumption should hold for other metals and commodities as well.
Page 85 of 144
Figure 8
Figure 8 shows the diagram of the market (stocks) of gold and the market for monetary gold (which represents all money in the economy). Note that the price of monetary gold is represented as the inverse of the general price level. Where lower case “g” represents gold and lowercase “m” stands for money.
This is the simplest version of the Mengerian money market. In such a world where only one good functions as money, we can now look at how it would react to shocks which could cause hub-and-spoke movements. In what follows I will examine increases in the demand to hold money, first stemming from a change in liquidity preference (k) and an increase in output (Y). These are the two shocks identified in Part
II, which have potential to create hub-and-spoke deflation respectively.60
60 Given that inflationary pressures are merely the reverse phenomena, they will only be mentioned briefly through the remainder of this Part. Page 86 of 144
Response to a Demand Shift with a Single Monetary Good
If we start with the system in equilibrium we could then first imagine some exogenous event – such as a war or an unstable political regime coming to power – which systematically alters the liquidity preference of a money using population. For this example, we assume a more uncertain future will increase aggregate liquidity preference, and therefore people wish to hold more money as a portion of their wealth portfolio than previous. Figure 9 depicts the shift in the demand to hold money, and the corresponding shifts in supply.61
Figure 9
Figure 9 shows that as demand to hold money shifts right, equilibrium moves along the supply of the stock of money on Sm1 do to the stock of nonmonetary gold being converted, and shows the new quantity and price of money at point B. However, according to L. White (1999, p.32), because money is now priced higher than gold flowing into consumptive uses, mining will begin to flow directly into the minting of new coins and the stock of money will shift outward to Sm2. This puts the long run equilibrium with a quantity of money at point C with a price at its initial level.
61 As with Figure 8, Figure 9 was again recreated from Lawrence White (1999, p.32). Page 87 of 144
While quantity of the money stock increases (as gold is easily converted from existing jewellery and ornamental uses), the price of monetary gold also rises in the short run. In the long run, there will be a shift in the supply as well. This shift latter shift in the stock of monetary gold is from the increased flow of newly mined gold. There should eventually be no change in the general price level caused by fluctuations in demand. While having the long run completely reverse the short run shift, as White points out similar systems under an international gold standard have many historical examples and all seem to confirm this “price-level-stabilizing property” (L. White 1999, p.32).
How this process works in more detail is that in the short run, monetary gold becomes valued more highly than non-monetary gold and therefore miners would then be expected to take their newly mined gold straight to the mints instead of putting it to alternative uses (ibid). However, the long run equilibrium can only come about by an increase first in the price of money, which is necessary to signal to miners to produce more monetary gold. But it is this short term rise in the price of gold (fall in the general price level) which should be expected to have the negative economic effects of hub deflation. Therefore, in the face on a velocity shock with a single money in the economy, we should expect money to act as a loose joint in the short run, and only being alleviated as new supply enters the market over time.
Unlike what will be shown to be the case with a fractional reserve system, here whether the demand shock stems from a change in k or a change in Y is inconsequential because there is only a single money market for the shock to take place in. If the shock was caused by economic growth, to satisfy Hayek's MV rule, prices would need to be allowed to fall, however the mining of new gold will offset this. In either case, we see
Page 88 of 144 disequilibrating effects, which will not let money remain neutral. Luckily, what will be shown in the next section, money should be expected to continue to evolve in ways which have more favourable macro monetary outcomes.
Fractional Reserve Free Banking
The previous section showed that money could naturally evolve, but that this natural evolution could exhibit many of the same problems as central banks have been accused of. That is, at least in the short run, they can create monetary disequilibrium.
However, our model thus far is still quite primitive, and it was not even necessary up to this point to have banks in the picture. Following Mises (1953 [1912], 2007 [1949]),
Selgin and White (1994) and Dowd (2002), it can now be assumed the banks come about as a logical progression into our story of monetary evolution.
Although it was suggested in Part I that a common medium of exchange drastically lowers transaction costs, it does not completely eliminate them. There would still be the costs of protecting, storing and transporting money (Dowd 2002, p.144).
Dowd sums up what will likely happen next:
Goldsmiths and some merchants already have facilities to keep large amounts of gold, and can therefore keep additional quantities of it at a relatively low marginal cost. These people find it profitable to accept gold for safekeeping for a fee that many current holders of gold are willing to pay, and depositors are issued with receipts that give them the right to demand their gold back (ibid p.144-5).
The first ‘banks’ then merely act as storage warehouses, and although warehouse receipts could circulate as a medium of exchange, 100% of the receipts in circulation would correspond to their respective gold unit of currency stored in a warehouse. At this
Page 89 of 144 point we have a 100% reserve free banking system. But because the banks are acting as warehouses, they do not alter the supply or demand of monetary gold. At this point the above model depicted in figures 9 and 10, still ought to hold.
However, such a warehouse system likely would quickly continue to evolve. As
Mises points out, 100% reserve banking has historically shown to be “a ruinous business”, because it is costly and undesirable for clients to use (Mises 2007 [1949], p.435). Banks quickly realized it is relatively harmless to lend out money which they held and to only keep a fraction of their assets idle in vaults. It is true that redemption would be random, but assuming a large enough number of total bank clients, the central limit theorem would allow for a precise estimate of the total withdraws in a given time period, “which allows the bank to confidently invest a large share of deposits in highly illiquid projects that yield a positive rate of return” (Calvo 2013, p.4).62 Therefore, so long as they made sure to maintain a position where they could comply with their obligations, loaning out assets makes economic sense (Mises 2007 [1949], p.794).
Hence, banknotes began to freely and safely circulate through the economy without corresponding gold stored in a warehouse, and therefore the fractional reserve system arose as part of the unhampered market process (ibid).
Banks would begin to issue transferable deposits and banknotes, with competition “compelling the banks to make their liabilities contractually and actually redeemable in the standard commodity money” (Selgin and White 1994, p.1791). This indeed brought on some risk, as of course not all claims could be redeemed at once,63
62Calvo’s discussion on the banking system’s use of the central limit theorem draws heavily from Diamond and Dybvig (1983). 63 L. White (1989, p.55) points out that if it is wrong for a bank to issue more claims than it could redeem if all clients showed up at the bank at once, then it should also be wrong for insurance companies to issue more claims than could be redeemed were they all to come due at a single Page 90 of 144 but so long as the banks were deemed solvent, banknotes continued to trade at par
(Mises 2007 [1949], p.432). Mises calls any banknotes which exceed the amount of commodity money held by the bank, “fiduciary media” (ibid p.433). He saw fiduciary media as a favourable market innovation. As he explains:
The issue of fiduciary media has made it possible to avoid the convulsions that would be involved in an increase in the objective exchange value of money, and reduced the cost of the monetary apparatus. Fiduciary media tap a lucrative source of revenue for their issuer; they enrich both the person that issues them and the community that employs them (Mises 1953 [1912], p.323).64
A fractional reserve system evolves naturally as it is preferred by customers, because they get to share in the profits of the money loaned out by the banks. Just like the creation of money in the first place, fractional reserve banking further reduces the high transaction costs of coordination and uncertainty. Once institutions have evolved, the dispersed risks gained from coalescing deposits, allows liabilities to be safely used in transactions (Hendrickson and Salter 2015, p.10-11). Banks can then pay interest to depositors interest and give other beneficial services (instead of warehouse fees) on accounts and allows customers to have on-demand money redemption without
moment. See Selgin and White (1996) for a more complete defence of fractional reserve banking against many arguments placed against it, including that it is inherently “fraudulent”. 64 Perhaps it would be more accurate to say Mises at times was favorable towards fiduciary media specifically and free banking in general. Chapter IV of “Theory of Money and Credit” seems to speak quite favorably towards it, while towards the end of the same book, he seems to speak of it in a different and less enthusiastic tone. Therefore, perhaps his overall view as of 1912 (and perhaps in 1953 when the second edition was published) is somewhat ambiguous. However, it seems clear from chapter 17 of Human Action that he had come to fully embrace free banking by 1949 (as well as the two further additions which came out in Mises’ lifetime in 63 and 66). See L. White (1992), Selgin and White (1996) and Cachanosky (2011) for a more detailed defense of Mises as a free bank advocate, or for the opposing view see Hülsmann (1996) and Huerta de Soto (2012) Page 91 of 144 sacrificing liquidity, while reducing heavily the amount of money that sits idle.65
Furthermore, this provides a coordination role as well as banks can conduct operations like credit checks and get a better picture of trustworthiness than regular people ever could if they tried to lend out money on their own.
Free Banking: Graphical Representation
The advent of fiduciary media creates a slightly more complex model of money than the previous sections model. Within a free banking system what should be expected to happen is that, as the banking system matures, the average person will stop using gold as the medium of exchange and instead will only use claims to gold, or fiduciary media, in the form of either banknotes or deposits. This seems to hold historically in countries which had banking systems nearing free banking, such as
Scotland and Canada. In Scotland between 1716-1845 almost no one used gold as a medium of exchange even though Scotland was on the gold standard. As Selgin has reported, it was said that the first thing Scottish citizens would do with gold when they received it in trade would be to take it to a bank and exchange it for banknotes or deposits (Selgin 1994, p.1450). There are similar stories in Canada between 1867-1935 as well (ibid).66 It can therefore be assumed that under a free banking regime, the
65 “Idle” money here refers to savings (in the form of money) which are not currently lent out, but otherwise would be if transaction costs were reduced. Just like Uber reduces the transaction costs involved in transportation, leading to less car sitting idle in a garage, and Airbnb reduces transaction costs of accommodation, meaning less rooms are empty, fractional reserve systems reduce the transaction costs of lending, and therefore more savings are invested. Loans that would have been too costly (not just in monetary terms, but other transaction costs as well), can be reduced to a more attractive price as banks solve coordination and uncertainty problems. 66 Canada will be discussed in further detail in the appended Case Study. Page 92 of 144 demand to hold money would be in the form of fiduciary media. The term for this specific money market, is “inside money” because it is the medium of exchange commonly used within, or inside, the economy (L. White 1989, p.49).
However, inside money still derives its value from the credible promise to be able to exchange it to some form of original or “base” money. While I will continue to use gold as our example base money, it should be important to note again that this is merely an assumption for simplicity sake. For the fractional reserve model to work, there only needs to be a base money, but it need not be gold or monetary metal. Although gold has many physical attributes that make it favourable as a medium of exchange, perhaps in a more modern economy a different commodity or even digital moneys would emerge as base money. What is important is that something would be used as the medium of exchange and that ultimately depends on the subjective preferences of market participants.
The base money would still be held in banks as reserves and would be used to settle all interbank clearing. This market for money is commonly called “outside money” because it is the money used outside of regular economic activity (L. White 1989, p.49).
For this reason, in a free banking system it should be assumed that there are two money markets, not one. Therefore, Figure 10 has an extra market beyond the initial system depicted in Figures 9 and 10. While there is still the flow of total gold and the stock of monetary gold, monetary gold is now the outside money, and the actual medium of exchange demanded by the public, the inside money, is fiduciary media.67
67 Technically, fiduciary media are only those notes or demand deposits in excess of reserves but given that in most free bank systems (see above or see Case Study attached after the Conclusion) reserves are incredibly low, often lower than 5%. Therefore, because most inside money would be in excess of the total reserve quantity, labeling all inside money as fiduciary, while not technically correct, in unproblematic for the theoretical implications drawn in this Part. Page 93 of 144
Figure 10
Figure 10 shows all three markets in equilibrium. Inside money is the fiduciary media used by most people for day to day exchange, whereas outside money is what banks hold as reserves and use to settle balances with other banks at a clearing house.
The analysis of inside money supply can begin on the micro level by understanding individual bank decisions as to the amount of fiduciary media they wish to supply. The cost of materials involved in fiduciary media creation are close to zero. As
Selgin puts it “the only cost involved would be the cost of the notes themselves – an investment in paper and engraving” (1990, p.112), and with digital money and debit cards the cost is reduced even further. A given bank's cost curve is derived therefore, not by the costs of producing this inside money, but by the cost of maintaining its circulation (L. White 1989, p.21). The real rising marginal costs to the individual bank of circulating fiduciary media are associated with reputation and risk. Like any supplier of goods, market forces will insure that banks will not supply more than is demanded to be held by their clients (Mises 2007 [1949], p.438). If an individual bank tried to over issue notes – meaning they put more note in circulation than wish to be held by the public – they would quickly see a drop in their reserve level below the acceptable risk level, due
Page 94 of 144 to both clients and interbank clearing redeeming the notes (L. White 1989, p.24). Over issue and excessively risky behaviour would hurt a bank's reputation and therefore limit the amount of people willing to hold their notes. Considerations of one's own solvency would force each bank to maintain “cautious restraint” in over-issuing fiduciary media
(Mises 2007 [1949], p.441).68
Selgin (1988; 1990; 1994), Sechrest (1993) and L. White (1989; 1999) have all covered this cost in greater detail and can be referred to for a more detailed exposition, but for this section what is important is that a bank's perceived risk is a function of gross clearing house activity. The desired reserve ratio of a given bank is related to how likely it is for notes or deposits to be redeemed in excess of the quantity of reserves (thus making the bank illiquid). In short, the more activity at the clearing house, the more likely the probability of dangerously high net losses. Therefore, the amount of reserves demanded by any given bank (which are needed to settle net clearing balances) will be a function of gross clearings. As Selgin (1994, p.1452) explains, “A bank's demand for reserves will be proportional to the standard deviation of its net reserve losses.”
68 One common worry put forth here is that, while no individual bank would see it advantageous to over expand, perhaps orchestrated simultaneous multi-bank increase in notes could be beneficial to the banks but harmful for the public. For example, de Soto (1995, p.33) expresses such a worry. However, this overlooks two important points. First is the game theoretic argument showing the difficulty of cartels and multi-lateral collusion in a free market system due to the persistent individual incentives to defect from the cartel, meaning that “a cartel is an inherently unstable form of operation” (Rothbard 2009 [1962] p.651). But secondly, and more specific to free banking is the concept which will be introduced on the following pages, and that is a bank’s “precautionary demand” (Selgin 1988, 1994; Horwitz 2000). As Selgin outlines (1988, p.66-68), an individual bank’s desired reserve ratio is a function of gross clearing house activity, meaning more clearing activity leads to more perceived risk, and ultimately the desire for a higher reserve ratio (see footnote 69). Gross clearing activity would increase in a cartel like expansion, and thus there would be no individual incentive to join a cartel in the first place. As mentioned, this precautionary demand principle will be flushed out more throughout this section. Page 95 of 144
With both the outside and inside money markets established, it can now be understood how a given bank will react to a demand shift. As will be argued, with both an outside and an inside money market established, changes in k and in Y will now have different effects. We will first analyze a change in k and then second a change in Y
Free Banking in Response to a Velocity Shock
As with the previous example, we can start by assuming an exogenous shock increasing the demand to hold money from a change in k. And as shown in Parts II and
III, this velocity shock can be represented as a fall in aggregate spending, and therefore a fall in aggregate demand. As noted, historically under such systems the people in the economy tend to only use privately issued inside money as their sole medium of exchange, and therefore, we should expect a fall in aggregate spending to manifest in the inside money market only (Selgin 1994, p.1459). With less spending in the economy, banks will end up on average with less of each other’s notes, and so the gross clearing activity at the clearing house should be expected to fall. Due to the fact that gross clearing is a factor of bank production cost – their precautionary demand to hold reserves – we can then observe a shift in the marginal cost curve of the bank representing a reduction of “marginal liquidity costs of free banks” because less reserves are now required to cover adverse interbank clearing (Sechrest 1993, p.55). Banks, holding desired risk constant, will therefore respond by issuing more loans, which will add to the total amount of money in circulation and “enter the steam of total nominal
Page 96 of 144 expenditures” (Salter 2017, p.460).69 Thus, as Larry Sechrest (1993, p.42) notes, “a decline in velocity [an increase in its reciprocal, the demand to hold money] reduces banks need for reserves.” To further illustrate what happens in the event there is an increase in demand to hold inside money, it is worth quoting Selgin and White at length:
Fewer checks are written per year per dollar of account balances. The marginal deposit dollar poses less of a threat to a bank’s reserves. Thus a bank can safely increase its ratio of deposits to reserves, increasing the volume of its deposits to the point where rising liquidity cost plus interest and other costs of the last dollar of deposits again equals the marginal revenue from a dollar of assets (Selgin and White 1996, p.105).
Figure 11 depicts a shift in demand to hold the common medium of exchange. It looks very similar to Figure 9, with one major distinction. Unlike an increase in demand under a single monetary unit, here there is no distinct short run equilibrium differing from the long run.
Again, as Selgin notes, “the money supply would grow in response to a fall in velocity sufficiently, so as to prevent any contraction of aggregate money income” (ibid p.1456). In AS-AD space, the increased demand for money, if not offset, would reduce aggregate demand, shifting the AD curve left (as in Part II, Figure 5). However, the pressure for this fall will be offset as the supply of money increases, and this keep AD stable. The net result is that “neither the price level nor income changes” (Sechrest 1993, p.55).
푅 ∅푦 69Selgin (1994, p.1453) represents this algebraically as M*= [ ]1/2. Where M* is the 푉 2(푏−1) quantity of inside money supplied by the bank, R is the (exogenous) stock of base money, V is velocity, y is output, b is the number of price-taking banks, and ∅ represents the proportion of real income transactions to total transactions. Given this model if “velocity falls to one-half its former level, the money stock will double, whereas if velocity doubles the money stock will fall to one half its original value, other things being equal.” Page 97 of 144
Figure 11
Figure 11 shows that as demand for the medium of exchange (inside money) shifts outward, the supply moves with it simultaneously, as the bank's new risk assessment leads them to desire less reserves than previous. Unlike a single money market, where the quantity in the short run rests at the intersection of Sm1 and Dm2, in fractional reserve we see immediate movement from point A to point B, to the intersection of Sm2 and Dm2.
Another way to interpret this process is to first recognize that by intentional design, banks explicitly fix the value of their fiduciary media to the value of outside money. This means that one banknote or unit of deposit is always redeemable for 1 unit of gold. In order for a fractional reserve system to operate, the banks must keep their fiduciary media trading at par with the outside money. It can therefore be conceptualized that the price of outside money is the price at which inside money is fixed. This will mean, in order to hold a credible peg, banks must passively adjust supply such that the total stock of medium of exchange is at the quantity where demand to hold inside money is intersected by the fixed price. It can be said that in response to a velocity shock, a well-functioning free bank system will have a supply curve that is (both
Page 98 of 144 in the short run and long run) perfectly elastic. This interpretation is illustrated in
Figure 12.
Figure 12
Figure 12 shows that because the movement from Sm1 to Sm2 happens in concert with the movement from Dm1 to Dm2, the supply both in the short and long run, as a response to a shift in demand, can be conceptualized as perfectly elastic, as depicted on the right hand side. As banks have fixed the price of inside money to the price of outside money, the price level will not move, even in the short run.
Thus, has been illustrated a crucial point, that increase in the demand to hold money (caused by a decrease in velocity) should not be expected to alter the price of the medium of exchange, due to the elastic supply of money. As Hayek pointed out “in order to make the volume of the money stream behave in a desired manner the supply of money must possess considerable elasticity” (Hayek 1990 [1978], p.81), and this is exactly what is happening here. Using the equation of exchange outlined in Part II, this can be represented as ↑M↓V=PY, where we see the supply of money increase to offset velocity without any change in prices or output. Mises also noted that this effect held
Page 99 of 144 historically with fractional reserve free banks, noting that the banks “increase and decrease their circulation pari passu with the variations in the demand for money... in doing so, they help to stabilize the objective exchange-value of money” (Mises 1953
[1912], p.312). This graphical interpretation with the perfectly elastic supply curve highlights the important point that without a rise in the price of money, there can be no hub deflation. Therefore, in response to a change in k (causing a change in V), free banking should be expected to achieve both the stable MV of the productivity norm, and the stable prices of the New Keynesians. Now that we have an inside money market with a perfectly elastic supply curve, that would eliminate any harmful hub price level movement, the next section shows how free banking would allow for the good, spoke, price level movements which accompany changes in output.
Free Banking in a Response to a Supply Shock
We have now seen how a free banking system should operate to stabilize the price level in the face of a velocity shock, while holding economic growth static. However, as discussed in Part II, in a growing economy, for money to remain neutral, we need to see prices fall. Yet how free banking would react to a non-zero growth rate of natural output, is somewhat uncertain given the current literature. For example, Selgin (1988, 1997),
Sechrest (1993), and Horwitz (2000) all assume that as Y* grows, and hence money demand grows, the money supply will shrink and hence perfectly offset the new demand with a higher price of money (a lower price level) with money quantity unchanged (See
Figure 13). This apparently follows from the observation "that free banks should
Page 100 of 144 perceive their marginal costs in real terms, that is the goods and services required to produce an additional dollar and maintain it in circulation” (Sechrest 19993, p.32).
Figure 13
Figure 13 recreates Sechrest’s depiction of the money market in response to economic growth
However, after the analysis thus far, what immediately becomes apparent with
Figure 13, is that it is ambiguous as to which money market it is showing; inside, outside, or both. Assuming this is the inside money market, there should also a shift in the outside money market, in order for the two markets to remain in equilibrium as per figure 12. The leftward supply shift in the inside market makes sense given that banks can control the amount of fiduciary media in circulation, but it is unlikely there is any such shift for reserves. In other words, we would have to conceptualize a reason for the outside gold currency to tighten.
However – as money increases in value due to the increase in productivity, and people demand more money as income rises – it seems likely that this new money demand would be for all money markets, given that it is the value of both which is changing. Therefore, we ought to see the demand shift in both markets. The quantity of
Page 101 of 144 base money supplied increases, and the banks passively adjust their inside supply. This is depicted in Figure 14.
Figure 14
Figure 14 depicts a rise in output in both the money markets. Note that while the quantity of inside money is depicted as holding constant, this is actually dependent on the elasticity of outside money supply and the proportion of which the demand shock is split between the two markets.
It seems that in the short run, price level will indeed still fall, although it is unclear by how much. Furthermore, recalling figures 9 and 10, the two money markets will eventually equilibrate with the gold (or whatever material has become money) in its non-monetary market. Therefore, this growth in natural output, in the long run, should trigger a greater flow of gold into the outside money market, which ought to bring the price level back up to its initial position, such as in Figure 9. In the long run then, there should be an increase in the total money supply as well, which, at least in part, would cancel out some of the pressure on the falling price level. Exactly how much of the growth in Y would be offset by a fall in P or a rise in M is a matter of empirics as to how
Page 102 of 144 fast new money would actually flow into the system and at what rate versus the rate of growth. Some historical examples suggest that the price level would still fall somewhat but not fall as fast as the rise in GDP, suggesting that the increase in new money does not come fast enough to fully offset the “good” deflation. This places the outcome of free banking in a growing economy somewhere in-between achieving a productivity norm and stable prices. We can assume that under free banking, 0% < inflation gap < rate of real GDP growth.70 Again, where the inflation gap sits between these would seem to be a matter of empirics. Using Canada as an example, I attempt to measure the exact size of the inflation gap in attached Case Study. 71
Summary of the Free Banking Model
Given the model, it seems as though a free banking system would follow a neutral monetary “policy” in response to a velocity shock.72 However, it is less clear as to how it would react in a growing economy. The model presented here suggests that it would not perfectly stabilize MV in this case, as a productivity norm would require, but it would allow for a price level decrease in the short run. In the long run it the system likely
70 Since the time of this writing, a recent working paper has come out (Salter and Young 2017) which uses the Selgin (1994) model to reach this same conclusion 71 While Part IV is the last official section of this thesis (due to page limits), as mentioned in the Introduction, there is an Appendix/Case Study attached after the Conclusion. While not necessary to the Thesis’ overall argument, this Case Study does bolster empirically the free banking model espoused in this Part. It examines a historical example of (near) free banking - that of Canada, from its conception in 1867, until the outbreak of World War One. Therefore, any reader further interested in Free Banking and/or who is skeptical of the model put forth is strongly suggested to read the Case Study. 72 Of course, there would be no explicit policy or target set under free banking. The decentralized and deregulated banking system, on a macro level, would merely operate “as if” there was such a policy. Page 103 of 144 would still see some price level decrease, but this would at least partially be offset by new money entering the economy.
Another way to put it would be to say that we want a perfectly elastic money supply with regards variations in money demand stemming from variations in liquidity preference, but a perfectly inelastic money supply with regards to variations in money demand stemming from variations in real output/income. The reasons for this were outlined in Part II, namely that the coordination problems which usually lead to sticky prices and thus monetary disequilibrium are not present during output growth, and therefore under this circumstance, the price level can fall safely (spoke deflation).
The model presented here showed that while free banking would indeed be perfectly elastic when it ought to be, it is unlikely to be perfectly inelastic when it should be. This result is surprising for two reasons; first, it means in the face of long term growth, free banking may actually create more hub inflation then previously speculated by many free bank advocates. However, secondly, this gives the surprising result that free banking may be closer in line with stable prices, and therefore should perhaps be more popular as a potential monetary regime in the eyes of New Keynesians or those in favour of constant NGDP growth.
A “k Percent Rule” on Base Money
Having now surveyed both some possible pragmatic central bank rules (Part III), and also the possibility of a monetary regime sans government (here in Part IV), here will be an attempt to combine insights from both. This proposal re-examinations proposals to freeze the monetary base or “outside money” (or have it grow at a fixed
Page 104 of 144 rate) and let private banks in a market setting be fully responsible for creating inside money and adjusting it to velocity shocks.
According to Milton Friedman, it was Gary Becker who first came up with the idea, in 1957, of a monetary base freeze with otherwise free banking.73 The intuition is as follows. If the supply of outside government money is fixed, and unregulated banks can privately issue inside money as they please, then without gold or a commodity standard, the outcomes of free banking could be achieved. As Friedman (1984, p.21) puts it, “the government’s monetary role would be limited to keeping the amount constant by replacing worn-out currency. In effect, a monetary rule of zero growth in high powered money would be adopted.” More recently Selgin (1988, 1994, 1997) and L. White (1999) have indorsed such a plan as well, stating that the difference from free banking on a commodity standard (as discussed above) and free banking on a frozen government fiat standard “is not really so great” (Selgin 1988, p.139).
From the macro point of view, if a growing economy should exhibit a rate of inflation equal to the Hayekian rate, such a base money freeze may actually be preferable to traditional free banking. To see why this is so, consider the discussion around Figure 14 (on page 101), it was noted that secularly rising incomes would trigger an increase in the supply of gold. Thus, the money supply would rise in such a way as to offset some of the beneficial spoke deflation that would otherwise have to take place.
However, if base money was fixed, this increase could not take place. This implies that a
73 This story of Friedman and Becker is told by L. White (1989, p.51). White points out that Becker's proposal was never published, and while Friedman does not quote a source, White (ibid p.65) has pointed to an unpublished manuscript of Becker’s from 1957 titled “A proposal for Free Banking”. Page 105 of 144 frozen monetary base would be more deflationary than standard free banking, and yet still offset any changes in velocity and thus maintain monetary equilibrium.74
Furthermore, such a proposal could be modified to meet other requirements and concerns already discussed in Part III. For example, if it is deemed that it is more beneficial to have steady NGDP growth at a positive rate, then as Selgin (1997, p.68-69) notes: “Getting nominal income to grow at some predetermined rate then becomes a relatively simple matter of having the central bank expand the stock of base money by that rate.”
Another potential worry is that demand for base money could itself be volatile.
Earlier in this Part I assumed (following Selgin 1994 amongst others) that outside money demand would not fluctuate with the public’s money demand, because the public would only demand inside money in the first place. However, while seemingly historically true, if such an assumption would no longer hold today, then a rule such as
Sumner’s futures market could be applied. Given that under such a regime a purchase or sale of an NGDP futures would automatically trigger open market operations (a change in base money supply), combined with privately issued inside money, this would have the same stabling effects. In fact, if outside money demand is indeed not volatile, then
Sumner (1989, p.161) notes that “the public would buy (or sell) GNP contracts whenever the money supply increased above (or below) target. In that case a nominal GNP rule would automatically revert to a money supply rule.”75
74 Recent work by Salter and Young (2017) suggests that – while a base freeze may be more deflationary than fully free banking with a commodity base – it still may be more inflationary than optimal from the perspective of the Hayek MV rule. 75 Sumner refers here to base money growth because he is operating under the assumption that NGDP should grow at a steady rate, however, his position could easily be adapted for a frozen base (0% NGDP growth) advocated here. Page 106 of 144
While letting the base expand at a predetermined rate, or letting the base expand or contract in concert with a futures market may have economic benefits in theory, again this must be traded off against public choice concerns. As L. White (1999, p.225) points out, any mechanism which would require “the central bank to remain in business must be enforced against a real-life agency staffed by experts in the field who naturally prefer to have discretion to use their expertise.” Therefore, it may still be preferable to freeze government issued base money and write it into law that the stock can never be altered, only maintained, as the best way to avoid “the “camel’s nose under the tent” problem of having in place an agency that has an inherent interest in lobbying for greater discretion” (ibid p.226).
For such a freeze to lead to these beneficial outcomes, Selgin lists a number of reforms that would need to take place to a modern banking system. 1) Remove from law all reserve requirements, 2) removal of any regional and nationwide branch banking restrictions (Selgin 1988, p.139), and most importantly 3) remove any regulation restricting banks from issuing private notes and depots accounts (ibid, p.140).
As such, this plan could perhaps most realistically be implemented not in the US or the
Eurozone, but in smaller less regulated countries such as Canada. As documented in the attached Case Study, the Canadian bank act of 1870, stated clearly that Canadian banks shall have no branching or reserve requirements, which would satisfy Selgin’s first 2 requirements. And while enacted nearly 150 years ago, this situation still holds in
Canada today. As for requirement 3, Selgin was writing in the 80’s, before debt cards, and digital payments became popular. In Canada, cash is now the smallest payment mechanism by value (Tompkins and Galociova 2016, p.3), and trends seem to be going
Page 107 of 144 further in this direction. Tompkins and Galociova (ibid p.11) explain the Canadian trends of cash usage:
The composition of POS [point of sale] transaction volume [in Canada] has been profoundly altered by a seven-year decline in cash use, which has resulted in about one third less cash transactions in 2015 than in 2008 (in volume and value). Since 2011, cash has been declining by around five per cent, on average, each year. Cash decline can be accredited to the wider use of prepaid, credit and debit cards, and more recently to the growing use of contactless and e-commerce payment channels... Cash makes up a much lower proportion of POS transactions when viewed in terms of transaction value. Here the decline is more pronounced, as cash is being used for fewer transactions and for smaller transaction amounts. As a result, cash has the lowest average transaction size of all of the payment methods – about $17.50 per transaction.
If these trends continue, there would be no need to allow Canadian banks to issue private paper money, as plastic (which is directly liked to, already privately created, deposit accounts) may soon fully satiate all public money demand. There is of course still the matter of government issued deposit insurance in Canada, which may cause moral hazard issues, but given that this moral hazard exists in the current regime, there is no reason to assume moving to a frozen base money standard would not be an improvement over the status quo.
This plan obviously needs further development, but as an area of future research, a base money freeze in the digital age could be a very promising proposal for macro- stability.
Page 108 of 144
Conclusion
In this thesis I have set out to investigate how money gains its value, and how fluctuations in that value pervasively affect all other markets. In Part I it was shown how the connectivity of goods in trade have a long-tailed distribution, and Part II examined the implications of this trade pattern on deflation and inflation. It was shown how price level movement can come from different sources and that the cause of the movement dictates its effect. If the price of money changes it affects all markets, which have to adjust in an inevitably uneven and painful way. Because money is at the center of the trade network and is pervasive though all markets, I have labelled this economically harmful price level movement at the “hub.” It stems from disequilibrium in the money market – either a shift in the supply of money or a shift in aggregate liquidity preference
(k). If a change in the price level comes from aggregating individual firm’s productivity gains and losses than this price level movement is benign, or even good, because of the signals it sends to the marketplace. Because all non-monetary goods are on the left-hand side of the frequency distribution and have relatively few connections, I’ve labelled this
“spoke” price level movement and it stems from changes technology and production which can be aggregated as changes in real income (Y).
Given this framework, Part III went into detail as to why current central bank's price stability goals can be problematic. When the two sources of price level movement are not properly distinguished, central banks can end up causing hub inflation by trying to prevent spoke deflation and vice versa. This leads to unnecessary market discoordination. I have argued that the ideal central bank monetary policy would be to target an inflation rate inverse to the growth rate – which I have labelled the Hayekian
Page 109 of 144 rate – by holding MV stable and letting changes in output be perfectly offset by the inverse change in the price level. In other words, we ought to keep the economy on a unit elastic aggregate demand curve, while letting aggregate supply fluctuate to reveal real scarcity and productivity gains. This is the essence of Selgin’s productivity norm.
By plugging the Hayekian rate of inflation into the Taylor rule as the inflation target, we see the most simple and pragmatic improvement central banking could make in order to better stabilize the money stream. It was then shown how this could be modified to target the level of nominal income instead of the rate, to give better long run predictability, as well a targeting the future for better foresight. It was also discussed, that in a low r-star world, if central banks wish to retain the interest rate as their desire target variable, then a more common NGDP target may be required to avoid the zero lower bound, and to keep monetary policy operational. However, this should not be seen as a first best solution, as it means purposely ejecting an inflation gap into the economy which will have the distortionary effects laid out in Part II.
Finally, throwing pragmatism aside, Part IV looked at free banking, and how market competition for the supply of money would have many macro benefits argued for in the earlier Parts. Using graphical analysis, it was shown how free banking, in the long run with a growing economy, may be too expansionary to keep the money stream stable.
Nonetheless, it still would allow for mild spoke deflation (especially in the short run) and would adequately avoid hub deflation stemming from velocity shocks. Therefore, although imperfect, free banking may be seen as a preferable system to rule following central banks because of the avoidance of knowledge problems and public choice concerns. A base money freeze, coupled with deregulated banking, could be a viable middle ground between the proposals in Part III and part IV, and it is possible that this
Page 110 of 144 could be implemented more easily now than ever before, given recent shifts in technology and trends is using less government issued cash. However, to fully understand the implications of the base money freeze, more research should be done.
In leu of further summary, I would like to take some time in this conclusion to briefly address why these topics are important in the bigger picture of political economy.
This work has spent many pages on the importance of monetary equilibrium, and the consequences of disequilibrium, but why should anyone beyond economist’s care?
Taking a line from my introduction, it is because when money goes wrong, everything goes wrong. And when everything is going wrong, it can sometimes be hard to pin down the cause. If a major liberal goal is smaller government, than avoiding booms and busts should be of utmost importance for the following reasons. As Simons (1936) famously noted, even if bad monetary policy is the culprit for a slow economic growth or even outright depression/recession, it is often hard for the public to see this connection, calling market failure in place of central bank failure. And so, what can often be the case, as Simons alluded to, is that monetary disequilibrium can be correlated with the large increases in government intervention. Each specific industry or market which is in trouble, looks for government fixes instead of realizing their problems ultimately are associated with supply and demand for money. When monetary disequilibrium causes recession and unemployment:
This makes it harder to insist on market-oriented policies, which typically call for creative destruction. Under creative destruction, unemployment in parts of the economy may be tolerated for the sake of allowing greater expansion elsewhere. When spending collapses, however, people will generally ask where the workers who have lost their jobs can go. This is not an easy question to answer, nor is it easy to argue against bailouts and other measures aimed at keeping firms or industries from failing. (Sumner 2012, p.18)
Page 111 of 144
As Sumner has also pointed out (ibid, p.20), some of the worst government interventions in history have come at the time of deep recessions; the great depression in the USA in the 30’s caused the New Deal and many more unproductive, or even destructive, government policies. And it was the same 30’s depression in Germany which contributed to the ascension of the Nazis to power. More recently, in the 2000’s,
Argentina’s deep recession led the new government to blame their troubles “not on tight money but on its former free-market policies, just as FDR had done 70 years earlier”
(ibid). Similar trends of increased size of government can be found across the world since the 2008 crisis.
All this is to say that monetary disruptions are not always clear to the public, and furthermore the solution is not always agreed upon by economists or politicians. From a classical liberal perspective then, getting money right may be the best strategy for convincing the public of the merits of open and voluntary trade, and the social benefits of market mechanisms.
Therefore, if successful, either the pragmatic calls for Hayekian monetary rules
(from Part III) or the more idealistic proposals for free banking (in Part IV), would help avoid the downturns that so often correlate with calls for greater government intervention. When markets are functioning absent monetary disruptions their benefits ought to be more apparent. I hope to have contributed here to a way forward in avoiding future monetary disruptions.
Page 112 of 144
Case Study
Evidence for Monetary Equilibrium with Free Banking: A look at Canadian Banking, 1870-1914
Part IV tried to show a relationship between free banking in theory and a productivity norm. This case study looks at whether or not a historical example can fit within that theory. Modern free banking advocates, such as Selgin (1994) and Schuler
(1992), have all pointed to Canada between 1870-1914 as a nice example of near free banking. I will use some sources from the time period to try and make a case that this claim is warranted.76 Next I will look for the same shocks in Canada as laid out in the
Part IV theory, beginning with a shock to k, and then a change in Y, to see how closely it fits the model. In both cases we see evidence that Canada indeed could be viewed as having a period of free banking.
The Beginning of Canada and its Banking
In the year 1867, the parliament of Great Britain created the “British North
American Act.” This gave the right to the provinces of British North America to confederate under the title of the Dominion of Canada (Walker 1899, p.49).
At the time, each province that entered into the Dominion of Canada had very different industries as generators of employment. The eastern provinces had
76 The two main source used in this section are “A History of banking in Canada” by Edmund Walker, written in 1899, and the “Canadian Banking System” by Roeliff Breckenridge written in 1893. Not a primary source, however “Canadian Monetary Banking and Fiscal Development” by R. Craig McIvor is also heavily relied upon for this section, written in 1961. Page 113 of 144 shipbuilding industries and fishing; Ontario and Quebec, around their more urban centers of Montreal and Toronto, relied heavily on manufacturing; and the Prairies were mostly agricultural (Firestone 1960, p.220). Despite this, Canada, whom was in many ways a decentralized nation at the time, had a federal, and therefore centralized, banking union from its inception in 1867 (McIvor 1961, p.64). The British North
America Act clearly stated that the new federal government alone possessed the power to legislate “coinage, currency and banking” (Walker 1899, p49).
Previous to confederation, each province had controlled its own money, not all of which traded on par with one another. Because of the reshuffling that needed to be done, a succession of banking acts passed quite rapidly, on an annual basis between
1867-69. However, by 1870, they had settled on a stable banking act (Breckenridge
1893, p.254; Walker 1899, p.50; McIver 1961, p.65). Incorporating Upper and Lower
Canada’s “Currency act” from 1854, the new federal government pegged the newly created Canadian Dollar (CAD) to the same amount of gold as the United States (1.49 grams per dollar) which indirectly pegged the currencies at a rate of 1 to 1 (Bank of
Canada 2010).77
As I will attempt to show, the Banking act of 1870 – which was not changed substantially until World War One (McIvor 1961, p.65) – outlined a very free market financial system, one in which all the major requirements of true free banking were nearly hit. However, this was almost not the case. During the legislative turmoil in the three years after British North American Act, many rules and regulations were nearly imposed on the banking sector.
77 Also pegging Canada to the British Pound at a rate of $1CAD = £4.87 (Bank of Canada 2010). Page 114 of 144
Some members of the House of Commons were pushing for a system that mimicked the United States, which at the time operated national banks (Walker 1899, p.50). The Minister of Finance also tried to create numerous currency creation restrictions as well, but as Craig McIvor (1961, p.64) notes:
Apart from the Bank of Montreal, which favoured this proposal because of its special relationship with the government, the chartered banks were strongly opposed to the recommendation. In arguing their right to continue the issue of notes, the banks emphasized the “inelasticity”, higher cost and inferior stability of the proposed alternative.
In the end the banks won this battle and the Finance Minister withdrew the resolution and eventually resigned. Furthermore, the act of 1870 failed to renew the
Bank of Montreal's privileged status “relating to the issue and redemption of government notes” (Ibid p.65), and until the Bank of Canada was created in 1935, no other bank was given any special privileges (Walker 1899, p.63; McIvor 1961, p.153-155).
After 1870 banks were treated much more like just any other business than they are today, with the regulation only in place to ensure each potential bank was a genuine business venture (McIvor 1961, p.64).
Of course, the bank act of 1870 wasn’t completely free of regulations. Parliament retained the power to grant or deny charters. However, it did not deny any charter applications except in the cases of “fraudulent applications” (ibid). To be granted a charter a potential bank had to show it had sufficient upfront capital, but compared to the main banks already in operation, these requirements were not restrictively high.78
78 Prospective banks had to show $500,000 had been secured with $250,000 up front. The largest banks had $12,000,000, $9,000,000, and $6,000,000 of held capital respectively (all dollars listed in CAD), showing that active banks held much higher capital, as a matter of good business, than the law required (Walker 1899, p.65; Breckenridge 1893, p.266). Page 115 of 144
Banks were mostly free to issue their own notes provided that they were five dollar notes or larger, while the government maintained a monopoly on note creation for all bills smaller (ibid p.65).79 There was also a cap on the total number of notes that Canada would allow in circulation, but in practice this ceiling was far above what banks were creating during this time (Walker 1899, p.65).80 After 1870, the bank act was only renewed and amended on ten year intervals which meant that:
In the interval the banks are almost free from attempts by demagogues or ambitious but ill-informed legislators to interfere with the details of the system; but during the sessions of Parliament preceding the date of the expiry of the charters they must defend the system against the demagogue, the bank-hater, the honest but inexperienced citizen who writes letters to the press, sometimes the press itself -- indeed, against all the kinds of attack to which institutions possessing a franchise granted by the people are subject when they come before the public to answer for the stewardship (ibid p.62).
In short, popular opinion and rash decision making could not affect bank regulation, and yet the banks needed justify the system in place, in which they were largely successful for a stretch of nearly 50 years.
The following bank practice and rules – which should give credence to the claim that Canada was indeed a near free banking system – are taken from the bank act of
1890 and onwards, however given that only minor revisions were made between the bank act of 1870 and the outbreak of the war, these can largely be viewed as the standard banking practices of the era.
79 According to the act, aside from this caveat, “The bank may issue and reissue notes payable to bearer on demand and intended for circulation” (Walker 1899, p.71). 80 Fiduciary media was set to a limit of $9,000,000CAD, any excess of this number was to be covered dollar for dollar with gold. Page 116 of 144
Note Issue and Reserve Requirements
Although Canada was on the international gold standard, there were no reserve requirements stated in any of the banking acts (McIvor 1961, p.65), only a requirement that whatever portion of their assets they wish to hold in reserves a portion of that had to be government issued notes.81 Bankers therefore had “perfect freedom” in the management of the total size of their reserves (Walker 1899, p.70). Actual held reserves were somewhat low and continued to fall as banking in the young country matured.
Although it was estimated that as of 1872 on average there was approximately 97.5 million dollars’ worth of Currency and Deposits in Canada, only slightly over 10% was either government notes or coin.82 By 1913 currency plus deposits had risen to over 1.1 billion in total, however the percent of which was government issued had fallen to just over 4%.83
Actual Canadian gold coinage was near non-existent as paper notes were preferred for most transactions, and bullion, or British and US coins were available for interbank or international settlements (McIvor 1961, p.66). In fact, it was said that the bank issued paper notes were the most popular medium of exchange, and gold and reserves were mostly not in general circulation (Walker 1899, p.70).
81 Like the monopoly on all bill below five dollars, this was explicitly not for banking stability or security, but for government revenue. The young federal government needed funding sources for large public work projects in a large and sparsely settled country (Walker 1899, p.70). 82 $10.2 million government notes, $0.4 million government coins, $25.3 million private bank notes, $61.5 million private bank demand deposits (McIvor 1961, p.67) Metcalf et al. (1996) estimate base money (M0) in 1872 at $19 million, making the private money to government money plus gold ratio roughly 5 to 1. 83 29.1 million government notes, $19.3million government coins, 105.3 million private bank notes, 1.0billion private banks demand deposits (McIvor 1961, p.67). Metcalf et al. (1996) estimate base money (M0) at $174 million in 1913, making the private money to government money plus gold ratio roughly 10 to 1 (a doubling since 1872). Page 117 of 144
Given the discussion in Part IV on the theory of free banking, we may again ask: given the little restriction on required reserves, what stopped banks from over issuance of the medium of exchange (i.e. supply of money exceeding demand)? Here, Walker discusses further the bank's motivation for keeping discretion on reserve size, being prudent, and not over issuing supply:
Because banknotes in Canada are issued against the general estate of the bank, they are subject to actual daily redemption, and no bank dares to issue notes without reference to its power to redeem, any more than a solvent merchant dares to give promissory notes without reference to his ability to pay. (ibid p.82)
Although Canada was new, the idea of fractional reserve banking in the provinces was not. Canadians, according to Walker, understood and enjoyed the norm that anyone had the right to “issue his promise to pay in any form, the only deterrent to the exercise of such a luxury being the difficulty of inducing anyone to accept in payment” (ibid p.71).
Throughout this time period, the Canadian banks had offices, agencies and correspondents in New York City, and it was common practice to employ funds into this larger market. Banks held the bare minimum amount of species they felt they could get by holding domestically and put “as much as possible of their holdings to profitable employment in New York, where they would be available in times of emergency”
(McIvor 1961, p.72).
The banks choice on the proportion of notes in circulation provided a generous means of profit for them. The nation as a whole also benefited from this arrangement, by receiving:
An elastic currency, increased sources of discount, and through the system of branches promoted by it, widespread and accessible banking facilities. To make the currency more secure would be a help to the banking interest no less than to
Page 118 of 144
the people; the one would be strengthened in credit, and the other protected from loss (Breckenridge 1893, p.289-290).
Allowing this kind of discretion to the banks was seen as “the only practical system if stringency and panic are to be averted” (Walker 1899, p.71).
Branching
The bank acts expressly permitted branches and agencies nationwide, and indeed
– as already mentioned branches were even in the US – the act was without any condition as to whether banks were confined to Canada or not (ibid p.74). This meant that unlike in America, Canadian banks could open branches from coast to coast, in all provinces, and therefore diversify their holdings throughout asymmetric markets. A good example of this is told by C.A Curtis (1947):
In many cases the first bank in a mining territory, for example, has been a tent with the bank's name on a board beside it. Yet this tent could offer the same facilities as the elaborate city office. Undoubtedly this capacity to offer the immediate service of a well-established organization is a great advantage of the branch system which is unrivalled in its capacity to meet the rapid development of an expanding country.
This account helps to illustrate that Canadian banks had diverse assets from coast to coast, meaning they were not tied to regional shocks. Instead these larger institutions were able to weather the storms, unlike the much smaller more locally dependant
American banks (Calomiris and Haber 2014, p. 304). Excess savings in Halifax were able to be funneled into the Northwest Territories and as far as Vancouver, where new business needing funding. This capital mobility meant that interests rates across the country often varied no more than one or two percent (Walker 1899, p.85). Page 119 of 144
Bank Failures
Canada did experience a number of bank failures during this time. It appears to be the case that between 1880 and 1910 “approximately thirty percent of Canadian banks failed” and that during this same time among national banks in the US only about five percent failed (McIvor 1961, p.76). However, despite this fact, net bank creation was still outpacing the loss of banks.
More importantly however, almost all banks which failed managed to redeem their note holders in full (ibid p.77).84,85 This feat is even more impressive given that there was no government deposit insurance, here is Walker's (1899, p.87) take on the mere idea:
We must not, however, expect that any government will relieve a depositor from the necessity of using discretion as to where he places his money. Governments never have done and never can do that. Men must use their intelligence, and after measuring the security offered, judge where they should entrust their money.
One reason note holders were almost always in paid in full is because of the double liability of shareholders being successfully enforced. (Breckenridge 1893, p.273).
This interesting feature of Canadian banking, the double liability, seems to be a big reason Canadian banks were able to fail without panic. It had been around before
Confederation in Upper and Lower Canada and was brought into the Federal Bank Act
84Total losses due unredeemed notes, equalled less than one per cent of the total liabilities of Canadian banks (Breckenridge 1893, p.314). 85 While the note holders of failed banks were indeed almost always paid in full, this often took time as banks went through the liquidation process. This caused a revision of the bank act in 1890 to include that the notes of failed banks must bear interest of six percent per year, from the date of suspension until they were redeemed (McIvor 1961, p.77). Page 120 of 144 once the nation was established (ibid p.118). This made shareholding potentially quite dangerous, as it could leave the holder liable for a second payment. Therefore, banks had to be very prudent and show responsibility to attract investors. When banks did fail, the law was upheld and shareholders kept the note holders from suffering (Walker 1899, p.80). Given that this double liability was somewhat unique, Walker speculates that
“there are probably few countries in the world where greater security is offered to depositors” (ibid p.87).
After some failure in between 1870-1880, the bank act – with input from the banks themselves– required a redemption fund be set up which pooled money from all banks to use as a lender of last resort. This “Circulation Redemption Fund” required each bank to contribute five percent of its average circulation, and each bank had to designate a redemption office for notes in each province. The fund, which was held by
Ministry of Finance, was to be used to redeem the notes of failed banks if the liquidator couldn’t use the double liability to do so within 60 days (McIvor 1961, p.77). After 1881, not a single Canadian “ever lost a cent through the note's becoming worthless” (Curtis
1947, p.117).86 The fund was more of a safety insurance and was rarely, if ever, actually used in this time period (although as footnote 86 notes, it was called upon quite heavily later in the great depression).
In the end, it is not altogether surprising or interesting really that some banks failed, and it is not clear why it would ever be predicted that government free
86 Although later than the main time period under discussion, this redemption fund was pivotal during the great depression of the 1930’s as it was able to assist in preventing bank failures (Calomiris and Haber 2014, p.305). The fragmented Banking system in the US saw thousands of banks fail leading to a national bank holiday, yet amazingly Canada did not witness a single failure during the great depression despite having a nearly identical drop in GDP (Briones and Rockoff 2005, p.404). Page 121 of 144 competition in an industry would prevent such failure.87 What is important to note was the most failures were small, and somewhat predictable. For example, many of the failed bank were like La Banque Jacques Cartier, whose policy was described as “reckless”. It only had a single branch, and their losses “were due to the poor management by which many ill-advised loans became lock-ups. The cashier was afterwards convicted for falsifying returns” (Breckenridge 1893, p.280). These isolated failures never cascaded into systematic failure or panic, and very few losses to creditors ever actually took place.
In short, bank failure in this time period was due to “faults of practice”, rather than faults of the system as a whole (ibid p.314).
Canadian Banking in Response to a Velocity Shock
At this point in the history, it should be clear that Canada between 1870-1914, was a reasonably good candidate to act on a macro scale as free banking theory would predict. Part III hypothesized that free banking would have perfectly elastic supply of inside money when the economy sees a change in k. The previous section noted that the
Canadian system indeed had developed two money markets as the theory would suggest
– gold coin or bullion as the outside base money, and privately issued notes as the day- to-day medium of exchange. Here I examine if the Canadian banking system exhibited the signs of a horizontal supply curve of fiduciary media.
Because business transactions were “almost entirely paid in paper money”
(Walker 1899, p.81), it was therefore of great importance that the system were to work
87 We expect failure in all other industry, and it is usually seen a part of “healthy” competition. Page 122 of 144 as predicted– that the amount of this inside money circulating through the Canadian economy at any given time should be as close to possible as the amount demanded. And indeed, it is reported that the banks had issued “such money when it was required and also a power to force it back or redemption when it was not required” (ibid p.81).
There is unfortunately no direct velocity data for this time. However, the ability of the Canadian system to exhibit a fully elastic money supply in the face of velocity shocks is well reported:
In Canada we find that between the low average of the circulation during about eight months of each year and the maximum attained at the busiest period of the autumn and winter there is a difference of twenty percent, the movement upward in the autumn and downward in the spring being so sudden, that without the power of the banks to issue, the autumn serious stringency must result, and without the force which brings about redemption in the spring there must be plethora. As a matter of fact, it works automatically, and there is always enough and never too much… The profit of issuing notes would at all times bear an exact relation to the amount of currency required by the country, the profit therefore changing not only as the currency rises and falls over a series of years, but also at the time of the sharp fluctuations within each year. (Walker 1899, p.83-84).
Even though agriculture effected money demand as well in the US, with its relatively stricter banking regulation by comparison, they could not see its notes increase during the autumn, and so was unable to increase supply when demand for currency was brought on by farmers (Schuler 1992, p.97). This meant that Canada kept fairly stable interest rates, while American interest rates showed strong seasonal patterns (Selgin 2017, p.96). The inability of the US to meet demand lead to credit shortages, further leading to financial panic in the US particularly in 1873, 1884, 1893,
1907 (ibid p.92). During these panics in the United States, Canadian banks actually provided liquidity to the New York money market and Canadian notes went into
Page 123 of 144 circulation as substitutes throughout the Eastern US (Schuler 1992, p.97). The ability for
Canadian private banks to branch across regions and to discretionarily print more notes allowed interest rates to stay smooth and compensated for sectoral booms and busts.
What this meant was, although not intentional, nominal income/output was able to follow a fairly consistent trend (ibid p.94).
One particular example was the depression of 1873. Both the US and Canadian economies hit with a particularly hard that year in real terms (Breckenridge 1893, p.272;
Walker 1899, p.70). The US saw bank runs and overall financial panic, and yet no panic of such sorts occurred in Canada (Breckenridge 1893, p.272). According to
Breckenridge, any potential bank runs which “started upon some of the solvent banks were cordially met, and in one way and another a bank panic was again averted” (ibid p.283).
Figure 15
Figure 15 shows seasonal variation of banknotes comparing fall and spring from 1871-1900, which Walker claimed had the most variation. High points are fall and low points are spring,
Page 124 of 144 confirming Walker’s statement. Source: Metcalf et al. (1998), own calculation (see footnote 88)
To further test whether inside money displayed a relatively horizontal supply curve with greater accuracy I have looked at the Metcalf et al. (1998) data on monthly
M0 and M2 numbers in Canada. In Figure 15, I’ve averaged them into seasonal values to see if Walker's 20% claims fit with the Metcalf et al. estimates.88
With this data we don’t quite see the 20% that was claimed by Walker, nonetheless, there is indeed a strong seasonal pattern, often with notes increasing as much as 16.5% in the fall compared to the spring. Without any accompanying velocity data, it’s impossible to know exactly if this money supply elasticity was able to hold MV perfectly stable throughout the seasonal changes in money demand. However, it is clear that as a crude relationship the times we know in which k rose (the autumn harvest), money supply also rose to meet these new needs, and fell as the reverse happened in the spring. Furthermore, we know it did so to a much better extent than its more regulated neighbours to the south.
Canadian Banking in Response to a Supply shock
In order to see how Canada fared in with more long-term changes in economic growth (changes in Y) we need to also look at price level data. Recall in Part II it was argued that the rate of inflation which would hold money neutral is the inverse of the
88To obtain seasonal estimates of fiduciary media (titled simply "notes" in Figure 15 for short) I subtracted m0 from M2. I've averaged monthly data from March, April and May of each year for "Spring" and September, October, November for "Fall". Page 125 of 144 rate of real economic growth – the Hayekian rate. Furthermore, the productivity norm was explained as a monetary rule which explicitly calls for this relationship, in order to hold MV in the equation of exchange stable.
Figure 16
Figure 16 shows Canadian price level movement on the left axis, and real GDP on the right. The general trend of growing output and a falling price level can easily be seen. Source: Geloso and Hinton (forthcoming)
Part III suggested that perhaps free banking could not perfectly achieve this, as in the long run new outside money would flow into the system, and therefore offset at least some of the deflation which would otherwise hold PY constant. Therefore, in Canada we should expect some, but not perfect, negative correlation with inflation to output. A
Page 126 of 144 comparison is made in Figure 16 using price level and real GDP data from Geloso and
Hinton (forthcoming) for 1870-1900.89
When a regression is run using price level as the dependent variable and real
GDP as the independent, a statistically significant result is produced in which a 1% change in GDP causes a 0.3% fall in the price level.90 The fact that the two do not perfectly offset one another is predicted by the free banking theory put forth in Part IV, and indeed in Figure 17 we can see M0 Growing as real GDP grows as well, as we would expect to see.91
Canada seems to hold quite well to the theory, although perhaps a less than ideal international flow of gold, as well as the government's minor interventions into the market (i.e. in issuing notes less than five dollars) has nudged Canada away from perfectly fitting. Being able to have more monthly and seasonal data would help clear up this story as well, however, it seems this is only available for the money supply and not for other variables such as interest rates, velocity and GDP. Nonetheless, it seems reasonable to state with confidence that, while we cannot show for certain that Canadian banking displayed all the features of free banking exactly, the large body of evidence collected does nothing to contradict the hypothesis.
89 Unfortunately, the Geloso and Hinton data set does not extend past 1900, and so the last 14 years of the time period are excluded from this regression. The oft cited Urquhart data set (2014 [1933]) is commonly used in the literature for Canadian price level and real GDP statistics and does cover past 1914, however as Geloso and Hinton point out (forthcoming), the Urquhart data misses many industries (such as textiles) and so has an inaccurate deflator. Therefore, it does not accurately capture all the spoke deflation which Canada saw during this time period. 90A Regression of the logged variables gave a coefficient -0.3 with a p-value of 0 and a R2 of 0.74. 91A Regression of the logged variables here with M0 as the dependant and GDP as the independent, gave a coefficient 0.69 with a p-value of 0 and a R2 of 0.87. Page 127 of 144
Figure 17
Source: Geloso and Hinton (forthcoming), Metcalf et al. (1998)
The End of Free Banking in Canada
As the first Great War drew closer, banks found themselves in a difficult position.
While unlimited note issue had been de facto permitted in the times prior, as the economy continued to grow, the banks found themselves being pushed against the note ceiling. While they were able to fight to get hikes on the ceiling during certain times of the year and for certain exceptions (McIvor 1961, p.84), this marked the beginning of the end of a banking system mostly devoid of intrusive regulation.
A new “Finance Act” was put in place in 1914, which was at first regarded as temporary, but ended up lasting twenty years after being re-enacted in 1923. It gave the
Page 128 of 144
Federal government power to advance Dominion notes banks upon the deposit and pledge of satisfactory securities as well as placing further controls on credit (Curtis 1947, p.118). And without a doubt, the biggest move the government made was to pull Canada off the gold standard. Amazingly, Canada still remained without a central bank until
1935 (McIvor 1961, p.154; Curtis 1947, p.120), but by then regulation had banking looking quite different than the period under study here.
Nonetheless, we have given an interesting case study from this period as to how banking could operate if banking was viewed by government was just another business.
In this time period the banks in Canada were based on the “admirable traditions of
Scotch and English banking” but they adapted to the vast lands of the North, which, according to Breckenridge, gave them “a keener appreciation of sound banking principles may be remarked in the declarations of managers and presidents in their published speeches to shareholders; it may be inferred from the fewer losses and bad debts incurred by the banks as a whole” (Breckenridge 1893, p.302). This banking environment which had evolved in Canada – even though there was no explicit governmental body setting out monetary policy – led to something somewhat resembling a de facto productivity norm.92
As interesting of a case study as this is, it is quite unlikely given our current climate, that free banking will ever be seen again. At least not in the developed world and not any time soon. However, many of the freedoms granted to Canadian banks in
1870, are still granted to this day (i.e. no branching or reserve requirements), therefore,
92 Some bankers at the time did not seem to fully realize the benefits of their system, as Kurt Shuler quotes the vice-president of the Canadian Bankers’ Association, whose sentiment reflect the times: “he had never heard of the quantity theory of money, and remarked further that ‘we do not want theories introduced into banking. If you get into theories, you are on dangerous ground’” (Schuler 1992, p.100). Page 129 of 144 as advocated at the end of Part IV, Canada, if it were so inclined, could move back to a freer banking like system with relative ease. Whether, such a return to a freer banking system would ever be politically popular enough to actually take place is another question altogether.
Page 130 of 144
BIBLOGRAPHY
Amato, Jeffery D. “The Role of the Natural Rate of Interest in Monetary Policy.” BIS Working Papers, no. 171, 2005, pp. 1–18. Aoki, Kosuke, and Kalin Nikolov. “Rule-Based Monetary Policy under Central Bank Learning. “Bank of England Working Paper, no. 235, 2004, pp. 5–45. Ball, Laurence, and N. Gregory Mankiw. “A Sticky-Price Manifesto.” Carnegie- Rochester Conference Series on Public Policy, vol. 41, Dec. 1994, pp. 127–151 Bank of Canada. “The Canadian Dollar under the Gold Standard.” Bank of Canada, 19 Nov. 2010,
Page 131 of 144
Monetary Policy Transmission." The Journal of Economic Perspectives 9.4 (1995): 27-48. Web. 10 Apr. 2017. Blanchard, Olivier, et al. “Rethinking Macroeconomic Policy.” Journal of Money, Credit and Banking, vol. 42, no. 1, Sept. 2010, pp. 199–215. Blanchard, Olivier, et al. “Jump Starting the Euro Area Recovery: Would a Rise in Core Fiscal Spending Help the Periphery?” NBER Macroeconomics Annual, vol. 31, no. 1, 1 Nov. 2016, pp. 103–182. Blinder, Alan S. "On Sticky Prices: Academic Theories Meet the Real World." Monetary Policy. NBER. Ed. N. Gregory. Mankiw. Chicago: U of Chicago, 1994. 117-54. Board of Governors of the Federal Reserve System. “Why Does the Federal Reserve Aim for 2 Percent Inflation over Time?” Board of Governors of the Federal Reserve System, 26 Jan. 2015,
Page 132 of 144
Renewing the Search for a Monetary Constitution. Ed. Lawrence H. White, Viktor J. Vanberg and Ekkehard A. Kohler. Washington D.C., Cato Institute, 2015, pp. 51-58 Buchanan, James M., and Gordon Tullock. The Calculus of Consent: Logical Foundations of Constitutional Democracy (1962). Liberty Fund, 1999. Cachanosky, Nicolás. “Mises on Fractional Reserves: A Review of Huerta De Soto's Argument.” New Perspectives on Political Economy, vol. 7, no. 2, 28 Jan. 2011, pp. 203–230. ______. “Hayek’s Rule, NGDP Targeting, and the Productivity Norm: Theory and Applications.” Journal of Stock & Forex Trading [Special Issue: “Economics, Finance and Public Policy] vol. 3, no. 2, 2014, pp. 1-28. Calomiris, Charles W., and Stephen H. Haber. Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. Princeton, NJ: Princeton UP, 2014. Calvo, Guillermo. “Puzzling over the Anatomy of Crises: Liquidity and the Veil of Finance.” IMES Discussion Paper Series, E, no. 9, Sept. 2013, pp. 1–23. Cannan, Edwin. "The Application of the Theoretical Apparatus of Supply and Demand to Units of Currency." Liberty Fund. The Economic Journal vol 31, no. 124 1921, pp. 1-10. Carlstrom, Charles T., and Timothy S. Fuerst. “Monetary Policy Rules and Stability: Inflation Targeting versus Price-Level Targeting.” Economic Commentary Federal Reserve Bank of Cleveland Research Department, Apr. 2002, pp. 1–4. Carney, Mark. “Monetary Policy After the Fall.” Bank of Canada. Eric J. Hanson Memorial Lecture, 1 May 2013, Edmonton, Alberta, pp. 1-27. Clarida, Richard, et al. “The Science of Monetary Policy: A New Keynesian Perspective.” Journal of Economic Literature, vol. 37, Dec. 1999, pp. 1661–1707 Clower, Robert W. "The Anatomy of Monetary Theory." The American Economic Review 67.1, Papers and Proceedings of the Eighty-Ninth Annual Meeting of the American Economic Association. 1977, pp. 206-12. Cooper, Russell, and Andrew John. “Coordinating Coordination Failures in Keynesian Models.” The Quarterly Journal of Economics, vol. 103, no. 3, Aug. 1988, pp. 441–463. Coulombe, Serge. “The Intertemporal Nature of the Information Conveyed by the Price Page 133 of 144
System.” Price Stability, Inflation Targets and Monetary Policy, A Colloquium Organized by the Bank of Canada, 1997, pp. 3–28. Curtis, C. A. "Evolution of Canadian Banking." The Annals of the American Academy of Political and Social Science vol. 235, 1947, pp. 115-24. Dantas, Flavia, and L. Randall Wray. “Full Employment: Are We There Yet?” Public Policy Brief, Jerome Levy Economics Institute of Bard College, no. 142, 2017, pp. 3–21. De Long, J. Bradford. “The Triumph of Monetarism?” Journal of Economic Perspectives, vol. 14, no. 1, 2000, pp. 83–94. De Soto, Jesus Huerta. “A Critical Analysis of Central Banks and Fractional-Reserve Free Banking from the Austrian School Perspective.” The Review of Austrian Economics, vol. 8, no. 2, 1995, pp. 25–38. ______. Money, Bank Credit, and Economic Cycles. Trans. Melinda A. Stroup. Third Edition Ed. Auburn, Ala.: Ludwig Von Mises Institute, 2012. Diamond, Douglas W., and Philip H. Dybvig. “Bank Runs, Deposit Insurance, and Liquidity.” Journal of Political Economy, vol. 91, no. 3, 1983, pp. 401–419. Dowd, Kevin, editor. The Experience of Free Banking. Routledge, 1992. ______. "The Invisible Hand and the Evolution of the Monetary System." What Is Money? Ed. John Smithin. 2nd ed. London: Routledge, 2002, pp. 139-56. Duffy, John, and Jack Ochs. "Emergence of Money as a Medium of Exchange: An Experimental Study." The American Economic Review vol. 89, no. 4, 1999, pp. 847-77. Eggertsson, Gauti, et al. “A Contagious Malady? Open Economy Dimensions of Secular Stagnation.” NBER Working Paper, no. 22299, June 2015, pp. 1–43. "European Central Bank." Web. 04 Dec. 2016.
Fisher, Irving. “The Debt-Deflation Theory of Great Depressions.” Econometrica, vol. 1, no. 4, 1933, pp. 337–357. Fletcher, Gordon. Great Thinkers in Economics Series: Dennis Robertson. Digital: Palgrave Macmillan, 2008. Frankel, Jeffrey, and Menzie Chinn. “The Stabilizing Properties of a Nominal GNP Rule. Journal of Money, Credit and Banking, vol. 27, no. 2, May 1995, pp. 318– 334. Friedman, Milton. A Program for Monetary Stability. Fordham University Press, 1960. ______. The Optimum Quantity of Money (1969). 2nd ed., Aldine Transaction, 2007. ______. “Monetary Policy for the 1980s.” Hoover Institution Archives, Stanford, CA. 1984.
Value of Money" (1928). Money, Capital and Fluctuations: Early Essays. Roy McCloughry, ed. University of Chicago Press, Chicago, 1984. ______. “Reflections on the Pure Theory of Money of Mr. J. M. Keynes.” Economica, no. 33, 1931, pp. 270–295 ______. Monetary Theory and the Trade Cycle. Translated by Nicholas Kaldor and H. M. Croome, Sentry Press NY, 1933. ______. Prices and Production. 2nd ed. New York: Augustus M. Kelly, 1935. Mises.org. ______. “The Use of Knowledge in Society.” The American Economic Review, vol. 35, no. 4, 1 Sept. 1945, pp. 519–530. ______. The Constitution of Liberty. The University of Chicago Press, 1960. ______. Full Employment at Any Price? Occasional Paper 45, The Institute of Economic Affairs, 1975 ______. Denationalisation of Money: The Argument Refined (1978). 3rd ed., Hobart Paper Special 70, Institute of Economic Affairs, 1990. Hendrickson, Joshua R. and Salter, Alexander William, Going Beyond Monetary Constitutions: The Congruence of Money and Finance (October 28, 2015). Available at SSRN:
Page 136 of 144
a Monetary Equilibrium Theory Perspective.” Mercatus Working Paper, Mercatus Center at George Mason University, no. 10-63, Oct. 2010, pp. 1–28. Hülsmann, Jörg Guido. "Free Banking and the Free Bankers." Mises.org. The Review of Austrian Economics vol.9. no.1, 1996, pp 3-53. Hummel, Jeffrey Rogers. “Central Bank Control Over Interest Rates: The Myth and the Reality.” Mercatus Working Paper, Mercatus Center at George Mason University, Arlington, VA, 2017, pp. 3–40. Hutt, William Harold. The Keynesian Episode: A Reassessment. Liberty Press, 1979. Jones, Robert A. "The Origin and Development of Media of Exchange." Journal of Political Economy vol84. no4, Part 1, 1976, pp. 757-76. Keynes, John Maynard. A Tract on Monetary Reform (1923). Cambridge University Press, 2013. ______. Keynes, John Maynard. A Treatise on Money (1930). Macmillan, 1971. Kiyotaki, Nobuhiro, and Randall Wright. "On Money as a Medium of Exchange." Journal of Political Economy vol.97 no.4, 1989, pp. 927-54. Klein, Peter G. and George Selgin. "Menger’s Theory of Money: Some Experimental Evidence." What Is Money? Ed. John Smithin. 2nd ed. London: Routledge, 2002, pp. 217-34. Koenig, Evan F. “Monetary Policy, Financial Stability, and the Distribution of Risk.” International Journal of Central Banking, vol. 9, no. 2, June 2013, pp. 57–82. Laidler, David E.W. Taking Money Seriously and Other Essays. MIT Press, 1990. Laidler, David, and Nicholas Rowe. “Review: George Simmel's Philosophy of Money: A Review Article for Economists.” Journal of Economic Literature, vol. 18, no. 1, Mar. 1980, pp. 97–105. Leijonhufvud, Axel. Information and Coordination: Essays in Macroeconomic Theory. Oxford University Press, 1981. Mahadeva, Lavan, and Peter Sinclair. Monetary Transmission in Diverse Economies. Cambridge University Press, 2011. Mason, J. W. “What Recovery? The Case for Continued Expansionary Policy at the Fed.” Roosevelt Institute Report, 25 July 2017. McCallum, Bennett T. “On Consequences and Criticisms of Monetary Targeting.” Journal of Money, Credit, and Banking, vol. 17, no. 4, Nov. 1985, pp. 570–597. Page 137 of 144
______. “The Case for Rules in the Conduct of Monetary Policy: A Concrete Example,” Federal Reserve Bank of Richmond Economic Review, vol. 73 September/October 1987, pp. 10-18. ______. “Alternative Monetary Policy Rules: A Comparison with Historical Settings for The United States, The United Kingdom, and Japan.” NBER Working Paper Series, No. 7725, June 2000, pp. 1–40. McInnis, Marvin. "Canadian Economic Development in the Wheat Boom Era: A Reassessment." unpublished paper presented to the annual meeting of the Canadian Economics Association, Toronto, 1999, pp. 1-44. McIvor, R. Craig. Canadian Monetary, Banking and Fiscal Development. Macmillan Co. of Canada, 1961. Menger, Carl. On the Origins of Money (1892). Trans. C. A. Foley. Auburn, Alabama: Ludwig Von Mises Institute, 2009. Metcalf, Cherie, et al. “New Estimates of the Canadian Money Stock, 1871-1967.” The Canadian Journal of Economics, vol. 31, no. 1, 1998, pp. 104–156. Mises, Ludwig Von. Human Action: A Treatise on Economics (1949). Ed. Bettina Bien Greaves. Vol. 2. Indianapolis: Liberty Fund, 2007. ______. The Theory of Money and Credit (1912). Trans. H. E. Batson. New Haven: Yale UP, 1953. Mises.org. Moran, Timothy, Markus Brede, Antonella Ianni, and Jason Noble. "The Origin of Money: An Agent-Based Model." Advances in Artificial Life, ECAL 2013. Murphy, Ryan H. “A Comparative Institutional Analysis of Free Banking and Central Bank NGDP Targeting.” The Journal of Private Enterprise, vol. 29, no. 1, 2013, pp. 25–39. Murphy, Ryan H., and Jiawen Chen. “A Simple Empirical Investigation into the Optimal Size of the NGDP Target and Level Targeting.” Journal of Economics and Finance, vol. 41, no. 2, 12 Feb. 2016, pp. 354–369. Nash, John F. “Ideal Money.” Southern Economic Journal, vol. 69, no. 1, July 2002, pp. 4–11. Negishi, Takashi. “Conditions for Neutral Money.” The Review of Economic Studies, vol. 31, no. 2, Apr. 1964, pp. 147–148. Niehans, Jurg. "Money in a Static Theory of Optimal Payment Arrangements." Journal Page 138 of 144
of Money, Credit and Banking 1.4 (1969): 706-26. JSTOR. Web. 02 Apr. 2017. O'Driscoll, Gerald P., and Mario J. Rizzo. The Economics of Time and Ignorance (1985). 2nd ed. Oxford: Blackwell Basil, 2002. O'Rourke, Kevin H., and Alan M. Taylor. "Cross of Euros." Journal of Economic Perspectives vol 27 no.3, 2013, pp. 167-92. Orphanides, Athanasios. “Monetary Policy Rules Based on Real-Time Data.” American Economic Review, vol. 91, no. 4, 2001, pp. 964–985. Patinkin, Don, and Otto Steiger. “In Search of the ‘Veil of Money’ and the ‘Neutrality of Money’: A Note on the Origin of Terms.” The Scandinavian Journal of Economics, vol. 91, no. 1, Mar. 1989, pp. 131–146. Price, Derek De Solla. “A General Theory of Bibliometric and Other Cumulative Advantage Processes.” Journal of the American Society for Information Science, vol. 27, no. 5, 1976, pp. 292–306. Poloz, Stephen S. “Economic Research Institute: Economic Planning Agency Discussion Paper.” Economic Research Institute: Economic Planning Agency Discussion Paper, no. 32, Dec. 1984, pp. 1–48. Poole, William. “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model.” The Quarterly Journal of Economics, vol. 84, no. 2, May 1970, pp. 197–216. Potužák, Pavel. “Capital and the Monetary Business Cycle Theory: Essays on The Austrian Theory of Capital, Interest and Business Cycle.” University of Economics Prague, 2015. ______. “Hayek MV-Rule” (October 22, 2016). Available at SSRN:
Economic Perspectives, vol. 31, no. 3, 2017, pp. 47–66. Rohac, Dalibor. Towards an Imperfect Union: A Conservative Case for the EU (Draft). Lanham: Rowman & Littlefield, 2016. Rohac, Dalibor, and Lars Christensen. “After the Eurozone Crisis: Causes, Consequences, and Lessons for European and US Policymakers.” American Enterprise Institute, 31 July 2017, pp. 1–20. Rothbard, Murray N. Man, Economy, and State, with Power and Markets: Scholar’s Edition.2nd ed., Ludwig Von Mises Institute, 2009. Rowe, Nicholas. "The Hub and Spoke Model of Money." Blog post. Worthwhile Canadian Initiative. 28 Sept. 2009.
Thought”, History of Political Economy, Vol. 27 (Winter) 1995, pp. 705-35. ______. Less than Zero: The Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs, 1997. ______. “Introduction” The Fluttering Veil: Essays on Monetary Disequilibrium. Leland Yeager, Ed. George Selgin. Indianapolis: Liberty Fund, 1997. 3-18. PDF ______. Money: Free and Unfree. Cato Institute, 2017. Selgin, George A., and Lawrence H. White. “How Would the Invisible Hand Handle Money?” Journal of Economic Literature, vol. 32, no. 4, 5 Dec. 1994, pp. 1718– 1749. ______. White. "In Defense of Fiduciary Media - Or, We Are Not Devo(lutionists), We Are Misesians!" The Review of Austrian Economics 9.2 1996, pp. 83-107. Selgin, George, et al. “The Productivity Gap: Monetary Policy, the Subprime Boom, and the Post-2001 Productivity Surge.” Journal of Policy Modeling, vol. 37, no. 2, 2015, pp. 189–207. Shambaugh, Jay C., Ricardo Reis, and Helene Rey. "The Euro's Three Crises." Brookings Papers on Economic Activity, Spring 2012, pp. 157-253. Simmel, Georg. The Philosophy of Money (1907). Trans. David Frisby. Abingdon: Routledge, 2011. Simons, Henry C. “Rules versus Authorities in Monetary Policy.” Journal of Political Economy, vol. 44, no. 1, 1 Feb. 1936, pp. 1–30. Summers, Lawrence. “Why Stagnation Might Prove to Be the New Normal.” Financial Times, Financial Times, 15 Dec. 2013,
Sumner, Scott and David Beckworth. “Mercatus Announces Futures Market to Forecast Nominal GDP.” Mercatus Center Policy Announcement, September 19, 2017.
Wicksell, Knut. Interest and Prices: A Study of The Causes Regulating The Value of Money [1898]. Translated by R F Kahn, Sentry Press, New York, N.Y., 1936. Wieser, Friedrich von. “Der Geldwert und seine geschichtlichen Veränderungen” Zeitschriftfür Volkswirtschaft, Sozialpolitik und Verwaltung. Band XIII. Wien, 1909. Williams, John C. “Preparing for the Next Storm: Reassessing Frameworks & Strategies in a Low R-Star World.” Federal Reserve Bank of San Francisco. The Shadow Open Market Committee, New York, New York. May 2017. Woodford, Michael. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press, 2003. Woolsey, W. William. "Index Futures Targeting and Monetary Disequilibrium." Renewing the Search for a Monetary Constitution. Ed. Lawrence H. White, Viktor J. Vanberg and Ekkehard A. Kohler. Washington D.C., Cato Institute, 2015, pp. 127-152. Wray, L .Randall. "Modern Money." What Is Money? Ed. John Smithin. 2nd ed. London: Routledge, 2002, pp. 42-66. ______. “A Post Keynesian View of Central Bank Independence, Policy Targets, and the Rules versus Discretion Debate.” Journal of Post Keynesian Economics, vol. 30, no. 1, 2007, pp. 119–141. Yeager, Leland B. "A Cash-Balance Interpretation of Depression." 1956. The Fluttering Veil: Essays on Monetary Disequilibrium. Leland Yeager, Ed. George Selgin. Indianapolis: Liberty Fund, 1997, pp. 3-18. ______. “The Significance of Monetary Disequilibrium.” 1986. The Fluttering Veil: Essays on Monetary Disequilibrium. Leland Yeager, Ed. George Selgin. Indianapolis: Liberty Fund, 1997, pp. 217-252. ______. “What are Banks” 1978. The Fluttering Veil: Essays on Monetary Disequilibrium. Leland Yeager, Ed. George Selgin. Indianapolis: Liberty Fund, 1997, pp. 111-136. ______. “New Keynesians and Old Monetarists” 1991. The Fluttering Veil: Essays on Monetary Disequilibrium. Leland Yeager, Ed. George Selgin. Indianapolis: Liberty Fund, 1997, pp. 281-303. Young, Allyn. "The Mystery of Money." The Book of Popular Science. Vol. 2. New York: Page 143 of 144
Grolier Society, 1929. 265-321. Young, Andrew. “Austrian Business Cycle Theory: A Modern Appraisal.” The Oxford Handbook of Austrian Economics, edited by Peter J. Boettke and Christopher J. Coyne, Oxford University Press, 2015, pp. 186–212.
Page 144 of 144