Question on Money
Jude Wanniski
March 3, 2000

 

To: SSU Students
From: Jude Wanniski
Re: Questions on Money

Free Banking
Floating for Nearly Thirty years
If We Went on a Gold Standard...
Governmentís Monetary Responsibility
Interest Rates Under Gold & Tax Simplification
Listening to Gold
Creating Domestic Capital
Money w/o National Debt
"At the Mint" or "At the Fed?"
A "Correct" Gold Price
Definition of Species
Fed Unable to Monetize Debt Prior to 1934
The Discount Window


Free Banking 

Q. John Carlson - In your 12-12-97 lesson, you state that only the central bank can provide the flexibility needed to properly manage the liquidity requirements of the economy; the Federal Reserve System should not be eliminated. But what would prevent private banks in a "free banking" system from supplying the economy with the proper liquidity using their own notes, provided the government maintains a stable unit of account? Throughout your articles, I think that Iíve been able to understand some of the mistakes made over the years, but I havenít been able to detect a "problem" with "free-banking" that was not ultimately caused by the political decisions made by our government. Please let me know where my thinking may be incorrect.

A. Free banking was fine in its day, but the U.S. economy matured to the point where it made sense to develop a system that would allow the pooling of risks nationally. I compare the central banking system we have today to the Interstate Highway network, which replaced the haphazard system of primary highways that criss-crossed the nation. Many of the problems faced by "free-banking," where individual banks could be banks of note issue, were not caused by "our government," but by foreign governments. That is, the European tariff wars of the latter part of the 19th century were transmitting waves of financial turbulence into our economy, with financial problems striking different regions in different ways. There is nothing wrong with the Federal Reserve system -- the Fed being the lender of last resort -- as long as it would be required to keep the dollar/gold exchange rate fixed. The turbulence of the last several decades is the result of the Fed being asked to lower the unemployment rate with cheap money.


Floating for Nearly Thirty years 

Q. Gary Boden - If the floating dollar is less efficient than the fixed dollar, then why have we kept it for nearly thirty years? Has the inefficiency been masked by technology-induced productivity? Do the establishment powers manipulate the game so as to prevent the natural tendency toward efficiency ? Are there just so many little forces that need to be lined up correctly to push toward efficiency that at any one time, not enough are pulling in the same direction? Or is it that efficiency is hard to achieve and must struggle against long odds, unlike inefficiency which is aided by entropy ?

A. The U.S. was spinning out of control on the floating system, until Reagan was elected in 1980 on a pledge to cut tax rates. The lower rates caused an increase in the demand for dollar liquidity that mopped up the surplus which had been pumped into the system in 1979-80 by Fed Chairman Paul Volcker, who had been spurred by the Friedmanites to hit their monetary targets. In subsequent years, the Fed at least began paying attention to the gold price in the making of monetary policy and its dollar price more or less stabilized. It is a wobbly unit of account, though, and would work much more efficiently if it were anchored to gold. The floating dollar remains because a great many people now make their livings in managing a turbulent monetary regime. When the big banks begin hurting again as a result of the dollarís inefficiency, they would take a more active interest in giving up the float for a fixed dollar. Those who are hurt worst by a floating dollar are those least able to cushion themselves against small swings in the dollarís value... which is why ordinary people are more likely to support a dollar as good as gold. Jack Kemp supports a gold dollar, but he is not running for political office and cannot build a mandate for gold. So we get along as best we can without it.


If We Went On A Gold Standard... 

Q. Charles Elkins - If the government decided tomorrow to go back on a gold standard, how would they decide on an equilibrium price and how could it be achieved with a minimum of market disruption? Also, the FOMC obviously wields a formidable amount of power under the current system. Could you elaborate on the potential abuse of that power, and where would the power shift to in the event of a return to a fixed system?

A. The Federal Open Market Committee (FOMC) only has formidable power because it is not required to maintain the dollar/gold exchange rate. If the government decided tomorrow to return to a gold standard, the President could do it by executive order, which is how President Nixon ended the gold standard in 1971. He would direct the Treasury to stabilize the dollar/gold price by buying and selling gold to keep it fixed at a price certain, with the Federal Reserve asked to respect the effort by not offsetting Treasuryís goal by offsetting Treasuryís interventions. A statute of the Congress could formalize this by requiring the Fed to assist by buying or selling government bonds when the gold price appeared to be moving in one direction or the other away from the fixed price. There could be a variety of ways chosen to pick the fixed price, but most likely it would be in the range of $300 or higher, which has been its average price for the last decade. This would minimize disruptions. The President himself could pick the price out of the air, as long as it was close to the market range, which is how President Roosevelt chose $35 in 1934, when he devalued the dollar from $20.67 per gold ounce.


Governmentís Monetary Responsibility 

Q. Lawrence Lau - Your discussion on money as unit of currency emphasized the role of government in maintaining a standard for the quality of money (a consistent benchmark against desired set of basic consumer goods). However, how can it adjust correctly for the desired quantity of money to match productivity? The wealth of nations is now measured by the productive capacity of its outputs. However, with information technology, it is possible to significantly increase utilization from the same set of inputs. If you have a fixed amount of monetary debt in the system, how would the government accommodate sudden shocks (i.e., demands on liquidity) from the first-movers (i.e., maximum initial profits) to fuel the necessary infrastructure investment? The modern internet craze is a case in point as there is inadequate savings in the system to fund capital raising leading to companies using share equity as proxy money. Is there a better solution?

A. It is not the job of the government or the central bank to provide capital to the market, only liquidity. The only capital available to the government is that which it taxes away from the private economy. The private sector creates capital out of the surplus time, effort and talent of individual people, a process that occurs when people see a good use and a potential positive return on their investments of time, energy and talent. By setting the value of the unit of account, at a fixed dollar/gold rate, the government provides the producers in the economy a means of eliminating the risk of dollar fluctuations -- and a greater efficiency in the creation of capital. The central bank -- the Fed -- supplies the liquidity being demanded by the private sector. As productivity increases because of the Internet expansion, that sector automatically increases its demand for liquidity as it attracts capital, and the Fed automatically supplies the dollars demanded. The fixed gold price simply tells the Fed when it is supplying too much or too little of what the marketplace is asking for.


Interest Rates Under Gold & Tax Simplification 

Q. Jones Patrick - Two questions. 1) Inflation in the USA is at an historic low, 2% p.a. and 90 day LIBOR is 5.75% thus real interest rates are 3.75%. Is it your argument that with a fixed standard (gold) that real interest rates would be less than current real interest rates ? If the answer is yes then it would be very illuminating to know what the impact lower interest rates would have on economic growth. More importantly, how would risk-taking by entrepreneurs and lenders be affected? 2) If we agree that the current USA tax system is overly complicated and siphons away resources that could be better utilized, then do you believe that by radically changing the tax system that economic growth will be enhanced? If the US abandons the "progressive" tax system and opts for a flat rate or better yet a consumption tax what impact can you foresee for the US economy? Anything that the US does that is successful will be copied here in Europe in time.

A. With a fixed dollar/gold rate, real interest rates would be the same as nominal rates, and nominal rates would rise or fall on risk factors other than monetary risk -- the risk that the Fed would err on the inflation side or the deflation side. If the United States and Japan today fixed their currencies to gold, interest rates would fall here and rise in Japan until they were almost the same. There would be differences as the markets made bets on the durability of the new regimes. When the Bretton Woods fixed system was in full swing, interest rates on dollar debt and yen debt were almost identical, but diverged as the market saw our government departing from strict adherence to the fixed system.

...On your second question, Tax simplification in and of itself frees human resources that are now totally devoted to managing the complexity of the tax system. If at the same time you set rates at points of the Laffer Curve where they are not discouraging capital formation, you add further to efficiencies of your economy and lift national living standards. The tax system need not be "flat," but could be flatter than it is. And a consumption tax is not necessarily better than an income tax.


Listening to Gold 

Q. "vieserre vieserre" - Is gold still a viable
indicator of present or future economic conditions -- in particular an indicator of inflation or excessive monetary growth - since it has recently not foreshadowed the positive changes in price of the CRB, oil and the like as it once did and has not responded materially to positive changes in global economic and monetary growth with expected increase in inflation?

A. Gold has never been a "viable indicator of present or future economic conditions." Prior to 1971, it was the official "money" of the U.S. government, by legal definition, a standard of measure. Gold remains the best indicator of monetary error by the central bank because it is the most monetary of all commodities -- the only commodity whose future price rises and falls with dollar interest rates. The future prices of wheat or corn or copper are often lower than spot prices, but the future price of gold is almost always the spot price plus the relevant interest rate.


Creating Domestic Capital 

Q. Allen Dolina - I have a question about "capital," coming as I do from a perennially capital deficient country -- the Philippines. We learned in school that the Philippines lacks capital and needs foreign investors to build up its productive resources. This has always been the justification presented for opening up the economy to American capital after WW2 (the Bell Trade Act). And yet, we now read about the so-called Filipino-Chinese taipans such as John Gokongwei and Lucio Tan who built up their businesses without access to foreign capital. The Filipino Chinese even helped Taiwan build its economy by exporting their surplus capital there in the 1950s. These two phenomena support the theory that the Philippines has capital resources of its own to build its economy. I suspect that capital, if seen as the surplus of production less consumption accumulated over time, is created by each national economy. Foreign currency is needed only if a country requires the products of another country, e.g. US capital equipment and Japanese transport. And, history has shown that the exporting country will make its currency available through foreign aid to facilitate its exports.

A. If the Philippines were the only country in the world, it could not "import capital," and would quickly discover that it had plenty of unused internal capital. Remember, capital is simply the surplus time, energy and talent of people, individually and in cooperative institutions. The Philippines -- and most other countries -- wastes much of its native capital by ignoring this definition. Its leaders often arrange tax laws that discourage creation of domestic capital in order to finance the import of foreign capital. A country optimizes its capital formation when it gets its monetary, fiscal and regulatory policies just right. Rarely do governments think in these terms.


Money w/o National Debt 

Q. Gary Anderson - Six questions:

Q1. You make the assertion "Money cannot exist w/o national debt." This doesn't seem correct. A private bank can create money in exactly the same way the Treasury and Fed do. If Joe Businessman borrows $1000 from 1st Wildcat Bank (FWB) and FWB simply credits Joe's DDA, then $1000 of new money has been created and exists w/o national debt. The FWB entries would be: Debit loans for $1000 and credit DDA for $1000. The difference between the Fed and FWB is that the Fed has no minimum reserve requirements and infinite reserves. FWB has reserve requirements and limited reserves.

A. You are correct in your example. Most "dollars" are not liabilities of the national government or the central bank but are created through the fractional-reserve banking system. The monetary base is almost exclusively government non-interest-bearing debt... government bonds that have been "monetized," by which we mean interest-bearing bonds that have been converted into non-interest-bearing deposits. Prior to 1934, the Federal Reserve could only monetize private debt at its discount window. If the government paid down all of its national debt, new "dollars" could only be created by private banks, which would then have to use some definition other than "the dollar" to take deposits and make loans, as the dollarís meaning is now only expressed in its debt.


"At the Mint" or "At the Fed?" 

Q2. You refer to a commercial bank's checking "at the Mint." Shouldn't it be "at the Fed"?

A. Again, correct. The actual currency flows through the central bank from the Mint, with each "Federal Reserve note" of denominations of $1 to $100 imprinted with the seal of a different Federal Reserve Bank, 12 in all. The regional Fed banks respond to local demand for currency and put it into circulation through its member banks, but the currency is legal tender everywhere in the United States. The money supply is shared, as you can see by checking your wallet and finding bills from other parts of the country, although new bills are being circulated without this fictional distinction.


A "Correct" Gold Price 

Q3. How does a central bank select the "correct" price of gold convertibility? What is more or less "right" about $100 per ounce vs. $350 per ounce.

A. I will answer this question in depth at some future lesson this semester, but as I suggested in answer to an earlier question, the price has to be roughly in a range that reflects existing contractual debt. If it is set too low, which $100 would surely be, creditors would benefit at the expense of debtors, who would have to pay back loans with much more "valuable" dollars. If set too high, debtors would benefit at the expense of creditors, who would receive much less valuable dollars than those they had loaned to begin with. An average price over the last several years would reflect the greatest volume of dollars in private contracts, which suggests a price between $300 and $350 would balance the interests of debtors and creditors.


Definition of Species 

Q4. In explaining the role of the Fed shortly after 1913 you mention the issuance of currency in exchange for species presented at the mint. Is the species, gold coin, bullion, dust or something else?

A. Any form of gold that could be refined to the purity by which the dollar was defined.


Fed Unable to Monetize Debt Prior to 1934 

Q5. Why couldn't banks monetize debts prior to 1934? It seems that as long as there is a fractional reserve system with less than a 100% reserve requirement a bank, any bank, can monetize debt by simply crediting a transaction account for the loan proceeds rather than paying out the proceeds in coin or folding currency.

A. The Federal Reserve was not permitted to monetize government debt prior to the Glass-Steagall Act of 1934. It was restricted to handing out cash or bank reserves through the discount window in exchange for eligible commercial debt. The change was made in 1934 on the theory that direct monetization of government debt would more easily liquefy the banking system and end the Great Depression. As soon as this was attempted, gold reserves ran out of the Treasury, as the problem was not too little "money," but tax and tariff rates that had forced the exchange economy to shrink.


The Discount Window 

Q6. In explaining the discount window after 1913, you mention that the Fed "pockets the difference." What is this difference? I would think the difference would be the discount rate less zero (the Fed's cost of money) but this is not clear.

A. Good catch. Yes, I was careless in glossing over this process. The Fed would take in commercial paper at the discount window as collateral in exchange for reserves that it created at no cost to itself. When the bank returned the liquidity to the Fed, it got back its collateral plus the interest that it had earned. The Fed "earned" the entire amount of interest charged on the loan, not any "difference."

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Thanks for the good questions, class.