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Free banking: myth and reality

Posted by M. C. on December 22, 2023

Dec 21, 2023·Alasdair Macleod

Central bank power has increased immeasurably with the removal of gold from the global monetary system. And as their power has increased, central banks have increased financial instability. This may have been unnoticed by everyone but the keenest observers, but the suppression of interest rates to the zero bound and below, followed by the rapid increase in interest rates to deal with the unexpected (that is by central bankers and their chorus of blind, deaf, and dumb monkeys) surge of price inflation is clearly down to policy failure.

https://www.goldmoney.com/research/free-banking-myth-and-reality

Surely, it is now apparent that central banks are guilty of mismanaging the economy. By slashing interest rates to zero and in some cases to an unnatural minus figure, then flooding financial systems with currency-equivalent credit conjured out of nothing followed by rapidly increasing interest rates in an attempt to stem the consequences, central banks have bankrupted themselves and much of their entire economies. 

Even though hapless economists and money managers are still in thrall to them, central banks have proved themselves to be unfit for purpose. It is time for a new system based on true economic demand for credit without state interference.

The ineptitude of the monetary planners is now sharply focused by events in Argentina, whose new president has vowed to close the central bank and introduce a currency board for the peso backed by the US dollar. Far from being a maverick politician, President Milei is being well advised. Currency boards work, imposing an automatic discipline on government spending.

This article opens up the debate between free banking without central banks under gold standards, and the fiat currency system which gives central banks the power of debasement. Commercial banking without central banks is the historical norm, and the evils of statist currency management is a more recent development.

Those who argue that central banks represent progress from free banking are clearly in the wrong.

Introduction

The new president of Argentina, Javier Milei, was elected on a platform that included closing down the nation’s central bank. He has been lauded by an eclectic bunch of free marketeers, monetarists, and even the IMF. So far, his monetary reform has included a 54% devaluation of the peso against the US dollar, which probably brings its official value close to the black market exchange rate. It is less of a devaluation and more an acceptance of reality.

Milei has made it plain that Argentina will adopt the US dollar as the nation’s currency through a currency board arrangement. Currency boards were originally the means by which some of Britain’s colonies tied their local currency to the pound. Operating mechanically and beyond the reach of meddling politicians, currency boards worked well. They also allowed free trade and import and export flows making exchange controls unnecessary. They are a quick fix for stabilising currency values, proved in practice to be extremely effective.

Under a currency board, a new peso will circulate backed at least 100% by US dollars. Pesos will be exchangeable for dollars and vice-versa at the holder’s option. It will cover not just banknotes, but sight deposits held at commercial banks. An issuing authority is required to discharge this duty by law, or at least with a clear mandate, precluding political interference. With the possible exception of acting as a lender of last resort, all the other functions of a central bank fall away, so it can be shut down. Where the dollars for Argentina’s currency board will come from is not yet clear, but like any fiat currency presumably the banking system will provide. In any event, dollars already circulate freely in Argentina, pesos being only money for the poor.

When “the establishment” sees its central plank, the fountain of its free financing removed inevitably there will be kickback. But Milei’s tactics are those of a boxer unexpectedly overwhelming his opponent. With the electorate behind him, he is raining rapid blows on the establishment, closing nine ministries, cutting subsidies, and cancelling tenders for public works projects. He appears to have learned the importance of acting quickly to continually keep the establishment off guard, unable to regroup and persuade Argentine’s socialistic media of an adequate response. It must be done early and quickly, while Milei retains the initiative and can always threaten opposition to his plans with a new plebiscite.

Perhaps the greatest danger to Milei is an army coup, which is the Argentine establishment’s normal way of eliminating the democracy problem.

Meanwhile, choosing the US dollar as the backing for a currency board has won him plaudits from foreign economists of various persuasions. The exception, perhaps, has been from the Asian hegemons, China and Russia who accepted Argentina’s membership of an expanded BRICS from next month. But they have kept quiet. From the US’s point of view, Milei’s election must be seen to be a positive development and a chance to throw a spanner into the BRICS works. But it is not so simple, because China recently helped the previous administration with a yuan swap line taken out with the people’s Bank to pay the majority of a dollar debt due to the IMF.

The swap is part of a pre-agreed line of up to 130 billion yuan with free access to the Argentinian central bank of 35 billion yuan of the facility. Abolishing the central bank will simply require the agreement to be novated to the finance ministry, so that shouldn’t be a problem. However, it appears that the delicacy between the previous administration’s ambitions to join BRICS alongside Brazil and Milei’s retrenchment to using US dollars are understood by Milei, because he is reported to being uncharacteristically diplomatic in his relations with China.

Milei will have to tread carefully over this thorny issue. As a free marketeer and said to be a disciple of the great Austrian economist, Friedrich Hayek, he almost certainly understands that the dollar is only a temporary monetary solution. Surely, from his libertarian instincts he observes US budget deficits and the dollar’s own debt trap in the context of its similarities with his own government’s profligacy and its debt traps. 

Apparently, he is a fan of bitcoin, which confirms this understanding. A dollar currency board is only a temporary solution lasting for so long as the dollar doesn’t face its own crisis. Milei would be well advised to assess whether Argentina’s 61.74 tonnes of gold reserves are sufficient insurance for protection against the dollar’s demise, because it is increasingly likely that a Plan B will be required, possibly before the ink is dry on Plan A.

We will watch these developments with great interest, particularly the return to free banking, which we can define as banking without the controlling influence of a central bank.

Central banks are a recent innovation

Given that the Romans invented banking, and that Italian banks adopted the modern form of credit creation through double entry bookkeeping in the fourteenth century, commercial banking without central banking has a far longer history than with central banking. While the Bank of England existed as a central bank following the 1844 Bank Charter Act (it had for a long time previously operated as a commercial bank with the monopoly of the government’s business, which is not the same thing), and America’s Federal Reserve Board came into existence before the First World War, central banking per se spread more widely from then on, coinciding with the end of gold standards, particularly in Europe.

Just as a currency board makes a modern central bank redundant, it also makes them redundant for gold standards, which require a similar and simple function of issue control. The failures of the Bank of England in the years following the 1844 Bank Charter Act were down to its crude attempts at interest rate management. The Act, which was based on currency school precepts, assumed that the separation if the issue department from banking was the solution. It wasn’t, proved when the provisions of the Act with respect to gold cover for the note issue were suspended only three years later in 1847, then in 1857, and in 1866. The legislators and the bank itself did not anticipate that the run on its gold reserves would come not from the public submitting bank notes for sovereigns, but from deposit balances in the banking department being encashed.

The Bank made the further error, which persists to this day, of trying to manage interest rates in an economic context. Besides the real problem of no central banker actually understanding the business of economics, interest rates should have been managed in the context of maintaining gold reserves. At least modern currency board operators have learned this vital distinction.

Modern economists tend to dismiss currency boards, as well as free markets. Their solution to problems, mainly of their own creation, is to double down on regulations increasing their scope and complexity. An entire industry of regulators, policy managers and hangers on has been created to discharge invented functions. 

Naturally, those employed in it support its continual expansion. For this reason, the practical simplicity of a gold standard and currency boards gets short thrift. This ignores the lessons of history, that the world evolved from a feudal state through the industrial revolution to a standard of life for the commoner which would have been the envy of kings only a century ago, all on the back of commercial bank credit. Yes, there have been upsets along the way: but the question to be addressed is whether commercial banks in their relationships with each other can minimise those upsets, or can governments through their central banks achieve a better outcome?

The monopoly over currency provision stems from the 1844 Bank Charter Act in English law, not adopted by the Scottish banks (Scotland has its own legal system) which to this day sees the major banks issuing their own bank notes, admittedly fully backed by their reserves at the Bank of England. While it was gradual, the withdrawal of the facility whereby English banks issued banknotes only served to consolidate the government monopoly over currency. Currency has come to be regarded as national money, and not a credit liability of a bank. The importance of this development tends to be overlooked. Very few are the economists today who understand that a banknote is actually a liability of the central bank, despite it still being evidenced as such in its accounts. They would not so readily take that erroneous view, surely, if commercial banks were still permitted to issue their own banknotes.

When a commercial bank issues banknotes, the notes are bound to have a similar rating to a deposit, the only difference is that a banknote is a promise to its unknown bearer. If the facility was reintroduced, it is certain that a bank would issue banknotes to rank as a substitute for the national currency. It may be that a bank would not take up this facility anyway, bearing in mind that London bankers ceased issuing notes in the 1790s, fifty years before their issue was banned in the 1844 Act. But there is no substantive reason why issuing bank notes should not be permitted, and if demanded by a bank’s customers, a commercial bank’s notes would simply circulate alongside notes issued by the government. Then, perhaps, economists would have a greater understanding of the credit status of banknotes.

The limit of statist involvement in credit should be to provide an updated version of the currency board, an issuing facility for banknotes and deposit balances totally backed by real, legal money, which is gold. The issuer must be charged with the sole responsibility of ensuring gold backing for its liabilities is always there. The issuer’s balance sheet would consist of notes and deposits as credit liabilities, and the assets entirely comprised of gold bars and coin. The profit and loss account would generate sufficient income from seigniorage to cover storage and minting expenses. And the directors of the issuer would be charged with managing interest rates purely with a view to maintaining gold reserves. It must be detached from all other financial activities.

In this way, credit generated through banking operations becomes a purely commercial consideration. Bank credit is a function of commercial banking, referenced to the rate set by the issuer by virtue of bank deposits held with it, but reflecting additional counterparty risks. To satisfy depositors’ likely demands for coin or bullion, a commercial bank can either maintain a deposit at the issuer gained by submitting gold in exchange or buy them in the market. This is sufficient to tie the value of commercial bank credit to that of the national currency, which unquestionably becomes tied to gold.

The error in the 1844 Bank Charter Act was to split the Bank of England into two departments, but under the same management. Its banking department was no less a credit operation than any commercial bank, and it was the inherent conflicts, particularly over the setting of interest rates, which led to the Act’s failures. 

Whether the state maintains a banking presence in the commercial banking system becomes a separate issue. Management of economic outcomes by interest rate manipulation is a dead duck, given that the interest rates objective can only be to maintain gold reserves. But there is still the thorny question of the need for a lender of last resort. In his plans to abolish Argentina’s central bank, this is an important question yet to be addressed by President Milei. 

Free market theory posits that this is unnecessary. In the knowledge that there will be no bail outs, bankers can be expected to pay proper attention to counterparty risk, and the faintest suspicion of impropriety would be immediately reflected in a bank’s credit rating in the interbank markets. And it is not beyond the ability of banks within the commercial network to deal with banking failures, because it is obviously in their collective interest to maintain systemic credibility. This is another lesson from the pre-central banking era.

The violence of Britain’s bank credit cycle abated in the decades following the Napoleonic wars due to improvements in clearing systems, as the chart of wholesale prices below shows: 

A graph showing the price of the uk Description automatically generated

A clearing system for the London banks was set up in the late eighteenth century, when for the first-time daily differences were settled between the banking members on a net basis. The Bullion Report (1810) reported that there were 46 private bankers who cleared a gross value of £4,700,000 daily by a net settlement of $220,000 in bank notes. This was a significant improvement on the earlier system whereby bank clerks walked around London, visiting other banks to settle claims. In 1854, joint stock banks were admitted into the London clearing system, and the Bank of England joined in 1864. By then, the system of settling balances in banknotes was done away with, replaced by bankers’ drafts settled twice daily with a final reconciliation in the late afternoon. Furthermore, over time other cities established similar clearing arrangements as well as intercity arrangements.

Over the time covered by these increasing refinements to interbank settling, wholesale prices became decreasingly volatile. In other words, as commercial banking became increasingly efficient as a system, the impact on prices from the bank credit cycle as credit was alternately expanded and contracted diminished. Given that the objective of a central bank is to ensure price stability, it amounts to evidence that this function is not needed. 

Inflationary considerations

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What the Central Bank Cartel has Planned for You | Mises Institute

Posted by M. C. on September 1, 2023

Whatever comes from states pursuing their own monetary interests, we should not get our hopes up that the states will provide sound money to the people. If states monopolize money production, they will use it predominantly to serve their own needs.

https://mises.org/library/what-central-bank-cartel-has-planned-you

The Austrian(TA): What is the global currency plot, and who benefits most from the success of this effort?

Thorsten Polleit (TP): The global currency plot denotes a rather inconvenient truth: the existence of states (as we know them today) sets into motion a dynamic process toward creating a single world fiat money controlled by a world central bank, and most likely a central world government. The beneficiaries will be the very few—the “elite”—in charge of running the state and those few privileged by the state, such as big business, big banking, Big Pharma, and Big Tech. However, the great majority of the people will suffer a very great disadvantage. In fact, a single world fiat currency would most likely entail tyranny.

TA: The first half of the book is largely focused on economic theory and method. Why is economics so important to understanding the global fiat currency threat?

TP: I would argue that thinking about the method of economic science is actually the most important part of all of this. You know, economics is not an empirical science but must be conceptualized as a science of the logic of human action—or “praxeology,” as Ludwig von Mises called it. The logic of human action allows us to understand that there are regularities in human reality to which we must adapt our actions to succeed. It also makes us understand what will happen if— under certain conditions—actions that are contrary to the logic of human action are taken. For instance, we can know in advance (without having to resort to any kind of testing) that a state—defined as a coercive territorial monopoly—will (other things being equal) continue to expand no matter what; that it will seek control of money, replacing commodity money with its own fiat currency; and that states will form a cartel and strive to eventually establish a world government with its own world fiat currency. The logic of human action reveals these dynamics that many people are most likely unaware of.

TA: What role do central banks such as the Federal Reserve play?

TP: It may be hard to swallow, but central banks were not created for the greater good but to support the state and special interest groups. After World War II, the US became the dominant economic and military power in the world, and the Federal Reserve (the Fed), founded in 1913, became the world’s most powerful central bank, issuing the US dollar, the world’s leading reserve currency. It is fair to say that the Fed does indeed call the shots in the international financial and economic system. The Fed acts as the unofficial world central bank. Central banks play a crucial role in making a fiat currency system possible, and if they form a cartel, they can basically create a single world fiat currency.

TA: The dollar has played a central role in the global economy for decades. Does the dollar’s global hegemony help or hinder efforts to create a single global currency?

TP: The dominance of the US dollar is certainly helping to push the world toward a single fiat currency. Just imagine a major crisis that will eventually hit us. When the worldwide fiat currency regime starts to unravel, the US dollar will likely be the last man standing. In such a situation, it is also very likely that many countries will try to peg their currency to the US dollar (i.e., effectively adopt the US dollar as base money). It may not sound realistic right now, but imagine a scenario in which the United States and China join forces and endorse exchange rate fixing through the International Monetary Fund’s special drawing rights, later declaring the exchange rates irrevocably fixed. The world would be closer to a single world fiat currency than ever.

TA: What would it look like if the dollar were replaced by some sort of new international currency?

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The Unintended Consequences of Unintended Consequences

Posted by M. C. on November 9, 2022

Any system that serves the interests of the few by choking off adaptability and the dynamisms of a free-for-all churn lacks the tools needed to avoid systemic collapse. By enabling elites to organize the nation to serve their personal interests, America has been stripped of the dynamics needed to adapt. Without these dynamics, collapse is the only possible outcome.

By Charles Hugh Smith

https://www.oftwominds.com/blognov22/imperial-corruption11-22.html

OfTwoMinds.com

Decades of central bank distortions and regulatory / market-share capture by cartels and monopolies have completely gutted “markets,” destroying their self-correcting dynamics.

Unintended consequences introduce unexpected problems that may not have easy solutions. An entirely different set of problems are unleashed as unintended consequences have their own unintended consequences. This is the problem with complex emergent systems such as economies, societies and global supply chains: the system’s feedback, leverage points and phase-change thresholds are not necessarily visible or predictable, yet these dynamics have the potential to cascade small failures into systemic collapse.

The unintended consequences of unintended consequences are called second-order effects: consequences have their own consequences.

So for example, you juice your economy with massive stimulus after a lockdown that upended consumers and global supply chains, crushing both demand and supply, and suddenly you have rip-roaring inflation as demand comes back while supply chains remain tangled.

Shifting critical industrial production to frenemies so corporations could maximize profits while reducing the quality of goods and services seemed like a good idea until the potential costs of that dependence on frenemies become apparent.

Assuming oil and natural gas would always be in abundance made sense when they were abundant, but geopolitical forces kicked that assumption into the gutter. All the reassuring economic stories we told ourselves–energy is only 3.5% of the economy and the household spending budget, so cost really doesn’t matter–fall off the cliff when availability and supply become the paramount issues setting price.

That 3.5% loses meaning when there’s not enough to supply demand and somebody loses the game of musical chairs.

Then there’s the fantasy that monetary policy imposed by central banks control inflation. The inconvenient reality is central bank monetary policy is akin to building sand castles on the beach: when the tide is ebbing, the castles look magnificent. When the tide is rising, the sand castles are quickly washed away.

Inflation is actually a consequence of much larger forces that central banks don’t control: demographics (labor supply), social changes (quiet quitting, laying flat, let it rot), supply of essential minerals/materials, flows of private-sector capital, and most profoundly, the real-world productivity of capital, labor and state policies.

The tide of inflation has reversed and is now rising. This tide is gradual and will temporarily be reversed by the gluts of supply that inevitably follow artificial scarcities and the deflationary impact of credit-asset bubbles popping. But these reversals will be temporary and misleading: inflation has reversed for structural reasons unrelated to credit-asset bubbles and temporary gluts.

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Fed Paper Admits Central Bank Can’t Control Inflation; Finger-Points At Federal Government

Posted by M. C. on September 1, 2022

Tyler Durden's Photo

BY TYLER DURDEN

THURSDAY, SEP 01, 2022 – 07:20 AM

Authored by Michael Maharrey via SchiffGold.com,

First, the authors acknowledge that the federal government uses inflation as a tool to handle its debt. In other words, it acknowledges that we’re all paying an inflation tax.

Second, the paper concedes that merely tinkering with interest rates won’t slay inflation if the government continues to spend far beyond its means.

https://www.zerohedge.com/markets/fed-paper-admits-central-bank-cant-control-inflation-finger-points-federal-government

It appears somebody at the Federal Reserve has figured out that the central bank can’t tame inflation, so it’s setting up a scapegoat – Uncle Sam…

A paper co-authored by Leonardo Melosi of the Federal Reserve Bank of Chicago and John Hopkins University economist Francesco Bianchi and published by the Kansas City Federal Reserve argues that central bank monetary policy alone can’t control inflation.

The paper’s abstract asserts, “This increase in inflation could not have been averted by simply tightening monetary policy.”

In a nutshell, Melosi and Bianchi argue that the Fed can’t control inflation alone.

US government fiscal policy contributes to inflationary pressure and makes it impossible for the Fed to do its job.

Trend inflation is fully controlled by the monetary authority only when public debt can be successfully stabilized by credible future fiscal plans. When the fiscal authority is not perceived as fully responsible for covering the existing fiscal imbalances, the private sector expects that inflation will rise to ensure sustainability of national debt. As a result, a large fiscal imbalance combined with a weakening fiscal credibility may lead trend inflation to drift away from the long-run target chosen by the monetary authority.”

There are a couple of startling admissions in this single paragraph.

First, the authors acknowledge that the federal government uses inflation as a tool to handle its debt. In other words, it acknowledges that we’re all paying an inflation tax.

Peter Schiff talked about this inflation tax in an interview on Rob Schmitt Tonight.

Inflation is a tax. It’s the way government finances deficit spending. Government spends money. It doesn’t collect enough taxes, so it has to run deficits. The Federal Reserve monetizes those defiticts – prints money. They call it quantitative easing, but that’s inflation. Government is getting bigger and bigger, and families across America are going to have to bear that burden through higher prices.”

Second, the paper concedes that merely tinkering with interest rates won’t slay inflation if the government continues to spend far beyond its means.

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Deflation: Bad for the Government, Good for Producers and Consumers. What’s Not to Like?

Posted by M. C. on April 15, 2022

Deflation is only bad for the government. In a deflationary economy, it cannot tax people indirectly via inflation and it can’t use monetary policy to artificially boost the economy and get votes before there is the inevitable recession. Consumers (mainly the poorer) and entrepreneurs are the ones who benefit from deflation (due to lower prices and larger profit margins, respectively).

https://mises.org/wire/deflation-bad-government-good-producers-and-consumers-whats-not

Andre Marques

Governments lie about the inflation rate and benefits from it, so, it is no surprise when they talk against deflation (for the purpose of this article, assume inflation as a general increase in prices and deflation as the opposite), which would be good for consumers and the economy, but bad for the government. (While Austrian Economists define inflation as an increase in the supply of money, the net effect of inflation is an increase in asset prices, as well as a distortion of the structure of production.)

Prices fall in a scenario where the currency is not inflated and, therefore, there are more sustainable investments and increased productivity. In an economy with little or no government intervention (at least few monetary interventions and few regulations, government spending and taxes), there are more long-term investments (capital investments, for example), which increase the economy’s productivity. In a deflationary economy, the purchasing power of money tends to increase, as there is no monetary inflation by central banks and prices tend to fall. Consumers can purchase more products and services and companies have higher profit margins.

But governments do not like deflation, they are the most indebted entities. Inflation is beneficial to borrowers, as they repay loans in a currency with lower purchasing power than when they took the loan. It is even more beneficial to the government since it can expand the money supply to pay the debt. Furthermore, inflation is good for the government because it creates an apparent economic boom, which will eventually be wiped out by a recession. But, as this can take a few years, the short-term incentive for the incumbents is to take advantage of this instrument.

Two typical arguments given by governments against deflation are as follows:

“Deflation Will Cost Entrepreneurs”

The reasoning behind this statement is that, if prices fall, entrepreneurs will sell products and services at lower prices than the cost to produce them. However, this statement does not hold if we consider the fact that, in a deflationary economy, the currency’s purchasing power tends to increase. So even if entrepreneurs get less money (nominally) than what their products cost, in real terms, they will still make a profit. In addition, the prices of the inputs used in production will also fall in a deflationary economy.

Therefore, with the use of productivity and management of expenses that every company must have, it is possible to sell the products at low prices, but with the same or even higher profit margin than in an inflationary environment. (Note: even if we disregard this gain in purchase power and lower production costs, it would be possible for the entrepreneur to protect himself through future contracts). And, precisely because prices get lower, consumers buy more products and services (without going into debt) and companies profit more due to the reduction in costs that occurs thanks to deflation. This is particularly the case in the technology sector. Computers today are cheaper and much better than they were 30 years ago. Because prices got lower (due to increased productivity), consumers began to buy more, which increased the industry’s profits, which brought more investments and higher productivity.

“Consumers Will Postpone Consumption under Deflation”

The reasoning behind this argument is that if prices are constantly falling, no one will buy the products and services because individuals will always expect prices to go down. This also does not make sense, as there are always products and services that people have to purchase (such as food and medicine). Nobody starves themselves to death or does not purchase medicines because a year later they will be cheaper. 

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What the Regime Will Do to Fight Private Digital Currencies | Mises Wire

Posted by M. C. on January 12, 2022

Yes, states have many tools to push the public to use the government’s money. But governments also know there are limits to this and they fear hyperinflationary scenarios. These situations have a tendency to bring extreme political and monetary instability. Cryptocurrencies may help make that fear more acute and immediate. If that’s the case, it’s good news.

https://mises.org/wire/what-regime-will-do-fight-private-digital-currencies

Ryan McMaken

During a confirmation hearing with the US Senate this week, Fed chairman Jerome Powell was asked about whether or not a digital currency issued by a central bank could exist side by side with private cryptocurrencies. Powell responded that there is nothing that would prevent private cryptos from “coexisting” with a “digital dollar.”

This, of course, is obviously true so long as federal regulators do not decide to ban the usage of cryptocurrencies.

Business Insider meanwhile has reported that Powell’s comments “appeared to be a shift” from his earlier comments stating that “you wouldn’t need” cryptocurrencies in a world of central bank digital currencies (CBDCs).

It’s not clear that this is a “shift,” however. Powell’s earlier comments simply communicated Powell’s apparent position that the Fed’s CBDC would be preferred by the users of these currencies. If the central bank’s digital currencies are wonderful, there no “need” to have any other. 

Central Banks Plan to Outcompete Crypto

Indeed, Powell’s two statements on this matter likely reflect the fact that the central bank apparently plans to outcompete private cryptocurrencies. This would be a reasonable goal for the Fed given the central bank’s vast regulatory power and legal privileges. Because the central bank directly regulates banks and is so entrenched in the financial sector overall, it could more easily facilitate a virtually seamless introduction of its own digital currencies into the financial sector and make its digital currency more convenient than others. Moreover, the Congress can use its powers to “encourage” the public to favor the regime’s currency, digital or otherwise. 

Does the Higher-Quality Currency Necessarily Win Out?

This doesn’t worry many supporters of cryptocurrencies, who are generally confident that their currencies are higher quality than anything a central bank can offer. When they say “higher quality” these private crypto backers—especially those backing bitcoin—often mean that their currency cannot be inflated as can fiat currencies. Thus, these private currencies do not lose their value as fiat currencies do. Presumably the public would flock to the higher-quality currency. 

It is debatable, however, whether this sort of quality really determines the use of a currency as a general medium of exchange. Indeed, if anything, experience suggests otherwise, and this has long been seen in the workings of Gresham’s law. When competing against “lower quality”—that is, more inflation-prone—currencies, “higher quality” currencies tend to become hoarded rather than used as money. This is reflected in the “HODL” movement, in which it is assumed that it is better to hold on to cryptos indefinitely rather than convert them into “inferior” assets, whether dollars or anything else. So long as this thinking prevails, it’s difficult to see how a crypto can make the transition to a general medium of exchange—i.e., money. Even if the inferiority of the government’s fiat currency is not in dispute, this does not necessarily lead to widespread use of the “superior” currency for daily use.

How to “Convince” People to Use Fiat Currency

Yet one could also define “quality” as the ease with which one can use a currency. Bitcoin advocates, for instance, have pointed to the relative ease with which bitcoin can be used in purchases without the need for intermediate institutions. Even in this arena, though, inflationary currencies controlled by central banks may nonetheless be competitive, even if inferior in terms of maintaining value.

This, of course, is one of the purposes of issuing new CBDCs. It’s to more fully and directly co-opt and compete with private digital currencies. Presumably, payments using CBDCs need not go through intermediary institutions either. Will these CBDCs be “better” than private digital currencies? Perhaps not by many metrics. But to stay relevant, fiat currencies need not be the best money. They only need to be good enough. Government regulations can do the rest. 

After all, when it comes to propping up the official currency, a regime or central bank has several tools. For one, the regime can continue to make a certain currency legal tender. Contrary to what many believe, this does not force people to use a certain currency for all transactions. Nevertheless, legal tender laws do impel users of money to favor one specific money over others for the repayment of loans and other uses. Moreover, a regime can mandate that tax bills be paid in the currency of the regime’s choosing. Borrowers would continue to pay back loans in devalued dollars—and this would likely include many huge institutional borrowers.

In an inflationary atmosphere, this can continue to offer significant support to at least some use of a currency—or a digital version thereof—even in the face of steeply declining value. Imagine, for example, a world in which every employer must pay withholding taxes in dollars and in which every homeowner must pay property taxes in dollars. Imagine a world in which every commercial and residential real estate lender—lenders heavily regulated by federal policymakers—must accept repayment in depreciating dollars. This is no small advantage for a currency—even one in decline. 

Using Coercion to Protect Fiat Currency

And then there are more crude methods of protecting the official currency. Beyond legal tender laws, the regime could use the tax code to punish the use of private currencies in other ways. Charging capital gains taxes on alternative money is just one method. Regimes have been known to become quite creative when it comes to punitive taxes against activities the regime does not like.

There is also always the “nuclear option,” which is banning these currencies altogether. Let it never be forgotten that the US regime once banned the private ownership of gold bullion, punishable by draconian fines and by imprisonment. 

None of this contradicts economic arguments that in an unhampered market, certain private cryptocurrencies are far superior to fiat money in terms of value retention. Those are economic questions, though. The political questions are different, and once government regimes become involved, the calculus can change considerably. States have long jealously guarded their prerogatives over the money supply and are likely to resort to any number of violent, dangerous, or risky policies when these privileges are threatened. 

But What If the Regime’s Money Hyperinflates?

On the other hand, states, with all their vast coercive power, sometimes lose their ability to ensure the continued usage of the state’s official currency.

As Daniel Lacalle recently noted, sometimes a government’s currency ceases to be money altogether:

If the private sector does not accept this currency as a unit of measure, a generalized means of payment, and a store of value backed by reserves and demand from the mentioned private sector, the currency becomes worthless and ceases to be money. Ultimately, it becomes useless paper.

This happens when a currency devalues so completely and so rapidly, that neither convenience nor legal status can save the currency’s status as money.

Extreme hyperinflation, however, appears to be the only scenario—short of big ideological changes undermining the state overall—under which a private cryptocurrency is likely to become the general medium of exchange. Government currencies would likely have to implode and not just slowly depreciate at a rate of, say, 5 or 10 percent per year. It has already been demonstrated for more than a century that deflationary fiat currencies can go on for many decades so long as inflation rates are within what the public considers to be a tolerable range. Unfortunately, the public also appears to have a high threshold for what is tolerable. 

The Importance of a Competing Store of Value

But even if regimes manage to prop up their currencies indefinitely, the existence of cryptocurrencies nonetheless has the potential for offering a valuable service. That is, the existence of private cryptocurrencies could work to force greater discipline on regimes in terms of deficit spending and other activities that lead to the debasement of government currencies. If users of fiat currency can more easily flee to some other store of value, this will put greater pressure on inflationary currency and force regimes to think twice about indulging in high levels of deficit spending and the all-but-inevitable money printing that follows. That is, if savers can easily sit on their savings in some form other than fiat currencies, this raises the political risk to regimes in terms of triggering dangerously high inflation rates. This means cryptocurrencies could serve a helpful political function even if they don’t lead to a scenario in which government fiat currencies are fully abandoned any time in the foreseeable future.

Yes, states have many tools to push the public to use the government’s money. But governments also know there are limits to this and they fear hyperinflationary scenarios. These situations have a tendency to bring extreme political and monetary instability. Cryptocurrencies may help make that fear more acute and immediate. If that’s the case, it’s good news.

Author:

Contact Ryan McMaken

Ryan McMaken is a senior editor at the Mises Institute. Send him your article submissions for the Mises Wire and Power and Market, but read article guidelines first.

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Since 2008, Monetary Policy Has Cost American Savers about $4 Trillion | Mises Wire

Posted by M. C. on November 19, 2021

Inflation: the hidden tax. Usually used to pay for war.

As one immediate step, Congress should require the Federal Reserve to provide a formal savers impact analysis as a regular part of its Humphrey-Hawkins reports on monetary policy and targets. This savers impact analysis should quantify, discuss, and project for the future the effects of the Fed’s policies on savings and savers, so that these effects can be explicitly and fairly considered along with the other relevant factors.

https://mises.org/wire/2008-monetary-policy-has-cost-american-savers-about-4-trillion

Alex J. Pollock

With inflation running at over 6 percent and interest rates on savings near zero, the Federal Reserve is delivering a negative 6 percent real (inflation-adjusted) return on trillions of dollars in savings. This is effectively expropriating American savers’ nest eggs at the rate of 6 percent a year. It is not only a problem in 2021, however, but an ongoing monetary policy problem of long standing. The Fed has been delivering negative real returns on savings for more than a decade. It should be discussing with the legislature what it thinks about this outcome and its impacts on savers.

The effects of central bank monetary actions pervade society and transfer wealth among various groups of people—a political action. Monetary policies can cause consumer price inflations, like we now have, and asset price inflations, like those we have in equities, bonds, houses, and cryptocurrencies. They can feed bubbles, which turn into busts. They can by negative real yields push savers into equities, junk bonds, houses, and cryptocurrencies, temporarily inflating prices further while substantially increasing risk. They can take money away from conservative savers to subsidize leveraged speculators, thus encouraging speculation. They can transfer wealth from the people to the government by the inflation tax. They can punish thrift, prudence, and self-reliance.

Savings are essential to long-term economic progress and to personal and family financial well-being and responsibility. However, the Federal Reserve’s policies, and those of the government in general, have subsidized and emphasized the expansion of debt, and unfortunately appear to have forgotten savings. The original theorists of the savings and loan movement, to their credit, were clear that first you had “savings,” to make possible the “loans.” Our current unbalanced policy could be described, instead of “savings and loans,” as “loans and loans.”

As one immediate step, Congress should require the Federal Reserve to provide a formal savers impact analysis as a regular part of its Humphrey-Hawkins reports on monetary policy and targets. This savers impact analysis should quantify, discuss, and project for the future the effects of the Fed’s policies on savings and savers, so that these effects can be explicitly and fairly considered along with the other relevant factors. The critical questions include: What impact is Fed monetary policy having on savers? Who is affected? How will the Fed’s plans for monetary policy affect savings and savers going forward?

Consumer price inflation year over year as of October 2021 is running, as we are painfully aware, at 6.2 percent. For the ten months of 2021 year-to-date, the pace is even worse than that—an annualized inflation rate of 7.5 percent.

Facing that inflation, what yields are savers of all kinds, but notably including retired people and savers of modest means, getting on their savings? Basically nothing. According to the Federal Deposit Insurance Corporation’s October 18, 2021, national interest rate report, the national average interest rate on savings account was a trivial 0.06 percent. On money market deposit accounts, it was 0.08 percent; on three-month certificates of deposit, 0.06 percent; on six-month CDs, 0.09 percent; on six-month Treasury bills, 0.05 percent; and if you committed your money out to five years, a majestic CD rate of 0.27 percent. 

I estimate, as shown in the table below, that monetary policy since 2008 has cost American savers about $4 trillion. The table assumes savers can invest in six-month Treasury bills, then subtracts from their average interest rate the matching inflation rate, giving the real interest rate to the savers. This is on average quite negative for these years. I calculate the amount of savings effectively expropriated by negative real rates. Then I compare the actual real interest rates to an estimate of the normal real interest rate for each year, based on the fifty-year average of real rates from 1958 to 2007. This gives us the gap the Federal Reserve has created between the actual real rates over the years since 2008 and what would have been historically normal rates. This gap is multiplied by household savings, which shows us by arithmetic the total gap in dollars.

savers

To repeat the answer: a $4 trillion hit to savers.

The Federal Reserve through a regular savers impact analysis should be having substantive discussions with Congress about how its monetary policy is affecting savings, what the resulting real returns to savers are, who the resulting winners and losers are, what the alternatives are, and how its plans will impact savers going forward.

After thirteen years with on average negative real returns to conservative savings, it is time to require the Federal Reserve to address its impact on savers.

Author:

Alex J. Pollock

Alex J. Pollock is a Senior Fellow at the Mises Institute. Previously he served as the Principal Deputy Director of the Office of Financial Research in the U.S. Treasury Department (2019-2021), Distinguished Senior Fellow at the R Street Institute (2015-2019 and 2021), Resident Fellow at the American Enterprise Institute (2004-2015), and President and CEO, Federal Home Loan Bank of Chicago (1991-2004). He is the author of Finance and Philosophy—Why We’re Always Surprised (2018) and Boom and Bust: Financial Cycles and Human Prosperity (2011), as well as numerous articles and Congressional testimony. Pollock is a graduate of Williams College, the University of Chicago, and Princeton University.

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We Don’t Need a Central Bank to Deal with Changes in the “Demand for Money” | Mises Wire

Posted by M. C. on September 8, 2021

If the market will settle on gold or any other commodity as money the amount of this commodity is going to be in line with people’s requirements.

Given that a commodity that is selected as money is part of the stock of wealth the increase in the supply of such commodity is not going to set in motion the menace of boom-bust cycle. This should be contrasted with the increase in the money supply out of “thin air”.

https://mises.org/wire/we-dont-need-central-bank-deal-changes-demand-money

Frank Shostak

Historically, many different goods have been used as money. On this, Ludwig von Mises observed that, over time,

[T]here would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.1

Similarly, Murray Rothbard wrote in “What Has Government Done to Our Money,”

Just as in nature, there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium, which causes more marketability, etc. Eventually, one or two commodities are used as general media-in almost all exchanges-and these are called money.

Through the ongoing process of selection, people settled on gold as their preferred medium of exchange. Some commentators, cast doubt that gold can fulfill the role of money in the modern world. It is held that, relative to the growing demand for money because of growing economies, the supply of gold is not growing fast enough. On this according to Insider from June 15, 2011,

See the rest here

Author:

Contact Frank Shostak

Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

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EconomicPolicyJournal.com: WARNING: Central Bank Digital Currency Will Be 100% Trackable Currency

Posted by M. C. on May 7, 2021

2. And this is not fully appreciated at all. Once a CBDC is established and becomes the method of general exchange, it will be very easy for governments to block any kinds of exchanges it desires to block. In other words, it provides the opportunity for cancel culture and authoritarianism at an entirely new level.

https://www.economicpolicyjournal.com/2021/05/warning-central-bank-digital-currency.html

The Financial Times reports:

What CBDC [Central Bank Digital Currency] research and experimentation appears to be showing is that it will be nigh on impossible to issue such currencies outside of a comprehensive national digital ID management system. Meaning: CBDCs will likely be tied to personal accounts that include personal data, credit history and other forms of relevant information.

There are two very important implications here:

1. Central banks will have to kill off private sector cryptocurrencies.

There is just no way that CBs are going to allow private crypto that can provide an end-run around CBDC.

2. And this is not fully appreciated at all. Once a CBDC is established and becomes the method of general exchange, it will be very easy for governments to block any kinds of exchanges it desires to block. In other words, it provides the opportunity for cancel culture and authoritarianism at an entirely new level.

Bottom line: It is not clear why bitcoin was originally created or by whom but may lead to being one of the worst inventions ever created by man.

 –RW

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Central Bank Digital Currencies and the War on (Physical) Cash | Mises Wire

Posted by M. C. on December 7, 2020

At the end of the day, central bank digital currencies are all about control, not meeting consumer demand. The ECB admits as much at several points in their report. Here is just one instance: If people are really demanding a digital euro, why would it have to be assigned legal tender status in order for it to be accepted, as the authors of the report clearly state would be necessary (p. 33)? The only scenario where introducing a CBDC makes sense is in order to phase out the use of physical cash in order to be able to impose whatever negative interest rate regime the central bankers in charge judge necessary. Helicopter money, restrictions on cash holding, and negative interest rates are all part of the bundle of desirable policies that can only—or most easily—be achieved with digital currencies fully controlled by the issuing central banks.

https://mises.org/wire/central-bank-digital-currencies-and-war-physical-cash

Kristoffer Mousten Hansen

Twenty twenty is a year dominated by bad news. While governments around the world have imposed extremely destructive restrictions on economic life and promise a “Great Reset” that amounts to a great leap forward into the socialist future, central bankers have advanced plans for implementing central bank digital currencies (CBDCs). These may arrive as early as next year. Yet what is the motivation behind this innovation? Reports recently published by the Bank for International Settlements1 and the European Central Bank2 provide part of the answer. These publications provide fascinating insight into the theories and ideologies driving central bankers in their pursuit of CBDCs.

Monetary Policy? Moi?

One perhaps surprising theme in both reports is the disavowal of any monetary policy behind plans for introducing CBDCs. The BIS report claims that “[m]onetary policy will not be the primary motivation for issuing CBDC” (p. 8) and the ECB report notes that a “possible role for the digital euro as a tool to strengthen monetary policy is not identified in this report” (p. 3). One might first of all suppose that introducing a new form of money would by definition amount to monetary policy, at least in a broad sense, and secondly perhaps find it a tiny bit weird that institutions dedicated to researching and implementing monetary policy would not have considered the potential effects of a new form of money in light of its effects on policy. But what is really striking is that both reports—and especially the one issued by the ECB—at great length detail the implications for monetary policy of CBDC. True, they say they don’t, but looking beyond the executive summary and paying attention to what is written in the report itself puts the lie to that claim.

In order to see this, we only need to look at the key features the central bankers identify as desirable in a CBDC: it should be interest bearing, and it should be possible to cap how much each individual can hold. Both measures are clearly aimed at supporting monetary policy. The cap on holdings forces people to spend their money, driving either price inflation or investment in financial assets, and by making the CBDC interest bearing (or remunerated, in the language of the ECB) it becomes a tool of setting and passing on policy rate changes, including negative interest rates.

The ECB’s Report on a Digital Euro in particular goes on at great length about the need to limit or disincentivize “the large-scale use of a digital euro as an investment” (p. 28). The reasoning behind this position is crystal clear: since monetary policy has driven interest rates into negative territory, the ECB should not allow large-scale holding of digital euros, since investors would then, quite sensibly, chuck their holdings of negative-yielding bonds and seek a safe haven in digital euros—that is, if they can hold them at no cost. Similarly, the ECB is averse to letting people convert their bank deposits into digital euros (p. 16), which would reside in their individual wallets rather than in a bank account. Indeed, the horror of what the BIS and ECB reports call “financial disintermediation” looms large in the minds of central bankers: if people keep their money outside of banks, these will have less money to lend out, thereby increasing borrowing costs. In the words of the BIS report, they are concerned that

a widely available CBDC could make such events [i.e., bank runs] more frequent by enabling “digital runs” toward the central bank with unprecedented speed and scale. More generally, if banks begin to lose deposits to CBDC over time they may come to rely more on wholesale funding, and possibly restrict credit supply in the economy with potential impacts on economic growth. (p. 8)

Of course, Austrian economists since Ludwig von Mises3 understand that “financial disintermediation” can really be a blessing. In the context of digital euros, all it means is that people would hold the amount of cash they deemed desirable outside the banks. They would only make true savings deposits in banks, i.e., they would only surrender money that they did not want instant access to. Under such circumstances, banks would be incapable of expanding credit by issuing unbacked claims to money; they could only make loans out of the funds their customers had explicitly made available for that purpose. This would not only result in a leaner or sounder financial system, it would also avoid the problems of the perennially recurring business cycle. And contrary to what the central bankers fear, the supply of credit would not be restricted, it would simply be forced to correspond to the supply of real savings in the economy. This, unfortunately, is an understanding of economics completely alien to central bankers.

Negative Interest Rates

One aim in introducing CBDCs that is only hinted at is the possibility of imposing even lower negative interest rates. In recent years monetary economists4 have increasingly discussed the problem of the “zero lower bound” on interest rates: the fact that it is impossible to set a negative interest since depositors in that case would simply shift into holding physical cash. When manipulating the interest rate is the main policy tool of central banks this is obviously a problem: How can they work their alchemy and secure an acceptable spread between the main policy rates and the market rate of interest when interest rates are already very low? Allowing for the cost of holding physical cash, –0.5 percent seems to be about as low as they can go.

With a centrally controlled digital currency this problem would disappear. The central bank could set a limit on how much each person and company could hold cost free, and above this limit, they would have to pay whatever negative interest rate (or “remuneration,” as the ECB insists on calling it) is consonant with central bank policy. In this way, holding cash would not obstruct monetary policy, as the cash holdings would be fully under the control of the central bank.

There is just one problem with using CBDC in this way: it only works if physical cash is outlawed. Otherwise, physical cash would still simply play the role it does today, i.e., as the most basic and least risky way of holding one’s wealth and of avoiding negative interest rates. The BIS report clearly identifies this problem (p. 8n7), as does the ECB (p. 12n18): a CBDC could help eliminate the zero lower bound on interest rates, but only if physical cash disappeared. So long as physical cash remains in use, the zero lower bound cannot be breached.

But the People Demand It!

However, people might of their own accord come to the rescue of the world’s central banks, sorely beset as they are by the zero lower bound. At least according to Benoît Coeuré, head of the BIS Innovation Hub (the group tasked with researching CBDC), plenty of people want a central bank digital currency. The ECB also sees the decline in the use of physical cash in favor of other means of payment as one of the main scenarios that would require the issue of a digital euro (p. 10).

Now, while some people might like CBDC, there is really no reason to believe, notwithstanding monsieur Coeuré’s anecdotal evidence, that there is widespread demand for central bank digital currency. The ECB admits as much when they write that physical cash is still the dominant means of payment in the euro area, accounting for over half the value of all payments at the retail level (p. 7). But Coeuré does not need to go far to see the continuing relevance of cash: in 2018 researchers at the BIS itself concluded that cash, far from declining in importance, was still the dominant form of payment.5 More recently, a study in the International Journal of Central Banking showed that cash usage is not only not declining, but even increasing in importance.6

Be that as it may, the central bankers are certainly right that there is an increased demand for digital payment solutions and for cryptocurrencies. However, it is erroneous to conclude from this that therefore a central bank digital currency is demanded. Demand for a payment solution is not the same as demand for a new kind of money. It simply means that people demand payment services that allow them to more cheaply transact with each other. Such services are plentifully provided by companies such as Visa, Mastercard, Paypal, banks, and so on and so forth. There is no reason to believe that central banks need to provide this service nor that they could do it better than private companies and banks, and it is simply a mistake to equate demand for such services with demand for a money.

The mistake in the case of cryptocurrencies is even more egregious. When people hold bitcoin or another cryptocurrency, it is not because their heartfelt demand for a CBDC has to go unfulfilled and this is their closest alternative. On the contrary, people want to own bitcoin precisely so they can avoid the negative interests imposed on the established banking system and the risks of holding inflationary fiat money. Introducing a CBDC would not mitigate those risks, but rather add to them, as the central bank would assume total control of the money supply through it and the attendant abolition of physical cash. The felt need for inflation hedges and the desire to escape central bank control, including as it does negative interest rates and caps on how much cash one could hold, would only increase.

It’s All about Control

At the end of the day, central bank digital currencies are all about control, not meeting consumer demand. The ECB admits as much at several points in their report. Here is just one instance: If people are really demanding a digital euro, why would it have to be assigned legal tender status in order for it to be accepted, as the authors of the report clearly state would be necessary (p. 33)? The only scenario where introducing a CBDC makes sense is in order to phase out the use of physical cash in order to be able to impose whatever negative interest rate regime the central bankers in charge judge necessary. Helicopter money, restrictions on cash holding, and negative interest rates are all part of the bundle of desirable policies that can only—or most easily—be achieved with digital currencies fully controlled by the issuing central banks.

Ironically, far from buttressing the role of central banks and government fiat money, imposing a CBDC may have the completely opposite effect. Replacing physical cash with a CBDC would only strengthen the undesirable qualities of fiat money and further hamper a free market in money and financial services, increasing the demand for alternatives to government money, such as gold and bitcoin.

  • 1. Bank of Canada, European Central Bank, Bank of Japan, Sveriges Riksbank, Swiss National Bank, Bank of England, Board of Governors of the Federal Reserve, and Bank for International Settlements, CBDC: Central Bank Digital Currencies: Foundational Principles and Core Features (N.p: Bank for International Settlements, 2020), https://www.bis.org/publ/othp33.htm.
  • 2. European Central Bank, Report on a Digital Euro (Frankfurt am Main: European Central Bank, October 2020), https://www.ecb.europa.eu/euro/html/digitaleuro-report.en.html.
  • 3. Ludwig von Mises, The Theory of Money and Credit, trans. H. E. Batson (New Haven, CT: Yale University Press, 1953), p. 261ff.
  • 4. See, e.g., Marvin Goodfriend, “Overcoming the Zero Bound on Interest Rate Policy,” Journal of Money, Credit and Banking 32, no. 4 (2000): 1007–35.
  • 5. Morten Bech, Umar Faruqui, Frederik Ougaard, and Cristina Picillo,”Payments Are A-Changin’ but Cash Still Rules,” BIS Quarterly Review (March 2018): 67–80.
  • 6. Jonathan Ashworth and Charles A.E. Goodhart, “The Surprising Recovery of Currency Usage,” International Journal of Central Banking 16, no. 3 (2020): 239–77.

Author:

Kristoffer Mousten Hansen

Kristoffer Mousten Hansen is a research assistant at the Institute for Economic Policy at Leipzig University and a PhD candidate at the University of Angers. He is also a Mises Institute research fellow. 

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