Scott Sumner  

A dilemma for libertarians: Should central banks be strong or weak?

Confessions of a Voc-Tech Teac... My Cato Talk...

Over at TheMoneyIllusion I have a post looking at the Fed's ability to engage in policies such as QE and negative interest on reserves. What are the limits to the Fed's ability to do these policies, and should there be limits?

strong or weak.jpg Here I'd like to take a broader view of the issues. Let me start off with an analogy. Should libertarians favor a strong or a weak police force? One the one hand, a weak police force might lead to mob rule, and the loss of property rights. On the other hand, police at every street corner might lead to a sort of police state, where people lose their freedoms. Of course it's far more complicated, on both sides of the issue. Under anarchy, private police might step in. Alternatively, perhaps having lots of police need not restrict our freedom. But I do think there is a somewhat ambiguous relationship between libertarianism and law enforcement, based on what I have read.

I see something similar with central banks. Many libertarians favor free banking. If we are operating under a gold standard, then I'm persuaded by experts like Larry White and George Selgin that we'd probably be better off without any central bank at all. While it's true that their claims represent a sort of fringe opinion within the macroeconomics community, it's an opinion that's actually better informed than the views you'd find in textbooks, or from educational materials from the Federal Reserve. (That's different from Austrian business cycle theory as a whole, where advocates are generally not any better informed than mainstream business cycle theorists like Bernanke and Romer, or monetarists like Friedman and Meltzer (and I?))

So I see the gold standard case as a pretty easy call for libertarians. Free banking sounds good if you are suspicious of big government, and it probably is good if you are on the gold standard. But fiat money is much trickier.

Libertarians are often suspicious of fiat money, but I'm not persuaded by their arguments. In any case, let's say we do have a fiat money regime, and we are trying to make the best of a bad situation. Do we want a strong or a weak central bank?

Weak might sound good to libertarians, as they'd be able to do less harm. But in the end I'd argue exactly the opposite. Indeed I fear that a weak central bank is much more likely to make major policy errors. That is, they'll have enough power to create monetary disequilibrium, but not enough power to repair the damage that they inadvertently caused.

If we are going to have a fiat money regime, then we at least ought to try to adhere to some sort of monetary rule that insures monetary stability, however defined. I define monetary stability as stable NGDP growth (perhaps per capita or per worker.) But there are other plausible definitions, such as price stability. In any case, whatever target they choose, it is essential that the central bank actually hit its target.

In 2008-09, the Fed clearly did not hit their target, and over at MoneyIllusion I argue that one reason was that they perceived there to be limits as to the size of their balance sheet. It's actually not clear that their are limits, but when it comes to monetary policy, perceptions can easily become reality. If the Fed is going to target inflation at 2%, or NGDP growth at 4%, then it is essential that they have the tools to hit that target. That means we need a strong central bank.

To summarize, with a gold standard regime, libertarians should advocate the complete abolition of central banks. But I think it's a mistake for libertarians to advocate a gold standard, as it might end up resulting in unstable NGDP, due to gold demand shocks. Don't bother leaving comments about how NGDP performed under the actual gold standard, because we lack good data from that period, and it's not even clear the data we do have would be relevant for today, as the world is far different. For instance, the volatility of real gold prices depends to some extent on how many countries adopt the gold standard. And wages are stickier. My worry is that if the gold standard didn't work out well, and if libertarians had been its strongest advocates, it would tend to unfairly discredit all of libertarianism.

NGDP targeting is the safer route to market-friendly policies. And that means that if we give the central bank a monopoly on the production of fiat money, we'd better make sure that they have enough power to achieve their targets.

One final point. It would be possible to combine free banking and NGDP targeting, if we took away the Fed's monopoly on currency issue. Perhaps we should do so, but this post is looking at the question of how much power the Fed should have if we assume that it continues to monopolize the issuance of currency and bank reserves.

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COMMENTS (16 to date)
Andrew_FL writes:

There is no dilemma. Central Banks should not exist. Any other position is statist, not libertarian.

Mark writes:

I think the issue is not so much with 'size' or 'strength' but discretion, on both matters. When institutions enjoy a lot of discretion in their actions, this inherently leads to friction with the rights of citizens; be it discretion in monetary policy (the libertarian preference being for a more 'rule-based' framework) or in policing, i.e., law enforcers getting to do whatever they want, interpret the laws however they please.

Of course there's also the issue that a larger police force costs more money and means higher taxes, more diversion of labor and resources away from the private sector; I don't think the same issue necessarily exists with central banks.

And of course, Andrew could be right. The least discretionary central bank is one that doesn't exist.

Scott Sumner writes:

Mark, You said:

"I think the issue is not so much with 'size' or 'strength' but discretion . . ."

That's a issue, but not the only one. The strength of the central bank is also a very important issue, and the subject of this post.

George Selgin writes:

This post disappoints me on several levels, Scott. First, it contributes to the unfortunate tendency to write-off those of us who have had favorable things to say about free banking as (1) libertarians and (2) gold-bugs. Speaking for myself, my arguments for free banking have never simply been a matter of "distrust of the state," or of ideology. They are mainly built on batches of positive propositions, with only the broadest appeal to norms (stability is better than instability; faster growth is better than slower; crises are bad) that all decent people, economists included, presumably accept. In short, free banking is plain-old economics, thank you very much! If it is bad economics, it must be because some of those positive propositions are wrong, and not because of the politics of those who write about it. So, let's talk about those propositions!

As for gold, it's literally the case that, except when discussing history, I have never assumed that free banking has to be based on a gold standard. Of course I do assume that, to work well, it has to be based on a well-behaved standard of some sort. In my first book I suggested a frozen fiat base as one possibility. (I also showed how free banks can make the multiplier "stretch" in such a system to accommodate changes in real money demand.) Since then, and for a long time now, I've suggested a system where the fiat base grows according to a less strict monetary rule, aimed at (hold your hats!) stabilizing aggregate spending. Under a free banking system, I suggested in Less Than Zero, achieving such an outcome is largely a matter of having the base supply keep up with factor input.

Of course I know that you know that I am a big fan of the stable spending (NGDP) ideal. But this post suggests that you imagine that there is some inconsistency in my being such and in my having also said nice things about free banking. On the contrary: my position is precisely that, however well an NGDP rule may work in the present regime,it will work better in one in which banks are less encumbered by harmful regulations, including both those that limit what they can do and those that promise to bail-out their creditors when they do bad things.

Free banking is, after all, just another name for unregulated, or at least far less regulated, banking. As such it is, fundamentally, something orthogonal to the choice of a base regime. If choosing a monetary regime is like choosing a meal at a Chinese restaurant, The base regime is column A; the bank regulatory regime is column B; and you get to choose one of each.

Here, then, is a challenge for you. If you reject free banking, tell us what bank regulations you like. No fair saying "a nominal GDP rule." That's column A. I'm talking about column B.

Lorenzo from Oz writes:

The convenience to states of central banks mean that we are likely stuck with them. And, as I pointed out back in a May 2014 post, the prime examples of successful free banking of Scotland and Canada are in fact case studies in why said ubiquity will tend to be trumps, since both were defended by the Royal Navy, financed by the Bank of England.

Steve F writes:

I tend to find the question odd because the clear answer is that if you have a monopoly that covers a domain, that monopoly needs to do everything it can to sufficiently cover that domain. So, if we have a central bank, that central bank needs to understand that it is the alpha and the omega of all things monetary policy; thus, it would be "strong".

Selgin's point is fantastic. Free banking is better. It's basic economics.

George Selgin writes:

In light of Steve F's comment, I want to stress that, although with a gold standard one must choose between free and central banking (including competitive vs. monopolistic production of redeemable paper currency), one can also have free banking with a fiat monetary standard, in which case one must have some authority responsible for limiting and otherwise controlling the fiat money stock, and especially (since commercial banks might supply all the needed paper currency, in the form of redeemable notes) the stock of bank reserves.

But how much "power" must that authority have? The answer, I think, is just enough to maintain stable spending, which, given the properties of money supply under free banking, and the lower "fragility" of free banking systems, isn't much. It is certainly no more power than is needed to maintain stable NGDP with an unfree banking system.

Finally, free banking is an ideal, that is, a theoretical ideal. If some imagine we can have it, they are entitled to their optimism. But if anyone wants to dismiss the ideal as utopian, then are we not equally entitled to dismiss such similar ideals as free trade and free markets more generally? IMHO, all monetary economists ought to study the workings of free banking systems, for the same reason that we expect trade economists to study the workings of free trade, and economists generally to study the workings of free markets. That it is mainly a handful of libertarians that care about free banking tells us more about the blinkered learning of most monetary economists than it tells us about free banking, or libertarians!

robc writes:

Andrew_FL gets the answer in the first post.

Beaver writes:
I think it's a mistake for libertarians to advocate a gold standard, as it might end up resulting in unstable NGDP, due to gold demand shocks.

I attempt a reply: a gold demand shock is the signal that too much of everything is being produced. If you think about it, this is like saying that the wrong things are being produced. I.e. we are producing too many cars, too many houses, apples, etc, and too little of something else that does not yet exist (robots, flying cars--- I don't know what; it's up to entrepreneurs to figure out what).

So we have a waste in the way society uses existing resources, and the gold demand shock is signaling that waste. Resources should therefore be reallocated in order to fix the problem. If you prevent the gold demand shock, society has no way to signal this, and the reallocation will never happen.

Scott Sumner writes:

George, You said:

"This post disappoints me on several levels, Scott. First, it contributes to the unfortunate tendency to write-off those of us who have had favorable things to say about free banking as (1) libertarians and (2) gold-bugs."

Actually, I said exactly the opposite, that it would be possible to have a free banking regime in the context of a fiat money regime. Indeed I support that outcome. I support free banking. I was responding to people who suggest we should abolish the Fed and move towards free banking. As you indicated, we'd still need to decide on a monetary regime.

Lots of people who favor free banking also favor the gold standard. I pointed out that this indeed is one possible solution; you don't need a Fed if you have a gold standard. Indeed I'm persuaded that a Fed would be a net negative if you had an international gold standard.

I'm puzzled by your assumption that I wrote-off your views as those of a gold bug, especially given that I also indicated that your views were correct and the mainstream was wrong.

Beaver, You said:

"I attempt a reply: a gold demand shock is the signal that too much of everything is being produced."

So if Switzerland had been on the gold standard during recent decades, and its NGDP plunged by 75% as a result, that would be a sign that Switzerland had been producing too much?

Actually, an increase in the demand for gold is a sign that the demand for gold has increased, for reasons such as China's decision to move away from communist economic policies in recent years. That's all.

George Selgin writes:

Scott, I apologize for not seeming to recognize the generosity of your position. My concern is with the suggestion that free banking only works well with a gold standard. There is, I see now, an ambiguity with your sentences, "Many libertarians favor free banking. If we are operating under a gold standard, then I'm persuaded by experts like Larry White and George Selgin that we'd probably be better off without any central bank at all." That can be taken to mean that you think that free banking can only work with gold; or it can be taken to mean that you think that you can only do without a central bank (public money issuing authority) with a gold (or commodity) standard. The last interpretation is one I agree with entirely--though it must be said that it is practically a truism to say that fiat money requires some institution to control it. The first interpretation is the one that caused me to believe you had us all at least implicitly banking on a return to gold.

I hope you this explains my reaction.

Mark writes:

I hope this doesn't derail the discussion too much, but I'm curious what Dr. Sumner (or Dr. Selgin for that matter) think of the possibility of free banking (or the role of a central bank) under an alternative commodity standard based on a consumer goods index, such as Robert Hall's hypothetical ANCAP currency (ammonium nitrate, copper, aluminum and plywood).

When people talk about free banking and central banks and how they relate (hypothetically or in reality) with commodity standards, it's assumed to be a precious metal standard, but a non-reserve, consumer goods (or bundle of consumer goods) based standard could have some advantages over precious metal reserves as a basis for currency.

Sorry for the somewhat tangential question.

George Selgin writes:

Mark, as I recall Hall's ANCAP standard stopped tracking the CPI closely not long after he recommended it. (I don't now how it has done lately). More importantly, it is premised upon a stable general price level ideal, whereas as Scott and others have argued, what a good monetary system should achieve is not stable P but stable NGDP.

Matthew Waters writes:

To echo Selgin, I have been trying to think of a free banking solution using pure fiat money. Specifically, the money would still be either paper notes or entries in the Fed's database of bank balances.

Fed reserves are just 1's and 0's on a few different mainframes. The Fed reserves change with:

1. FedWire transactions.
2. Deposits and withdrawal of currency.
3. Fed's lending programs to members (daylight overdraft and discount window).
4. Fed's check-clearing and ACH programs.
5. Credits and debits to primary dealer accounts for OMOs.

In theory, the FedWire system could be opened up based on IT security rather than national banking charters from OCC. As much as I loathe bitcoin, a zero-knowledge blockchain could assure same personal ownership as paper currency but in electronic form. I'm not altogether sure the "blockchain" part is worth it or if a centralized database like the Fed's is fine.

The monetary base couldn't be frozen in time either. I've thought of the Fed selling unlimited NGDP futures at the target. The amount people go long or short NGDP would trigger auctions similar to Treasury auctions. They would either buy or sell Treasuries. The auctions would be open, similar to Treasury auctions today with Treasury Direct.

This is all crazy and has a lot to be worked out. For one thing, the Fed could either run out of Treasuries to buy or Treasuries to sell at high/low NGDP extremes. When this happens, the Fed could print new bonds for too high NGDP or have a helicopter-money mechanism for too low NGDP.

Scott Sumner writes:

George, No problem. I suppose that point was addressing someone less enlightened than you. Thus some people tell me they oppose the existence of the Fed and support free banking. You are correct that those are not necessarily either/or positions. But often those that want to abolish the Fed support the gold standard, so I suppose I had that group in mind in that comment. At the end I pivoted to point out that you could actually combine free banking with a fiat money regime.

Mark, I agree with George.

Matthew, I've sometimes thought the Fed could just control bank reserves, with an eye toward stabilizing NGDP futures prices, and let private banks produce currency notes, which would be redeemable into bank reserves. There are lots of other possibilities, some of which don't require a central bank at all.

Matthias Goergens writes:

Scott, a free banking system is indeed compatible with both a fiat regime and a gold standard. But no single individual has to decide: individual note issuers (and deposit taking institutions) can decide whether they want to offer redemption in any fiat money or gold or something else or even nothing at all.

So, yes, free banking leaves open the choice of monetary regime. But that doesn't mean some clever individuals have to figure out what the best one is. The market can and will figure that one out.

Though from a practical point of view, if today's US was going to a free banking system, the market would most probably still use the USD as the unit of account and redemption. At least for as long as the central bank keeps the dollar's value relatively stable. Network effects of convenience are just too big.

I expect this result even if legal tender laws were abolished or greatly weakened.

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