[Warning: long post about economics]
Back in 1967 Greenspan wrote an article called “gold and economic freedom” in which he supports the gold standard, and he also supports fractional-reserve banking (though he didn’t use those words). But the part I found particularly interesting was the discusion of government borrowing.
When a bank creates credit for a private loan this leads to an expansion in broad money supply. If nothing else changes, an increase in broad money will lead to inflation (too much money chasing too few goods).
However, the bank will only provide the loan if they expect to get a good return. Which means the borrower will need to increase their wealth in the future by enough to pay back the loan + interest. In this way, the monetary system only increases broad money roughly in line with national production. If future production does not rise then some of the loans will not be repaid… this will decrease the assets of the bank and the bank will have to reduce the amount of credit it offers. So broad money and production move together.
This avoids the problem of inflation.
But the same does not apply when the government takes a loan. From the bank’s perspective, the government is a “good bet” because in the future they can always repay the loan simply by taxing the people. So the banks will create credit and broad money will increase. So far the story is the same.
However, in contrast with the private sector (which needs to expand production to pay back the loans) the government has no market dicipline to ensure that their spending increases national production. Indeed, government spending often decreases national production though distorted incentives, deadweight loss, administrative and compliance costs, waste and corruption. This means that there will be more money chasing the same (or fewer) goods… leading to inflation.
Greenspan suggests that only a gold standard can prevent this. But he is wrong. All of these problems still exist with a gold standard. If the government is still allowed to borrow and tax, then even under a gold standard banks will have an incentive to create credit for the government without ensuring an equivalent increase in production.
The only way to ensure a stable monetary system is either to (1) remove the government’s power to tax; or (2) remove the government’s right to borrow; or (3) allow them only to borrow when the future repayments on the loan do not come from tax revenue.
The current system in Australia
In the current system we do not try to have a stable monetary system. Instead the government distorts the market in many different ways and tries to ensure that these distortions all off-set each other. So to offset the inflationary effects of their borrowing the government (or their agents, such as the RBA) would increase interest rates, which will decrease the money base.
The virtue of this system is that at least the government is trying to do the right thing. They are aiming to keep the value of money stable (ie low inflation) and to some degree they have done a decent job. This is a substantial step forward compared to other systems which attempt to use monetary policy to create growth or employment (the most dramatic recent example being Zimbabwe). This step forward represents the victory of the Monetarists over the Keynesians.
But the current system has a major problem. It relies on the judgement of a few people about the nature of a few very difficult-to-assess economic variables. And it is always possible that political pressure re-introduces a Keynesian element to the equation (which is often demanded by financial traders, politicians and economic journalists).
These problems are avoided if we have an asset-based currency. The most popular version is the “gold standard”, though there are other options, such as silver, whiskey, cigarettes, property, shares, shells, etc.
I’m not going to dwell on which is the best asset to use. I would prefer that we had free banking and let the market decide which type off currency would prevail. But the main point I’m making here is that all of these systems can still be destabilised by the government if they retain the power to both borrow and tax.
Restrictions on government borrowing
My preferred solution to this problem is to remove the government’s right to tax.
But a more moderate option would be to restrict the government’s ability to borrow. The government should not be allowed to use tax revenue to pay off their loans. Instead, a loans should only be repaid from the profits made from whatever was done with that same loan. This effectively limits government borrowing only to infrustructure projects, and only those projects where the government gets a return on its investment.
Government spending that doesn’t get a return (like welfare), or where the government chooses not to attempt to get a return (like a new freeway without a toll), should be paid for through taxation or previously saved money.
Some will argue that it is only important that the government could get market return on their investment, and it doesn’t matter whether they actually collect or not. Theoretically this is true. However this is also true of any private investment — and we don’t provide all private investors with access to taxpayer money (or at least, we shouldn’t). The problem is that people do not always correctly assess the viability of their own projects. The goverment, like all groups seeking debt, would argue that all of their projects produce huge benefits… but the only way to assess the merits of these projects is by exposing them to the scrutiny of the financial markets.
To argue otherwise is to suggest that the government knows best where the capital markets should allocate their money. This is, without exageration, exactly what lead to the inefficiencies and eventual collapse of socialism.
Under the above system, government infrastructure projects which genuinely do meet market criteria for a loan can proceed on debt. Not only does this remove the monetary distortion, but it also ensures that government infrastructure spending is not wasted. Banks will not simply be loaning money on the basis that the government can always repay (though tax), but instead will be assessing the risk and expected return from the project and only loaning the money if the project is viable.
I expect two final objections: A final resort to Keynes; and a humanitarian plee.
The Keynesians will argue that in a deep recession it may be necessary to pursue deficit spending to “pump-prime” the economy. At the heart of this argument (often not well understood by those making the argument) is the suggestion that in a deep recession the banks aren’t simply refusing to create credit to give to businesses. This reduction in the “credit multiplier” leads to a monetary contraction which leads to deflation. As some prices are “sticky” (ie they don’t adjust quickly) this can lead to imbalances — the most important example is in the labour market where deflation and sticky prices would lead to unemployment.
There are four points to note here. First, without the pre-existing monetary distortions there would be fewer deep recessions. Second, deflation is not necessarily a bad thing and prices don’t stay sticky forever. Third, with a stable monetary system banks would be more likely to correctly manage and quickly adjust their distribution of credit. And finally, while it is theoretically possible for the perfect intervention to improve the market outcome, this has to be weighed against the probability that the government will get it wrong and the many consequences from those mistakes.
This leaves me with only the humanitarian objection. This argument would be that in a down-turn there is less tax to pay for social services, but more demand on social services. True. However there are various alternative way to deal with this without government borrowing. First, the government could save during the good years, and then draw down on this saving during the bad years. This is how most responsible adults manage their lives. Second, the government could borrow against the returns on a pre-existing assets (for example, the “Future Fund”). Third, the government could cut spending on other projects which weren’t aimed at the poor (such as the arts, sports, corporate welfare, middle-class welfare, defence, etc). And finally, perhaps we shouldn’t have such a big welfare state anyway.
In refusing this humanitarian argument it must be remembered that we are not choosing between a “good” and a “bad” outcome, but between two bad outcomes. Active fiscal policy is not “money from heaven”, but brings its own set of problems — such as potential inflation, future debt, crowding out, ricardian equivalence and inefficient spending.
Phew. That post was longer than I expected. My conclusion is that the major cause of monetary instability is the government, and that even in the best monetary system the government will still create distortions unless you restrict either their right to tax or the right to borrow.
So the choices are, in my order of preference: (1) abolish tax; (2) restrict government borrowing; or (3) accept monetary instability. Oh… and a distant last in my order of preference is (4) ban banking.