Prof. Bryan Caplan

Econ 918

Spring, 1998

Week 10: Privatizing Money, I: Commodity Standards

  1. Privatization of Money
    1. From weeks 1-2 it has been implicitly assumed that money is under the monopoly control of some government.
    2. But while true in the modern world, this manner of presentation ignores the alternative of non-government provision of the (?) monetary system.
    3. Next three weeks will consider the several angles on the alternative of private supply of money:
      1. Theory
      2. Objections
      3. Relevant historical experiences
    4. All key aspects of a monetary system will be examined through this lens, so at the end of three weeks it should be possible to envision a fully privatized monetary system.
      1. This week: Private supply of base money.
      2. Next week: Deregulation of banking and note issue.
      3. Third week: Further topics.
  2. Privatizing the Monetary Base
    1. From the outset of the course the monetary base has always been assumed to be:
      1. A monopoly of the government.
      2. Costless to create.
    2. The connection between this two assumptions should be clear: if money is costless to create, then competition driving price down to cost drives the purchasing power of money to zero.
    3. In week 3, alternatives that challenge this inference - in particular privately supplied fiat money - will be considered. For now we turn to the most easily understood and historically relevant solution: commodity standards.
    4. Under a commodity standard, one (or possibly more) commodities are simply used as money. The price level is finite because real resources must be used to produce the commodity.
      1. From now on Iíll refer to gold standard and commodity money interchangeably, but note that that is not a necessary equivalence. Note further that unless stated otherwise, Iím discussing a hypothetical gold standard without a central bank, not the historical gold standard.
      2. Note: Mint also assumed to be privatized. (Inefficiencies of government mints; Polish example)
    5. Assuming that gold is a sufficiently focal commodity, all of the standard results on money demand from week 1 hold. Any exceptions?
    6. Main difference: supply of commodity base money is inherently endogenous, even in a closed economy. Unless gold is irreproducible, a rise in the price level ipso facto implies a lower gross return to mining more gold, and vice versa.
    7. Under CRS in gold mining, and assuming no innovations in productivity or money demand, the market endogenously generates an equilibrium money supply, such that if the price level rises too high, gold mining ceases, and if the price level falls too low, unlimited resources flow into the gold mining sector.
      1. Under these assumptions, new mining merely replaces wear-and-tear of existing gold stock.
    8. More realistic assumption: extremely inelastic supply due to increasing ACs. (World) money stock equilibrates at glacial rates, though flows between regions may still be quite rapid.
      1. Humeís specie flow mechanism.
    9. Questions/puzzles:
      1. What crucial assumption must one make about elasticities for Humeís specie flow mechanism to work?
      2. Does jewelry demand play an extraordinary role under the gold standard?
      3. Why were Europeans always searching for gold instead of non-monetary commodities during the Age of Exploration?
      4. Why does the market tend to select commodities with non-monetary uses for monetary purposes, when an inelastically supplied commodity without any non-monetary uses would be more efficient?
  3. 100% Reserves vs. Fractional Reserves
    1. One variant on commodity standards - seriously considered not just by Rothbard but also by Friedman and others - combines gold base money with a ban on fractional-reserve banking.
      1. How would banks support themselves? With fees - just like safe deposit boxes.
      2. You could still write checks or use bank notes instead of gold coin, but these would be backed 100% by gold.
      3. Note currency board analogy.
    2. Positive analysis: what would the impact of imposing the 100% reserve standard be? Look at it through Famaís lens, in which reserve requirements are a tax on one type of mutual funds:
      1. A reduction in the price level.
      2. A shift from banks issuing "money" to other kinds of mutual funds not subject to the required reserves law.
      3. What determines the relative size of these two effects? Which would be larger in e.g. the current U.S.?
    3. Normative analysis: why would anyone want to impose a 100% reserve requirement?
      1. Definitional complaints about "money."
      2. Makes sharp deflations nearly impossible, since banking system is forced to be perfectly liquid.
      3. Makes absence of deposit insurance credible (similar to narrow banking).
    4. Legal fractional reserve banking does to a 100% gold standard what abolishing reserve requirements does to the current system:
      1. Raise the price level.
      2. Cause an expansion in the banking sector and a contraction in the non-bank financial services sector.
    5. Normative analysis:
      1. Fractional reserve system is potentially vulnerable to sharp deflations - but C-K suggest that this is a largely artificial problem.
      2. Unregulated reserves prevents need to artificially shed the "bank" label.
      3. Fractional reserve system probably allows higher growth rate of nominal GDP due to greater freedom of financial innovation.
    6. General comment: With well-developed financial markets, 100% reserves would probably provoke massive flight from banking sector. Non-bank sector might be run-proof, but could still experience sharp crashes that would have the same impact as bank failures now.
  4. Main Objections to Privatizing the Monetary Base
    1. Resource waste. Commodity standards are wasteful because the same function could be served by a money without an alternative non-monetary use.
      1. Gets small for fractional reserve systems.
      2. Governments have not generally sold off their gold stocks even after abandoning gold standard, and greater inflation volatility has made gold a more valued hedge. So paradoxically, dropping the gold standard has restricted industrial and consumer uses of gold more, not less!
    2. Greshamís Law. Among the most popular, but quite weak. Applies only if:
      1. Price controls are imposed, as in bimetallism.
      2. Or, verification of the authenticity of money is more costly for merchants than for customers.
    3. Fraud. Again quite weak - "Private enterprise has been able to supply an almost infinite number of goods requiring high precision standards; yet nobody advocates nationalization of the machine-tool industry or the electronics industry in order to safeguard these standards." (Rothbard)
      1. Analogous to machine tools, or more like designer jeans?
      2. In any case, less of a problem than bad checks.
    4. Makes discretionary macro policy impossible. Given the time consistency literature, this almost seems like a benefit, especially since the empirical evidence suggests that countries are still not trading off any real performance when they "buy" lower inflation.
    5. But: Would the gold standard be vulnerable to severe deflations, supply shocks, etc? I.e., is there a large class of macro ills that discretionary policy has solved so well they are no longer observed?
    6. Commodity standard inconsistent with optimal inflation rule. Depends on which policy is optimal (consider 3 rules discussed in class).
      1. Normal case under a gold standard is arguably a higher growth rate for real output than for the gold stock, but both tend to be positive, so nominal GDP should still show trend growth.
  5. The Gold Standard Era in Perspective (from Bordo, "The Gold Standard, Bretton Woods and Other Monetary Regimes")
    1. Three caveats:
      1. Under historical gold standard, central banks held much or most of the monetary gold, and stayed on the gold standard by pegging the price of gold in terms of domestic currency. So even in its heyday it was a much weaker gold standard than the pure case considered above.
      2. Pre-WWI CGS differed markedly from post-WWI "gold-exchange" standard. Will be explored more fully in Week 13; current discussion focuses on pre-WWI CGS.
      3. Large measurement error for early periods means variances tend to be over-estimated. (See e.g. Christina Romer's piece "Is the Post-War Stabilization a Figment of the Data?")
    2. Four major eras - plus several notable sub-periods - in the monetary history of the G-7 countries over the past century or so:
      1. Classical gold standard: 1881-1913
      2. Interwar period: 1919-39
        1. Floating exchange rates: 1919-1925
        2. Gold exchange standard: 1926-1931
        3. Managed float: 1932-1939
      3. Bretton Woods: 1946-1970
        1. Pre-convertible: 1946-1958
        2. Convertible: 1959-1970
      4. Floating: 1971-present
    3. How does the classical gold standard measure up?
    4. Inflation:
      1. Classical gold standard had the lowest rate of inflation of any period except the interwar period.
        1. N.B. Countries' inflation rates also showed most convergence during CGS era.
      2. Inflation volatility of CGS beats all other periods (though convertible Bretton Woods sub-period beats inflation volatility of CGS).
    5. Real output growth (per capita):
      1. Bretton Woods period beats CGS on both level and volatility. (Could this be due to greater measurement error in early years? What kind of measurement error?)
    6. Money growth:
      1. CGS had lowest money growth except for interwar period.
      2. Money growth volatility of CGS actually loses to floating exchange rate regime, but beats Bretton Woods. (Interwar regime does worst of all).
    7. Interest rates:
      1. Short-run nominal - CGS level lower than all except interwar period. Volatility lowest of all.
      2. Short-run real - CGS second-highest (only interwar higher). Same for volatility.
      3. Long-run nominal - CGS mean lowest of all. Same for volatility.
      4. Long-run real - Highest level except for interwar; lowest volatility.
    8. Persistence: Inflation found to be white noise during CGS, highly persistent in other periods.
    9. Responsiveness: Responsiveness of prices to D and S shocks founds to be much greater during CGS. (Why? More flexible labor markets, more restricted suffrage, less understanding of short-run benefits of policy hence less temptation...?)
  6. Friedman and Schwartz on Gold Standard
    1. (pp.87-88) Note mention of deflation combined with high output growth.
    2. (pp.90-91) Note 2 periods of U.S. gold standard, and agitation for silver inflation.
    3. (pp.104-105, 114-119) Free silver agitation peaks, then collapses, leaving CGS in tact. "The political campaign of 1896 on these issues was conducted with notorious bitterness involving both class and sectional conflicts. Fear and smear techniques were freely used on all sides..."
    4. (p.135) High gold inflation; note prescient remarks on the future height of inflation: price level increased by over a factor of 5 from 1960 to 1995.
    5. (p.159) Note C-K insight appears in n36!
    6. (p.160-161) Note seasonal currency patterns and currency premium of up to 4% during suspension.
    7. Other comments?