In a sentence which Milton Friedman made famous, J.S. Mill wrote: âmost of the time the machinery of money does not matter but when it gets out of control it becomes the monkey wrench in all the machinery of the economyâ (Friedman 2006). In the century of US dollar hegemony, since the breakdown of the international gold standard during the First World War, money has mattered most of the time because it has been almost continuously out of control. Money has been profoundly unsound.
Unsound money has spawned and enabled tyranny in multiple ways. Sometimes the link runs from the generating of bubbles and busts to devastating geopolitical consequences. The extreme example here was the role of a massive bubble in stocks and global credit fuelled by the Federal Reserve and its subsequent burst in the Weimar Republicâs collapse. Other times political malaise forms due to unsound moneyâs destruction of opportunities for general sustained advances in economic prosperity over long periods.
Always, under unsound money regimes, the state gains tremendous power to obtain revenue without explicitly levying new taxes or hiking old taxes. Monopolists and would-be monopolists use bubble finance as generated by monetary inflationâincluding fantastically priced equity issues to investors mesmerized by speculative narratives of vast eventual profit marginsâto crush free market competition. Historical examples extend from the Dutch East India Company in seventeenth-century Holland to the notorious list of suspects under anti-trust investigation in the US at the start of the 2020s. Monopoly power is inimical to free society.
Individuals constrained by laws and practice to use fiat monies whose issuers pursue monetary inflation are exposed to the huge risks of sudden evaporation of their financial well-being, whether from asset inflation turning to asset crash, or from the outbreak of goods and services inflation. Widespread economic and financial suffering imperils always fragile liberty. The propaganda machine of the tyranny (including the central banks and their âtransparent communicationsâ) grinds on relentlessly. In sum, the severe ways in which âthe machinery of moneyâ has acted as monkey wrench go well beyond anything that J.S. Mill imagined or Milton Friedman described.
How to Judge Monetary Soundness
The essence of sound money is its high quality services (store of value and medium of exchange) produced by âmachineryâ (as in J.S. Mill quote) under the continuous control of automatic mechanisms. These are well protected from governments or other authorities (including central banks) who would tamper with them in pursuit of wider objectives including general economic policy and taxation. Beyond that general statement, what are the criteria by which we should judge the soundness of an actual monetary regime?
There should be a clear and well-understood pivot or anchor to the monetary system. This takes the form of monetary base for which a broad and stable demand exists over the long run, and whose supply is strictly limited. Automatic mechanisms determine and enforce those limits. The mechanisms operate within the context of constitutional rules sometimes including a pledge of convertibility into gold, other metals, or real assets.
Short- as well as long-term interest rates are set wholly by market forces, without official fixing or manipulation. Prices of goods and services are observed to fluctuate widely, sometimes over sustained periods, downwards and upwards, but show a tendency to revert to the mean over the very long run, as determined by the pivot or anchor. There can be no assurance that this mean is constant. There should be widespread conviction, though, that any drift upwards or downwards in this mean will be well-bounded and at any point in time the prospects of an upward drift over the long run should be equal to those of a downward drift.
As illustration under the pre-1914 gold standard it was possible that big new gold discoveries could bring an upward drift in the long-run mean to prices; but it was equally possible that a secular growth in demand for money and trends in the gold mining industry (lack of new discoveries or new technologies) could bring a downward drift.
By contrast, the essential aspects of unsound money include manipulation of interest rates by the government or its central bank (there exists a wide spectrum of possible manipulation practices), the absence of an anchor to the monetary system, and a fixation of the monetary policy makers on stabilizing prices (the so-called price level or the inflation rate) whilst moderating the fluctuations of the business cycle (in the process, lengthening economic expansions).
The ways in which the monkey wrench jams up the economic machinery go far beyond the traditional (and sometimes misplaced) concerns of consumer price inflation (or deflation) or violent business cycle fluctuations. The starting point (for the monkey wrench) is the haywire signalling of prices, particularly in asset markets. This leads on to a general malfunctioning of the invisible hands, together with misallocation of resourcesâespecially capital.
The false signalling guides capital into a whole range of projects far more intensely than what would have occurred otherwise (with correct signalling). The resulting opportunity losses in prosperity from such malinvestment are potentially huge and long-lasting, even though there might be for a considerable periods of time some apparent benefits to consumers. Extraordinarily low-cost capital to some firms, reflecting wild speculative narratives about future monopoly profits, allows these to gain market share by predatory action, including extended periods of cheap pricing and also systematic elimination of any new entrant challenger by pre-emptive buyouts.
Sound and Unsound Exits from the False Dawn of Monetarism
Sound money requires skilful architecture and construction. By contrast, the monetarism as pioneered by Milton Friedman rested on a firm belief in positive economics (see Friedman 1966). There it is for the economic scientist to find out whether a stable demand function could be reliably estimated for a money supply aggregate, having once selected this in the given monetary and banking system. If successful, then the task of the monetary authorities would be to keep the growth of that aggregate in line with demand (the product of real demand and the targeted price level) over the medium and the long run.
That task could be fulfilled via the control of monetary base, so long as a stable relationship could be demonstrated between this and the chosen wider monetary aggregate (another test for the scientist). With no big gap between the growth in supply and demand for that aggregate, money should not get out of control and the feared monkey wrench would remain locked up. The monetarists in general did not contemplate what damage the monkey wrench might do (if not locked up) in terms of malinvestment and asset price inflation. Their focus was on goods and services inflation and its potential ill effects.
In practice, monetarism has long since withered away. The US experiment in applying this doctrine was particularly short (1979â82). Under actual institutional arrangements, the authorities had considerable difficulty in determining exogenously the supply of a broad or semi-broad money aggregate with any precision at all (the Bundesbank came closest by utilising high reserve requirements on banks). In any case, earlier empirically determined stable demand functions for the chosen monetary aggregate often proved to be erroneous.
Yes, the supply of monetary base (the narrowest aggregate) is completely under the control of the authorities in a fiat money regime. But the demand for monetary base, under post-1914 monetary regimes in the US and abroad, even before considering the radical changes (in particular, QE and payment of market interest on reserves) of the past two decades, has been far from broad or stable or easily estimated, even over long-run periods. The problem here has been that the components of the monetary base under modern fiat money regimesâdeposits of the banks at the central bank and cashâhave many close substitutes (for example Treasury bills, instant non-penal credit facilities at the central bank, payment and credit cards which the holder can use to transact at the same retail prices as users of cash). They are not in effect high-powered money except in name. Small changes in interest rates, rate spreads and fees can induce big shifts in demand for monetary base. By contrast, under a regime where the monetary base includes mainly instruments with a distinctive high âmoneynessâ, as would be the case for gold coin, gold bars and banksâ holdings of reserves as aggregated across countries on a gold standard, demand for monetary base is firmly related to income and wealth.
In principle, there are two exits from the disillusions of monetarism.
The first is to move forward along the road to sound money, learning where appropriate from past errors including those of the monetarists.
Progress would consist of eliminating the government (and central bank) manipulators of interest rates and constructing a monetary system based around a strong anchor. Price level and inflation targets would be scrapped in favour of automatic monetary mechanisms (operating in effect to set upper and lower bounds to monetary base expansion), which should mean a very long-run tendency for prices of goods and services on average to revert to the mean (moving down or up for sustained periods in the medium term). This mean is not absolutely fixed nor totally pre-determined.
The biggest challenge for the sound monetary system architects would be the designing of a monetary base. It is important that there should be a broad and stable demand for this aggregate. That requires structural reforms in the sense of curtailing radically âtoo big to failâ (whereby systemically important banks in effect have access to government bail outs), deposit insurance, credit and payment card oligopolies (which try to prevent retailers passing on interchange and other fees to card users), and other barriers to cash circulation (e.g. small upper limits to size of banknote denomination). All these reforms together would powerfully bolster and broaden the demand for monetary base.
The second exit from the failure of monetarism is to abandon the quest for sound money and instead install top macro-economic managers in the monetary administration (via the central bank) whose stated aims would be high employment and stable prices.
The tools at the disposal of these managers would be designed to manipulate interest rates along a path mapped out by powerful econometric models. They do not use the monetary base as a control mechanism, though in principle they determine its size. They would not return to the practice of the Federal Reserve at times between 1920 and the mid-1980s in cross-checking that their chosen path for short-term money market rates results in the monetary base cumulatively staying within a target or quasi-target range. (The cross-check in the 1920s and 1960s occurred in the context of whole and then partial convertibility of the dollar into gold; growth in the fiat component of monetary base as consistent with the Fedâs chosen rate path could bring into question whether gold reserves were sufficient and trigger a tightening of policy.)
The managers would also have âemergency accessâ to a bag of unconventional tools to be deployed towards reaching their aims. The monetary administration, headed by political appointees, is a part of government, albeit with some weak outward semblance of independence. A key unstated part of the monetary administrationâs purpose is the levying of monetary repression tax and inflation tax; their success in this is very important in terms of their relationship with government.
US Hegemon Leads World Down Unsound Path
The US as monetary hegemon led the world along a deeply flawed path out of monetarism.
Stanley Fischer (1977) amongst others was at the forefront of the academic assault on monetarism and advocated enlightened central bank economic management based on the power of modern econometrics. Later, these economists demonstrated great skills in the corridors of monetary power, scaling the ladder to become top monetary bureaucrats and advisors to Presidents, who saw the potential for neo-Keynesian engineering to win a second term at the next election (and after that le déluge, possibly, but who cares).
Before this ascent of the neo-Keynesians, dollar devaluation policy had resumed in the second Reagan Administration. In early autumn 1985, Fed Chief Volcker joined with Treasury Secretary James Baker in implementing the Plaza Accord. The turbulence this produced on the European currency sceneâincluding a new revaluation of the Deutsche markâplayed a big role in powering the train towards European Monetary Union (see James 2012).
Through the 1990s, after the global asset price deflations and recessions of 1989â92, the Federal Reserve having totally abandoned the last vestiges of monetary rules with respect to monetary aggregates (broad or narrow) and focusing under Alan Greenspan on masterly piloting of short-term interest rates, gained acclaim for the so-called Great Moderation. The NASDAQ crash and apparent mini recession of 2001/2 blemished that record, such that in 2002/3 President George W. Bush, facing difficult elections in 2004, resolved to use the power of appointment to guide the Fed on to a âpro-growth courseâ.
Accordingly, President Bush appointed renowned âinflationistâ and neo Keynesian Professor Ben Bernanke (a disciple of Stanley Fischer) as a Fed Governor (then fast-tracking him into the âEconomic Cabinetâ in preparation for the top Fed post), and meanwhile extended Greenspanâs tenure for a half-termâall in the implicit expectation (no evidence of any direct negotiation on this) that policy would be âstimulatoryâ in the run-up to the 2004 elections. The âbreathing in of inflationâ on the basis that this was too low at around 1% became a milestone in the development of the 2% inflation standard and in Europe similarly we had the famous press conference of the ECBâs eminence grise, ex-Bundesbanker Otmar Issing, in early 2003.
The payment of market interest rates on monetary base (authorized by Congress in autumn 2008) and successive bouts of quantitative easing (QE) dealt the final coup de grace to any residual ailing anchor to the US monetary system. The demand for monetary base became so unstable and indeed unknowable that it could not possibly function as anchor. All of this was a far cry from the norm of Fed practice through most of its prior existence, at least until the early 1990s, where in setting the interest rate path, it accepted that the growth of monetary base in some loose fashion constrained its freedom of action.
Counterfactually, what would have been the sound money way out of the flaws of monetarism? Short answer: to reconstruct the monetary regime in a way which would ensure a strong and resilient anchor to the monetary system such that the principles of sound money could triumph.
A longer answer starts with a look at what we should learn from the flaws of monetarism.
Prices Are Not Stable Under Sound Money
We have already considered the problems in applying monetarism due to no stable demand and exogenously determined supply for wide or semi-wide money aggregates. But there is a deeper issue. Even if the holy grail of such an aggregate and its supply conditions could have been found, would all have ended happily under monetarism?
Most likely not: for prices do not follow a smooth monotonic path under a sound money regime. Yet that is the implicit standard of success for the monetarists, albeit that Friedman cautioned against making the price level the target of monetary policy. He argued that the central bank should be judged by what it can cont...