The Money Obsession

For many libertarians, the single most important policy reform today would be abolishing the Federal Reserve and replacing it with competing currencies issued by unregulated, private banks. Ron Paul has repeatedly introduced bills to abolish the Fed and has made the issue a key theme of his presidential campaigns. Many libertarians get involved in efforts to use silver as a medium of exchange, such as the Liberty Dollar and Shire Silver.

Why do so many libertarians think that abolishing the Fed should take such a high priority? Some economists have explored the history and theory of “free banking,” such as Larry White and George Selgin. But I suspect many libertarians derive their monetary ideas not from reading White or Selgin, but from Ron Paul or lurid, conspiratorial books like The Creature from Jekyll Island. One commonly encounters views such as, “The Fed is creating hyperinflation that will destroy the value of the dollar,” and, “The Fed prints money to fund the government’s war machine.”

It’s important to note that these views are not correct. The main way that the Fed creates money is by reducing the interest rate it charges to member banks, not by buying government bonds. The main beneficiaries of this new money are member banks and debtors. Recently, the Fed has undertaken large purchases of government bonds, activities that have come to be called “quantitative easing.” But the reason for quantitative easing has not been a desire to fund the “war machine,” but the sincere belief of central bankers that monetary stimulus is effective at bringing an economy out of a severe recession. A further round of quantitative easing now appears unlikely, and so does massive inflation. The Fed doesn’t like inflation beyond a low, consistent level, because the Fed is largely comprised of career bankers and academic economists who realize that high or variable inflation erodes savings and leads to malinvestment.

Isn’t the Federal Reserve a “central planner”? Central planning is bound to fail, so market economists believe. Therefore, shouldn’t the Fed be headed for a fall?

I don’t think the Fed actually is a central planner. The Fed doesn’t determine the actual money supply directly. It can’t force people either to hold or to spend money. It can’t even force its own member banks to loan money. The Fed does tinker with monetary instruments to try to harness the business cycle, often unsuccessfully. The Fed deserves its share of criticism, but there are several reasons why in 21st-century America, its power is limited.

First, the U.S. lacks capital and exchange controls. If you want to convert dollars to gold, silver, platinum, oil, land, or euros, you’re free to do so. Therefore, there is an important competitive constraint on the Fed that central planners don’t face. If the Fed inflated too much, people would get rid of their dollars, the value of the dollar would fall, and the Fed’s monetary policy would become increasingly irrelevant. (If the Fed were orchestrating massive inflation, we would expect to see capital and exchange controls imposed.)

Second, the U.S. doesn’t ban exchange in currencies other than dollars, or force anyone except creditors and government bodies to accept dollars in payment. Most Americans use the dollar because it’s proved to be a convenient medium of exchange and unit of account. It’s passed the market test. Even an advocate of a fully private, deregulated banking and currency market like myself has to concede that such a system would face more costs in this area. In a more competitive system, merchants would have to assess the validity and reliability of each note or coin passed to them. In practice, they are likely to accept only notes from the most reputable issuers, such as the Federal Reserve!

Third, the U.S. government doesn’t actually ban banking outside the Federal Reserve system. Almost all banks choose to join the system because in doing so they enjoy the substantial benefit of taxpayer-subsidized deposit insurance. Now, deposit insurance truly is a bane on the financial system, infecting it with great moral hazard. Because of deposit insurance, most bank customers consider only the interest rate when they choose a bank, a sure incentive for banks to take on risky assets.

So instead of abolishing the Fed, why not argue for abolishing deposit insurance, allowing financial institutions to suspend payments in order to forestall runs, and enacting a credible ban on all future bailouts? Once that happens, the Fed will be more or less just one more note issuer in a competitive market. But don’t expect a business-cycle-free utopia to take hold. The Fed has made plenty of mistakes, but they have also learned how to avoid creating another great depression or another great stagflation. Obsession with free banking makes much less sense than obsession with, say, ending the war on drugs or reforming entitlements.

19 thoughts on “The Money Obsession

  1. The reason we’re not seeing runaway inflation right now is not because the Fed learned its lesson or because they haven’t printed too much money: it’s because our banking sector is shot. The reason why printing money causes inflation is because of the multiplier effect. This effect disappears when banks don’t lend. So if, somehow, our economy picks up, we WILL start to see hyperinflation, unless the Fed acts quickly to deflate.

    Second, the Fed promotes counterfeiting on the part of commercial banks by redicounting. It replaces illiquid bank assets (i.e. loans outstanding) with its own paper that, by government fiat, is legal tender. Therefore, the commercial banks can lend out more cash then they have on hand, which presents a problem that manifests in bank runs. The Fed takes care of that by allowing banks to default (cease payments) without actually going bankrupt. The FDIC is basically one big bank to rule them all that can stop other banks from failing without failing itself purely because of its size, but if banking collapses demonstrate contagion (which they have) and there is a widespread collapse, the FDIC will fall, and that is the last domino.

    Last, to say that because people use the dollar it is therefore a good currency is not a great argument. It’s a Hobson’s choice. The government effectively bans any other entity from producing notes (see the Liberty dollar) and took measures to prevent actual commodity trade (by making gold illegal for half a century, effectively taking it out of circulation and selling it to foreign banks who hold it in their vaults), so people who use dollars as currency do it because they have no other choice, not because it’s a good currency.

    1. The government doesn’t ban other note issuers; they went after the Liberty Dollar because of complaints from vendors that they were essentially fraudulent, being passed off as U.S. dollars. People are fully able to buy gold and silver and do. They are also allowed to buy goods and services with gold and silver if they want – but they choose not to. Sometimes people do buy goods and services in my area with Canadian dollars. That option is available, because there’s some demand for it. There’s no public demand for trading in gold and silver.

      If significant inflation were to set in, the Fed would definitely take rapid steps to deflate. I’m willing to bet on it.

  2. You say that the US government does not ban exchange in other currencies except creditors or government bodies. In a legalistic sense, yes, in a practical sense, no. The reason you don’t use Euro’s at Walmart is not because Walmart lacks faith in the Euro it’s because Walmart must collect and pay sales tax in dollars and Walmart must pay it’s taxes, payroll, et al in dollars. So the dollar is the monopoly currency whether the government formally bans other currencies or not.

    If the government could not dictate which currency is accepted for payment of taxes then the government would become severely constrained in its ability to tax. borrow and spend. That’s the reason libertarians want to get rid of the fed and have competitive currencies. Few libertarians believe that competitive currencies would result in more efficient exchange. But competitive currencies would limit the growth of government. This is historically true. The growth of government occurs concurrently with the advent and acceptance of fiat monopoly currencies in the 20th century. Prior to that governments were severely constrained by their ability to collect or borrow non-fiat, i.e. commodity money.

    “why not argue for abolishing deposit insurance, allowing financial institutions to suspend payments in order to forestall runs, and enacting a credible ban on all future bailouts”. Nearly all libertarians argue for that too. Abolishing one doesn’t preclude abolishing the other.

    1. Wal-Mart could freely exchange its euros into dollars in order to pay taxes, so I don’t think that explains why Wal-Mart only accepts US dollars. (I wouldn’t be surprised if they also accepted Canadian dollars in border areas.)

      Fiat money allows government growth when the central bank is dependent and can be used to monetize debt. With the exception of QE, the Federal Reserve does not monetize government debt and is relatively independent of government.

      Abolishing one doesn’t preclude abolishing the other.

      I agree, and I would vote for abolishing the Fed if it were part of a sensible, comprehensive financial reform package. But my point is that this reform is almost unnecessary when other, more important financial reforms are undertaken.

      1. Again, in a legal sense you are right, the Fed is independent. As a practical matter, the fed has monetized the government debt on regular, continuing basis since the Fed was created. All government debt ever issued has been repaid with new debt payable in the continually debased currency which the fed created. Thus, either the fed is inept at its independent role as protector of the currency or the fed works with the government to debase the currency.

      2. But the gov’t doesn’t necessarily benefit from the debasement, because when new money is created through the banking system, it goes first to private borrowers. The gov’t may either lose or win from inflation, depending on whether the prices and wages it pays rise before it gets access to the new money or after.

      3. The beneficiaries of debasement are always the borrowers. The benefactors are the lenders and bondholders. As the world’s largest borrower, the government benefits more than anyone else.

        That’s the irony of the Federal Reserve. It was the result of a movement at the end of the 19th century to protect the interests of lenders and bondholders with a sound currency. Today it exists to protect the interests of the world’s largest debtor with a continually debasing currency.

      4. Only if the government were borrowing directly from the Fed would it make sense to say that the government benefits from increases in the money supply and the concomitant price inflation. Debtors in general don’t necessarily benefit from inflation. They typically do benefit from unexpected inflation. But the Fed has pursued a policy of low variance in inflation rates over time.

    2. Debtor’s, in general, do benefit from inflation. It’s a basic principle of both macro-economic and public finance theory that inflation especially benefits government, and hurts its creditors.

      1. Unexpected inflation. Expected inflation is built into the interest rate. If the bank thinks inflation is going to be 3%, and they want a real return on their loan of 5%, they’ll charge an 8% interest rate.

        BTW, many federal bonds are inflation-indexed, so even unexpected inflation wouldn’t help the feds depreciate the real value of those.

    3. It’s hard to not benefit from from say: borrowing a hundred dollars today and then pay back the one hundred dollars ten years from now with a currency that is worth say: half as much. That’s what the government does. The ability to pay back a loan in money which is debased is a great boon to government especially since it can tax or borrow again in the debased currency. That goes back to my first statement about why libertarians are opposed to central banking. Central banks, by monetizing debt, provide an avenue for unchecked government growth.

      Inflation expectations having an impact on bond prices/interest rates are strictly an academic construct. They have little basis in the actual bond market.

      I worked as a retail broker for ten years. In the actual bond market, bond prices and interest rates are purely a function of supply and demand for bonds. The nature of the demand is highly diverse. When a banker in Shanghai, a life insurance company in Frankfurt, a bond fund in houston, and a blue-haired lady in Topeka buy a US bond, they all do so with totally different motives and expectations. The totality of their actions and those of millions of others sets bond prices and interest rates. Unless they all have inflation expectations at the top of their mind when they ask to buy or to sell, then inflation expectations have very little to do with the actual price.

      1. In the actual bond market, bond prices and interest rates are purely a function of supply and demand for bonds.

        Well, of course that’s what you observe. Actual prices of anything are a function of supply and demand. But observed demand is higher when there is more money chasing fewer goods, so prices go up. Investors are less likely to demand a bond at interest rate X when inflation goes up. The government will have to offer them a higher interest rate. Why are inflation-linked bonds such an important part of the market if investors don’t care about inflation?

      2. US Treasuries form the basis for the entire US Bond yield curve. Eighty percent of all US Treasuries are held by the Social Security Administration and Foreign governments or Foreign institutions. The remaining twenty percent of US Treasuries are owned by US Banks, US Insurance companies and US Mutual funds. A tiny, tiny percentage are held by US individual investors. Pricing of US treasuries is basically controlled by the the first group which owns that eighty percent. The remaining twenty percent have a more muted impact. The inflation rate in the United States has minimal impact on those institution’s bond purchasing decisions. Ergo, it must follow that it has minimal impact on the treasury yield curve. If the treasury yield curve is the basis for the rest of the curve then inflation expectations have a minimal impact on interest rates in general.

        This matches my anecdotal experience. I have never had a bond investor mention the word inflation. The conversations with bond buyers were always about the relative safety of the principal vis a vis the yield. To clarify, I am referring specifically to investors who like bonds or only deal in bonds. That’s not to say other types of investors don’t bring up inflation. Generally, when they do, then you direct their attention to equities or preferrreds.

      3. I agree that in the academic literature the concept is popular and has been around a long time. I first read about it as an econ undergrad in the early eighties. That doesn’t make it valid.

        The problem lies in the premise of the concept. The premise is that bond market participants consider the US inflation rate. If eighty percent of treasury market participants consist of the US government or foreign institutions then they most likely do not consider the US inflation rate. The basic premise doesn’t stand up to the basic scrutiny of who compose the actors in the bond market. If the basic premise doesn’t stand up to scrutiny then none of the rest of it follows.

        I will continue to respectfully disagree with you on that matter.

  3. How do those private commodity currency folks deal with the danger of fraudulent debasement? How do I know that the shire silver in the card is actually the specified amount of silver since it could have been tampered with post-sale and debased?

    1. Just as you switch products or brands when the price of one becomes too high; the private commodity folks deal with currency debasement by switching to a different currency that is more solid. This implies a responsibility upon the bearer to pay attention to these things.

      A better question is how do these central-banking/monopoly-currency folks deal with the danger of deliberate, state sanctioned debasement?

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