Privatizing money.

• Author: Yeager, Leland B.
• Position: Essay

Restoring global financial stability requires attention to the currencies themselves that circulate at home and abroad. I'll focus attention on that aspect of the problem.

Be Prepared

The dollar's continuing role as the world's key currency has come into doubt. What might replace the dollar if it collapses or becomes unmanageable? Let's hope it doesn't, but we should be ready with ideas just in case. Even if our current system survives, contemplating radical alternatives can provide a new perspective on it and on possible improvements. Just as conjectural or "what-if?" history can improve our understanding of the actual course of events, so "what if?" monetary systems may help us better understand, by contrast, what we now have.

How would a system function without a dominant issuer whose banknotes and deposits defined the unit of account? How would the system work if the unit ("dollar") were defined, separately from any particular medium of exchange, to have a stable value? What if no base money existed distinct from ordinary means of payment, so that questions of reserves, reserve ratios, and the money multiplier could not arise? Would the quantity theory of money still apply?

According to Milton Friedman and Anna Schwartz (1987: 313), if our present system does fail, "what happens will depend critically on the options that have been explored by the intellectual community and have become intellectually respectable. That--the widening of the range of options and keeping them available--is, we believe, the major contribution of the burst of scholarly interest in monetary reform."

A system without government money and with competing private issuers rules out central control of the quantity of money and requires some other way of giving a definite value to the dollar. The dollar must then be linked to some single good or a combination of goods and services. The present article urges no specific reform along these lines, but it does sketch one out as an example and as an introduction to aspects requiring attention.

Inflation is one danger to our current system. It may emerge once recovery from the current recession carries further and banks make use of their total and excess reserves, which the Federal Reserve had greatly expanded to fight the crisis. Activating idle reserves will multiply total money. Businesses and consumers will become readier to spend from their cash balances (velocity will recover). In principle, the Federal Reserve, if clever enough and sheltered enough from politics, could reverse its anti-crisis measures in good time. A worry for the longer run is that the government may quasi-repudiate its soaring debt, both explicit and implicit under entitlements, by pressuring the Federal Reserve to inflate it away by monetizing it.

Talk about deflation, instead, as today's pressing short-run problem was familiar until recently. On this view, inflation can be dealt with if and when the time comes; and inflation is easier to deal with anyway. Robert Reich said so on Lawrence Kudlow's TV program in May 2009. An editorial in The Economist (May 2009) recognized "something to both fears. But inflation is distant and containable, while deflation is at hand and pernicious." Many of us here could argue just the opposite.

Perhaps the dollar will escape inflationary destruction. Benjamin Friedman explains a related worry. It concerns the central-bank base money that banks hold as reserves against their ordinarily much larger volume of deposit liabilities. Central banks exercise their power by manipulating this reserve base, indirectly through interest rates if not by directly controlling its size. Yet these bank reserves (not total base money, including currency held at home and abroad) have become small in crisis-free times, not small in dollar amount but relative to national and international money flows, total output, and ordinary checking accounts, near-moneys, and innovative means of payment. Central banks exert their leverage with an ever more rubbery lever working on a relatively shrinking fulcrum. Much higher reserve requirements and substantial interest paid on reserves could conceivably mitigate this difficulty. Otherwise, how long will it take before the traditional monetary control becomes unworkable? (See Friedman 1999, 2000a, 2000b; Moini 2001: 269; and Brittan 2003: 151.)

The Nominal Anchor in a Decentralized System

A monetary system works with transferable receipts/vouchers--receipts for the values of goods and services delivered and vouchers for obtaining goods and services available on the market at their values in prevailing or agreed prices. These receipts/vouchers ("tickets") take the form of coins and currency and entries on the books of financial institutions. The system greatly facilitates multilateral transactions. It records transactions--provides evidences of them--and monitors them to deter dishonest persons from taking more values off the market than they have contributed or will contribute as promised.

Such a system of tickets requires a dollar in which to express and record values. Now, what at any given time establishes the dollar's size, its purchasing power? What provides determinacy?

A determinate system keeps the quantity of money and the price level from drifting unrestrained in a mutually reinforcing way. Determinacy presupposes a "nominal anchor." Joseph Schumpeter (1970: 217-24, 258, and passim) spoke of a "critical figure" set otherwise than by ordinary market forces. Either or a blend of two ways can provide the anchor: (1) Control, either explicit or indirect, over the size of some monetary aggregate, most obviously the money supply, (1) or (2) definition of the dollar by one or more goods and services, with the definition made operational by redeemability.

Abandoning method (1) rules out central control of the money supply, even control through targeting on an interest rate. (2) (Loss of interest-rate control may not be entirely regrettable, particularly since the central bank's habitual interest-rate smoothing tends to retard rate adjustments and make base money behave procyclically or at least not countercyclically (Hetzel 2009).

Abandoning route (1) to determinacy also precludes any policy of making the price level rise or fall in a particular way (other than in conformity with a commodity definition of the dollar). If, for example, we want the price level to drift downward in conformity with George Selgin's productivity norm (Selgin 1997a), we must retain central control of money. (Selgin's argument for letting the price level vary inversely with productivity is the best argument known to me--though not a conclusive argument--against aiming for a steady price level.) Central control would also be necessary to make any other nominal aggregate, say nominal GDP, behave in a particular way.

Privatizing money thus requires taking route (2) to determinacy: definition of the dollar and convertibility of money in one or more goods and services. That method controls the quantity of money in a decentralized and indirect way, since the monetary commodity is itself scarce. (3) The simplest example is a privatized gold standard.

The Quantity Theory under Decentralized Money

The quantity theory is unduly narrowed if applied only to the most easily explained case--an exogenously supplied fiat money, with causation running only from its quantity to prices. A reasonable extension recognizes, rather, a correspondence between money and prices. Causation may run the other way, as in a single city in the United States or a small country under an international gold standard. There, the quantity of money becomes the quantity demanded at an exogenously determined price level.

The quantity theory holds in that expanded sense even under a privatized and decentralized system. Under a privatized gold standard, banks issuing notes and deposits must conduct their business to stay ready to redeem their issues in gold, even or especially when arbitrageurs demand the gold. Banks' prudence keeps the quantity of money from growing beyond what is willingly held at the price level corresponding to the dollar's gold content and gold's relative price against other goods and services. If, in the opposite direction, the actual quantity of money should start to fall short of the quantity demanded and cause incipient price deflation, banks would have an opportunity and an incentive to buy gold relatively cheap to back an expanded volume of their money and their lending. (Under a government gold standard, holders of relatively cheap gold take it to the mint for coinage.)

Durability of a Private Standard

Allowing private banks to issue currency notes as well as deposits would avoid the complications of a variable currency/deposit ratio, which are familiar when government monopolizes currency issue (Selgin 1997b). The discipline of redeemability would be tighter under a privatized gold standard, since each bank would have to stand ready in effect to redeem any adverse clearing balances in the routine daily clearings of notes issued by and checks drawn on the various banks, whereas a government issuer would avoid this routine clearing and would have to guard against only internal and external drains on its gold reserves.

Furthermore, abandoning or debasing a gold standard is easier for the government than for competing private issuers of money. People come to regard government money as itself defining the dollar. If the government cuts the gold content of the dollar or abandons the gold standard, people continue regarding its money as the unit of account, the basis of pricing and contracting. Historical experience so testifies.

In a system of competing private banks, by contrast, the money of no specific issuer has that special status. Contract law and concern for competition and reputation inhibit each bank from violating its commitment to redeem its money in gold. This advantage remains even...