CIAO DATE: 06/2012
Volume: 32, Issue: 2
Spring / Summer 2012
Monetary Reform in the Wake of Crisis
Editor's Note (PDF)
James A. Dorn
The Eurozone Crisis and Global Monetary Reform: A Conversation (PDF)
Robert B. Zoellick, Sebastian Mallaby
Sebastian Mallaby: We are here to talk to Bob Zoellick. I have been in Washington 16 years, Bob is the personification of the kind of silo busting polymathic energy which says, I am not just interested in international economics, I am not just interested in international relations, I am not just a U.S. government official, I am also going to do multilateral diplomacy. So Bob has been on all sides of those various divides. He has a voracious intellect, so it is always interesting to speak with him whether he is in office or out of office.
Understanding the Interventionist Impulse of the Modern Central Bank (PDF)
Jeffrey M. Lacker
The financial crisis of 2007 and 2008 was a watershed event for the Federal Reserve and other central banks. The extraordinary actions they took have been described, alternatively, as a natural extension of monetary policy to extreme circumstances or as a problematic exer- cise in credit allocation. I have expressed my view elsewhere that much of the Fed's response to the crisis falls in the latter category rather than the former (Lacker 2010). Rather than reargue that case, I want to take this opportunity to reflect on some of the institutional reasons behind the prevailing propensity of many modern central banks to intervene in credit markets.
Federal Reserve Policy in the Great Recession (PDF)
Allan H. Meltzer
Overresponse to short-run events and neglect of longer-term con- sequences of its actions is one of the main errors that the Federal Reserve makes repeatedly. The current recession offers many exam- ples of actions that some characterize as bold and innovative. I regard many of these actions as inappropriate for an allegedly independent central bank because they involve credit allocation, fill the Fed's portfolio with an unprecedented volume of long-term assets, evade or neglect the dual mandate, distort the credit markets, and initiate other actions that are not the responsibility of a central bank.
The Fed's Fatal Conceit (PDF)
John A. Allison
I strongly believe that the recent financial crisis, ensuing recession, and slow recovery were primarily caused by government policy. The Federal Reserve made some very bad monetary decisions that created a bubble, i.e., a massive malinvestment. The bubble ended up being focused in the housing market largely because of government affordable housing policies-specifically, the actions of Freddie Mac and Fannie Mae, government-sponsored enterprises that would not exist in a free market. When Freddie and Fannie failed, they owed $5.5 trillion including $2 trillion in affordable housing (subprime) loans. It's true that a number of banks made serious mistakes, and I would have let them fail, but their mistakes were secondary and within the context of government policy.
I've known many people in the Federal Reserve, in monetary policy. They are very smart people. They are highly committed people. However, in my experience, they are guilty of what F. A. Hayek (1989) called "the fatal conceit"-that is, the belief that smart people can do the impossible. I don't care how smart you are or how great your mathematical models are, you cannot coordinate the economic activity of seven billion people on this planet.
The real issue is: What does government policy incentivize real-world human beings to do? I'm going to share with you my own expe- riences in that regard and also my insights into the actions of other financial company CEOs.
Only a Crisis Will Bring Money Reform (PDF)
George Melloan
"Well, if I had a nickel, I know what I would do. I'd spend it all on candy and give it all to you. . . . Cause that's how much I love you baby." That wasn't a very generous proposition even in 1946, when country singer Eddy Arnold wrote those words. But at least a nickel would buy a good-sized Baby Ruth or Clark bar. Today? A jelly bean, perhaps?
Banking Dysfunction (PDF)
James A. Grant
"Has anyone bothered to study the cumulative effect of all these things?" the chief executive officer of JPMorgan Chase reasonably inquired of the chairman of the Federal Reserve Board at a bankers gathering in Atlanta last June. The CEO, Jamie Dimon, was referring to the combination of cyclical hangover and regulatory constriction. The chairman, Ben Bernanke, replied, "It's just too complicated. We don't really have the quantitative tools to do that" (Grant and Masters 2011: 1).
Banking dysfunction is the subject at hand. For what ails us, I am about to blame modern regulation, the asphyxiating philosophy of modern regulation, the bankers themselves, the pure paper dollar, manipulated interest rates, and the human condition. Concerning bank capital, I favor just enough but not too much, the exact amount best known to people who have not been elected to Congress. It isn't the lack of capital that's put the American banking system behind the eight ball; it's a shortage of capitalism.
What Should a Central Bank (Not) Do? (PDF)
Benn Steil
The financial crisis that began unfurling in 2008 has led to the refashioning of the model central bank governor along the lines of Churchillian war leader, willing to try anything with the money he conjures to restore economic growth. This raises important questions as to what limits, if any, elected officials should impose on such aspir- ing great men, and what limits markets will ultimately impose on them if elected officials forbear. This article focuses on the second of these questions.
L Street: Bagehotian Prescriptions for a 21st Century Money Market (PDF)
George Selgin
In Lombard Street, Walter Bagehot (1873) offered his famous advice for reforming the Bank of England's lending policy. The financial crisis of 1866, and other factors, had convinced Bagehot that instead of curtailing credit to conserve the Bank's own liquidity in the face of an "internal drain" of specie, and thereby confronting the English economy as a whole with a liquidity shortage, the Bank ought to "lend freely at high rates on good collateral." Bagehot's now-famous advice has come to be known as the "classical" prescription for last-resort lending.
Largely forgotten, however, is Bagehot's belief that his prescription was but a second-best remedy for financial crises, far removed from the first-best remedy, namely, the substitution of a decentral- ized banking system-such as Scotland's famously stable free banking system-for England's centralized arrangement. Bagehot's excuse for proffering such a remedy was simply that he did not think anyone was prepared to administer the first-best alternative: "I pro- pose to maintain this system," he wrote, "because I am quite sure it is of no manner of use proposing to alter it. . . . You might as well, or better, try to alter the English monarchy and substitute a republic" (Bagehot 1873: 329-30).
Like Bagehot, I offer here some second-best suggestions, informed by recent experience, for improving existing arrangements for dealing with financial crises. Unlike Bagehot, who merely recommended changes in the Bank of England's conduct, I propose changes to the Federal Reserve's operating framework. And although, like Bagehot, I consider my proposals mere "palliatives," I do not assume that we cannot ultimately do better: on the contrary, I doubt that any amount of mere tinkering with our existing, discretionary central banking system will suffice to protect us against future financial crises. To truly reduce the risk of such crises, we must seri- ously consider more radical reforms (see, e.g., Selgin, Lastrapes, and White 2010).
Gold and Government (PDF)
Judy Shelton
Something has gone terribly wrong with the world's monetary system. It's evident that some kind of fundamental reform needs to be implemented. The question is: Can governments be trusted to issue sound money, or is money too important to be left to the politicians?
Is it reasonable to expect governments to abide by the discipline required to maintain sound money? Or have we set up an irresistible temptation by empowering governments to control both fiscal and monetary policy? Would it make more sense to return money to markets by privatizing money issuance?
In this article, I propose a reform that would bring the power of market forces and competition to bear on the challenge of providing sound money while still giving government a principled role in the monetary system.
My recommendation is to introduce a special class of medium-term U.S. government debt obligations to be designated "Treasury Trust Bonds (TTBs)." These zero coupon bonds would grant the holder the right to redeem in either gold or dollars. This article provides details on how TTBs would be structured and how they might spur a transition toward new global monetary arrangements.
The issuance of TTBs would fit into a pro-growth economic agenda based on limited government, low taxes, rule of law, and global free trade. Linking the dollar to gold through TTBs would be a bold step toward completing the original economic agenda laid out by President Ronald Reagan, which called for a stable dollar. Consider it a "trust-but-verify" approach to sound money.
From Constitutional to Fiat Money: The U.S. Experience (PDF)
Richard H. Timberlake
Over the course of more than two centuries, the United States has had two monetary systems. The first was a gold-silver standard that was framed in its essentials by the U.S. Constitution. In practical terms, it said that any legal tender money created by the federal union or the states or the "people" had to be gold or silver coins, or redeemable in gold or silver coins of specified weight and fineness. Since both gold and silver were constitutional media, the country had a bimetallic standard that ultimately became a monometallic gold standard.
During the period in which the gold standard functioned through-out most of the 19th century until 1914 and with some qualifications until 1930, the purchasing power value of the dollar, as measured by any statistically valid price index, was secularly constant. Occasionally, mild inflations or deflations occurred, and from 1862 to 1879 the federal government instituted a paper-money ("greenback") inflation, but the tendency for the dollar to maintain its exchange value was notable. For all practical purposes, the long-term value of the dollar was constant for more than a century.
In spite of its enviable record for approximating price level stability without human hands-on controls, the gold standard had its critics. Different factions argued for relief from its discipline. Many businessmen chafed at its restrictive effect on monetary availability for industrial expansion, and debtors complained during the occa- sional bouts of "dear money." Cheap money, plenty of it, and low interest rates became political slogans, but gold endured the strain. For one thing, a standard based on the naturally limited quantities of a metallic commodity was obviously what the Framers of the Constitution had intended, and, second, nothing else seemed consti- tutional enough to replace it.
The second monetary institution to appear was the Federal Reserve System in 1913, just as the gold standard system looked enduring and stable. Both a gold standard and a central bank determine an economy's stock of money. However, the original Fed was not intended to replace the gold standard in that capacity; it was not to be a central bank. It was not an expression of the federal government's "complete power over the monetary system." The congressional debates and the Federal Reserve Act's concluding sentences confirmed the preeminence of the gold standard and, by implication, constitutional constraints over the monetary system. The final bill stated: "Nothing in this Act . . . shall be considered to repeal the parity provisions contained in an act [Gold Standard Act] approved March 14, 1900."2 The Fed was to be nothing more than a group of primarily private, super-commercial banks that would help client "member" banks endure short-term liquidity crises. This low-profile image of the original Fed immediately raises the question: If true, how did the Fed subsequently acquire its monetary omnipotence?
The Coming Fiat Money Cataclysm and the Case for Gold (PDF)
Kevin Dowd, Martin Hutchinson, Gordon Kerr
A recurring theme in monetary history is the conflict of trust and authority: the conflict between those who advocate a spontaneous monetary order determined by free exchange under the rule of law and those who wish to meddle with the monetary system for their own ends. This conflict is perhaps most clearly seen in the early 20th century controversy over the "state theory of money" (or "chartalism"), which maintained that money is a creature of the state. The one side was represented by the defenders of the old monetary order-most notably by the Austrian economists Ludwig von Mises and Friedrich Hayek, and by the German sociologist Georg Simmel. The other side was represented by the German legal scholar Georg Friedrich Knapp and by John Maynard Keynes. They argued that on monetary matters the government should be free to do whatever it liked, free from any constraints of law or even conventional morality.
States have claimed the right to manipulate money for thousands of years. The results have been disastrous, and this is particularly so with the repeated experiments with inconvertible or fiat paper currencies such those of medieval China, John Law and the assignats in 18th century France, the continentals of the Revolutionary War, the greenbacks of the Civil War, and, most recently, in modern Zimbabwe. All such systems were created by states to finance their expenditures (typically to finance wars) and led to major economic disruption and ultimate failure, and all ended either with the collapse of the currency or a return to commodity money. Again and again, fiat monetary systems have shown themselves to be unmanageable and, hence, unsustainable.
The same is happening with the current global fiat system that has prevailed since the collapse of the Bretton Woods system in the early 1970s. The underlying principle of this system is that central banks and governments could boost spending as they wished and ignore previous constraints against the overissue of currency and deficit finance; implicitly, they could (and did) focus on the short term and felt no compunctions whatever kicking the can down the road for other people to pick up. Since then loose monetary policies have led to the dollar losing over 83 percent of its purchasing power. A combination of artificially low interest rates, loose money, and numerous incentives to take excessive risks-all caused, directly or indirectly, by state meddling-have led to an escalating systemic solvency crisis characterized by damaging asset price bubbles, unrepayable debt levels, an insolvent financial system, hopelessly insolvent governments, and rising inflation. Yet, instead of addressing these problems by the painful liquidations and cutbacks that are needed, current policies are driven by an ever more desperate attempt to postpone the day of reckoning. Consequently, interest rates are pushed ever lower and central banks embark on further monetary expansion and debt monetization. However, such policies serve only to worsen these problems and, unless reversed, will destroy the currency and much of the economy with it. In short, the United States and its main European counterparts are heading for a collapse of their fiat money regimes.
Why Monetary Freedom Matters (PDF)
Ron Paul
I've thought about and have written about the Federal Reserve for a long time. I became fascinated with the monetary issue in the 1960s, having come across the Austrian economists, especially Hayek and Mises, and I was very impressed with August 15, 1971, because the predictions made in the 1960s came about. As a matter of fact, Henry Hazlitt made that prediction in 1944 when the Bretton Woods system was set up. He said it wouldn't work and it would fall apart-and it did-so that was a strong confirmation.
But even after all these years of studying and reading and trying to figure out the monetary system, I have come to the conclusion that the Federal Reserve is unconstitutional-and we don't need it (Paul 2009). So with that approach I have worked hard in Congress for sound money.
Where Is Private Note Issue Legal? (PDF)
Kurt Schuler, William McBride
During the 18th and 19th centuries and for part of the 20th century, more than 60 countries had free banking. The major characteristics of free banking are competitive issue of notes (paper money) and deposits by commercial banks, low legal barriers to entry, little regulation unique to the industry, and no central control of reserves (the monetary base) within the national monetary system (Dowd 1992, White 1995). Among the countries that had a form of free banking was the United States. Even after the freest period of free banking ended, with the Civil War, banks continued to issue notes until the federal government effectively monopolized note issue in 1935.
Making the Transition to a New Gold Standard (PDF)
Lawrence H. White
Suppose for the sake of argument that we all agree to the following proposition: If we could change the monetary regime with zero switching cost, merely by snapping our fingers, we would prefer the United States to be on a gold standard. In the most general terms, a gold standard means a monetary system in which a standard mass (so many grams or ounces) of pure gold defines the unit of account, and standardized pieces of gold serve as the ultimate media of redemption. Currency notes, checks, and electronic funds transfers are all denominated in gold and are redeemable claims to gold.1 We then face the question: What would be the least costly way for the United States to make the transition to a new gold standard? We need to choose a low-cost method to ensure that the agreed benefits of being on the gold standard exceed the costs of switching over.
Two transitional paths suggest themselves (1) let a parallel gold standard grow up alongside the current fiat dollar, and (2) set a date after which the U.S. dollar is to be meaningfully defined as so many grams of pure gold. This second, more conventional path, was fol- lowed after the suspension of the gold standard during the U.S. Civil War. It is more commonly described as establishing an effective parity stipulating so many dollars per fine troy ounce of gold. In our present situation, where Federal Reserve liabilities (book entries and currency notes) and Treasury coins constitute the basic dollar media of redemption for bonds and commercial bank liabilities, that implies converting the Federal Reserve System's liabilities and the Treasury's coins into gold-redeemable claims at so many grams of gold per dollar (or equivalently so many dollars per ounce of gold).
We see analogs to these two transitional paths when we observe how two countries have made the transition to using the U.S. dollar. In Ecuador in 1998-2000, a parallel unofficial U.S. dollar system emerged as the annual inflation rate in the local currency rose from low to high double digits, then to triple digits. The private sector of the economy was already heavily dollarized when the plug was finally pulled on the heavily depreciated local currency unit in 2000. In El Salvador in 2001, the government chose to permanently lock in the dollar value of the currency-by switching from a dollar-pegged exchange rate to outright adoption of the U.S. dollar-while inflation was low and the local currency still dominant. In a nutshell, when the official switch to the harder currency came in Ecuador, it was an act of necessity in the midst of a hyperinflation crisis. In El Salvador it was an act of foresight, to rule out such a crisis.
Natural Rates of Interest and Sustainable Growth (PDF)
Roger W. Garrison
The evolution of macroeconomic theory and monetary policy has brought us to a state that calls for critical reflection. It is undoubtedly true that no newcomer to the field can even begin to understand the current state of macroeconomics and policy formulation without understanding just how, dating from the pre-Keynesian era, the profession has arrived at this state. High theory today takes the form of stochastic dynamic general equilibrium analysis, while policy discussion, which concerns itself with economy-wide disequilibrium, centers on the effectiveness (or ineffectiveness) of old-style fiscal and monetary stimulants. The market is a process and so too is the theorizing about it. The history of macroeconomic thought reasserts its relevance at times of economic crises and almost inevitably leads us to the question "How far back do we have to go to start all over?"
Toward a Global Monetary Order (PDF)
Gerald P. O’Driscoll Jr.
I will begin by disputing that there is a global monetary system. We do not have a system in any meaningful sense. There are 182 independent currencies in the world. Some currencies are fixed in relation to other, larger currencies (e.g., the Hong Kong dollar to the U.S. dollar). Some currencies move within a band against other currencies (e.g., the Singapore dollar and the Chinese yuan). Many currencies float on foreign exchange markets, but few float freely. Four major currencies float against each other: the U.S. dollar, the euro, the pound, and the yen. Countries also change their foreign exchange regime (e.g., Mexico in recent decades).
The multiplicity and changeability of arrangements defies the use of "system," certainly not in comparison to arrangements of the past or possible arrangements of the future. Stability and certainty of expectations are not possible. The dollar still dominates, and one might suggest that "the Fed rules." But the Federal Reserve follows no rule, and is not the source of stability or certainty.
No one designed the global fiat monetary arrangements; the world stumbled into them. Global fiat money came about because of flaws in the prior global monetary arrangements and political considerations in the United States.
There certainly were advocates for the current system. They believed that fiat monies would work better than the gold standard. The problem is that all the supposed advantages have proved elusive, and the predicted deficiencies have been realized in practice. The issues were debated in the 1930s, and that debate remains surprisingly modern.
Aaron Ross Powell
Political Philosophy, Clearly, part of Liberty Fund's "Collected Papers of Anthony de Jasay" series, gathers nearly two dozen essays from the prominent economist and philosopher. From them emerges a fascinating overview of de Jasay's thought on the nature of order, justice, and the state.
Ivan Osorio
President Ronald Reagan’s firing of more than 12,000 illegally striking air traffic controllers in August 1981 is widely considered a defining moment both for Reagan’s presidency and for American organized labor. For Reagan, it was the first of many lines in the sand he drew during his presidency. For organized labor, it marked an assault from an anti-union president determined to prevail against a Democratic constituency.
Does the Elephant Dance? Contemporary Indian Foreign Policy by David M. Malone (PDF)
Malou Innocent
After more than 20 years of major market reforms that followed a foreign exchange crisis in 1991, India’s stunning economic growth has enlarged its international profile. But unlike China, India’s security challenges and perspectives on foreign policy remain largely unknown to the rest of the world. What kind of great power does India aim to be?