Tuesday, September 23, 2014

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.


  1. You'd be interested in reading George Selgin's work on precisely this topic. Selgin and Sumner have maintained a dialogue (search "Between Fulsomeness and Pettifoggery" for its origins).

    Selgin delves more in depth into this topic in his paper entitled "Synthetic Commodity Money" (formerly "Quasi-Commodity Money" presented at PPE two years ago). There he basically outlines how cryptocurrency technology enables us to implement a Friedman type money growth rule (albeit better, in the form of NGDP Targeting ala Sumner) that completely removes discretion from the Central Bank and allows for an endogenous, market responsive money.

    He combines this "first step" reform with his former proposed reforms from "Theory of Free Banking" and "Free Banking and Monetary Reform" (with White).
    The steps are (roughly) as follows:
    1. NGDP Targeting rule - disband the FOMC and BoG (in effect, "set up the code and throw away the key!")
    2. Remove the Fed's monopoly on currency provision.
    3. Privatize the clearinghouse functions of the Fed and remove all bank-specific regulations (legal reserve requirements, capital requirements, FDIC, TBTF, etc.)
    4. Remove legal tender laws and legal restrictions on alternative monies (competition in base money)
    5. Then let her open the box. It's my d*** in a box!

    I might've left out some steps or confused them with Andy Samberg's steps for monetary reform, but you get the point. This is roughly the steps to reform I've outlined in a forthcoming, with a little more attention paid to non-USA markets who could easily implement these sort of reforms without waiting (fruitlessly) for sensible monetary reform here.

    It's a great topic. I've described Selgin and Sumner's work for our generation of monetary economists to be akin to the effect Hayek's "Denationalization" and "Competition in Currency" had on the first generation of M.E. Free Bankers (White, Selgin, etc.)

  2. As researchers continue to develop the literature, NGDP targeting and free banking can play an important role in the policy debate. I like the general scheme. The project that this post is part investigates what possibilities exist in a regime with a monopoly on issue of base money. We can come very close to approximating a free banking system with a few elementary tweaks in central bank and regulatory policies. At that point, the system is only small steps away from full blown free banking.