Topic: Finance, Banking & Monetary Policy

A Rush to Judge Gold

Of course I didn’t expect my recent post, listing “Ten Things Every Economist Should Know about the Gold Standard,” to stop economists from repeating the same old misinformation. So I’m not surprised to find two of them, from the New York Fed, repeating recently some of the very myths that I would have liked to lay to rest.

The subject of James Narron and Don Morgan’s August 7th Liberty Street Economics post is the California gold rush. After describing the discovery at Sutter’s mill and the “stampede” of prospectors anxious to get their hands on part of the “vast quantities of gold” whose existence that discovery had revealed, Narron and Morgan observe that the

large gold discovery functioned like a monetary easing by a central bank, with more gold chasing the same amount of goods and services. The increase in spending ultimately led to higher prices because nothing real had changed except the availability of a shiny yellow metal.

No economist worthy of the name would deny that, other things being equal, under a gold standard more gold means higher prices. But other things evidently weren’t equal in the U.S. in the late 1840s and early 1850s, for if they had been the path taken by the U.S. CPI between 1830 and 1880 would not have looked as it does in the chart shown below, which was also in my above-mentioned post:

U.S. CPI

*Graphing Various Historical Economic Series,” MeasuringWorth, 2015.

As you can see, the gold rush didn’t even cause a blip in the CPI, which was about as stable from 1840 to 1860 as it has ever been. Indeed, prices fell slightly, making for an annual inflation rate of minus .19 percent. For the shorter period of 1845 to 1860 the inflation rate is, admittedly, much higher: a whopping .63 percent. But even this higher rate is, according to the Fed’s current credo, was dangerously low. Were one to assume that a 2 percent inflation rate was as desirable 167 years ago as Fed officials claim it to be today, one would have to conclude that the gold rush, far from having made the U.S. money stock grow too rapidly, didn’t suffice to make it grow rapidly enough.

Ecuador’s Ambassador Misses the Point: Dollarization

Ecuador’s ambassador to the U.S., Francisco Borja Cevallos, wrote a letter, “Ecuador’s Progress,” which was published in the New York Times on August 8th. Ambassador Borja reviews a number of Ecuador’s recent economic accomplishments. Fine. After all, by Latin American standards, Ecuador has performed well. Indeed, my Misery Index rankings for the region in 2014 show that only Panama, Mexico, and El Salvador performed better than Ecuador did.

What Ambassador Borja failed to mention is the true source of Ecuador’s relative success: dollarization. Yes, Ecuador is dollarized. Ecuador represented a prime example of a country that was incapable of imposing the rule of law and safeguarding the value of its currency, the sucre. The Ecuadorian sucre traded at 6,825 per dollar at the end of 1998, and by the end of 1999 the sucre-dollar rate was 20,243. During the first week of January 2000, the sucre rate soared to 28,000 per dollar.

With the sucre in shambles, President Jamil Mahuad announced, on January 9, 2000, that Ecuador would abandon the sucre and officially dollarize the economy. Telephone calls from both President Bill Clinton and U.S. Treasury Secretary Larry Summers encouraged Mahuad to dollarize. The positive confidence shock was immediate. On January 11th — even before a dollarization law had been enacted—the central bank lowered the rediscount rate from 200 percent a year to 20 percent. On February 29th, the Ecuadorian Congress passed the so-called Ley Trolebus, which contained dollarization provisions. It became law on March 13th, and after a transition period in which the dollar replaced the sucre, Ecuador became the world’s most populous dollarized country. And dollarization remains, to this day, highly popular; most Ecuadorians — 85 percent — still give dollarization a thumbs up. What Ecuadorians fear is that President Rafael Correa, who has opposed dollarization in the past, might just abandon the greenback, which is Ecuador’s anchor of stability.

Milton Friedman and Monetary Freedom

Although I don’t call myself a Friedmanite or a monetarist (or anything else), and many of my opinions on monetary economics are ones that he rejected, I’m a huge Milton Friedman fan. I regard him as the most influential champion of free market economics after Adam Smith, and as one of the greatest monetary economists of the last century. He is certainly among the dozen monetary economists of any era from whom I have learned the most. Finally, in my own dealings with him I found him to be an upright and generous man, as well as one who gave me a great deal of encouragement and support when I most needed it.

Consequently it distresses me to see Friedman attacked, and especially so when the attacks come from persons who share my fondness for monetary freedom. One such attack came my way two weeks ago, in the shape of a complaint about a Cato email notice commemorating what would have been Friedman’s 103rd birthday, on July 31. The writer, a free-market gold standard advocate, and a generally pleasant and mild-mannered fellow, called “Chicago School” monetary economics “a virulently anti-free market conception that has institutionalized our unstable…monetary system,” and said that, in leading it, Friedman “did us and the world an unfathomable disservice.”

That’s Right: “Famously Sound and Famously Stable”

In one of my recent posts I observed, not only that Canada’s ca. 1913 currency and banking system was sound and stable, but that it was “famously” so. Many of my readers may wonder about that description. After all, relatively few people today are aware of Canada’s having had such a successful system; and most current writings on U.S. monetary history don’t even refer to it. That one can read one official Federal Reserve account after another of that history, and especially of the Fed’s origins, without hearing so much as a whisper about Canada’s having had a well-working banking and currency system, albeit one without a central bank, goes without saying.

But the story was far different a century or more ago. Back then, just about any U.S. adult who paid attention to current events knew all about Canada’s smoothly-working monetary system, and also about various reformers’ efforts to replicate it’s success in the U.S. Where’s my proof? It’s all right here, in hundreds of articles that appeared in scores of U.S. newspapers between 1890 and 1913.

Read ‘em, or some of them at least. And weep.

Rules versus Discretion: Insights from Behavioral Economics

For half a century now, the “rules versus discretion” debate in monetary economics has focused on the so-called “time inconsistency” problem.  The problem is that, although a discretionary central bank might promise not to allow the inflation rate to rise above zero (or some other ideal value), the fact that an inflation “surprise” can boost employment and output in the short run will tempt it to break its promise.  Realizing this, market participants will anticipate higher inflation.  The long-run result is a higher inflation rate with no improvement in either employment or output.  By limiting the central bankers’ options, a monetary rule solves the time inconsistency problem.

An earlier rules-versus-discretion debate had taken place in the 1920s and 1930s.1  The later one, which was inspired by the stagflation of the 1970s, differed in that it was influenced by the New Classical revolution that was taking place around the same time.  Consequently, the later critics of monetary discretion, including Finn Kydland and Edward Prescott,  Guillermo Calvo, Benn McCallum, Robert Barro and David Gordon, and John Taylor,2 differed from their predecessors by building their arguments on the premise that central bankers were both well (if not quite perfectly) informed and well intentioned.  Discretion, according to them, leads to less than ideal outcomes not because central bankers are ignorant or misguided, but because of misaligned incentives.

The Federal Reserve’s War on Drugs

That’s right: the Federal Reserve is now in the business of enforcing the U.S. government’s drug laws, even if that means making a mockery of both state governments’ right to set their own drug policies and the Fed’s own governing statutes.

The Fed’s involvement in drug prohibition became official last month, when the Federal Reserve Bank of Kansas City informed Denver’s Fourth Corner Credit Union — a non-profit cooperative formed by Colorado’s state-licensed cannabis manufacturers — of its decision to deny its application for a master account.  Since asking any sort of depository institution to operate without such an account, and hence without access to the Fed’s payment facilities, including its check clearing, wire transfer, and ACH facilities, is like asking a commercial airline to make do with propeller-driven biplanes, and established banks don’t want the extra hassle that comes with dealing with pot growers, the Kansas City Fed’s action forces Colorado’s marijuana industry to do business on a cash-only basis, with all the extra risk and inconvenience that entails.[1]

The Fourth Corner Credit Union isn’t taking this sitting down.  On the contrary: it is suing the Federal Reserve Bank of Kansas City.  Your typical civil action isn’t exactly a page turner.  But this one reads like a chiller, largely because that’s exactly what it is.  If you like a good horror story, I suggest you read the whole thing.  But for the sake of those in a hurry, here are the Cliff Notes.   Unless otherwise indicated, the details are as alleged by the lawsuit itself.

The basic legal facts as set forth in that document are, first, that it is the essence of the so-called “dual” banking system that both state governments and the Federal government have the right to grant charters to banks and other depository institutions, and, second, that, according to the 1980 Monetary Control Act, “All Federal Reserve bank services…shall be available to nonmember depository institutions and such services shall be priced at the same schedule applicable to member banks.”

Reserve Requirements Basel Style: The Liquidity Coverage Ratio

Over the last couple of decades, reserve requirements all but vanished as a means of bank regulation and monetary control. But now a new variation on reserve requirements is being introduced through the capital controls of the Basel Accords.

Canada, the UK, Sweden, Australia, New Zealand, and Hong Kong have all abolished traditional reserve requirements. In many other countries, reserve requirements have become a dead letter. In the U.S., for instance, the Fed under Alan Greenspan reduced all reserve requirements to zero except for transactions deposits (checking accounts), while permitting banks to evade reserve requirements on transactions balances by using sophisticated computer software to regularly “sweep” those balances into money market deposit accounts, which have no reserve requirement. In 2011 Congress went a step further by allowing the Fed to eliminate all reserve requirements if it so desired. The Eurozone, for its part, began with a reserve requirement of only 2 percent, which was reduced to 1 percent in January 1999.

There were good reasons for this deregulatory trend. Economists consider reserve requirements an implicit tax on banks, requiring them to hold non-interest earning assets, while central banks considered changes in such requirements too blunt an instrument for monetary control. The Fed discovered the latter shortcoming when, in the midst of the Great Depression, having just gained control over the reserve requirements of national banks, it doubled them, contributing to recession of 1937.