Private Money

Dear Friends,

TQE 73 described the monetary system of the United States and other countries that have created central banks. By lending "bookkeeping gold" (also known as reserves), they enable commercial banks to supply people with more money when it is needed to produce an expanded gross domestic product (GDP). If GDP grows and the money supply does not, prices will fall because a larger quantity of goods will have to be sold for the same quantity of dollars. If on the other hand the money supply expands more than GDP, inflation follows ("more money chasing the same goods"). Creating money to finance a war leads to inflation, because the goods are blown up and cannot be bought by those who receive the salaries and profits from their manufacture (more money, no more consumer goods).

The Fed has two objectives: (1) to create money in the same proportion as GDP is expanding, to keep the price level stable, and (2) perhaps create a bit more money in order to spur full employment (with a little inflation). Since it cannot do both, it waffles, sometimes one, sometimes the other. At present, prices of most goods (not education, not rent) are gradually falling, in a condition known as deflation.

Let us think innovatively, centuries ahead. Suppose in 2250 central banks are all abolished because they operate poorly, creating more money than is needed for civilian purposes: they have financed wars, mansions for presidents, and unneeded public works, with no other purpose than to keep people employed (as in Japan today). Not trusting national currencies, people begin to keep their wealth in (say) globalized mutual funds. Then private individuals (mutual-fund managers) lend new money like the goldsmiths of yore (see TQE 73). For simplicity, let us call these currencies dollars, yen, pesos, and euros, which have claims on the mutual funds whose managers issue them. In a globalized world, they are not related to particular countries. They are not created by central banks, but they are notes payable by private companies, which hold mutual funds (or other investments) as reserves. These companies seek profit by lending more currency than they have funds to back it, just the way goldsmiths used to do (If you think all profit is "evil," you'd better stop reading now).

Reserves would now be any kind of investments (e.g., mutual funds, other stocks and bonds, commodities, anything of marketable value), not only gold. Thus, unlike gold, reserves will expand as more GDP is produced.

Let us also suppose that borrowers choose their currencies. To finance their investments, they borrow dollars, yen, pesos, or euros from different mutual-fund managers. The grocer might prefer euros while the customer prefers dollars. Grocery prices in euros are quickly translatable into dollars by pressing on a credit card (at the current exchange rate, which is constantly being broadcast in). The customer presents a credit card which (in 2250) will pay the grocer in euros while deducting dollars from the customer's bank account. And so on for employers and employees, and whoever transacts business anywhere. The holder of any given currency takes the risk of the exchange rate, since any currency may depreciate. (None of this is science fiction; all this technology is known today.)

When borrowing, which currency will the investor choose? The one that has the best reputation for remaining stable (no inflation, no deflation). If the investor builds his or her factory in 2250, he or she has to predict the prices of products ten years later. (It's the same problem today, in which inflation or deflation can scuttle the best thought-out projects.) So, the fund managers create only that amount of currency that will not generate inflation or deflation in that currency. Mutual funds lending in yen compete on this point with those lending in dollars, euros, and pesos. Both this competition and their limited supply of reserves (stocks, bonds, or other values) prevent the money managers from lending excessively to make egregious profits. Price stability is assured because people want it, not because the Federal Reserve Bank (the "Fed") does.

The private-money issuers of 2250 therefore will operate with only the first objective of the central bank today: to keep prices stable. Full employment will be satisfied by other institutions, such as unemployment insurance and flexible job markets.

Flexible job markets? Already today, labor mobility in the United States makes price stability easier than it does in Europe. If wages are low in New York but high in Texas, workers move from New York to Texas, thus raising wages in New York, through a decrease in worker supply, and lowering them in Texas, as more workers compete for jobs, until they are again equal. That happens less in Europe. Germans do not move easily to Britain, though they do, a little. If Ireland is prosperous and Germany is not, will the European Central Bank lower the euro interest rate to help Germany, while causing inflation in Ireland? A big problem for Wim Duisenberg, the chairman of the European Central Bank.

Inflation is a tax. Those who get to the bank first (often the government) borrow the new money and spend it, driving up prices for the others. Prices would normally go down again once they put their goods on the market — thus the increase is constantly being balanced out. But if there is no offsetting consumer product (as in a war or when governments waste the money with corruption), nothing offsets the price rise. When I was a child, I bought a double-dip ice cream cone for five cents; now it costs at least a dollar. This process has constituted a transfer of real resources, over time, from the consumer to those fortunate enough to get to the bank first.

I was explaining this in a lecture for students at the University of Córdoba, Argentina, four years ago, where John Kenneth Galbraith, a more noted economist than I, was saying that a little inflation would be useful to create full employment. I countered that Galbraith was condoning robbery, so long as it was just a little robbery. Unfortunately, he was speaking in English and I in Spanish, so he did not understand me. We never did argue the question out.

Sincerely your friend,

Jack Powelson

P.S. JD Von Pischke, a member of the editorial board of The Quaker Economist, added the following note:

Jack introduced the idea of competing currencies based on different indexes or other bases. This idea was presented by Hayek in a pamphlet, Choice in Currency: A Way to Stop Inflation (1976). Hayek wrote from an historical perspective that included systematic debasement of coins and paper money that became worthless with inflation.

All history contradicts the belief that governments have given us a safer money than we would have had without their claiming an exclusive right to issue it (p. 16). There could be no more effective check against the abuse of money by the government than if people were free to refuse any money they distrusted and to prefer money in which they had confidence (p. 18). We have always had bad money because private enterprise was not permitted to give us a better one.

Hayek initially proposed that Common Market currencies circulate freely, Europeans making contracts could choose to deal in the legal tender they preferred (francs, marks, pounds, etc.) Currencies of those countries trusted to pursue a responsible monetary policy would tend to displace gradually those of a less reliable character. The reputation for financial righteousness would become a jealously guarded asset of all issuers of money, since they would know that even the slightest deviation from the path of honesty would reduce the demand for their product. (p. 20).

P.P.S. Today is Robin's and my fiftieth wedding anniversary! — Jack

Revised 12-Jan-06 to reflect the fact that Alan Greenspan has retired as Chairman of the Federal Reserve Board.

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Readers' Comments

I enjoyed TQE 74, outlining the idea of globalizing the money supply, allowing people/companies to choose their source of money the way they choose where to buy their footwear, or their automobiles, i.e. where they get the best value. Not very likely, I say, even in 2250.

As long as there are sovereign national governments which can legally control the use of their money, they'll never allow such large scale freedom of movement of financial resources... For example, as I recall, in the 1960's part of the flood of dollars into Europe was segregated by the national banks into "Euro-Dollars" which could only be spent for dollar-denominated goods.

Control of a currency's value is of enormous political importance to a national government, simply because inflation, and consequent devaluation of the currency has been a wonderful way for governments to expiate their sinful overspending. By devaluing a currency, governments are able to pay off their federal debts with cheaper money, and create an "invisible" tax on the people who loaned them money. Government bonds are "certificates of guaranteed confiscation" was the way an old friend used to put it. I believe that the average life of a currency before it is officially devalued is something like 50 years... and there are plenty of examples of currency that last for a much briefer time than that. The saving grace of this situation, in my view, is that this is a form of progressive taxation (since it is mainly the rich people who lend money to the government), and this somewhat offsets the current Administration's tilt.

— Tom Selldorff, Weston (MA).

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I want to ask for your thoughts on my latest economic opinion: I think that globalization and productivity [growth] are pulling the economy in the direction of deflation, and that Government spending that is out of control is pulling the economy in the direction of inflation. Why? Because both forces reduce the disposable income of the American consumer.

— Herb Clark, Homewood Friends Meeting, Baltimore (MD).

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Happy Anniversary! I wonder if there is any correlation between length of marriage and religion. Are Quakers too boring to get divorced? Or just easily amused? Or just able to find that of God in their spouse, even after all those years? In any case, enjoy the next 50, and my husband and I (26 years) will try to follow in your footsteps.

— Signe Wilkinson, Chestnut Hill (PA) Friends Meeting

Note: There were several other messages from readers wishing us a Happy Anniversary! I do not publish them all. — Jack

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Jack, you haven't bought a double-dip ice cream cone in a very long time.

— Bob Sheffield, Boulder (CO) Friends Meeting.

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Thanks for two newsletters that comprise one of the more coherent explanations of the Federal Reserve system I have seen.

— Charles Rathmann. Milwaukee (WI) Meeting

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Long before 2250 we should have just one currency in the world, shouldn't we? But we are slow getting there. If I send a check from one euro bank account to another euro bank account in another country, it is still a foreign exchange transaction. The banks like it that way. I'm not so sure that the fund managers who issue credit in their own currency are going to be so eager for the public good. After all, they will be competing with other fund managers in the same currency.

— Henry Helson, Berkeley (CA) Vine Street Meeting.

Note: TQE #74 suggested exactly the opposite: many competing currencies. I do not like monopoly. Also, it is my understanding that transactions in euros among European countries can be made without restrictions. — Jack

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You wrote that inflation is a tax. I was interested to find an estimate of just how much of a tax it is in Robert Lucas' article in the March American Economic Review. He estimates that a ten-percent annual rate of inflation is equivalent to a one-percent reduction in income, and a 200-percent inflation costs about seven percent of income.

— Asa Janney, Herndon (VA) Friends Meeting.

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I have just severed relations with a bank that has gotten into payday loans where the fee translates into an imputed interest rate of well over 100%. They say they have over 20,000 customers. I told them the story of Leo Weill. An African American couple entered his restaurant about 1960 and a table of whites left and used the nasty word. Leo stood at the door and said, "I guess there is some business I just plain don't need!" And we had the first integrated restaurant in Louisville.

— Lee B. Thomas, Jr., Friends Meeting of Louisville (KY).

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Now the discussion of "job markets" in 2250 is where my futurist speculation really gets going. 100 years ago, something like 80% of Americans were fully committed to creating food. Today that figure, including processing and distribution, is somewhere in the 5% range. 100 years ago, several thousand workers were required to engage in the construction of large buildings. Today, this is accomplished with several hundred. An immediate challenge globally is to ensure that we can manage a world with 10-12 billion people by 2050. By then, current UN statisticians expect limited or no further population growth. Developed ÿountrieÿ today ÿll are ÿxperiencing declining populations net of immigration. My belief is that the real challenge to our current system of capitalist classical economics will come long before 2250, and relates specifically to labor markets. Here it is: how will the system work when there is essentially no need for most humans to perform labor, as mechanization and technological innovation makes our physical work superfluous to that of robots, computers and machines?

— Christopher Viavant, Salt Lake City (UT) Meeting.

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I like your idea of a privatized money system, Jack. Your system would go far to take Politics out of international economics. I take to be based on the understanding that currencies are ultimately backed by productivity in general. In a global world, it really does not make much sense to divide productivity on the basis of national boundaries which are increasingly arbitrary as far as economic activity is concerned. I am often bemused by those who look for a fixed standard, such as gold — which is, aside from its historical role as money, merely another commodity subject to inflation and deflation like any other (as the collapse of mercantilism demonstrated). I believe that fixedly currencies are destructive because they force economies to adjust to currencies rather than the other way around (bad central-bank policies are similarly "mercantilist" and destructive). I agree with you that competition in moneys will tend toward price stability and the moderation of swings in currency valuations (which most people don't seem to understand).

— Ken Allison, Episcopalian, Paradise Valley (AZ).

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The situation that JD Von Pischke described, really happened. In Europe from the mid 1980's, European firms were free to borrow and sell in what ever currency, the result of this was an increasingly tight 'shadow peg' to the Deutschemark. This led in turn to the possibility of the euro. A move that was expected to improve the efficiency of the euroland economy.

— Kruskal Hewitt, Media (PA) Meeting.

Note: Yes, they were free to enter into those transactions, but the currencies were not legal tender outside the country of issue, and there were many legal restrictions. — Jack

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I am very frustrated with the messages from friends at our meeting. I believe that the attractiveness of the Quaker style has evolved into a melting pot for various political objectives.

I am very interested in learning more about others views. It either confirms my own, or gives me a pause to consider an alternative. I do not always concur with your (and others) messages. But they are helpful. As a conservative and having worked in the financial sector of the business world for over 20 years, I am continuing to search for how my beliefs and Quaker values work in concert.

— Richard S. Parry, Atlanta (GA) Friends Meeting.