Wednesday, December 28, 2016

Sumner vs. White on Fiat Money vs. the Gold Standard

    I enjoyed this short video of Scott Sumner and Larry White discussing fiat currency versus the gold standard.   Check it out here.

    Sumner's key argument is that a properly managed fiat currency can out perform a gold standard.   Sumner is optimistic that central banks are learning to do a better job.    White responds that central banks have not done better than a gold standard.   Further, he argues that the very existence of central banks causes problems because they will seek to tinker with the monetary system causing more harm than good.

     I think Sumner pointed out the key problem with a gold standard, and that is its decent performance requires appropriate monetary policy by foreigners.   White argues in favor of free banking.   Suppose that his argument wins the day in the U.S., but China adopts the gold standard while rejecting free banking.   Now the world economy is held hostage to the Chinese central bank's foolish notions.    (Or, the world economy might be improved by wise policy by the Chinese central bank.)

       I don't really agree with White's emphasis on central bank mischief.   A government has no need for a central bank to implement a monetary policy under a gold standard.    The Treasury can sell newly issued government bonds for gold and create an economic contraction.   Or, it can sell off gold and pay down its national debt and create an expansion.    The contraction has an interest cost--it must pay more interest on outstanding government bonds than otherwise.   And the inflation has an upward limit--the government's gold reserve.  

      Of course, there is also the traditional government power of devaluation and revaluation.  Interestingly, central banks have not had that power delegated to them.   I suppose White just would like to forbid that power to government.    My own view is that devaluation would be the least bad response if some foreign central bank pulled a France--accumulating gold reserves.

      Consider how President-elect Trump would respond if a  gold standard China were to devalue its currency and build up as a gold reserve the resulting gold inflow?    Tariffs?  Or is this an act of war?  
       With a free banking system, the resulting U.S. recession (depression) would almost certainly result in the exercise of the option clause.   The interest penalty for the banks would motivate a measured deflation.   I think the answer is for the government to devalue so that there is no deflation and instead try to guess on a new price of gold so that nominal GDP would continue to stay on its trend growth path.

      Irving Fisher long ago explained how regular devaluations and revaluations of gold would provide price level stability in the context of a gold standard.   Of course, the compensated dollar is hardly a gold standard at all.   It would seem that gold can be dispensed with (though the emphasis of central bankers on interest rates and the odd bicycle nature of interest rate targeting suggest that the compensated dollar might have its uses.)

      And it is that sort of thinking that makes the concept of "fiat currency" defended by Sumner problematic.   It creates the habit of mind where paper currency plays the role of gold.   With free banking, paper money is instead a debt instrument.    Removing gold and using another nominal anchor doesn't change that.   Even under current institutions, paper money is better understood as a kind of government debt.   In my view, the key problem with gold as a nominal anchor is that it serves as a tolerably good money itself.   And changes in the demand for it, from anywhere in the world, results in tremendous economic disruption.

     That is why I prefer free banking to be tied to some other nominal anchor.   Slow and steady growth in nominal GDP looks to be the least bad option to me.


  1. I think had we had free banking all along we would have evolved away from gold by now. Currency would be backed by bank assets.

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