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.