Two Roads?: Endogeneity of the Monetary Base during the Gold Standard (Part II)

In some ways, a nominal income target emulates the operation of a gold standard. Both a gold standard and a nominal income target allow the stock of base money to adjust to demand for money. The historical gold standard serves as an ideal case study as data exists for both the supply of and demand for monetary gold. The largest increases in demand for gold occurred as a result of the decisions of Big Players – central banks – so it will be useful to observe changes in gold production and prices relative to changes in central bank holdings of gold and changes in the official gold price in different countries (Koppl 2002). In order to understand how the central bank affected the gold market as a Big Player requires that we consider the mechanism of the market for money.

Under a gold standard, production of gold responds the price of gold as determined by gold’s demand and supply. Below is a graph comparing the yearly change in the world’s total gold stock with changes in the real price of gold (U.S. Gold Commission,1982). The time required for the quantity of gold supplied to adjust to changes in demand typically took one to two years (Rockoff 1984). Not surprising, changes in the gold stock trail movements in the real price of gold. The divergence between the price of gold and the rate of increase of the gold stock during the first decade of the twentieth century was likely due to the emergence of the cyanide process at the end of the 19^th century. This represented a positive shock to the supply of gold. On the demand side, changes in central bank gold reserves exercised tremendous influence over the price of gold. The data does not express this as clearly as the relationship between gold’s price and the quantity of gold supplied as the Federal Reserve did not consolidate much of the gold stock in the United States until the end of World War I. A similar problem holds after 1931 when England and other nations began to abandon the gold standard and 1933 when president Roosevelt devalued the dollar, thereby raising the world price of gold (Freidman and Schwartz 1963; McCloskey 1984). For the remainder of the decade changes in demand for gold are not fully captured by changes in gold reserve at central banks. During years where the data does not suffer from complications (1918-1931), there is a clear relationship between changes in gold reserves and changes in the real price of gold.

As noted above, the gold market was sometimes subject to distortions from price fixing. For example, France fixed the price of gold at an arbitrarily high price in 1927, after which point France began to accumulate a disproportionate share of the world’s gold (Irwin, 2012). In 1933, the United States made a similar move when the dollar was devalued so that the price for an ounce of gold rose from $20 per ounce to $35 (Friedman and Schwartz 1963). It is no surprise, then, that in the years that followed these price increases, the annual rate of increase in the world gold stock consistently rose for more than a decade. Ideally, a commodity standard would not be subject to price fixing.

In any case, there is a clear pattern. Changes in demand for gold correlate positively with a change in price. Changes in the production of gold are, subject to a 1-2 year lag, positively correlated with the price of gold. The quantity of gold supplied adjusts to meet the quantity demanded at a given price. That is to say that when gold serves as money, it is subject to Say’s principle. Say’s principle tells us that if there is a glut of goods subject to a single array of prices, then there is not enough money in the economy to clear all markets simultaneously at those prices. What is the cause of the excess supply of goods, but an excess demand for money? A higher real price of gold caused by an increase in demand for money promotes the production of more gold and the conversion of non-monetary gold into monetary gold. The market attempts to remedy the imbalance of trade, which in this case was caused by unpredictable central bank policies, by increasing the stock of base money. Prices convey that the remedy is needed.

We can see by this exposition that endogeneity of the money stock is critical for the functioning of a healthy monetary economy. Prices signal the wants and needs of consumers and scarcity of resources to producers (Hayek, 1945). Embedded in the use of a commodity as money is the market’s auto-poetic response to a shortage in money. It should come as no surprise that the supply of money has come to include a mechanism that responds to disequilibrium pricing. The development of money itself was the market’s response to the high transaction costs of barter (Menger 1976). Its quantity adjusts in response to changes in demand. Under a gold standard, this adjustment translates to a reduction of gluts in the production of goods that are not gold.

Two Roads?: Nominal Income Targeting and Free Banking (Introduction)

I'm beginning a series on nominal income targeting and free banking. Today I suggest a rough outline for synthesis of the two views. 

Over the last few decades, economists with monetarist sympathies have proposed alternative arrangements for the modern financial system. Proposals tend to fall under one of two categories. Under one scenario, the central bank targets the long-run level of nominal income, offsetting changes in demand for money by inversely adjusting the base. Crises that exhibit positive shocks to the demand for money are alleviated as the central bank increases the base money stock, returning nominal income to its former level. The second option differs in that it would eliminate the central bank altogether. Instead, private banks adjust the total volume of currency in circulation in accordance with changes in demand for bank currency. As demand for bank currency increases, banks can increase their liabilities relative to their net assets. Banks increase the quantity of fiduciary currency in circulation until the marginal cost of issuing currency is equal to the marginal revenue earned from issuing new loans (White 1999). Under this proposal, the quantity of money is entirely dependent upon market processes which occur within a scheme of private ordering.

Although the two proposals are often thought of as distinct schemes, it is possible, if not necessary, to integrate the two perspectives. The reason for this requires elaboration. In a world of free banking, legal tender monopoly does not exist. A banker can create new credit against assets using whatever unit of account he prefers. He will most likely choose whichever dominant unit of account arises within the market. The asset that is used as the unit of account will serve as base money whose quantity produced in a given period is dependent upon its demand in the market. The base money stock is therefore endogenous under free banking. As long as legal tender laws exist, however, this proposal is not possible. Base money will continue to be the fiat legal tender prescribed by law. Its quantity is determined in part by the whims of policy makers.

Nominal income targeting can be seen as a halfway house between free banking and the current monetary regime. It does not require the elimination of a central bank and the end of a fiat legal tender standard. Instead, it endogenizes the base money stock according to theory derived from Say’s Principle and the equation of exchange (Clower and Leijonhufvud 1963). The rule emulates the functioning of a commodity standard where production of the commodity serving as base money fluctuates concomitantly with changes in demand for that commodity, but adjustments occur instantaneously. This mechanism will be described more robustly in later posts. Alongside these adjustments in the base money stock, private banks are free to extend credit in a manner consistent with free banking theory and thereby offset demand deficiencies in markets where the existent money stock is not sufficient to clear the existence stock of goods. Thus, a nominal income targeting regime can approximate the functioning of a commodity base money stock. It does not preclude the existence of a free banking regime. It only constrains the unit of account used by such a regime. If free banking cannot be approximated in this manner, the problem is one of financial regulation, not a central banking regime that maintains a nominal income target. 

In following posts, I will argue that nominal income targeting is a necessary stepping stone toward a free banking regime. First, I will present a narrative of the gold standard that conveys the significance of the endogeneity of the base money stock. Second, I will investigate the mechanics of credit creation and its relation to the endogeneity of the money stock. I will follow by explaining the theory behind a nominal income target, its mechanics, and its role in stabilizing expectations. Finally, I will close by tying the two theories together and proposing an outline of marginal policy changes that will greatly improve financial systems ability to respond to shocks.

Bringing Big Players into the Gold Standard Narrative and the Argument for Nominal Income Targeting

I've made some adjustments to my paper to incorporate Roger Koppl's "Big Players". It really helps tie together my argument for nominal income targeting and narrative of the gold standard.

Central bank activism under the gold standard can be typified by the Big Player problem. “Big players are privileged actors who disrupt markets (Koppl 2002).” They are capable of doing so because by virtue of their size, their immunity from market discipline, and their reliance on discretion:

They are big in the sense of that their actions influence the market. They are insensitive to the discipline of profit and loss. And, they are arbitrary in the sense that their actions are based on discretion rather than any set of rules. Big Players have power and use it. (Koppl 1996, 262)

The Federal Reserve, or any other central bank, when not constrained by a rule, acts as a Big Player. From this logic, exchange rate stabilization was not just a policy that would have minimized price distortions if implemented. As a rule, it would have prevented the Big Player type distortions that result from uncertainty of future policy. Of concern is the effect of the Big Player on expectations. When Big Players intervene in markets without clear constraints on their actions, markets are unable to form clear expectations. Activist policy makers cannot be modeled by other economic agents as they lack stable parameters that guide their decisions (Koppl 2012, 123-24). As Big Players do not act consistently, a given state of reality can yield a variety of policy decisions (125). Market actors are left in a position where they must attempt to forecast the future given the possibility of very different policies being implemented. Divergent expectations can arise as some actors invest according to fundamental analysis – price is the discounted sum of the expected future revenue stream – while others bet on different possible states that can result from different policies. Expectations diverge and price and output volatility results. Increased randomness makes profitable investment more a function of luck then of accurate modeling. Markets thus lose information held by “fundamentals” investors and become more fragile as a result. 

The modern international monetary system, comprised of independent central banks who issue fiat currency, is not subject to the same restrictions as a gold standard. This is not to suggest that a gold standard is without merit, only that any managed commodity standard with fixed exchange rates – stated simply, a fixed price for money – is inherently fragile, especially when policymakers act as Big Players. The Big Player problem has not disappeared. In the modern system, instead of holding gold, central banks expand the monetary base by purchasing debt. Many central banks hold primarily dollar denominated debt and target a specific exchange rate with the dollar. Such policies are reminiscent of the fixed exchange rates of the gold standard. Thus, the same problems related to discretion that plagued the gold standard are present in the modern system.

Assuming there is no radical regime change, these problems can at least be remedied in part by the implementation policy rules (Koppl 2012, 185). Unlike gold, whose quantity produced responds slowly to changes in demand, dollars can be issued by the Federal Reserve via the open market. If foreign or domestic demand for dollars increases, the Federal Reserve – the central bank at the center of the international monetary system – can change the volume of base money to offset the effect of increased demand on prices. The Federal Reserve can adopt a policy of nominal income level (MV) stabilization. Observed and expected changes in demand for dollars are automatically adjusted for under a nominal income target regime. Which measure of nominal income is most appropriate is a subject beyond the purview of this paper, but the policy can at least be analyzed theoretically.

Lesson of the Gold Standard: The Central Bank Should Target Nominal Income - Revisions to My Latest Paper

I've finished the next revision of my paper, "Wither Gold: A Reformulation of Austrian Business Cycle Theory". I've made substantial revisions. Of interest to many of my readers, it now includes commentary arguing that the mechanics of the gold standard suggest that nominal income targeting is an appropriate policy for a central bank at the center of a financial system. Here's a peak at the new section.

Fortunately, the modern international monetary system comprised of independent central banks who issue fiat currency is not subject to the same restrictions as a gold standard. This is not to suggest that a gold standard is without merit, only that any managed commodity standard with fixed exchange rates – stated simply, a fixed price for money – is inherently fragile. This shortcoming has not entirely disappeared. In the modern system, instead of holding gold, central banks expand the monetary base by purchasing debt. Many central banks hold primarily dollar denominated debt and target a specific exchange rate with the dollar. Such policies are reminiscent of the fixed exchange rates of the gold standard. Thus, the same problems that plagued the gold standard are present in the modern system. 

Assuming there is no radical regime change, these problems can at least be remedied in part by the implementation policy rules. Unlike gold, whose quantity produced responds slowly to changes in demand, dollars can be issued by the Federal Reserve via the open market. If foreign or domestic demand for dollars increases, the Federal Reserve – the central bank at the center of the international monetary system – can change the volume of base money to offset the effect of increased demand on prices. The Federal Reserve can adopt a policy of nominal income level (MV) stabilization. Observed and expected changes in demand for dollars are automatically adjusted for under a nominal income target regime. Which measure of nominal income is most appropriate is a subject beyond the purview of this paper, but the policy can at least be analyzed theoretically.

It goes on to support an nominal income futures market so as to endogenize Federal Reserve policy according to market expectations.

Endogenous Credit Creation and Nominal Income Targeting: In Defense of Nominal Income Level Targeting

Many Austrian economists are skeptical of the efficacy of a nominal income level targeting policy for a central bank. For example, Alex Salter argues that nominal income (he discusses NGDP) should not be treated as an object of choice for central bankers. His perception that nominal income level targeting treats nominal income as an object of choice is representative of a widespread Austrian critique concerning prices and the role they play. The argument misses important nuance in comparing fiat regimes with hard money regimes. Given that the target is predicted by a futures market, it is not actually an object of choice. The central bank would not attempt to determine nominal income. Instead, it would respond to the best estimation of aggregate demand available. (That the target inflation rate is an object of choice is up for debate. For now I will assume that there is no inflation target embedded in the policy.) In this post, I will confront this objection by analyzing the mechanisms through which a regime that targets nominal income would function. I will also confront other objections as necessary.

Nominal income level targeting is a policy suggestion that unfolds from Say’s law. In a market where there is an excess supply of goods, there is an excess demand for money (Clower and Leijonhufvud 1973; Yeager 1956). That is, nominal cash balances are not high enough to clear all markets at curent prices. Under a gold standard, increases in demand for money lead to an endogenous increase in the money stock. This increase is not instantaneous as the supply of gold is relatively inelastic. Nor are these changes in the gold stock neutral. The economic effects of the entry of this money depend on the injection point – i.e., where is the gold first spent or deposited? It is true that under a pure free banking system, the injection point is guided by real demand. It is also true that the endogenous mechanisms that guided the production of base money – gold – do not exist under the modern system of fiat currencies. The primary endogenous mechanism of money creation available under the present system is credit expansion. In markets where there are excess supplies of goods, the creation of credit helps clear these markets. Without a similar endogenous mechanism for the creation of base money, demand deficiencies are more likely to persist. Despite the objection from Salter that nominal income is an outcome and should not be targeted by the monetary authority, the lack of an endogenous mechanism to control the base money stock makes a nominal income level targeting regime necessary.

Whether or not the central bank practices nominal income level targeting, the fact remains that the central bank still operates.  We should not be given to the “Nirvana Fallacy.” Salter admits that nominal income level targeting might be preferable to the current regime. I think there is theoretical reason for fully embracing the norm. (I don’t have an answer for the public choice critiques at this time, so my defense concentrates on monetary theory.) The choice for policy makers is not between a free banking system and a system with a central bank. There is no policy choice that leaves the central bank on the sideline to do nothing in our present world of fiat currency regimes. We must ask, then, which policy will minimize nominal distortions? Which policy will promote healthy, flexible credit markets that can neutralize problems stemming from monetary disequilibrium?

Economic analysis allows us to imagine what an ideal regime would look like. As Hayek argued in Pricesand Production, MV stabilization is a theoretical ideal, but that ideal includes not just some aggregate stabilization. Monetary injections are provided at precisely the points where demand for money has increased. Such a norm is impossible for a central bank to implement directly. It is for this reason that Selgin and White promote a free banking standard under which the money stock responds to changes in demand for fiduciary currency (White 1999; Selginand White 1994). What is not typically appreciated in the argument about nominal income level targeting is that this policy norm would also be aided by financial intermediaries whose actions help stabilize nominal income much like in the Selgin and White free banking model.

Nominal income level targeting is not, on its own, an economic panacea. Expansion of the money stock always has non-neutral effects. Since injections occur through the financial sector, injections will affect interest rates. This is not as big of a shortcoming as the critics of nominal income level targeting claim it is. If the money stock is insufficient to meet the demands implied by expected nominal income, then we can expect interest rates to rise as an elevated demand for money does not allow markets to clear. As heightened demand for liquidity pushes up interest rates in this manner, all else equal, the market rate of interest is pushed above the natural rate which is the rate that reflects time preference. Credit markets are in disequilibrium.

In the case of disequilibrium, an expansion that offsets MV serves the same role that gold flows and gold production did under the gold standard. The difference is that the response of the base money stock to changes in demand for money occurs much more rapidly than it did under the gold standard. The employment of a nominal income futures market will allow the adjustment of the monetary base to offset changes in liquidity preference that affect credit markets in a way that emulates the response of the base money stock to changes in demand for money under a gold standard.

As mentioned above, monetary expansion by the Federal Reserve is channeled through the financial sectors. Some may voice objections relating to the channel of expansion (Selgin 2012). The Federal Reserve expands the money stock by buying from and selling to primary dealers of securities. Selgin correctly argues that confronting this problem will promote stability. Similarly, some worry that the policy will have asymmetric effects in different geographic regions and that efficient markets hypothesis will not hold with respect to the NGDP futures market (Murphy 2013). I agree with the first proposition, but even under the current circumstances, the alleviation of a general excess demand for money will be more stabilizing than the next best option, whether or not the allocation of the expansion of the base is improved.   If I am right that nominal income targeting will help offset distortions in the interest rate caused by liquidity preference, I do not believe the first objection is problematic. The implementation Selgin’s policy suggestions would certainly improve a nominal income targeting regime! Nor are the other objections fatal to the efficacy of nominal income targeting. My response to these require elaboration.

Markets can handle small shocks quite well. It is in the face of large negative shocks that are self feeding – for example, a scenario of heavy deflation that makes credit markets dysfunctional, thus leading to further deflation – that markets have difficulty remaining anywhere close to the expected nominal income growth path. To be more specific, under a scenario of heavy deflation, both goods markets and intertemporal markets fail to clear as a rise in demand for money constrains liquidity. Bad central bank policy, like that of the Bank of France and the Federal Reserve leading into the Great Depression, can destabilize the economy and lead to such a situation. Under a nominal income targeting regime, problem caused by fluctuations in money demand are alleviated. Dramatic fluctuations in nominal income due to changes in money demand will be prevented. The shocks that are most damaging to the functioning of a healthy economy are neutralized. Even better, monetary policy that promotes this sort of disequilibrium - much like gold hoarding policies of the Great Depression - are not allowed under a nominal income targeting rule. 

So what of the significance of inaccuracies of expectations and asymmetric demand for money? The critics are correct that no measure is perfect. So long as the futures market actually reflects nominal income within a limited margin of error, credit markets can adjust the money stock for these small perturbations. The beauty of nominal income targeting is that it ensures that the credit market will be able to function, and thereby offset these problems. By increasing the base money stock and thereby aiding liquidity, a nominal income level target promotes more robust credit markets that can adjust the broader money stock to conform to particular circumstances not accounted for by the employment of the equation of exchange. In this sense, nominal income targeting and free banking should not be thought of as totally distinct. The endogenous response of the money stock that is at the core of free banking theory is very much present in modern credit markets. Without a well functioning credit sector, nominal income level targeting falls short of its goal. 

Final thought: A nominal income level target requires a credible commitment from the central bank to not bail insolvent institutions. This is where the public choice critique must be answered.

A Draft of My New Paper, "Whither Gold?: A Reformulation of Austrian Business Cycle Theory"

The first draft is up!

The textbook formulation of Austrian Business Cycle Theory argues that a boom that results from expansionary monetary policy inevitably sows the seeds of its own destruction. Monetary expansion creates nominal distortions and lengthens the structure of production by making long term investments appear to be more profitable than they actually are. Although the theory was formulated in a gold standard world, the relationship between gold flows and the capital structure in a system with less than fully backed base currency has never been fully explicated. This paper integrates gold flows into the framework and considers the interdependent nature of the policies of national monetary regimes. This framework reveals that policy is limited by the “Impossible Trinity” and that Austrian style analysis must take this monetary trilemma into consideration when critiquing monetary policy. Absent a central bank that maintains 100% reserve ratios, a monetary regime can only achieve a second best policy of exchange rate stabilization.